‘Sensitivity Analysis’ may sound a scientific or complicated term, but really it is very simple but too often misunderstood or ignored.
Here we look at how the business owner and lender view sensitivity differently, and how unless one understands the other it will end in tears.
OK, What is it?
Many businesses will generate several different financial forecasts, based on a best, worst, and likely trading scenario. In its simplest form this is sensitivity analysis. The issue here is that different people see it differently, and it is not just about sales, it is about costs, payment terms and how much credit you can take.
So What Impact Can It Have?
Let’s look at a quick example. Business A Limited, is presently trading the accounts last year looked like this –
- Sales 500,000
- Gross Profit 250,000
- Costs 175,000
- NP 75,000
So, on paper it all looks pretty good. So what would happen if sales fell by 10% and costs rose by 10%, with net profit of £75,000 you might think it is all OK.
Look at performance with a 10% change –
- Sales 450,000
- GP 180,000
- Costs 192,500
- NP (12,000)
All of a sudden the company has made a loss of £12,000.
What is the likelihood of this happening?
Not that unlikely, energy prices have gone up 11% in November 2012, add on fuel costs and everything else and 10% is not unlikely.
What Should I Do?
Any lender will look at what impact these changes will have on their affordability. Any lender will also add in a hike in base rate (from 0.5% to around 4%) then judge affordability.
Bear in mind that your lender do 3 things with your best, worse and likely projections. They will ignore the worst, read the likely, and listen to the worst. After that they will sensitise the worst case.
In this way you may have shot yourself in the foot.
Now, we are not saying don’t produce a worst case scenario, but we are saying think about it. If necessary show what you have done, why you have changed costs. In other words do what the bank are going to do, but do it for them.
If you want any more information about sensitivity then please add your comments below, email us via the website, or simply pick up the phone. We are always here to talk.
By Dave Farmer
See our other blog posts –
Why Profits Are Good, But Cash Really Matters /2013/01/14/cash-cash-cash
Six People Who Can Change Your Business /2013/01/13/the-6-people-i-met-who-changed-my-business
How Your Bank Sees Profitability, Not How You Do /2013/01/13/profitability-and-what-is-it-in-the-eyes-of-a-banker