Financial Simulation Analysis Explained
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By John Alexander Adam
Anyone who has ever been responsible for the financial wellbeing of a company will know only too well that there is the original plan and then what actually happens. Economies are dynamic and whatever the nature of a particular business there are external factors which influence, that cannot be controlled. The price of raw materials could go up, or interest rates. The regulatory framework may change or unions could provoke a strike. Good financial planning involves looking at all the potential scenarios in terms of costs and income projections deviating from the course of the original plan expectations.
Companies use financial simulation analysis to build models of how different courses of action and external variables may impact their finances, building models that allow them to react quickly, with a plan already in place. Financial simulation analysis is also often referred to as ‘sensitivity analysis’ and ‘what if analysis’: how robust financial planning based on the expected scenario is to potential changes to external influences.
A Simple Guide to Building a Financial Simulation Analysis
Bigger businesses with more complex structures and interconnecting parts to their operations will build financial simulation analyses that can become quite complex. However, regardless of the complexity of any simulation analysis, it will basically boil down to these key considerations:
- Develop and begin with your forecast business plan including forecasted income statement, fixed and variable costs.
- Increase and decrease your income based on sales volumes
- Increase and decrease your expenses based on potential changes to fixed costs
- Increase and decrease your expenses based on potential changes to variable costs
- Create a range of different scenarios bases on changes to income, variable and fixed costs
Scenario Analysis vs. Simulation Analysis
Financial Simulation Analysis looks at abstracted changes to revenues and expenses, without attaching probable cause to them. They simple show what the impact would be to the bottom line when different income and expense variables are adjusted. Sometimes prior knowledge means scenarios can be more specific and this is then referred to as a Scenario Analysis. For example, for a retail operation there may be a clear statistical correlation between footfall and sales. In this case, a financial simulation analysis could look at the impact on footfall of planned construction works in the area, such as the renovation of a pedestrian street. This would help the business reach a decision as to whether it remains financially viable, or advisable, to keep the store open for the duration of the construction work.
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