Creating different scenarios for your financial model is the process of examining and evaluating possible events or scenarios that would impact your assumptions and, in turn, change the result of your projections.
Why is scenario analysis useful
Scenario analysis is often used to get an idea of the most extreme directions that a financial model could take. It is useful for founders and investors to get an idea of what would happen if everything goes “bad” or if everything goes “right”.
Let’s see how to create scenarios for your financial model.
Different scenarios breakdown
A scenario could be used to indicate a specific evolution of the sector where your business operates, a different approach to your assumptions or a shift in the economy. For startup founders it is especially useful since it allows them to predict how their startup will do in different cases, in the end being more likely to find the right set of assumptions and the right projections. Usually three different scenarios are used:
- Base case scenario: it is the most likely scenario, the one that you think about when you create the financial model in the first place. This should be the most likely outcome with the most likely assumptions.
- Worst case scenario: this is the most severe scenario, where all the bad things that could happen have happened. This is what you should think about when planning for the worst case. This is where you use your “bad assumptions”, for instance you could insert a very high churn rate, or a very low conversion rate.
- Best case scenario: this is the ideal scenario, where all the pieces fall in right place and you instantly find product-market-fit. This is usually the scenario that plays out for unicorn companies. This is where you use very optimistic assumptions, like a very high organic traffic, or a high ARPU.
Using scenario planning for financial modeling in Excel
Adding scenarios to a financial model is important for any business, even more for those with a lot of assumptions or for those starting out (startups) since the uncertainty is very high and there isn’t any historical data to reference.
To add scenarios to an existing model:
- Group all the assumptions that you want to use in the scenarios.
- Copy and paste all the assumptions according to the number of scenarios that you want to create (base, worst, best) and label them accordingly.
- Change you assumptions according to the scenario in which they are.
- Create a new cell called “Live Scenario”. This is used to switch between the different scenarios using the function CHOOSE.
- Link the “Live Scenario” numbers to the rest of the financial model.
The pros of using scenario analysis
Making predictions is very hard and inherently risky, so having different scenario can help alleviate the uncertainty and reduce errors. There are some notable benefits:
- Investors can get a peek into the risk involved in the business.
- You can be aggressive in planning for the worst case so that even in the worst possible case you can continue to operate your business at top efficiency.
- You can project future profit for a potential good case for an exit.
- It requires a high level of skill to create and maintain a model with different scenarios.
- It is time consuming.
- Even with different scenarios you still can’t model every possible case.
As an alternative of creating a financial model with all the complexity of scenario planning, you can use Sturppy since all the hard work for you is already done:
Creating a scenario is a matter of just one click, we pre-populate the assumptions for the new scenario for you, starting from your base case scenario assumptions. Of course you can still go in and edit everything you want.
If you have any question please, feel free to contact us, we are always happy to talk to like-minded people. Also, if you are a startup founder or are interested in running a startup in the future you might like what we have built here at Sturppy, a financial modeling tool for startups that is fast and easy.
Good luck on your journey.