Scenario analysis involves assessing potential
future events or situations and predicting their possible outcomes. In finance,
it is used to gauge how different favorable and unfavorable events might affect
the value or financial performance of a business. Businesses often employ
scenario analysis to anticipate profits or possible losses in various
situations, like the best-case or worst-case scenarios.
During scenario building, managers define various
future states about the business (like revenue growth, product price, operating
costs), industry dynamics (such as new competitors or regulations), and
economic conditions (like inflation and interest rates). Using these
assumptions, projections are made for different scenarios to determine outcomes
such as profits, losses, or cash flows, aiding decision-making processes.