Sensitivity analysis and Common Size analysis

Presented To :- Presented By :-

Mrs. Pankaj Sharma Ksheerod shri toshniwal

MBA/25008/20
Content :-
 Sensitivity analysis

 Common size analysis

Sensitivity analysis

 Sensitivity Analysis is a tool used in financial modelling to analyse how the different values of a set
of independent variables affect a specific dependent variable under certain specific conditions.

 In general, sensitivity analysis is used in a wide range of fields, ranging from biology and geography
to economics and engineering.

 A Financial Sensitivity Analysis, also known as a What-If analysis or a What-If simulation exercise,
is most commonly used by financial analysts to predict the outcome of a specific action when
performed under certain conditions.
Sensitivity Analysis Example

John is in charge of sales for HOLIDAY CO, a business that sells Christmas decorations at a shopping
mall. John knows that the holiday season is approaching and that the mall will be crowded. He wants to
find out whether an increase in customer traffic at the mall will raise the total sales revenue of
HOLIDAY CO and, if so, then by how much.
Approach to analyse
 
 Local sensitivity analysis −
The term local determines about derivatives of a single point. This method is used for only simple
functions not for complex models. This tool or technique is used to analyse the impact of only one
parameter on the cost function by keeping other parameters constant or fixed.

 Global sensitivity analysis −

This technique or tool uses Monte Carlo techniques.
Uses of Sensitivity Analysis

Here we discuss the uses of sensitivity analysis:

 
 Developing Recommendations for the Decision-makers
 Feasibility testing of an optimal solution
 Identifying the sensitive variables
 Identifying critical values and break-even point where the optimal strategy changes
 Assessing the degree of risk involved in strategy or scenario
 Communication
The common areas of application of the models of sensitivity
analysis are:

 Business: In resource allocation, guide the future data flows, identify critical assumptions
 Environmental: Impact of water purifying plant, global climate models
 Social Sciences: Econometric Models
 Engineering: Testing designs
 Chemistry: Measurement positions
 Meta-Analysis: To check whether the results are sensitive to the restrictions included Time-critical
decision making.
Advantages of Financial Sensitivity Analysis

 Sensitivity analysis adds credibility to any type of financial model by testing the model across a
wide set of possibilities.

 Financial Sensitivity Analysis allows the analyst to be flexible with the boundaries within which to
test the sensitivity of the dependent variables to the independent variables. For example, the model
to study the effect of a 5-point change in interest rates on bond prices would be different from the
financial model that would be used to study the effect of a 20-point change in interest rates on bond
prices.

 Sensitivity analysis helps one make informed choices. Decision-makers use the model to understand
how responsive the output is to changes in certain variables. Thus, the analyst can be helpful in
deriving tangible conclusions and be instrumental in making optimal decisions.
Disadvantages of Financial Sensitivity Analysis
 
 Results are based on historical data.
 Not 100% accurate.
 Not sure about future predictions.
Common-size analysis  
 A common-size analysis is a tool financial managers use to learn more about a company over time.

 Also known as vertical analysis, a common-size analysis expresses each line item in a financial
statement as a percentage of a base amount for that time period.

 The common-size analysis also gives financial managers a simple way to evaluate financial
statements.

 This type of analysis only provides a quick overview rather than an in-depth assessment of financial
metrics.

 This is especially useful when you desire to make a comparison, either to other organizations or to
previous financial statements.
Common-size analysis formula

The formula for a common-size analysis is:

Percentage of base = (amount of individual item / amount of base item) x 100
Vertical vs. horizontal common-size analysis
There are two types of common-size analysis.

The most common type is vertical analysis. In vertical analysis, a financial manager looks at the
relationship between numbers at a certain moment in time.

For example, a vertical common-size analysis may look at a single income statement or balance sheet
and compare the amounts on each financial document.

A horizontal common-size analysis, however, looks at the amounts over a longer period of time, just
like trend analysis.

In horizontal analysis, a financial manager gathers the base amount from an earlier time period, such
as from three years earlier.

They can then divide the current year's line item by the base amount to determine the percentage of the
base. The financial manager can also compare line item ratios across several years to look for recurring
trends.
Uses for common size analysis

Financial managers can use a common-size analysis to study the primary financial statements their
companies use, including for:

1. Income statements

 An income statement shows an organization's revenues and expenses during a set time period.
Financial managers use a common-size analysis to calculate the net profit margin, the gross margin

and the operating margin.

 For example, assume a clothing company has $50,000 in total revenues in 2020. On its income
statement, the company lists $5,000 for its advertising costs. To calculate the percentage of base for
advertising, the company uses the common-size analysis formula:

Percentage of base = (amount of individual item / amount of base item) x 100

Percentage of base = ($5,000 / $50,000) x 100
Percentage of base = 10%
2. Balance sheets

 A balance sheet summarizes an organization's financial balance. It lists a company's assets, liabilities
and shareholder's equity for a specific accounting period.

 The base value in a common-size analysis of a balance sheet is often the value of the total assets.
Financial managers can use the common-size analysis on a balance sheet to see how their
organizations' capital structures compare with other organizations.

 For example, assume a financial manager wants to use the common-size analysis to determine the
ratio of their company's long-term debt to total assets. If this number is too high, it tells the financial
manager that the organization is in poor health. So if the organization reports a total asset value of
$200,000 and a long-term debt value of $10,000 on its balance sheet, it would use the capital
analysis formula like this:

Percentage of base = (amount of individual item / amount of base item) x 100

Percentage of base = ($10,000 / $200,000) x 100
Percentage of base = 5%
3. Cash flow statements

 A cash flow statement shows how changes in an organization's balance sheet affect its cash and cash
equivalents.

 The purpose of a cash flow statement is to measure how well an organization generates cash in order
to pay its debts and fund its operations.

 A financial manager can use a common-size analysis to compare current cash flow against previous
years.

 For example, an organization divides its cash inflows into sources such as sales, deferred income
taxes and property investments. It then calculates the percentage of the base for each line item. It
can then use this information to see if sales make up enough of the total incoming cash flow. 
Thank you