By definition, strategic planning and financial forecasting require making assumptions about the future. However, common sense tells us that the future seldom unfolds as expected. Therefore, a well-developed business plan and forecast should address that inherent uncertainty head-on by explicitly identifying important assumptions and by quantifying the financial impact if those assumptions prove to be inaccurate.
Scenario analysis is an indispensable tool for addressing the risks and uncertainties inherent in forecasting and business planning. By linking major risks and uncertainties to key variables in the financial forecast, scenario analysis enables management to quantify the impact of those risks by using an alternative set of assumptions about the future (i.e., by changing key variables).
At the most basic level, scenario analysis answers the key question: If the plan assumptions prove to be overly optimistic, how much of the institution’s earnings and net worth are at risk?
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