Sensitivity analysis in accounting

2. Performing sensitivity analysis

Sensitivity analysis can be performed using multiple techniques.  The basic premise is to change one or several assumptions and see what impact such change has on the outcome.

In financial reporting, for example, sensitivity analysis would generally be based on changes in assumptions regarding discounts, interest or exchange rates, prices, pension obligations, etc. However, if a profit estimate is more sensitive to changes in other economic assumptions, such as development or operating costs, the sensitivity analysis should be based on changes in those assumptions.

For instance, if we are talking about price sensitivity and Company ABC’s profit is $15 million as well as revenue is $100 million, then price sensitivity will be $15,000,000 ÷ $100,000,000 x 100% = 15%.  In other words, if the company decreases its prices by 15% and all other assumptions remain the same, the company will have a zero profit.

Alternately, sensitivity may show how a relative increase or decrease in the input data would impact the cash flow under consideration. For instance, if Company ABC has borrowings for $20 million with the average fluctuating interest rate of 4%, then a 5% interest rate would reduce the annual income by $1 million (i.e., 20 million multiplied by 5%).

As another example, if Company ABC’s Euro balance is 5 million, Euro strengthening (weakening) by 10% would result in a $0.5 million ($5 million multiplied by 10%) increase (decrease) in profit.

In the case of pension expenses, sensitivity analysis is provided to the company by an actuary and may read as follows: “The Company’s 20X3 total pension expense was $9 million using a discount rate of 4.3%. An increase in the discount rate would reduce pension plan expense, and vice versa. As an indication of the sensitivity, 1 percent increase in this assumption would have reduced total pension plan expense for 20X3 by approximately $0.85 million. A 1 percent increase in the discount rate for this same plan would have reduced pension expense for 20X3 by approximately $0.19 million.”

3. Advantages of using sensitivity analysis

A sensitivity analysis is an easy and quick tool that provides useful information for decision-making. It helps to identify those critical assumptions that give rise to volatility of assets, liabilities and consequently financial results. By the means of sensitivity analysis, the attention of management and users of financial statements is brought to the most risky areas. If risks and uncertainties were not considered in financial statements, too much confidence might have been placed on the financial results of an entity.

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