At a minimum, a financial model should include at least the following three scenarios, or at least some version of them:
- Best case: Set all assumptions to the highest possible value you can conceive as being achievable (even in your wildest dreams).
- Base case: Set all assumptions to what you actually think is going to happen.
Be realistic! This is not the place to be conservative in your estimates — that’s for the worst-case scenario.
- Worst case: Set all assumptions to the lowest imaginable value that you think might happen. If everything that could possibly go wrong does go wrong, what does our model look like?
- Legislation: If changes in government legislation will have an effect on the price you can charge for your product, material supply, or additional costs such as labor, then change the inputs in your model to reflect this.
- Foreign exchange: If fluctuation in currency exchange rates will affect pricing or costings, change the inputs affected by foreign exchange in this scenario.
- Competitors: If the introduction of a new competitor to your market would cause margin squeeze (meaning that you’re no longer able to charge the same amount for your product), you could include a scenario that shows a decrease in price.
Compared to formula mistakes, logic errors can be more difficult to spot. Problems with logic may involve incorrect timing, inserting the wrong inputs and source data assumptions, or using pretax instead of post-tax inputs, for example. Sometimes the mistakes can be a combination of both formula and logic errors, and scenario analysis is a good way of identifying if these sorts of mistakes exist and flushing them out.
Thorough stress-testing, along with scenario and sensitivity analyses, will provide your financial model the rigor and robustness to cope with the variety of fluctuations in assumptions that are possible in the real world.