Analysis of the sensitivity of the project. Sensitivity analysis method
In order to get foreign investments in a business, a business entity must be attractive to potential investors. What is this attractiveness measured against? Let's try to figure it out.
What is a sensitivity analysis?
Each investment project is very risky, and in order to understand how problematic or profitable it will be, a number of procedures are carried out to identify thin spots.
One of these studies is called sensitivity analysis. It is used in the event that it is necessary to identify the stability and strength of influence of one of the components of the project. From the common chain, in a regular sequence, the values of the element members change, and it is determined by how much these changes have affected the whole mechanism. At the same time, the basic criterion on which the entire sensitivity analysis is based, NPV (net present value), is calculated anew each time.
As a result, experts have a percentage deviation value, which shows how much one hundredth change in one or another component influenced the project as a whole. After each element is ranked depending on the degree of importance, and the overall picture of the thin spots is displayed.
The need for this procedure
A sensitivity analysis of a project helps to identify the most critical components that have the greatest impact on the viability of a business idea. In addition, the procedure allows you to check the significance of their consistent change in the process of translating ideas into reality.
Also, sensitivity analysis is often called single-factor, and data for its implementation are selected by the procedure earlier in the qualitative assessment of the project. This process of influence of one or another component is elementary in its execution, therefore it has several minor flaws:
- the technique is expert, therefore different specialists can get their individual data at the exit;
- Well, during the procedure, the correlation interdependence between the constituent elements is not measured.
Despite its elementary performance, the sensitivity analysis of the project is carried out in several stages:
- An indicator is selected for which calculations will be made. Often this is net present value (NPV), less often - the rate of return (IRR).
- Next, the components are selected in which the expert is less confident - these can be both investments in current assets, capital construction costs, and various market factors of various kinds - the quantity of products sold and its price.
- After that, the limiting numerical values of these indicators are established on both sides.
- The net present value or rate of return is calculated for each value of the variable.
- The sensitivity analysis is completed by the construction of a graph that covers the indicator of each component considered, which allows you to visually assess the most critical places in an investment project.
Role in break-even analysis
Each of us probably heard more than once about such a procedure as finding a break-even point, but few people thought that it was an elementary sensitivity analysis that was the basis of this procedure.
What is it necessary to do? Every entrepreneur needs to know the boundary indicator of the volume of production, with the unsuccessful implementation of which the company probably will not lose working capital, so a certain break-even point is calculated. Thus, the assessment of the effectiveness of the project is reduced to a single indicator indicating the conditions under which the totality of all fixed and variable costs is equal to the income received. In other words - at this point, the entrepreneur does not receive any profit, but the resulting losses do not ruin it, since they are fully covered by the earned money.
The break-even point is expressed in two equivalents - quantitative, indicating the necessary volume of production, and money, which is equal to the income received.
What else you need to know about the evaluation of the investment project
Do not forget that investing is a process that does not stretch for several months, or even for one year. Therefore, the analysis of investment sensitivity in its basis must always take a long-term perspective.And this means that when investing a considerable amount of money for long-term construction, it is desirable to follow a few unspoken rules:
- Before launching the project, it is necessary to consider any other means of generating income that will have the same degree of risk - perhaps there will be ideas with far more profit than the current one;
- By the way, a few words about the degree of risk - you should not forget that this indicator grows depending on the length of the payback period, and vice versa - the shorter it is, the less risks there are in the idea;
- and it is important not to forget about the time value of money - they tend to depreciate.
Key Project Evaluation Indicators
As we said above, the sensitivity analysis method is based on any of the key indicators that are selected depending on the purpose of the study.
The most common is net present value (NPV). He takes the benchmark in the case when the entrepreneur intends to find out the value of the absolute cash flow from the launch of the project. Despite its popularity, the method is far from accurate, since it is rather difficult to predict in advance what the basic capital rate will be in a few months.
The next most common is an indicator of the internal rate of return (IRR). Despite the fact that this method takes into account the depreciation of cash flows over time, it is unable to show the most profitable project of the series presented. Here we can see only the extent to which an idea can pay off over a certain period.
Also sometimes for the key variable take the ordinary accounting rate of return. The technique is simple in execution and can show how much money an entrepreneur can gain from launching a project, but again without taking into account the depreciation of financial flows and force majeure circumstances at work.
Sensitivity Analysis - Graphic Example
For a substantive understanding of this seemingly complicated procedure, let's try to analyze one of the graphs, which is compiled at the last stage of the sensitivity analysis of an investment project.
The figure shows the result of the calculation, according to the method of net present value: alternately, each of the indicators decreased in half and increased in tenths, and each time the variable was changed, the NPV value was recalculated again.
Suppose that the red line expresses the quantity of products sold, the green line represents the direct costs of production, the violet means indirect costs, the blue line indicates the staff salaries, and the brown one is the direct amount of investment.
As we can see from the presented figure, the project remains cost-effective if the direct costs increase by 30%, and the volume of output is reduced by almost half.
Additional factors of influence
Undoubtedly, risk sensitivity analysis plays an important role in deciding whether to launch a particular investment project, but its result is not a final indicator.
In any assessment by experts, attention is paid to the expediency of launching an idea as a whole and to what extent it corresponds to the strategic plans of a business entity for the near future. An important role is played by the marketing aspect - after all, it is unlikely that someone will approve the launch of the project if sociological data indicate that the intended output will not find proper recognition from the consumer.
Do not forget about the time factors - at any time payments may be delayed, but a breakdown will occur in production, which will add several hours or even days to the release of a batch of finished products.
You will be surprised, but also inventory management can be attributed to uncontrolled factors affecting the implementation of an investment project. No entrepreneur will be able to predict in advance the amount of their damage in warehouses, in the process of delivery, as well as in manufacturing defects.
Therefore, a pure sensitivity analysis, which does not take into account a number of processes uncontrolled by us, is not enough to make a decision about the feasibility of implementing this or that idea.
What else you need to remember before investing
We all understand that in the current market conditions there is a huge mass of proposals for investing our own money in someone's young production. Starting entrepreneurs do not have enough of their own funds to keep the business afloat, so many of them resort to the services of sponsors.
But it is not enough for each business entity to offer its idea for review, it is also necessary to meet the stated requirements, in other words - to increase its investment portfolio.
Therefore, in the first place, an assessment of the effectiveness of the project should be carried out by an entrepreneur, and if there are any inappropriate risk factors, it is easier to correct them before they are discovered by potential investors.