Sensitivity Analysis

Definition - What does Sensitivity Analysis mean?

A sensitivity analysis typically entails changing the various assumptions in a financial model. In the context of a purchase and sale of a business, a buyer or a seller's business broker will prepare a 1 to 3 year projection for a target that will contain significant assumptions such as product pricing, equipment utilization, direct cost percentages, levels of overhead, interest and tax rates, etc. A sensitivity analysis can then be conducted to "stress test" the results by seeing what happens to the outputs as each individual assumption is toggled up or down.

Divestopedia explains Sensitivity Analysis

More often than not, buyers will discount the seller-prepared projections if they appear to be overly optimistic. Buyers are more interested in knowing what kind of EBITDA and free cash flow the business can regularly do, rather than what an optimistic future earnings projection looks like if all assumptions play out positively.

This is why a well-designed financial model that lends itself to sensitivity analysis is invaluable. The buyer (and also the seller to better understand the company's own risks and opportunities) can play with the assumptions to see where the business may start having difficulty or where free cash flow drops to the point where it makes a potential deal look less attractive. Sellers often do well when their advisers prepare well thought out projections all the way to the cash flow line with an ability to stress test these numbers. This is simply because the trust or credibility factor with the management team goes up with the buyer when this level of financial sophistication is displayed.

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