How to complete a sensitivity analysis
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A sensitivity analysis is a financial model that allows you to understand the effect of fluctuations in selected variables on your business' profitability.
Want to know what would be the effect of a 10% drop in your sales for example? How about understanding the effect of a 5% increase in the cost of materials? A sensitivity analysis can provide the answer and allow you to prepare a strategy to deal with these eventualities.
Caroline Comiré, Assistant Vice President, Business Restructuring, and Julien Bélisle, Director, Business Restructuring, at BDC, explain how to develop a sensitivity analysis to improve your business's resilience.
How to calculate your break-even point
Before starting the sensitivity analysis, it is important to know at what level of sales your business will be profitable. To find out, you must calculate your break-even point, which is the level of revenue you need to achieve to cover all your expenses and start making a profit.
To determine your break-even point, you will first need to calculate your gross profit by subtracting the cost of sales from your revenue.
Gross profit = total revenue - cost of goods sold
Gross profit is the amount of money left over to absorb sales, administrative and financial expenses (fixed or overhead costs).
Gross margin is a related term that refers to gross profit as a percentage of revenue. Calculating your gross margin will allow you to calculate the income needed to reach your break-even point.
Revenues x 100
To calculate your break-even point, you will then have to divide the fixed costs by the gross margin.
Consider a business with revenues of $1,000,000, cost of goods sold of $450,000 and fixed costs of $550,000.
The business's break-even point is as follows:
Total revenue ($1,000,000) - cost of goods sold ($450,000) = gross profit ($550,000)
Revenues (1 000 000$) X 100
Gross margin (55%)
This calculation tells us that with 1 million dollars of sales the business will reach its break-even point.
"It's very important for a business to know what level of sales it needs to achieve to generate profits," says Julien Bélisle. "If reaching $1,000,000 in sales is not achievable, you have to make changes in your business to be profitable with fewer sales."
Target your business’s key variables
The target variables in a sensitivity analysis will differ from one business to another. However, two variables will be relevant for the majority of businesses:
- gross margin
Other variables you may want to analyze will differ depending on the business's activities. For example:
- the price of plastic for a chair manufacturer
- the price of fuel for a carrier
- the exchange rate for an importer
Assessing your level of dependence
In industries where one factor has a particularly large impact on profitability, a small variation can make a big difference. One way to assess whether this is the case for your business is to look at important items of expenditure.
"For example, a one-cent difference in the price of gasoline for a high-mileage transportation business can completely change the bottom line," says Comiré. "The business must be alert to variations and the sensitivity analysis allows it to be prepared. Because if the manager has no control over a variation, they must at least be able to adapt their cost structure to limit such impact."
Example of a sensitivity analysis
Once you have chosen the variables to be analyzed, you will need to make various projections by making them fluctuate according to different probable scenarios, and look at the impact of those fluctuations on your profitability.
Let's take the example of the plastic chair manufacturer. Since the price per ton of plastic has a great impact on the business's profitability, it is important to examine how variations would affect the business. For example, we can analyze the effect of a $1 increase or decrease in the price of a ton of plastic.
If you realize that you will not be able to meet your sales target in a profit-making way, you have to move on to the step where you review your cost structure.
In the example below, we can see that an increase of more than $2 could result in a net loss for the business.
"The goal is to be able to translate the impact of different scenarios on the bottom line into simple terms: In this example, we could say that for every additional dollar that a ton of plastic costs, the impact is $5,000 in lost profit at the end of the year," says Bélisle.
We can then do the exercise with another factor, such as the selling price.
"If you realize that you will not be able to meet your sales target in a profit-making way, you have to move on to the step where you review your cost structure," says Bélisle. "You then have to ask yourself some tough questions. Is the business efficient enough? Are we paying too much for our raw material? The cost structure must be adjusted so that the business can ultimately generate sustainable profits."
Check the impact of changes on liquidity
While you should always be trying to understand when you will be profitable, you should not overlook the impact of fluctuations of these various variables on your cash flow.
"For example, if the business's growth has exploded and it needs to buy a large amount of raw materials, it needs to make sure it won't exceed the amount it can actually borrow on its line of credit. It is therefore also necessary to assess the impact of the projected changes on its cash position," says Bélisle.
By doing a sensitivity analysis to see which factors are most critical to your business' profitability, it will be easier to keep an eye on variations that could have a significant impact. By looking at both the impact on profitability and liquidity, you will be ensuring that you are well prepared in case of major fluctuations.