5. Model Building and Forecasting

g. describe how ratio analysis and other techniques can be used to model and forecast earnings.

What is a sensitivity analysis? The study of how the variation in the output of a model can be apportioned to different sources of variation. (e.g., what will be the net income if more debt is issued?)

What is scenario analysis? This considers both the sensitivity of financial outcome to changes in key financial variables and the likely range of variable values. The least “reasonable” set of circumstances (low unit sales, high construction costs, etc.) and the most “reasonable” set are specified first. The financial outcomes under the bad and good conditions are then calculated and compared to the expected, or base-case, outcome. Even though there are an infinite number of possibilities, scenario analysis only considers a few discrete outcomes.

What is Monte Carlo simulation? This is a risk analysis technique in which a computer is used to simulate probable future events and thus estimate the profitability and risk of a project. Random values of input variables are generated on a computer. The mean of the target variable is computed to measure the expected value. Standard deviation (or coefficient of variation) is computed to measure risks.