Definition
Sensitivity analysis is used as part of financial modelling. It is primarily used to study the impact of changes in different independent variables on a dependent variable, basis certain assumptions. It uses 'what if' questions to analyse how multiple sources of uncertainty can impact a company's performance forecast.
Example
For example, a company can study the potential revenue increases from an investment in a technological resource. This can be done by modifying the demand levels of the final product/service, performance downtime range, service cost, etc. As another example, suppose a company is trying to estimate the range of profits from a prospective patent purchase. While the patented product is relatively new, there are chances that a more advanced product enters the market. This could reduce the company's targetted sales. Accordingly, the company carries out a sensitivity analysis to gauge the investment's lifetime profitability by assuming certain sales levels in case the advanced product does not capture market share.
Why it matters
Sensitivity analysis can offer a number of benefits. Since it involves an in-depth study of multiple variables, the predictions can be fairly relied upon. It allows company's management to identify the specific areas that need improvement and thereby make sound financial decisions for the company.