Managerial Finance Sensitivity analysis, incremental cash flow, and risk analysis

Managerial Finance

Sensitivity analysis, incremental cash flow, and risk analysis

Sensitivity analysis – a look into the concept

The term sensitivity analysis is used to refer to the method employed for the determination of the impacts made by the values of independent variables upon a specific dependent variable under consideration under a particular group of assumptions. The usage of this analysis is dependent upon the input variable – either one or more, under preset limits, as, for example, the impact that a change in the rate of interest will have over the price of a bond. This technique is also called what-if analysis.

Sensitivity analysis finds application in a wide range of activities and systems – be it planning a vacation based upon specific variables under consideration or important organizational decisions at the corporate level. The prime principle based on which this analysis technique works is to observe the changes in behavior once the model under consideration is changed (Allaire, Jouve & Toader, 2004). For conducting a sensitivity analysis, it is essential to pay attention to the involved parameters. The experimental design covers the parameter combinations that would be varied. The next parameter that must be considered is the elements that can be varied – the count of activities, the objective as per assumed risks, technical parameters, limit constraints, and many more. The third parameter includes the elements that must be observed – the strategy objectives, decision variable values, relation between the objective functions, et cetera.

The incremental flow of cash – a prime consideration for projects

Incremental cash flow is referred to as the auxiliary operating cash flow enjoyed by a business from a new project that it has undertaken. It is of two types – positive (when the project brings in an increase in cash flow into the organization since its acceptance) and negative (increased outward cash flow requiring increased expenses or investment). A positive inclination of the incremental cash flow states that the organization should take an interest in making an investment in the specific project under consideration.

Understanding the incremental cash flow of a project requires the professionals to consider the various components – the initial outlay, expected cash flow as a result of project undertaking, terminal value or cost, time schedule of the project, and its scale (Rayburn, 1986). It is often described as the net flow of cash from the various cash inflows and outflows within a constrained time when two or more opportunities of business are simultaneously compared together. It is required by the organizations for the calculation of the net present value of a project, its internal return rate, and the period of payback. It enables organizations to increase the quality of making more informed decisions.

Risk analysis – some of the best practices

Risk analysis is a crucial task in project management as it helps the organization to know the potential threats that can impact the project and develop plans to mitigate the same. Some of the best practices of risk analysis in an organization include:

• Voluntary risk analysis

Many organizations often consider risk assessment to be a time-consuming task. However, conducting voluntary risk analysis sessions enables businesses to understand business risks and take steps for employee protection and safety cost reduction.

• Well-designed forms for assessing risks

Identifying the items for analyzing the risks makes the process easier. Risk assessment forms that are easy to follow are logically designed and lesser prone to errors. Also, it can be completed faster (Seeger, 2006).

• Workplace-specific hazard identification

It is one of the essential identifiable elements for a practical risk analysis approach. As the hazards specific to the workplace are recognized, handling the risks becomes easier.

Involving experienced personnel for the task who can head the analysis instead of putting it in the cupboard is essential for all organizations for detailed risk analysis of its projects.

Reference

Allaire, G., Jouve, F., & Toader, A. M. (2004). Structural optimization using sensitivity analysis and a level-set method. Journal of computational physics, 194(1), 363-393.

Rayburn, J. (1986). The association of operating cash flow and accruals with security returns. Journal of Accounting Research, 112-133.

Seeger, M. W. (2006). Best practices in crisis communication: An expert panel process. Journal of Applied Communication Research, 34(3), 232-244.