How to Model Financial Business Scenarios in Excel

Modeling financial business scenarios in Excel is essential to validate, review, and analyze your company’s financial performance. You can use Excel to model financial business scenarios by creating a series of mutually exclusive and exhaustive decision trees. These models are called decision trees because you follow a structured decision tree process that branches out from a starting point called the root node. A financial business scenario is a set of conditions or events that may or may not occur. Scenarios help you understand the potential impact associated with various assumptions about future market conditions, regulatory environments, technology adoption rates, and other factors that could have an impact on your company’s overall financial performance. By using Excel to build decision trees for your company’s financial performance model, you can identify which options will result in the best outcomes for your business while avoiding the worst outcomes.

What are the benefits of using Excel to build financial business scenarios?

Excel provides you with the flexibility to model financial business scenarios using the most appropriate financial metrics based on the industry in which your business operates. This helps you validate and review the assumptions that drive your company’s financial performance. You can use Excel to build shared decision trees, which allow you to collaborate with colleagues in real time to identify the best financial decision for your company. You can also build decision trees that are accessible to a wider group of stakeholders.

What is a financial business scenario?

A financial business scenario is a set of conditions or events that may or may not occur. You can use financial business scenarios to understand the potential impact associated with various assumptions about future market conditions, regulatory environments, technology adoption rates, and other factors that could have an impact on your company’s overall financial performance. Financial business scenarios are often expressed as a conditional “If-Then” statement. For example, “If the price of crude oil increases by 3%, then the demand for our company’s product will decrease by 5%.” Financial business scenarios are often used in conjunction with scenarios for business operations, such as product adoption rates, technology adoption rates, and market conditions. Financial scenarios are the most complex of these three scenarios because they are often determined by a variety of external factors beyond your company’s control.

How to build an Excel decision tree

A decision tree is a useful tool for modeling financial business scenarios because it helps you identify all of the possible paths your business could take, given the current conditions and a set of assumptions. A decision tree is a hierarchical diagram that consists of a root node, one or more intermediary nodes, and one or more leaf nodes. Root Node - The root node is the starting point for your decision tree. It consists of a single scenario and provides a single outcome. Intermediary Nodes - An intermediary node is a connection between the root node and a leaf node. Intermediary nodes can be used to combine two or more root nodes. An intermediary node can contain one or more conditional statements that will be evaluated based on the outcome of the root node. Leaf Node - A leaf node represents the final outcome of a decision tree. The only scenario connected to the leaf node is the root node.

Identify Best and Worst Scenarios

To build your decision tree, start with a baseline scenario called the “Best Case Scenario.” Your company’s best-case scenario is the most optimistic outcome that could occur if everything goes according to plan. Next, you will create a “Worst Case Scenario.” The worst-case scenario is the most pessimistic outcome that could occur if everything goes wrong. These two scenarios will form the roots of your decision tree. Create an intermediary node to connect these two scenarios. In this intermediary node, identify all the factors that could influence the occurrence of each scenario. For example, the price of crude oil factors into both scenarios because it affects the demand for your company’s products. Create additional intermediary nodes to connect the scenarios between the root nodes and the leaf nodes. These intermediary nodes can contain conditional statements that identify when one scenario leads to another scenario. For example, the price of crude oil may factor into both the best- and worst-case scenarios.

Determine probabilities for each outcome

Every scenario that you connect to the root node in your decision tree will result in one of two outcomes: “True” or “False.” A True outcome means that the scenario occurred, while a False outcome means that the scenario did not occur. Create an intermediary node to connect each scenario to the root node. In this intermediary node, identify the probability that each scenario will result in a True outcome. For example, the probability that the price of crude oil will increase by 3% is 50%. By creating this connection, you can model the potential impact of each scenario in your decision tree.

Identify Actions to be Taken When a Condition is met

After you have created your decision tree, you can determine which actions should be taken when a particular scenario is met. For example, when the price of crude oil increases by 3%, your company’s product demand will decrease by 5%. This means that you will need to adjust your supply chain accordingly. Create an intermediary node to connect the scenario to the action that should be taken. This can be done by creating a formula that evaluates the result of the True or False outcome of the scenario. By creating this connection, you can model the potential impact of each scenario in your decision tree.

Define Your Company’s Baseline Scenario

Your company’s baseline scenario is the most likely scenario (i.e., the average outcome) that will occur while your company is operating at a normal level of activity. Because this is the most likely scenario, it is important to model this scenario first to establish a baseline by which you can compare the other scenarios. Your baseline scenario should be based on your best estimate for the future based on the current state of your company. When creating the baseline scenario, you can use current metrics, current events, and other external factors that may influence your company’s financial performance.

Assign Probability to Each Scenario

After you have created your decision tree and associated the baseline scenario, you can identify each scenario and assign a probability to each scenario. To do this, you can select each scenario node and enter the probability that each scenario will occur. Your scenario probabilities should reflect your best estimate for the future based on your company’s current state.

Confirm Outcomes and Summing Up

After you have created all of the scenarios in your decision tree, you can use the “Calculate” function to determine the overall outcome of each scenario. Once you have calculated the outcome of each scenario, you can use the “Sum” function to identify the overall outcome of your decision tree. This overall outcome represents the company’s best and worst outcomes, as well as the scenarios that are most likely to occur.

Conclusion

In this article, we discussed how to model financial business scenarios in Excel. We learned that the most important aspect of financial business scenarios is identifying which scenarios will result in the best outcomes for your company. Creating a decision tree is a useful tool for modeling financial business scenarios because it helps you identify all of the possible paths your business could take given the current conditions and a set of assumptions. By creating a decision tree, you can model the potential impact associated with various scenarios that could occur for your company.