Sensitivity analysis in investing – how to effectively assess risk?

Sensitivity analysis is one of the key tools used in investments to assess financial and operational risk. It allows investors and entrepreneurs to better understand which variables have the greatest impact on project outcomes and how changes in these parameters can affect the profitability of an investment. In this article, we will explain how to perform a sensitivity analysis, what factors to consider, and how to use the results of the analysis to minimize investment risk.

Table of contents

• What is sensitivity analysis and what are its applications?
• How does sensitivity analysis help reduce investment risk?
• Key factors affecting the sensitivity of project profitability
• Key variables in the sensitivity analysis of investment projects
• Risk analysis methods in the context of sensitivity analysis
• What information about project effectiveness does sensitivity analysis provide?

What is sensitivity analysis and what are its applications?

Sensitivity analysis is a technique that examines the impact of changes in individual input variables on the outcome of an investment project. It allows key risk factors to be identified and the limits of the project's profitability to be determined.

It is most commonly used in industries such as:

• construction,
• energy sector,
• finance and investments.

Sensitivity analysis makes it possible to identify areas that are particularly vulnerable to change and to flexibly adjust strategies. This is an extremely valuable method in a dynamically changing market environment, where conscious risk management is the key to success.

How does sensitivity analysis help reduce investment risk?

By conducting a sensitivity analysis, investors can simulate various scenarios of change, e.g., in costs, revenues, or rates of return, and assess their impact on the profitability of the project. This makes it possible to:

• identifying the most important risk factors,
• introduction of preventive measures,
• better preparation for potential threats.

Reduced uncertainty and better investment planning translate directly into increased financial efficiency and stability of projects.

Key factors affecting the sensitivity of project profitability

In the sensitivity analysis, three basic groups of variables have the greatest impact on the project's profitability:

• costs (e.g., production costs, fixed and variable costs),
• revenues (sales prices, sales volume),
• capital expenditures (expenditures on the purchase of fixed assets, technologies).

The interrelationships between these elements determine whether the break-even point will be reached. Even minor changes in operating costs or revenues can significantly shift the project's break-even point, which is why it is so important to analyze them in detail.

Key variables in the sensitivity analysis of investment projects

An effective sensitivity analysis should primarily take into account:

• NPV (net present value),
• cash flow,
• sales and revenue levels,
• operating costs.

Modern tools such as MS Excel enable advanced simulations to be carried out using the Data Table function and the Solver tool. This makes it possible to quickly check the impact of different scenarios on the financial results of a project.

Risk analysis methods in the context of sensitivity analysis

The following are mainly used in risk analysis related to sensitivity analysis:

• ceteris paribus analysis – examining the impact of a change in one variable while assuming that the others remain constant,
• scenario analysis – creating different variants of situation development based on changes in several variables simultaneously.

Both methods enable the identification of critical risk points and allow for better planning of preventive measures. Simulations can also be used to determine project safety margins and prepare for changing market conditions.

What information about project effectiveness does sensitivity analysis provide?

Sensitivity analysis provides valuable data on:

• the impact of changes in costs and revenues on profitability,
• the impact of changes in capital expenditure on IRR (internal rate of return),
• boundary values of variables for project profitability.

The simulations carried out enable the precise determination of the investment safety margin, which helps to make informed strategic decisions and minimize financial risk.