What does sensitivity analysis involve in financial modeling?

Sensitivity analysis in financial modeling primarily focuses on understanding how changes in one or more input variables affect the outcomes of a model. By systematically altering these inputs, such as sales growth rates, cost estimations, or discount rates, analysts can observe the corresponding changes in the outputs, which often include metrics like net present value (NPV), internal rate of return (IRR), and other financial projections.

This approach is crucial because it allows stakeholders to identify which variables have the most significant impact on the results, helping to prioritize areas of focus and manage potential risks. Additionally, sensitivity analysis can highlight the robustness of a financial model by revealing how sensitive the outputs are to fluctuations in input values. This makes it an essential tool for decision-making and risk management in finance.