Step 1: Introducing uncertainty
In this step, we extend the basic model by introducing uncertainty into the model. Let us assume, that the initial assumptions would describe the median case well.
But because we model future developments, there is uncertainty about the future and we thus assume deviations in price and (in the next step) of quantity to occur.
How do we deal with such uncertainty?
The following chart depicts our original assumption: fixed annual sales of 100 units of product A p.a.
Original quantity assumption: No uncertainty: we sell 100 units of product A per annum
After consulting with the marketing department, you develop the following scenario:
Quantity assumption: Distribution of quantity (shown are 95% boundaries)
You expect the actual quantities sold to be with high probability within the range shown. If we look at the year 2025 for example by doing a cross-section, we find the following expected distribution of quantities:
Step 1: Quantity distribution estimated for the year 2025
If there is uncertainty regarding quantities sold, we have uncertainty about the revenue (and the variable cost). The question is, what impact does this have on our balance sheet and our P&L?
The significant impact of this change in assumption on the BS and P&L are shown below:
Balance Sheet assuming uncertain quantities sold. Given are 95% values. (Click to enlarge)
Profit and Loss if quantity sold is assumed to be uncertain/risky. 95%-case given. (Click to enlarge)
As we can see, changing the expected quantities rather harshly has quite a hard impact on the financial plan as well:
- Earning Before Taxes (EBT) are now broadly distributed as well:
EBT in time if quantities sold are assumed to be volatile.
- And the firm could potentially become illiquide…
Liquidity over time if quantities sold are assumed to be uncertain.
Step 1 Take-aways
- Even if we start from a fixed balance sheet, just one uncertain variable (here being the quantity sold assumption) will make the P&L uncertain.
- If the P&L is uncertain, the future balance sheet projections will be uncertain as well.