What is the purpose of sensitivity analysis?

Sensitivity analysis is a key financial modeling technique used primarily to understand how different values of an independent variable impact a particular dependent variable under a given set of assumptions. Specifically, it investigates changes in net present value (NPV) as a result of variable adjustments within a financial model. By varying one input at a time—such as sales volume, cost of goods sold, or discount rates—analysts can observe how these changes affect the overall outcome, typically focusing on NPV.

This process helps in identifying which factors have the most influence on the project's viability, allowing decision-makers to prioritize risks and uncertainties that could significantly affect the financial projections. Essentially, sensitivity analysis provides insights into potential variability in financial outcomes, helping stakeholders make informed decisions based on different scenarios.

The purpose is not about measuring the general effectiveness of forecasting or determining the certainty of future cash flows; rather, it specifically highlights how various inputs can influence NPV, thus reinforcing that option as the most precise description of sensitivity analysis.