Financial planning fundamentals and strategies

Financial planning for corporations is the process of planning the firm's revenues and expenses for the next year. Such planning provides managers with the insight needed to aid decision-making. Every company has specific activities that they would like to undertake, be they market expansions, new product launches or upgrades to existing systems. In order to budget for those activities, the financial planning function must be conducted. This allows managers to match the sources of revenue with expenditures that they need or want to make in the future. Financial planning also provides the basis for long-range strategic planning. The financial planning process can, for example, reveal budgetary constraints and shed insight into other potential problems that can affect the firm's operations and its plans. Therefore, financial planning plays in essential role in the budgeting process and by extension the strategic management process.

This paper will serve as an overview of the financial planning function. Attention will be given to the different financial planning models that are commonplace -- how do managers make their financial projections? These models will be evaluated and analyzed according to their level of practicality and according to their underlying rationale. In addition, attention will be given to the differences between long and short-term financial planning, and the central issue of working capital and why it is so important to the financial planning process.

The Role of Financial Planning

Financial planning plays a critical role in corporate strategy. It provides an understanding of the firm's expected financial position going forward, it helps to identify constraints and it provides the basis for analysis of a wide range of strategic and financing decisions. The ultimate goal of most financial planning activity is to develop a set of budgets that illustrate the firm's potential financial future. These budgets provide the basis for managerial decision-making. They are a snapshot of the company's expected financial position in the coming years. This has significant relevance to strategic management because managers make decisions today that will impact the firm in the future. This means that past financial data, while possible a valuable data set, is not as relevant to these decisions as future financial data.

Strategic management requires financial planning in part because the financial planning process typically reveals risks and constraints. A company may, for example, want to expand a factory but the financial plan may reveal that their debt position is expected to be poor for the coming five years. This provides the company's managers with valuable information about a key constraint -- they may be able to afford debt financing today but not next year -- that will impact on the final decision. Part of the strategic management process is to understand the degree to which today's decisions will affect the company in the future.

A manager in the above scenario may deem the project too important to pass by. In this case, the information about the constraint may guide the manager to investigate other avenues of financing, such as equity or mezzanine financing. These decisions and their impact on the company can be evaluated against one another using financial planning techniques. By providing a means for managers to gauge the firm's financial future, financial planning is a critical component of the managerial process.

Short-Term vs. Long-Term Financial Planning

The short-term financial plan is one that encompasses the upcoming fiscal year. Anything beyond that is considered to be a long-term plan. This is consistent with the time orientation of assets and liabilities on the financial statements. The short-term plan is considered, by and large, to be most relevant for short-term tactical planning. Conversely, the long-term plan is more suitable for use in long-term strategic planning.

On the surface, the two will be structured much the same. In their usage, however, there will be differences. The short-term plan is used to address more immediate issues such as solvency and working capital; the long-term plan is focused on capital structure, liquidity, and long-term growth. Of the two, the short-term plan is expected to be the more accurate. It is easier to estimate the size and nature of transactions the closer one gets to them. Because of this, the short-term plan is the more directly actionable of the two. Decisions are made with the underlying assumption that the short-term plan is a fairly accurate reflection of the company's impending financial situation. The long-term plan is approached by managers with more caution. Whatever methodology is adopted, the long-term plan is considered more of a guidepost than an actionable plan, and only serves to provide an approximation of the company's financial position, to be used loosely rather than adhered to strictly.

The long-term plan, however, is useful for managers to get an overview of the organization. In particular, long-term plans are used when organizations are planning mergers and acquisitions, to make decisions with respect to the firm's capital structure and as a guidepost with respect to the firm's long-term financial performance. Managers seek to address long-term trends that they see emerging in a proactive manner, so long-term financial planning can be useful to reveal those trends.

Working Capital

Working capital is strictly defined as the company's current assets less its current liabilities. Working capital therefore is considered to be not only a barometer of the firm's short-term financial health but also as a measure of the company's efficiency (Investopedia, 2010).

The role of working capital in short-term financial planning is best understood in terms of the working capital cycle. The working capital cycle reflects the degree to which capital is processed through the company. Each element of working capital -- inventory, payables and receivables in particular -- has a time component attached to it. It is important to remember that even if the number on the balance sheet does not change, this does not mean that the same inventories or payables are present. The measures -- ratios such as inventory turnover or receivables turnover -- reflect the degree to which the company operates efficiently. It is the pace by which the company turns over its working capital that reflects its ability to convert assets to cash and how quickly they do it. The cash, under a basic model, is converted into long-term assets (that is, taken out of working capital) (PlanWare, 2009).

Understanding how the firm's working capital cycle functions is an essential element of short-term financial planning. Working capital finances economic activity at the firm. Therefore, in order to create a short-term financial plan, the working capital cycle must be understood as this will give management adequate insight into the amount of cash they will need for the upcoming year, into how they will meet their debt obligations, into how they can meet their needs for investment, and into what sort of returns their shareholders can expect.

It should be noted that changes in the working capital can reveal a number of different things about the firm. For example, working capital can increase as the result of an increase is inventory. Such an increase, however, would be considered negative because it reflects difficulty in selling that inventory. Conversely, a working capital inventory based on an increase in cash, however, could result from the company improving its inventory and receivables turnover and then holding the cash. Therefore, it is important to understand that a change in the working capital position must be analyzed before judgment is passed with respect to the implications that the change has on the firm's finances. Moreover, it is also worth remembering that the working capital is measured on the basis of the company's financial statements at a given point in time. The actual financial situation of the company with respect to working capital may be different by the time the managers look at those statements.

Financial Planning Models

There are a number of models that managers can use in order to construct their financial plans. These models vary significantly in their underlying philosophy, their execution and their output. There is no one correct model, since realistically none of them are truly expected to be accurate all the time. However, analysis reveals that some models are stronger than others in their ability to deliver realistic, workable forecasts. One common method for deriving financial forecasts is the percentage of sales method. This method involves taking the previous year's income statement, calculating the percentage of sales for each line item, and then using those same percentages to derive those line items based on this year's forecasted sales level. The percentages are also applied on the balance sheet as well. Another common method is the budgeted expense method. This method can be either top-down or bottom-up but in either case derives expense estimates from pre-set spending levels. A third method is trend analysis, wherein the percentage trends of the past for line items are extrapolated into the future.

The most common method of financial planning is the percentage of sales method. This method has a number of advantages that contribute to it being the most popular method. The first advantage is that it is easy. The math associated with the percentage of sales method is very simple to execute. The underlying premise of this method is that most of the items on the income statement and on the balance sheet will vary with sales. In addition to direct variable costs, such as cost of goods sold, indirect costs will also vary roughly in line with sales. These costs include fixed costs such as selling, general and administrative expense, and even fixed assets. As the company grows, the line items will grow in roughly equal proportion.

For example, if in 2008 a firm's cost of good sold is 40% of its revenues, then it would be assumed that the same would hold true in 2009. The revenues themselves would be the one component of the equation that is left to management to determine. They would need to estimate the cost of sales without a set formula, but after that the remainder of the income statement and balance sheet would fall into place based on the established percentages.

It is understood that the percentage of sales method is imperfect. However, it is also understood that all methods of forecasting are imperfect and that this method is the most accurate relative to the amount of effort it requires. Other methods may ultimately be more accurate, but they also require more effort on the part of the management. Percentage of sales, therefore, is the quick and dirty method of deriving future financial statements.

The underlying theory of this method is that the organization scales up its cost structure and balance sheet-based with revenues. In practice, this is only true for the most stable of organizations. Companies in mature industries, not engaged in any merger & acquisition activity, are the most likely to get sound results from this method. There are a number of companies for whom this is reasonable, especially small companies that have stabilized in terms of their size and cost structure. For most public companies, however, there are too many externalities for the percentage of sales method to hold much relevance. It is difficult for firms operating with a number of different products in a number of different environments to effectively utilize this technique -- the structure of their organization is simply in too much flux. Therefore, the percentage of sales method is somewhat limited, in particular for complex organizations and those that may be subject to variability as a result of either the nature of their operations or externalities.

Although the percentage of sales model is by far and away the most popular model for financial planning in corporations, there are other models in use as well. Another important model is the budgeted expense model. This model is especially popular with in public budgeting, but is also useful for corporations whose constituent companies are subject to fluctuating operating conditions, such that the percentage of sales method would be inaccurate. The budgeted expense model expects that the future budgets are based on the compilation of contemporary budgets of constituent agencies or departments. In a top-down scenario, the parent would dictate the budget amount to the agency or department, that would then be compelled to meet that budget. In a bottom-up model, the agencies or departments would set their own budgets based on previous years' spending. The parent would then make its own budget for the next year based on the aggregated agency/department forecasts.

This method is based on the underlying philosophy that the most accurate way to reflect future spending and revenue amounts is by aggregating the constituent budgets of the organization's various components. For many organizations, this is a reasonable approach because future spending levels primarily reflect future spending levels. For many corporations, however, this method is weak. Expense levels are not taken in most corporations as a given -- they fluctuate not only with revenues but also with the organization's cost-control measures. Therefore, this method is most popular in public budgeting rather than with public corporations. It can be effective at the broadest corporate -- conglomerate -- level however. A conglomerate can set its budget on the basis of the budgets turned in by its constituent corporations, but beyond that the constituent corporations must still find their own system of budgeting that will lead to the overall budgeted expense budget.

A third model for financial planning is via a trend analysis model. In this model, the projections of future revenues, expenses and other line items are derived from trends in those items that have developed over the past several years. For example, assume a company has the following income statements. In this situation, a trend analysis would reveal that the revenue has increased 26.5% on average each year. The COGS has increased 15.4% each year on average. It is assumed that these trends will continue through 2009, such that the 2009 income statement is as follows.

This methodology is based on the underlying theory that past trends are roughly analogous to future ones with the company. This contrasts to the percentage of sales method, which essentially extrapolates the performance of just one previous year to derive estimates of future years' performance. Trend analysis emphasizes using data from multiple years into order to determine the trends. Because the data is derived from multiple years, it is also more likely to be valid over the long-term.

Trend analysis has the benefit of using more data points than other methods to derive its estimates of future performance. As a result, this method tends to be more accurate than other methods that are based on data points from just a single year. In addition, this method is relatively easy to determine. Although slightly more complicated than the percentage of sales method, trend analysis nonetheless relies strictly on basic math in order to derive its projections.

Another method is the zero growth method. This is utilized by firms that operate in mature markets, or by firms that are facing adverse economic or competitive circumstances. In this scenario, the firm assumes that revenue will flatline. The budget may or may not contain expense reductions, but the underlying principle is that the firm cannot count on revenue improvements and must therefore attempt to operate under a cost containment scenario. This method is not accurate to the extent that few firms have sustainable flat revenue growth, but there are years in which the projection of a zero growth scenario would be appropriate. Under such circumstances, this form of estimate will have value.

Another method is to build the financial plan from scratch. This method is highly complex and requires significant input from multiple levels of management. However, these methods can be accurate because of that high degree of input. The underlying principle of this method is that most of the easier methods are ultimately not particularly accurate. They are based on estimates derived more for their practicality than their accuracy. For some firms, that is unacceptable and a more sophisticated method must be used. Building the financial plan from scratch involves consultation with a wide range of managers to derive their estimates of potential revenues and costs. The financial plan is then an aggregate of this information.

This method is perhaps the most realistic, assuming that the managers are capable of relatively accurate foresight. In addition to being subject to the ability of the managers to exhibit accurate foresight of the firm's operations, this method is also subject to the quality of the information available. For example, a manager planning in late 2007 may have made estimates that were logical at the time, but rapid fuel costs in the first half of 2008 may have rendered those estimates inaccurate by a wide margin.

The primary drawback to this method is that it is the most time-consuming. In order to execute this model, managers will need to spend an inordinate amount of time analyzing their organizations in order to derive accurate estimates of future performance. There is a tradeoff that must be evaluated with respect to the quality of the information and the time and effort needed to develop that information in the first place.

In addition, this method is subject to changing environmental factors. The best efforts of managers to build projections from scratch based on their expected actions over the next year can be rendered moot by changes in the external environment, or even the internal environment (for example, a major takeover or a major restructuring). All methods are subject to such changes, but because this method is based entirely on managerial interpretation of the future and because it is so time-consuming, there is more downside associated with such major shifts in the firm's external environment.

Lastly, the combination method takes into consideration both the percentage of sales method and the budgeted expense method (Slideshare, 2009). The combination method considers that for some line items it is reasonable that they will fluctuate largely in line with sales. For these items, the percentage of sales method is utilized. For other items, however, management recognizes that the figures for the next year are unlikely to be as they have been in the past. For example, if the price of coffee was very low in 2008 but the harvest was terrible, Starbucks may assume that the cost of coffee will increase dramatically for 2009, and therefore the coffee expense as a percentage of sales will be much higher in that year. Their labor costs as a percentage of sales may remain relatively stable, however. The combination method requires management to make a judgment with respect to the category into which each line item must be placed.

This method is more complicated than the percentage of sales method, but is less complicated that the budgeted expense method. The accuracy and value of the combined method, however, likely falls in between the two as well. It allows managers to exercise some degree of discretion but gives them an out for items where their discretion may be no better than a rough estimate.

Of these methods, however, building the financial plan from the ground up is the method that does the best job of incorporating the practical realities of business into the model. While this method is subject to shifts in the external or internal environment, at least it takes such factors into account. A manager building such projections may not be aware of a new merger coming down the pipeline, but may be aware of a major expansion into a new market, or a major investment in a plant that will affect the firm's costs and assets, but not the revenues. Such changes cannot be easily predicted by the other models, and must therefore be predicted by the hands-on model.

Each of the other major models has some basis for their popularity, but that basis is derived from the compromise between usefulness and ease of compilation. Methods such as the percentage of sales model and trend analysis have some reasonable basis for their use in terms of their fundamental philosophy. However, they are entirely based on those rough, core assumptions and therefore lack flexibility. There is no room for managerial interpretation, for the introduction of new information or for adjustments to reflect economic projections beyond sales. For example, an airline may have a sales projection that is close to reality, but the cost of jet fuel may increase significantly over the course of the year. This would throw the percentage of sales or trend analysis out of equilibrium. Any changes, therefore, render the projects in the more basic models irrelevant.