Smaller startups are often less concerned with long-term planning than getting off the ground and surviving. While many businesses may benefit from long-term financial planning, the more established businesses tend to have the resources and stability to analyze the long-term.
Why do companies bother with financial planning? Because financial planning establishes guidelines for the firm. Additionally, a company's growth rate and financial policy are linked. The goal of financial planning is to:
- Identify the firm's financial goals
- Analyze the difference between goals and current financial status
- State actions needed for the firm to achieve its financial goals.
Short-Term & Long-Term Defined
The short-term is usually defined as the coming year. The long-term is usually defined as longer than one year. Often, the long-term is defined as the coming two to five years.
What is Corporate Financial Planning?
A financial plan is a statement of what needs to be done in the future to achieve company goals.
Long-term financial planning is required to implement decisions that have long lead times. For example, if a company wants to build a factory next year, contractors probably have to be lined up this year.
Financial plans are made up of the combined capital budgeting analyses of each the firms projects. So, the smaller investment proposals of each operational unit are added up and treated as one big project.
Financial plans are meant to:
- Make the link between different investment proposals and the financing choices available to the firm.
- Help the firm work through finding the best investment and/or financing option.
- Help the firm avoid surprises by identifying what may happen in the future if certain events take place.
Elements of a Financial Planning Model
Companies come in all different sizes and sell different products. There is no boiler plate financial plan template for all companies. There are however, some common elements that are found in a financial plan:
- Sales forecast. Financial plans require a sales forecast. Perfectly accurate forecasts are impossible but specialists can hep assess the impact of unforeseen events.
- Pro forma financial statements. Financial plans have a forecast balance sheet and income statement. Financial statements that estimate future financial position and earnings are called pro forma statements.
- Projected capital spending. The plan describes required assets and proposes uses for net working capital.
- Financial requirements. The plan discusses dividend policy and debt policy. Firms may also consider selling new shares. In that case, the plan should take into account what types of securities are to be sold.
- Economic assumptions. The plan describes the state of the economic environment that the firm expects over the life of the plan such as interest rates.
- Plug variable. The “plug” (or “balancing item”) is a mathematical concept that is important to note because it is used in financial plans. Let's say the financial planner assumes net income will grow at a particular rate. The financial planner also expects assets and liabilities to grow at different rate. In order for the financial statements to remain balanced and consistent, the growth rate of stock outstanding may be chosen as the “balancing item”. Outstanding stock growth rate is then set to whatever value that allows the financial statements to remain mathematically correct. Of course, dividend payout or another variable may be used as the plug, it doesn't have to be outstanding stock.
What Determines Growth?
Specified sales growth rates are often stated as corporate goals. Why sales? Because it is assumed that if sales grow, the value of the firm (shareholder value) will grow accordingly. This logic is flawed because profitability can decrease even with increased sales.
Growth should not be the goal, but it should instead be a consequence of the firm's chosen projects that maximize net present value (NPV). If the firm accepts negative NPV projects just to grow in “size”, it generally makes shareholders worse off.
In our article about the time value of money we discuss net present value. To summarize, the NPV of a project is the today's dollar value of the future income that project generates, minus today's value of the costs incurred by the project.
Financial Planning Models – Caveats!
Of course, financial plans are only as accurate as the assumptions that go into the plan. The GIGO principle applies – garbage in, garbage out.
There are other concerns about financial planning models.
- Financial models don't uncover which financial policies are best.
- Financial planning models are too simple. In reality, their assumptions don't always hold.
- In practice, especially in large corporations, financial planning relies on a top-down approach. Senior managers determine a growth target, and financial planners tweak the plan with overly optimistic figures to match that target.
A financial plan can serve to provide guidelines but don't rely on the plan blindly.