What Is Financial Planning?

Financial planning is a process consisting of:
1. Analyzing the investment and financing choices open to the firm.
2. Projecting the future consequences of current decisions.
3. Deciding which alternatives to undertake.
4. Measuring subsequent performance against the goals set forth in the financial plan.
Notice that financial planning is not designed to minimize risk. Instead it is a process of deciding which risks to take and which are unnecessary or not worth taking.
Firms must plan for both the short-term and the long-term. Short-term planning
rarely looks ahead further than the next 12 months. It is largely the process of making sure the firm has enough cash to pay its bills and that short-term borrowing and lending are arranged to the best advantage.
Here we are more concerned with long-term planning, where a typical planning
horizon is 5 years (although some firms look out 10 years or more). For example, it can take at least 10 years for an electric utility to design, obtain approval for, build, and test a major generating plant.
FINANCIAL PLANNING FOCUSES ON THE BIG PICTURE
Many of the firm’s capital expenditures are proposed by plant managers. But the final budget must also reflect strategic plans made by senior management. Positive-NPV opportunities occur in those businesses where the firm has a real competitive advantage.
Strategic plans need to identify such businesses and look to expand them. The plans also seek to identify businesses to sell or liquidate as well as businesses that should be allowed to run down.
Strategic planning involves capital budgeting on a grand scale. In this process, financial planners try to look at the investment by each line of business and avoid getting bogged down in details. Of course, some individual projects are large enough to have significant individual impact. When Walt Disney announced its intention to build a new theme park in Hong Kong at a cost of $4 billion, you can bet that this project was explicitly analyzed as part of Disney’s long-range financial plan. Normally, however, financial planners do not work on a project-by-project basis. Smaller projects are aggregated into a unit that is treated as a single project.
At the beginning of the planning process the corporate staff might ask each division to submit three alternative business plans covering the next 5 years:
1. A best case or aggressive growth plan calling for heavy capital investment and rapid growth of existing markets.
2. A normal growth plan in which the division grows with its markets but not significantly at the expense of its competitors.
3. A plan of retrenchment if the firm’s markets contract. This is planning for lean economic times.
Of course, the planners might also want to look at the opportunities and costs of
moving into a wholly new area where the company may be able to exploit some of its existing strengths. Often they may recommend entering a market for “strategic” reasons—that is, not because the immediate investment has a positive net present value, but because it establishes the firm in a new market and creates options for possibly valuable follow-up investments.
As an example, think of the decision by IBM to acquire Lotus Corporation for $3.3 billion. Lotus added less than $1 billion of revenues, but Lotus with its Notes software has considerable experience in helping computers talk to each other. This know-how gives IBM an option to produce and market new products in the future.
Because the firm’s future is likely to depend on the options that it acquires today, we would expect planners to take a particular interest in these options.
In the simplest plans, capital expenditures might be forecast to grow in proportion to sales. In even moderately sophisticated models, however, the need for additional investments will recognize the firm’s ability to use its fixed assets at varying levels of intensity by adjusting overtime or by adding additional shifts. Similarly, the plan will alert the firm to needs for additional investments in working capital. For example, if sales are forecast to increase, the firm should plan to increase inventory levels and should expect an increase in accounts receivable.
Most plans also contain a summary of planned financing. This part of the plan
should logically include a discussion of dividend policy, because the more the firm pays out, the more capital it will need to find from sources other than retained earnings.
Some firms need to worry much more than others about raising money. A firm with limited investment opportunities, ample operating cash flow, and a moderate dividend payout accumulates considerable “financial slack” in the form of liquid assets and unused borrowing power. Life is relatively easy for the managers of such firms, and their financing plans are routine. Whether that easy life is in the interests of their stockholders is another matter.
Other firms have to raise capital by selling securities. Naturally, they give careful attention to planning the kinds of securities to be sold and the timing of the offerings. The plan might specify bank borrowing, debt issues, equity issues, or other means to raise capital.
Financial plans help managers ensure that their financing strategies are
consistent with their capital budgets. They highlight the financing decisions
necessary to support the firm’s production and investment goals.
FINANCIAL PLANNING IS NOT JUST FORECASTING
Forecasting concentrates on the most likely future outcome. But financial planners are not concerned solely with forecasting. They need to worry about unlikely events as well as likely ones. If you think ahead about what could go wrong, then you are less likely to ignore the danger signals and you can react faster to trouble.
Companies have developed a number of ways of asking “what-if ” questions about both their projects and the overall firm. Often planners work through the consequences of the plan under the most likely set of circumstances and then use sensitivity analysis to vary the assumptions one at a time. For example, they might look at what would happen if a policy of aggressive growth coincided with a recession. Companies using scenario analysis might look at the consequences of each business plan under different plausible scenarios in which several assumptions are varied at once. For example, one scenario might envisage high interest rates contributing to a slowdown in world economic growth and lower commodity prices. A second scenario might involve a buoyant domestic economy, high inflation, and a weak currency. The nearby box describes how
Georgia Power Company used scenario analysis to help develop its business plans.
THREE REQUIREMENTS FOR EFFECTIVE PLANNING
Forecasting. The firm will never have perfectly accurate forecasts. If it did, there
would be less need for planning. Still, managers must strive for the best forecasts possible.
Forecasting should not be reduced to a mechanical exercise. Naive
extrapolation or fitting trends to past data is of limited value. Planning is
needed because the future is not likely to resemble the past.
Do not forecast in a vacuum. By this we mean that your forecasts should recognize that your competitors are developing their own plans. For example, your ability to implement an aggressive growth plan and increase market share depends on what the competition is likely to do. So try putting yourself in the competition’s shoes and think how they are likely to behave. Of course, if your competitors are also trying to guess your movements, you may need the skills of a good poker player to outguess them. For example, Boeing and Airbus both have schemes to develop new super-jumbo jets. But since there isn’t room for two producers, the companies have been engaging in a game of bluff and counterbluff.
Planners draw on information from many sources. Therefore, inconsistency may be a problem. For example, forecast sales may be the sum of separate forecasts made by many product managers, each of whom may make different assumptions about inflation, growth of the national economy, availability of raw materials, and so on. In such cases, it makes sense to ask individuals for forecasts based on a common set of macroeconomic assumptions.
Choosing the Optimal Financial Plan. In the end, the financial manager has to
choose which plan is best. We would like to tell you exactly how to make this choice.
Unfortunately, we can’t. There is no model or procedure that encompasses all the complexity and intangibles encountered in financial planning.
You sometimes hear managers state corporate goals in terms of accounting numbers.
They might say, “We want a 25 percent return on book equity and a profit margin of 10 percent.” On the surface such objectives don’t make sense. Shareholders want to be richer, not to have the satisfaction of a 10 percent profit margin. Also, a goal that is stated in terms of accounting ratios is not operational unless it is translated back into what that means for business decisions. For example, a higher profit margin can result from higher prices, lower costs, a move into new, high-margin products, or taking over the firm’s suppliers.1 Setting profit margin as a goal gives no guidance about which of
these strategies is best.
So why do managers define objectives in this way? In part such goals may be a mutual exhortation to work harder, like singing the company song before work. But we suspect that managers are often using a code to communicate real concerns. For example, a target profit margin may be a way of saying that in pursuing sales growth the firm has allowed costs to get out of control.
The danger is that everyone may forget the code and the accounting targets may be seen as goals in themselves.
Watching the Plan Unfold. Financial plans are out of date as soon as they are complete. Often they are out of date even earlier. For example, suppose that profits in the first year turn out to be 10 percent below forecast. What do you do with your plan?
Scrap it and start again? Stick to your guns and hope profits will bounce back? Revise down your profit forecasts for later years by 10 percent? A good financial plan should be easy to adapt as events unfold and surprises occur.
Long-term plans can also be used as a benchmark to judge subsequent performance as events unfold. But performance appraisals have little value unless you also take into account the business background against which they were achieved. You are likely to be much less concerned if profits decline in a recession than if they decline when the economy is buoyant and your competitors’ sales are booming. If you know how a downturn is likely to throw you off plan, then you have a standard to judge your performance during such a downturn and a better idea of what to do about it.