Term Paper on "Financial Planning"

Term Paper 15 pages (4271 words) Sources: 4

[EXCERPT] . . . .

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… READ MORE

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