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Financial planning is a critical activity for every business irrespective of its age and size. For new enterprises, the preparation of financial projections is integral to the business planning process. For larger companies, financial planning forms part of annual budgeting and plays an important role in long-term planning, business appraisals, corporate development etc.
Central to the task of preparing a set of projections is the construction of a mathematical model to reflect the finances and activities of a business. Sales minus Costs equals Profits (i.e. S - C = P expressed as a formula) is an example of a very simple model for deriving projected profits from assumptions about future sales and costs.
In practice, financial planning models are much more complex as they must accommodate multiple time periods (months, quarters and years) and handle hundreds of variables relating to sales, costs etc. The volume of data mounts up very quickly when each variable is multiplied by the time horizon, for example, by twelve months. Figure 1 below lists typical assumption variables used to generate a set of financial projections.
|Figure 1 - Some assumption variables used by a financial model to produce projected P&Ls, cashflows and balance sheets for a manufacturing business.|
Selling & distribution costs
Tax rates for inputs
Research & development
Tax rates for sales
Changes in loans/debt
Bad debt provisions
Operating leases & HP
Target finished stocks
Current year debtors/creditors
Opening balance sheet
|Fixed asset values
Direct manpower levels
Capital & revenue grants
Fixed asset disposals
Other direct costs
Phasing of opening balances
A comprehensive model can contain many thousands of formulae with functions ranging from simple addition to complex conditional statements (e.g. if projected cashflow is positive, reduce the overdraft before adding any residual balance to the cash account).
Financial models are used to compile forecasts and budgets; to assess possible funding requirements; and to explore the likely financial consequences of alternative funding, marketing or operational strategies. They can also be used for business planning, raising finance, investment or funding appraisals, financial analysis, corporate planning etc.
Used effectively, a financial model can help prevent major planning errors; identify or evaluate opportunities; attract external funding; provide strategic guidance; evaluate financial and development options; monitor progress etc.
Our Exl-Plan range of Excel-based planners are ideal for financial modeling and planning. Based on a user's assumptions, they generate fully-integrated projections for up to five years ahead. Also, Cashflow Plan produces fully-integrated cashflow projections for 12 months ahead and incorporates a roll-forward facility to simplify updating of projections.
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2. Using a Computer for Financial Projections
A personal computer with appropriate software can help prepare financial projections. A computer-based model reduces the tedium of carrying out numerous repetitive calculations; simplifies the alteration of assumptions; and improves the presentation of results.
When using a computer, a manager or planner can utilize a spreadsheet to build a model from first principles. While the development of a spreadsheet model of a company's profit & loss account should be well within the capabilities of many managers, the development of an integrated and comprehensive financial planner is an infinitely more challenging, time consuming and difficult task. A manager must know when to draw the line between using a spreadsheet to plan and becoming a spreadsheet programmer.
As an alternative to a DIY model, a manager or entrepreneur can purchase a ready-made model which can be either (a) loaded as a template into a spreadsheet or (b) run as a stand-alone package.
The main advantage of building a bespoke model is that it can be fine- tuned to meet very specialized requirements. However, the drawback is that building a comprehensive, error-free and user-friendly financial model could require hundreds of hours of development and testing along with considerable programming and financial expertise. This work inevitably distracts from the real task of planning the business and begs the question as to why managers, entrepreneurs, advisers etc. should reinvent the wheel whenever a set of financial projections are required.
3. How Financial Planning Models Work
A computer-based financial model is the electronic equivalent of a very large sheet of ruled paper which, depending on circumstances, could be 10 to 20 square feet in area. The computer's screen serves as a small window on this electronic sheet which usually displays variables and values along rows and time periods in columns.
A model utilizes assumptions for sales volumes, prices, operating costs, funding etc., to produce projected balance sheets, profit & loss accounts and cashflow statements. Typically, it makes monthly projections for the first year and less detailed projections for the following years. For example, PlanWare's models will produce projections (P&Ls, cashflows, balance sheets) for the first year on a monthly basis and for the following two years on a quarterly basis. As all the components of a model are linked by formulae, a change to any assumption in any period results in appropriate adjustments to profits, cashflows etc. throughout the model for the remaining months, quarters and years.
Once initial assumptions have been entered, they can be readily altered to evaluate alternative scenarios. For example, a model could be used to explore the extent to which future sales can be increased while holding borrowings within predetermined limits; to assess the effects of varying selling prices and/or volumes on net profits; or to determine the optimum level and mix of future funding for a business.
As a practical example, Figure 2 below shows the results of using one of PlanWare's models to undertake a "what-if" analysis where sales volumes and prices have been increased by a fixed percentage.
Given a choice between a 20% increase in sales volumes or a 10% increase in selling prices, the model shows that the latter would be a far more attractive option. The results also offer an insight into the underlying cashflows and funding requirements. Our software planners, Exl-Plan and Cashflow Plan, offer extensive facilities and utilities for doing "what-if" sensitivity analyses.
4. Planning to Make Business Plan Projections
For managers of an existing business, or promoters planning a substantial new venture, financial modeling can be an invaluable tool to assist the preparation of a business plan. However, business planning should not be confused with the preparation of financial projections. The former must provide the foundation for the financial projections which can be derived arithmetically by a model. The model and its forecasts should contribute to but never dictate the contents of a written business plan.
Once basic issues relating to markets, sales and operations have been fully researched and considered, a model can be used to produce the financial projections. However, the veracity and usefulness of these projections will be completely determined by the quality and reliability of the underlying assumptions determined outside the model. For example, if sales or cost forecasts are unrealistic or inadequately researched, then the value of a model's output is greatly diminished. An impressive set of financial projections is of little benefit if unsupported by research or only based on speculation or wishful thinking.
Before using a financial model to help plan the future of a business, a manager or entrepreneur should:
Recognize the danger of presenting too much detail or too many reports. Most senior managers, investors and financiers seek simple financial statements which have been based on detailed analysis and realistic assumptions.
5. Tips & Traps when Projecting Finances
When preparing financial projections, be conscious of the pitfalls and dangers listed in Figure 3 below. These can arise as the result of a lack of foresight or insight, or because of excessive optimism. As they can lead to underestimation of the resources required to develop a business with potentially disastrous consequences, it can be counterproductive to overstate its potential.
Realistic views should always be taken of a business's prospects, prospective profits, funding requirements etc. There is often merit in compiling "worst" case projections to complement "most likely" or "best" forecasts. In practice, the realization of financial projections, especially for a new business without any trading history, might easily take twice as long and cost twice as much as expected. Remember that it is much less painful to deal with a flaw in a business at the planning stage, than later on when commitments have been made and the business has started trading. Our software planners - Exl-Plan and Cashflow Plan - offers comprehensive facilities for doing sensitivity analysis (using Quik-Plan and by changing individual values).
6. The Next Steps in Business Planning
Preparing a set of financial projections is only a means to an end. Once plans or projections have been approved or in the process of being implemented, they should be regularly updated and compared with the results being achieved.
A plan is only useful if it is being adhered to, if it serves as a benchmark for control purposes, and if the projected outcomes are being realized.
While a clear business plan with sound projections cannot guarantee success, the absence of a plan or poor projections could ensure the eventual failure of a business.
For further information on business planning issues, refer to other papers in this series which cover business planning, cashflow forecasting, strategic planning, devising business strategies and getting new business ideas. If planning to raise venture capital, business angel finance or bank loans, check the paper on raising finance.
7. Introducing PlanWare
PlanWare develops and sells a range of financial planning packages - Exl-Plan and Cashflow Plan - for businesses of all sizes & types. Trial versions can be downloaded from our PlanWare site here and from many other sources on the 'Net.
PlanWare also features:
8. Copyright & Legal Stuff
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