Financial planning can make the difference between success and failure for companies in today’s dynamic markets. In most companies, Financial Planning & Analysis (FP&A) teams are responsible for outlining financial plans using an analytical toolbox to deliver consistent and flexible insights that feed the corporate decision-making process. Financial planning methods are the fundamental elements in this FP&A toolbox.
The purpose of this article is to outline 3 financial planning methods and how to execute those methods in Microsoft Excel, as well as 2 types of financial planning into which it all fits.
Financial planning methods:
- Budget and business planning
- Cash flow planning
- Funds planning
Types of Financial Planning:
- Organic growth planning
- Strategic growth planning
How financial planning works: developing a financial plan
Before we jump into methods and techniques, you need to understand how financial planning works in a company. At a high level, it happens in these three steps:
- Qualitative outline. Business decision-makers outline what the company will need in order to better serve its customers in a period of at least the next 365 days.
- Quantitative outline. Financial analysts use the qualitative plan to determine how much it will cost, how much revenue it is expected to generate, if the company can afford to fund the plan, and if not, how to fund it.
- Revision of the qualitative plan. Perhaps the most painful step, revision is the process by which financial analysts explain how the strategic qualitative plan may negatively impact the company financially. They must then make suggestions on how to modify the plan. It’s painful because, in most companies, business decision-makers don’t like changing their plans. (Honestly, does anyone like changing their plans?)
These steps stand in opposition to popular opinion, which says that financial planning is a complex, math-heavy process that requires advanced studies to implement. This is far from the truth. In reality, financial planning is the process of reflecting the financial impact of strategic business decisions.
In most companies, sales, executive, and product departments make suggestions for how the business should pursue better serving its existing customers or serve new customers over a period of at least one year, and in most cases 5 years. This part of the financial plan is the qualitative section.
It is the most important section. Without a detailed qualitative explanation of what the business should do, the financial plan is nothing more than random numbers in Excel. In other words, financial planning starts with the qualitative plan and becomes the quantitative plan.
Financial planning basics
The basics of financial planning help weed out the myths that financial planning is complicated. Broken down, the essential components of a company are simple: costs, revenue, and funding. The basics of financial planning ask the following three questions:
- How much does it cost to buy the goods we need, and how expensive are our employees?
- How much will customers pay for the products we produce?
- How can we fund the costs of our plans if we don’t have enough cash on hand?
Complexity only enters the equation when we translate these basic concepts to the three financial statements, but don’t worry about those for now. Just remember the basics.
In a sentence, the basics of financial planning are:
- Costs of the plan,
- Revenues it will generate, and
- Funding needed to pay for the costs.
Methods used in financial planning
So, how do we analyze costs, revenues, and funding? We use the financial statements, and most importantly, the profit & loss statement (aka Income Statement, or P&L for short).
As a brief reminder, the P&L looks like this:
| Revenues | Sales ordered, but not necessarily paid for |
| Cost of Sales | The direct cost of those sales, but not necessarily paid for |
| Operating expenses | The non-direct costs in the company, i.e salaries, water, electricity |
| Depreciation | The part of a big purchase recording in the current period (year) |
| Taxes | Taxes paid in the current period |
The process of completing the three financial statements with relevant information requires three financial planning methods:
- Budget & business planning,
- Cash flow planning, and
- Funds planning.
Let’s look at them in more detail.
Budget & business planning
Budget & business planning requires that we establish known costs and expected revenues for the first year (budget), then use growth metrics to project costs and revenues going forward (business plan).
The easiest way to understand budget and business planning is with an example. Imagine you run an e-commerce business called Batch Watch that sells watches to retailers. You would like to move into luxury watches, since you currently sell only running watches. The luxury watch will be called Gamma.
You’ve looked at your competitors, and you think you can sell Gamma watches for $750 each (unit revenue). To build the watches, you need to spend $450 on glass and metal per watch, and you need a special machine to work with high quality metals. The machine costs $500,000 and lasts 10 years.
As your financial analyst, I’m going to first build a P&L to show how profitable this venture could be. I assume that the company will sell 1/4 as many luxury watches as running watches, which comes out to 1,000 in the first year. Here’s how profitable it could be:
| Description/calculation | Account | Amount |
|---|---|---|
| 1,000 * $750/watch | Revenue | $750,000 |
| 1,000 * $450/watch | Cost of Goods Sold | $450,000 |
| $500,000/10 | Depreciation | $50,000 |
| Assumed tax rate of 30% on earnings after depreciation | Taxes | $75,000 |
| Revenue – all costs, depreciation, and taxes | Profit | $175,000 |
Now that we have the 1st year budget, we can use growth metrics to see what this will look like over the next 5 years.
We assume that the revenues will grow by 1% year-over-year. CoS will always remain the same proportion of revenues (450/750, or 60%). Depreciation remains the same each year, and the tax rate will not change. A 5-year profitability business plan, thus, could look like the following:
| Account | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
|---|---|---|---|---|---|
| Revenue (+1% yearly) | $750,000 | $757,500 | $765,075 | $772,726 | $780,453 |
| Cost of Goods Sold (60% of revenue) | $450,000 | $454,500 | $459,045 | $463,635 | $468,272 |
| Depreciation (flat 50k) | $50,000 | $50,000 | $50,000 | $50,000 | $50,000 |
| Taxes (30% * after depr. earnings) | $75,000 | $75,900 | $76,809 | $77,727 | $78,652 |
| Profit | $175,000 | $177,100 | $179,221 | $181,363 | $183,527 |
Cash flow planning
Now we know the project would be profitable given our assumptions about revenue and growth rates, but we need to see if Batch Watch has enough cash to start the project, and how much it might need over time.
The reason we look at cash as separate from profitability is due to two financial phenomenon: purchases on credit (aka accounts receivable), and depreciation. Accounting principles dictate that we record revenues at the time they are delivered, not when cash arrives. This means that if Batch Watch allows retailers to pay for watches 30 days after delivery, the company sustains a cost without any cash inflow for that month.
At the same time, Batch Watch has to bear the weight of the $500,000 for the luxury machine. While on the P&L profitability view, we only show $50,000 on the books each year for tax purposes, we had to pay all $500k up front in year 1.
In other words, we need roughly $950,000 in cash during year 1 to start making the luxury watches. But that’s not the only concern. We also need to see how long it will take for Batch Watch to be paid on average for its watches so the company never goes cash negative even after the initial $950k payment.
The easiest way to do this is with a cash flow schedule. Cash flow schedules simply show the starting amount of cash, plus inflows, and minus outflows over time. Let’s assume Batch Flow has 800k in cash as of January 1st, at which point it wants to launch the project. A cash flow schedule might look like the following:
As you can see, we start with $800k in the bank. The initial $500k purchase for the machine, as well as a subsequent $225k purchase for watch raw materials bring Batch Watch cash level down considerably. While we start to see some interest with $75,000 purchases in March, we become cash negative in April with another $225k purchase of raw materials.
This cash flow schedule helps us understand that while we may be profitable from a P&L view, we would not be cash positive. So what do we do when we need more cash to fund activities? We turn to the third financial planning method: funds planning.
Funds planning
Funds planning (or funding for short), is the process by which analyst find external funding for financial plans. The funding process is usually the last step in quantitative financial planing, since most companies are only interesting in taking on external funding when 1. they know that the project will be profitable, and 2. that their cash flow will be negative without it.
Once you have outlined your cash flow projection, you know how much money you will need, and when. The next step is simply to decide what kind of outside funding the company will use. There are two types of funding available:
- Loans. Without a doubt, loans are the number one source of funding in financial planning for stable companies. In a sentence, you use a loan to get a surge of cash inflows, then pay it back in manageable installments over time. While consumers are most familiar with mortgage-type loans, the most common types for business are revolving credit facilities, or RCFs. RCFs allow companies to draw down small sums within a given limit, then reimburse it with monthly accumulated interest.
- Equity. Equity is a much more common option for growth-phases companies that need huge cash injections to launch their products. By issuing or selling equity, company shareholders “give up” parts of their ownership in order to raise huge sums, and fast.
Let’s look back to our example cash flow schedule. We saw that in the month of April, Batch Watch went cash negative. In order to prevent this, we decide on a funding strategy. Since it’s a small amount, we decide to go with a RCF.
The brilliance of the RCF is that we can draw down the amount we need almost instantly when we’re approved. Take a look at this cash flow schedule that assumes we take the loan in April. We then start receiving more substantial orders.
(NOTE: one element I’m not including in the chart is the cost to reimburse the loan once it’s drawn down. RCF repayments are special in that the reimbursement plan is flexible. Much like a credit card, when you draw it down, you will accumulate interest until it’s reimbursed. No fancy mortgage payment calculations needed!)
Example in Excel
Organic financial planning vs. Strategic financial planning
There are two frameworks that guide financial planning methods: organic financial planning & strategic financial planning.
Organic financial planning uses budget & business planning, cash flow planning, and funds planning to show how a company can grow organically — that is, by excluding the use of external funds.
Strategic financial planning uses budget & business planning, cash flow planning, and funds planning to show how a company can grow through the use of divestitures, acquisition, and external funding.
Organic financial planning focuses on the use of company resources, instead of paying interest rates on loans and yielding equity ownership to generate cash. It’s a low-risk endeavor, but it’s slow.
Strategic financial planning focuses on rapid growth by leveraging external funding, taking on interest, and selling ownership for cash. It’s a high-risk endeavor, but it moves very, very quickly.
Analysts typically use these frameworks to guide assumptions about growth metrics and potential revenues in the profitability view. They use it to examine long term cash flow needs, and whether to include external cash in the funds planning.
