The most challenging part of planning is trying to predict the future. There are three major formats for financial planning:
Budget: The target management aims for.
Forecast: What management expects to happen.
Projection: What might happen in different scenarios
Actual results usually fall short of what management hopes for, so that is why having projections with several scenarios is so important.
Improved methods can improve the accuracy of the planning process.
There are several areas of the planning process that can open it up to large deviations from actual results (which I will dig deeper into in future posts):
Critical assumptions
Risk identification and measurement
Market performance and political events
Budgeting is a process which is gradually being replaced by rolling forecasts, due to the historical wide variation between the budget and actual results. A rolling forecast is more adaptable to the changing climate. It also works with smaller segments of time, so it is more up to date. Therefore, rolling forecasts tend to be more helpful for effective decision-making. Also, rolling forecasts are more adaptable to other business segments, and have become more popular with sales, supply chain management and hiring decisions. Rolling forecasts are also very helpful in identifying cash flow shortages.
Long-range projections are helpful for evaluating potential investment opportunities, acquisitions, and comparing different strategic plans. They tend to project one to ten years into the future. They help to align the long-term goals of the company with current business decisions. They also help by setting a clear goal for the future, and a plan for how to get there.
Long-range projections generally incorporate input from several key areas of the company - operations, sales, manufacturing, management, etc. The efforts of involving the various departments will help with ensuring that all departments are contributing to the long-term vision in effective ways.
Long-range projections also help with resource management. By planning out long term resource needs, the company can improve their use of assets, which will lead to cost savings and improved bottom line performance.
Capital Investment Decisions (CIDs) are often done using metrics such as Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period. These metrics often use numbers derived from projections. Capital Invesment Decisions can also use various scenarios for each of the metrics in order to understand both the risk and the opportunity more completely.