FINANCIAL PLANNING AND BUDGETING “As certainly as financial planning centers about commitments and utili-

FINANCIAL PLANNING AND BUDGETING “As certainly as financial planning centers about commitments and utili-

zation of capital, the protective function of management is also germane to the process. This function comprehends the integrity of capital, the profitable survival of the business entity, and the safe-guarding of the rights of the capital contributors,” Paul M. Van Arsdell, Corporation Finance (New York: The Ronald Press Company, 1968), p. 550.

A strategy is the direction a firm takes to meet its objective. A strategic plan is how a firm intends to go in that direction. In financial manage- ment, a strategic investment plan includes policies to seek out possible investment opportunities: Do we spend more on research and develop- ment? Do we look globally? Do we attempt to increase market share?

A strategic plan also includes resource allocation. If a firm intends to expand, where does it get the capital to do so? If a firm requires more

3 The case of Schlitz Brewing is detailed in George S. Day and Liam Fahey in “Putting Strategy into Shareholder Value Analysis,” Harvard Business Review (March–April

1990), pp. 156–162.

SELECTED TOPICS IN FINANCIAL MANAGEMENT

capital, the timing, amount, and type of capital (whether equity or debt) comprise elements of a firm’s financial strategic plan. These things must

be planned to implement the strategy. Financial planning allocates a firm’s resources to achieve its invest- ment objectives. Financial planning is important for several reasons. First, financial planning helps managers assess the impact of a par- ticular strategy on their firm’s financial position, its cash flows, its reported earnings, and its need for external financing.

Second, by formulating financial plans, the firm’s management is in

a better position to react to any changes in market conditions, such as slower than expected sales, or unexpected problems, such as a reduction in the supply of raw materials. By constructing a financial plan, manag- ers become more familiar with the sensitivity of the firm’s cash flows and its financing needs to changes in sales or some other factor.

Third, creating a financial plan helps managers understand the trade- offs inherent in its investment and financing plans. For example, by devel- oping a financial plan, the financial manager is better able to understand the tradeoff that exists between having sufficient inventory to satisfy cus- tomer demands and the need to finance the investment in inventory.

Financial planning consists of the firm’s investment and financing plans. Once we know the firm’s investment plan, we need to figure out when funds are needed and where they will come from. We do this by

developing a budget, 4 which is basically the firm’s investment and financ- ing plans expressed in dollar terms. A budget can represent details such as what to do with cash in excess of needs on a daily basis, or it can reflect broad statements of a firm’s business strategy over the next decade. Exhibit 29.2 illustrates the budgeting process.

Budgeting for a short-term (less than a year) is usually referred to as operational budgeting; budgeting for the long-term (typically three to five years ahead) is referred to as long-run planning or long-term planning. But since long-term planning depends on what is done in the short-term, the operational budgeting and long-term planning are closely related.

The budgeting process involves putting together the financing and investment strategy into terms that allow the financial manager to deter- mine what investments can be made and how these investments should be financed. In other words, budgeting pulls together decisions regarding capi- tal budgeting, capital structure, and working capital. Managers prepare budgets by preparing financial statements that represent these decisions.

4 The term “budget” originates from the French bouge, meaning a bag and its con- tents. We use the term budget to refer to the allocation of a firm’s resources (in dol-

lars) over future periods. The bag is therefore the firm; its contents are the firm’s resources, its funds.

Strategy and Financial Planning

EXHIBIT 29.2 The Budgeting Process of a Firm

Consider Sears. Its store renovation plan is part of its overall strategy of regaining its share of the retail market by offering customers better quality and service. Fixing up its stores is seen as an investment strategy. Sears evaluates its renovation plan using capital budgeting techniques (e.g., net present value). But the renovation program requires financing— this is where the capital structure decision comes in. If it needs more funds, where do they come from? Debt? Equity? Both? And let’s not forget the working capital decisions. As Sears’ renovates its stores, will this change its need for cash on hand? Will the renovation affect inventory needs? If Sears expects to increase sales through this program, how will this affect its investment in accounts receivable? And what about short-term financ- ing? Will Sears need more or less short-term financing when it renovates?

While Sears is undergoing a renovation program, it needs to esti- mate what funds it needs, in both the short-run and the long-run. This is where a cash budget and pro forma financial statements are useful. The starting point is generally a sales forecast, which is related closely to the purchasing, production, and other forecasts of the firm. What are Sears’ expected sales in the short term? In the long term? Also, the amount

SELECTED TOPICS IN FINANCIAL MANAGEMENT

that Sears expects to sell affects its purchases, sales personnel, and advertising forecasts. Putting together forecasts requires cooperation among Sears’ marketing, purchasing, and financial management.

Once Sears has its sales and related forecasts, the next step is a cash budget, detailing the cash inflows and outflows each period. Once the cash budget is established, pro forma balance sheet and income state- ments can be constructed. Following this, Sears must verify that its bud- get is consistent with its objective and its strategies.

Budgeting generally begins four to six months prior to the end of the current fiscal period. Most firms have a set of procedures that must be fol- lowed in compiling the budget. The budget process is usually managed by either a Vice-President to Planning, the Director of the Budget, the Vice- President of Finance, the Chief Financial Officer, or the Corporate Con- troller. Each division or department provides its own budgets that are then merged into a firm’s centralized budget by the manager of the budget.

A budget looks forward and backward. It identifies resources the firm will generate or need in the near- and long-term, and it serves as a measure of the current and past performance of departments, divisions, or individ- ual managers. But we have to be careful when we measure deviations between budgeted and actual results. We must separately identify devia- tions that were controllable from deviations that were uncontrollable. For example, suppose we develop a budget expecting $10 million sales from a new product. If actual sales turn out to be $6 million, do we interpret this result as poor performance on the part of management? Maybe, maybe not. If the lower-than-expected sales are due to an unexpected downturn in the economy, probably not. But yes, if they are due to what turns out to

be obviously poor management forecasts of consumer demand. Sales Forecasting

Sales forecasts are an important part of financial planning. Inaccurate forecasts can result in shortages of inventory, inadequate short-term financing arrangements, and so on.

If a firm’s sales forecast misses its mark, either understating or overstat- ing sales, there are many potential problems. Consider Coleco Industries, which missed its mark. This company introduced a toy product in 1983, its Cabbage Patch doll, which enjoyed runaway popularity. In fact, this doll was so popular, that Coleco could not keep up with demand. It was in such demand and inventory so depleted that fights broke out in toy stores, some parents bribed store personnel to get scarce dolls just before Christmas, and fake dolls were being smuggled into the country.

Coleco missed its mark, significantly underestimating the demand for these dolls. While having a popular toy may seem like a dream for a

Strategy and Financial Planning

toy manufacturer, this doll turned into a nightmare. With no Cabbage Patch dolls on the toy shelves, other toy manufacturers introduced dolls with similar (but not identical) features, capturing some of Coleco’s market. Also, many consumers—the parents—became irate at Coleco’s creating the demand for the toy through advertising, but not having suf- ficient dolls to satisfy the demand.

Coleco Industries tried but failed to introduce a toy as successful as the Cabbage Patch doll. It filed for bankruptcy in 1988, with most of its assets (including its Cabbage Patch doll line) sold to Hasbro Inc., a rival toy company. Hasbro was then acquired by Mattel, Inc. Cabbage Patch Dolls are experiencing a resurgence of interest, thanks to the increased marketing power of Mattel and a tie-in with the 1996 summer Olympics.

To predict cash flows we forecast sales which are uncertain because they are affected by future economic, industry, and market conditions. Nevertheless, we can usually assign meaningful degrees of uncertainty to our forecasts. We forecast sales in one of the following ways:

■ regression analysis; ■ market surveys; and ■ opinions of management.