Financial Planning & Analysis
written by : William F Bryant Financial Planning & Analysis (FP&A), in short, verifies the financial feasibility and economic plausibility of strategic decisions from the C-suite, Board of Directors, equity holders or sole proprietor and is the real option valuation tool to determine everything from CAPEX expansion, new product lines and even M&A transactions.
Let’s face it, every strategic decision is complex when it comes to your business. Companies and organizations are multifaceted organisms, comprised of multiple departments and disciplines, each with multiple personalities of workers, all trying to sell a product or service in a penetrative or developmental, competitive market strategy. A single decision can have a reverberating affect throughout the company and, to top it all off, every strategy and the corresponding decisions will require capital. The questions you should immediately begin asking upon an agreed strategy is, what are our alternative options, what is the cost amongst the options, can we afford these options, how will we pay for the options, what will we get in return, is it worth it, are the payoffs quantitative, qualitative or both and, perhaps the most overlooked, how will the strategy impact the company at an employee level. FP&A is the tool to use to assist in evaluating all of these questions. Companies exist because there is a profit to be made, but others realize this and compete for the same market share. This defines a competitive market and it is the nature of healthy markets. To stay competitive, strategies must be developed under the caveat that capital in-flows must meet expectations and exceed the outflows. An FP&A scenario can go top-down or bottom-up or a combination, but will almost always begin by evaluating the company’s overall financial health. The financial health will involve gauging the usage of debt and ability to cover interest, the company’s operating assets, operating liabilities, sources of cash flow and the usage of working capital to further increase those cash flows. Drilling down, a company may desire to examine departments, departmental budgets, product lines and product margins. Obviously, in any analysis, the question needing to be answered will determine what needs to be evaluated, but understanding where the company is presently is needed to determine a path to where the company wants to go. Stated another way, this creates benchmarks for a measurable comparison. With your company, department or product line benchmarked, there is not only a measurable comparison, but you now have the key ingredients to evaluate strategic decisions. First, you have a way to determine your needed return on invested capital for any strategic endeavor and a baseline to compare amongst strategic options. Second, you have the knowledge of your capital capacity and budget for a strategy; this includes the cash for operations, the cash available for investment and whether additional financing is needed, available and can be used to your company’s advantage. These ingredients are fairly intuitive and can be worked out in short order, but the most important part of FP&A, the step that involves the artistry and understanding of more than just the numbers, the key to the analysis, is the forecasting of the cash flows. Forecasting is the calculating out of the unknown, but anticipated, expected future cash flows, possibly within a confidence interval, using any number of modeling methods and the knowledge to discern amongst the methods. Of course, your strategy depends on the accuracy of these cash flows and any statistical model is only as good as the data used; this is the artistry and why you look to a knowledgeable analyst. Your analysis may require the ability to understand any or all of the following, finance, modeling, operations, asset needs, supply chain, capacities, economies of scale, industry market segments and competition, target customers, marketing strategy and any other areas that would potentially affect cash flows. The analysis may therefore incorporate every department involved in the strategy and rightly so, but it may also prove useful to get an outside evaluation or consultation. When assessing planning strategies there are a number of useful rules that can be drawn from portfolio theory in regards to both the valuations of strategies and their corresponding IRRs and NPVs and to time horizon of investment when matching maturities for cash flows. First, it is common for a company to evaluate options for planning in terms of free cash flows and using those free cash flow to find the IRR or NPV in order to make an accept/reject decision. It is important to understand that IRR is a rate of return and NPV is a dollar equivalent value. If simply considering and valuing one project, it is fine to use the IRR as it usually gives a correct accept/reject determination. However, if you are comparing several options, the IRR does not allow a comparison of projects of different sizes. The NPV must be used to assess the accept/reject comparison of mutually exclusive projects. The reason stems from the risk measurement of percentage gains versus dollar gains. Second, time horizon. Time horizon is key when planning. While anyone that has planned financing for a project knows that real options of opting out can be of value over time horizons with uncertain futures, they might not have considered the correlation to risk in portfolio theory and the matching of maturities. If the project is not up and running then a firm risks not receiving incoming cash flows, but also risks the uncertainty of the economic environment as time progresses. This actually is working proof that you can not diversify away risk with time. Although, many believe that a longer horizon is less risky for investments, it is simply incorrect as you pick up the risks of the extended periods which ends up being equivalent to the risk pooling of assets and increasing risks over time. Examining equivalent periods of time in terms of risk to return, matching, works similarly whether investment in a project or a portfolio, as is the borrowing of debt to pay for the investment or project as, in the end, its actually matching expected cash flows and standard deviations, risks. FP&A is a standard tool for business strategy and all businesses, no matter the size of their sales. A segment from my post under the Financial Analysis : Planning Analysis. Of interest is that while 2017-2018 and 2018-2019 where large bumps in sales, the previous three years saw consecutive declines YoY to sales of -5%. It is also important to keep in mind that growth is not linear, nor does is it by percentage (elasticities) representation. The percentage representation is a method to simplify relationships amongst the operational accounts. Sales grow by units. If your percentages do not seem feasible when in units, then the percentage should not be used. Accurate and realistic projections are necessary to get the most out of your models. As the saying goes, Garbage-In, Garbage-Out for any model. That said, the following is a roughed-out model and not any semblance of a final product.
...One final note on this status quo forecasting model, Inflation is here. This inflation is not transitory no matter how many times the Fed says it is transitory. The interest rates will have to outpace inflation in order to keep the inflation from taking off, but when this will be realized is for a separate paper. This circumstance will have multiple behavioral and market forces play out together. As a currency loses purchasing power, the general investor will ‘lose’ relative discretionary income. Any investments will need to be, not only, “risk-free” but also affordable and of more perceived value than usage elsewhere. The return on equity would, therefore have to be more than the inflation rate, but can a company keep growing income in real, not nominal, terms while its cost are increasing and fewer customer may be purchasing their products? Another corresponding issue is the dividend, or lack thereof. Will companies be forced to go back to dividends as real productivity and real assets are purchased with real labor and real value currency; dollars in the hand are worth more as dividends? These are some thoughts for companies going forward.
What do the projections reflect in real terms at the status quo: ...While it should be obvious that improvements in every area would result in the top value of operations, there are things to consider. Cost. Cost. Cost. Benefit. Benefit. Benefit. In other words, every benefit comes with a cost and the real-world examples of the economic concept of diminishing marginal returns is always present. This means that for additional incremental costs, they will produce decreasing incremental benefits. Cost-Benefit analysis is not a linear function!
The OP ratio, CR ratio and ROIC are the one year forecast that correspond to a 1% change in the scenarios. The value of operations and intrinsic stock price reflect a 1% change throughout the forecast in the given scenarios. The OP ratio was simplified to a 1% decline in (operational expenses/sales) each year. The CR ratio was a 1% change down in the operational asset ratios with a corresponding 1% increased change in the AP/sales ratio, holding the accruals the same. Given these scenarios, it is obvious that, holding all else constant in the scenarios, the company gets the most distance from addressing operational expenses.
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