Longer Forecast Horizon

Long‐term projections (LTPs) will have an extended time horizon, ranging from two to five or more years. The methods and considerations used for short‐ to midterm projections are usually not well suited to LTPs. There should be less emphasis on performance details and more understanding of strategic issues, market forces, and long‐term performance drivers.

Greater Uncertainty

The longer the horizon of our plan or projections, the greater the uncertainty. Few of us standing here now could have reasonably expected many of the events and changes experienced in just the past several years. Many of the strategic plans developed five years ago may appear absurd in hindsight, given the changes that could not have been anticipated. So why plan? Again, the value is in the planning, not the plan itself. If these organizations identified risks and opportunities and developed alternative scenarios, then they likely were better prepared to react to unforeseen changes that have unfolded.

Capability Required to Model Strategic Alternatives and Scenarios

The value in any plan is not the document or a single projection. The value is the critical thinking, anticipation, and identification of critical assumptions, critical success factors (CSFs), and performance drivers.

The model must be robust to consider radical changes to an organization's market, distribution channel, business model, and cost structure over a three‐ to five‐year period. One scenario should be a simple extrapolation of recent performance trends. Other scenarios should flex key assumptions about the economy, market drivers, key cost drivers, and other factors. An important aspect of strategic planning is the identification of alternative courses of action. The long‐term model must be able to portray the financial implications and results of various alternatives.

The key lies in the critical thinking the management team steps through in thinking about a range of potential scenarios.

Comprehensive View of Performance

Many organizations limit the content of long‐term projections to the income statement. Long‐term projections must include a complete view of the expected performance, including the balance sheet, cash flow and investment evaluation, and valuation. Any evaluation of future decisions or alternatives must include expected capital requirements, liquidity, a determination of the economic value created, and an evaluation of the investments contemplated in the plan. Why would any responsible executives embark on a plan that, if achieved, does not create value or cannot be financed by the firm?

Strategic Planning

LTPs must be developed as part of any strategic planning process. These projections will estimate the results of a certain strategy and allow for the evaluation of strategic alternatives. The LTPs must be developed using a robust model that can project financial results over several years (the planning horizon).

New Product Development

The evaluation of potential new products should include a complete plan containing strategic plan, execution plan, and financial projections. New product development activities are investments and should be analyzed as such. The financial projections must include all investments in development and capital as well as projected sales and expenses. New product development projections are covered in Chapters 20 and 21.

New Business Creation

The evaluation of potential new businesses should also include a complete plan containing strategic plan, execution plan, and financial projections. New business creation activities are investments and should be analyzed as such. The financial projections must include all investments in development and capital as well as projected sales and expenses. Projections for new business plans are covered in Chapters 20 and 21, and the valuation of businesses is covered in Chapter 22.

Mergers and Acquisitions

Mergers and acquisitions (M&A) represent substantial investments that must yield a return in the form of future financial results. The evaluation of potential acquisitions should also include a complete plan containing strategy, execution, and financial projections. The investment in an acquisition includes the purchase price, associated costs, and costs to implement synergies. Future projections must consider the stand‐alone results of the acquirer and the target and the projected synergies resulting from the combination. M&A is covered in detail in Chapter 23.

Other Capital Investment Decisions

In addition to new products, new business, and M&A decisions, many other capital investment decisions will require long‐term projections. Examples include geographic expansion, purchases of manufacturing equipment, and plant expansions, which will all require the development of long‐term projections.

Assess Current Situation

As with any projection, LTPs must start with an assessment of the current situation and environment. This is particularly true with long‐term projections. This process must include an assessment of the organization's strengths, limitations (or weaknesses), opportunities, and threats (SLOT) (Figure 14.1). The external environment must be monitored and reflected in the plan. The analyst must also be familiar with the strategic plan. A determination of the status of previous strategic objectives must be made. Recent performance trends must be identified and their impact on future performance considered.

Incorporate and Review Historical Results

In developing the model for use in developing LTPs, it is important to incorporate history. This has two advantages. First, the inclusion of history helps to identify key drivers and assumptions that are critical to projecting future projections. Second, it provides confidence in the relationship between these drivers and the actual financial results posted in prior years represented in the LTP model.

Identify Strategic Issues

Strategic issues must be considered in the development of LTPs. These may include changes in the overall market, competitive threats, weaknesses that must be overcome, and many other issues that will impact future financial performance.

Identify and Model Critical Assumptions and Business Drivers

Critical assumptions and business drivers that will affect future performance must be explicitly identified. Too often, these are buried in formulas in a model that prevent review and testing. These items will vary for each individual business. In some cases, market forces will be the most important. In others, product life cycles and introduction plans are critical. Key costs drivers must be identified and incorporated into LTP models.

Critical assumptions must be documented, reviewed, and tested. Sensitivity and scenario analysis should be integral elements of the plan.

Evaluate Strategic Alternatives and Scenarios

One of the objectives of strategic planning is to consider alternatives to the company's existing or primary strategic direction. This may be the most important contribution of the strategic planning and LTP process. Examples of strategic alternatives include alternative distribution channels, entering new product or geographic markets, and acquisitions. Other scenarios that are often explored are competitive threats, disruptive technologies, or flexing broad economic assumptions. The LTP model must be flexible enough to develop these alternative scenarios efficiently.

Projecting Key Performance Drivers

This section briefly covers techniques for projecting key areas of financial performance. These will be illustrated with two models in this chapter. Of course, any model must be tailored to the specific situation of each organization. Additional models and best practices are included in Part Four, Planning and Analysis for Critical Business and Value Drivers.

Capital Requirements

In developing LTPs we must consider two capital requirements: (1) working capital and (2) property and equipment.

Working Capital. Working capital requirements can be a significant cash requirement, especially in growth situations. These can easily be estimated in the future by using key metrics such as days sales outstanding (DSO) and inventory turns to project receivables and inventory balances in the future. However, these metrics may change in the future owing to changes in distribution channels, markets, manufacturing, and integration decisions.

The Capsule Financial Summary table at the end of this main section includes projected working capital based on historical measures for DSO, days sales of inventory (DSI), and accounts payable and accrued as a percentage of sales.

Property, Plant, and Equipment (PP&E). If significant, future estimates of PP&E should be based on the existing bases of assets and future capital requirements. Depreciation and accumulated depreciation should be based on the anticipated additions.

Most organizations have a base level of expenditures to support general business and replacement requirements. To this base level of capital expenditures, we must estimate any large expenditures to support strategic initiatives, for example manufacturing facilities to support new product introductions and also to expand manufacturing facilities.

Once the capital plan is developed, depreciation expense can be estimated using a model similar to Table 14.3.

Strategic Model for Tumultuous Industries

Many organizations are facing significant changes in their market or disruptive forces such as technology or nontraditional competitors. Such is the fate of traditional brick‐and‐mortar retailers as e‐commerce retailers continue to drastically cut into their market share.

In the past, a projections model for a retailer would focus on maintaining sales for existing stores and opening new stores. Table 14.5 is a high‐level summary of the key drivers. Revenue growth would be driven by opening new stores and increasing sales per store.

Now these retailers are faced with declining sales in their stores and are forced to offer more promotions and discounts to retain customers. Some are attempting to change the product offerings and store experience to stem the tide. Many traditional retailers are also attempting to build online businesses to participate directly in this new retail segment. Consider how these dynamics would be represented in a long‐term projections model. (See Table 14.6.)

This simple model allows us to consider the dynamics of the new reality for retailers, including:

• Lower sales per store
• Reduced rate of new store openings
• Store closings
• Investments in existing stores to change experience and format
• Investments in an e‐commerce platform, including technology, distribution, and other infrastructure

Figure 14.3 provides a comparison of the traditional retail environment to the new reality. This comparison of the traditional versus the new reality retail environment clearly demonstrates the challenges faced by brick‐and‐mortar retailers and the significant change in their business models going forward.