Historical Perspective

Budgets, in some form, were originally used by the British Empire and other governments hundreds of years ago. They were in common use by commercial enterprises in the late nineteenth century. Budgeting became very popular in the twentieth century and was adopted as a key part of managing the business by most companies and organizations. Incremental improvements were made to the process, and significant gains in information technology facilitated preparation.

Typically, the organization would prepare a budget once each year, several months before the new fiscal year began. For example, the budget for 1954 would likely have been prepared in the fall of 1953. This process served most businesses well during this time. Revenues were relatively stable and predictable. Costs and expenses were, for the most part, easily controlled and estimated on a detail basis. The pace of change and innovation was far slower than recent experience. The process typically included four steps, as illustrated in Figure 12.1.

Evolution of Financial Projections

Over time, deficiencies in the annual budget process were recognized. As a result of economic, political, technological, and global developments, the pace of change increased, often resulting in the budget being obsolete or at least dated soon after it was prepared. Many organizations began updating the budget or reforecasting the expected performance several times each year. In addition, pressure from the capital markets for updated forecasts of earnings (and severe and disproportionate reactions to missed forecasts) drove many finance teams to update and monitor projections frequently. Organizations began preparing strategic plans, which required the ability to produce estimates of financial performance over an extended time period.

Actual Results Often Fall Short

Actual results often vary significantly from plans and forecasts. Most variances represent shortfalls from projected results. There are several causes of this bias. First, most humans, and particularly managers, are inherently optimistic. Second, many plans or projections are incorrectly prepared as goals rather than probable outcomes. Third, less attention is paid to identifying and managing potential risks and downsides to the plan. This phenomenon is particularly evident in long‐term projections, due to the long period between developing the projections and the day of reckoning. This makes it difficult to hold managers accountable for long‐term projections, even if they are still in the chair several years later.

Improved practices in planning and developing projections as well as improvements in performance management can significantly improve the effectiveness of planning. Specifically, identifying and testing critical assumptions, identifying risks and upside events, and developing scenarios will greatly improve the effectiveness of developing projections. In addition to the general practices and techniques advocated in these chapters, the optimistic bias of plans can be countered with stated guidelines, development of multiple scenarios, focus on execution and accountability, and measuring forecast variances.

Types of Financial Projections

Financial projections are utilized in a multitude of applications in managing and optimizing performance. Because of this wide usage, it is important to hone projection skills within an enterprise. This can be facilitated by adopting best practices detailed later in this and succeeding chapters. A few of the most common FP&A and management uses of projections are identified next.

Projections Are Not a Finance Exercise!

While the finance team is typically the facilitator and process owner, it is important that all projections reflect the best estimate of the manager, executive, or team responsible for achieving them. Unfortunately, in many organizations, the ownership of the projections is often transferred to finance. Operating managers must be fully engaged in developing projections, including assumptions, estimates, decisions, risks, and upsides, and the execution plan to achieve the results. The executives with overall responsibility for achieving the results should also formally approve the final plan. Labels are also important! Changing “Forecast” to “Business Outlook” or “Budget” to “Operating Plan” can help to shift the perception of these exercises from financial to operational.

Trend Analysis and Extrapolation

Most financial projections for established businesses contain some element of extrapolation – that is, basing the projections on recent financial performance trends. We could start with recent financial statements and extrapolate financial trends into the future. Recent sales growth rates can be extended into the future. We could assume gross margins, expenses, and asset levels maintain a constant percentage of sales. This method is reasonable in very stable environments, which are increasingly becoming the exception rather than the rule.

This is generally not the best way to project financial performance. Most businesses are dynamic, and key variables will change over time. However, it may provide a useful view in serving as one potential scenario – that is, assuming that recent trends will continue into the future. This can be very useful in cases where other scenarios appear optimistic relative to historical performance. Extrapolation can also be used for certain areas that are stable or unlikely to vary over time.

Strike Balance between Bottom‐Up and Top‐Down

The traditional budget process started at the lowest level of revenue, costs and expenses. My first exposure to a budget process in the early 1980s highlights many of the pitfalls with this approach. The entire organization, which was very profitable but slow growing, embarked on the process with little direction. The result was a huge effort, spanning six weeks and involving hundreds of work hours across the organization. When the results were processed and tabulated, we presented a projection that included a 40% increase in staffing, 30% increase in other expenses and a tripling of capital expenditures, turning a profitable business unit into a substantial loss. Since the management team had not developed a game plan or macro view of expected performance, department managers submitted wish lists of investments, staffing, and expenses. There were five iterations of this bottom‐up detail process spanning a total of four months before it approached a reasonable plan.

Other organizations operate at the other end of this spectrum, essentially dictating performance expectations for the coming year from the top. They may or may not consider fundamental drivers, changes, risks, and upsides in this process.

The best solution in my experience is a combination of realistic guidelines, boundaries, and targets in the form of planning guidelines. Of course, managers should always be encouraged to present additional opportunities and risks. If the organization is effectively using rolling forecasts or DBOs, the process is more efficient and effective, since a view into next year's performance is already on the table.

Go Beyond the Numbers

For most significant decisions, managers should prepare well‐thought‐out financial projections. A well‐developed planning process will have less detail than the bottom‐up approach and will focus attention on the most critical drivers of performance. In addition to historical performance and trends, the projections should consider the impact of several factors, including:

• Strategic objectives
• Actions and potential actions of customers and competitors
• Anticipated changes in prices, costs, and expense levels
• Investments required to achieve the strategic objectives
• Economic variables

Managers must carefully address several questions in order to estimate future performance on key value drivers. We will discuss key financial inputs to each value driver in Part Four. A few examples are provided here.

Revenue

• How fast is the market growing?
• Is our market share expected to increase or decrease? Why?
• Will we be able to increase prices?
• What new products will be introduced (by our company and competitors)?
• What products will post declining sales due to product life cycles or competitive product introductions?
• What general economic assumptions are contemplated in the plan?

Costs and Expenses

• What is the general rate of inflation?
• What will happen to significant costs such as key raw materials, labor, and related expenses such as employee health care?
• What increases to headcount will be required to execute the plan?
• What operating efficiencies and cost reductions can be achieved?

Asset and Investment Levels

• What level of receivables and inventories will be required in the future?
• Will we need to increase capacity to achieve the planned sales levels?

Financing and Cost of Capital

• Will we need additional financial resources to execute the plan?
• Do we plan to change the mix of debt and equity in the capital structure?
• Is our business profile becoming more risky or less risky?
• What is likely to happen to interest rates over the plan horizon?

Identify and Test Assumptions

Developing projections of any type requires the use of assumptions. Critical assumptions should be identified, evaluated, and “flexed” to determine a range of potential outcomes and sensitivity. Managers should test the sensitivity of the projections and the decision criteria to each critical assumption. Once identified, these critical assumptions can be closely monitored as leading indicators of the firm's ability to achieve the plan.

Link to Performance Management

Most projections are presented and evaluated through a financial lens with a focus on outcomes. Cost center reports, profit and loss statements, and working capital and cash flow projections are all financial tools and reports that are based on expected performance of people, processes, projects, and other activities. With the possible exception of a few acceptable areas, you cannot directly manage financial outcomes; you can only manage people processes and activities that result in those outcomes. Many organizations utilize key performance indicators (KPIs) and dashboards as part of an overall performance management framework. By integrating these KPIs into the planning process, we directly link the financial results to business processes and activities.

A simple example is the projection of accounts receivable. Many organizations plan the receivables level based on past days sales outstanding (DSO) levels. However, receivables balances and DSO are the financial result of several important drivers, including:

• Credit terms and creditworthiness
• Timing and pattern of revenues
• Product and revenue process quality
• Customer service, problem resolution, and collection activities

It is far more effective to model future receivables levels based on these drivers and assumptions. Any projected improvements in DSO will be based on achieving improved performance on these drivers. These activities are leading indicators of future receivables levels and DSOs. They can be monitored against plan assumptions to ascertain that the projected outcome is likely or that some management intervention is required.

Evaluating Financial Projections (Note: Nearly All Projections Are Wrong!)

It is important to recognize that it is difficult to predict the future and that all projections incorporate a large number of assumptions. Therefore, nearly all projections of performance will be incorrect. However, there are several things that managers can do to improve the financial projections, their understanding of the dynamics affecting future performance, and the probability of achieving planned results. Multiple scenario and sensitivity analyses of financial projections will provide an understanding of how the key decision variables will be impacted under various scenarios and assumptions.

Another useful way to evaluate projections is to simply compare them to recent performance trends. For long‐term projections, it is always useful to compare projected results to an extrapolation of recent history. This is not to say that future performance cannot depart from historical trends, but it clearly presents the issue and would lead to identifying and reviewing the factors that would lead to the projected reversal. In the example provided in Figure 12.2, a slow decline in revenues is projected to reverse in the future. Notice how effectively the graph presents this comparison compared to the table. Evaluation of this forecast should focus on the factors that will lead to this sudden and dramatic change in performance. If we don't soon change our direction, we will wind up where we are headed!

Short‐term projections can be compared to recent trends and against last year's results. In Figure 12.3, we compare the weekly run rate of revenues year to date (YTD) to last year (YTD‐LY) and to the plan (YTD‐Plan), and compare the rest of year forecast (ROY) to last year (ROY‐LY) and to the plan (ROY‐Plan). This year's run rate of sales is slightly below last year's, but the forecast projects a significant increase over the same period last year and the plan. Again, what are the specific drivers that support the dramatic change from the past?

Another useful tool to evaluate forecast performance is to track actual performance against forecast amounts. Figure 12.4 shows the actual revenue level achieved compared to the forecast range for recent quarters.

Identify Assumptions, Risks, and Upsides to the Projection

Unless otherwise intended, managers should set the expectation that a projection should be the best estimate of the outcome under the present strategy and expected market and economic conditions. Some organizations clarify this expectation by using language such as “most probable” or establishing desired confidence levels. This base plan includes numerous assumptions, including the probability and estimated impact of potential events. It is useful to identify and present how these potential events have been reflected in the plan. For example, if the plan assumes a continued favorable economic expansion, then a potential downside would be an economic recession. Other downside events may include competitive threats or loss of a major customer or contract. A summary of upside and downside events is presented in Table 12.1.

In addition, to assess the potential impact on the financial projections, this analysis allows management to monitor these potential factors and to develop preliminary contingency and response plans.

The summary presented in Table 12.1 raises several concerns. First, the absolute value of downside risks is two times greater than potential upsides. Second, the probability of two downside events is quite high, 50% and 60%. This suggests the plan is unbalanced, with greater downside exposure than upside. Since two of the downside risks have at least 50% probability, these risks should be further evaluated and perhaps incorporated into the base plan.

Scenario and Sensitivity Analysis

Multiple scenario and sensitivity analyses provide context and insight into the dynamics of expected performance.

Sensitivity Analysis. This technique determines the sensitivity of an outcome (e.g. profit projection) to changes in key assumptions used in a base or primary case. Any projection or estimated value must be viewed as an estimate based on many inherent assumptions. Sensitivity analysis is very useful to understand the dynamics of a projection or decision and to highlight the importance of testing assumptions. For example, Figure 12.5 presents the estimated sensitivity of a company's profit projection to changes in a key assumption, the price of fuel.

Scenario Analysis. While a sensitivity analysis provides insight into the importance of one variable, a scenario analysis contemplates the effect of an event or change in circumstances. The scenario will typically require reevaluation of several different variables in the plan. For critical projections including plans, it is essential to run several different versions of financial projections; for example:

• Base Case: This is the most likely outcome.
• Extrapolation of Recent Performance: Provides a reference point to evaluate other scenarios.
• Conservative Scenario: A scenario reflecting lower expectations or downsides.
• Upside or Stretch Scenario: A scenario reflecting the potential of certain upside events.
• Recession Scenario: What will happen to the projections if a recession occurs?
• Competitive Attack.

Once scenarios are identified, projections are developed for each specific scenario. This is a critical aspect of scenario planning. Unlike sensitivity analysis, where we simply flex selected variables, we will revise the base projections for expected changes under the scenario. For example, in a recession, a company may experience price pressure and lower demand. That company may also experience different interest rates, labor rates, and commodity pricing.

Once alternative scenario plans are developed, these can be used to determine a range of potential outcomes. A “most probable” estimate can be calculated by weighting each estimated outcome by the probability of occurrence. Figure 12.6 presents a recap for various scenarios.

In Table 12.2, we illustrate the use of weighting a range of revenue levels by the estimated probability of each occurring. In this case, the analysis shows that there appears to be more downside than upside to the base forecast of $115,000.

Building on the Business Model

In Chapter 3 we introduced the business model as an analytical tool. Using this conceptual framework, managers will set prices, establish business plans, evaluate business proposals, set expense levels, and make other critical business decisions. For example, a company that is developing a product with a cost of $450 would likely set a target selling price of $1,000 to maintain a 55% margin. In establishing the research and development (R&D) budget, the company may target spending at 8% of projected sales.

The business model can be a useful way to initiate or to set high‐level targets for the operating plan, as illustrated in Figure 12.7. Starting with the actual or forecast results for the current year (2017), a preliminary model for 2018 can be estimated by maintaining key ratios and measures. Executives can then adjust this preliminary result for known or anticipated changes for 2018, for example increased revenue growth and expenses related to new product introductions.

The considered estimate can be used as a starting point or basis for setting targets and boundaries for the development of the 2018 operating plan.

Comprehensive Financial Picture

There is a tendency to evaluate business decisions solely based on the effect on profit and loss (P&L) or earnings per share (EPS). In order to provide a complete summary of expected financial performance, financial projections should include the P&L, balance sheet, and statement of cash flows. Exceptions would include limited‐scope exercises such as a forecast of quarterly EPS or expense savings.

Many decisions should be based on the economic analysis of projected results, including measures such as net present value and return on investment, and capital requirements and cash flow should be incorporated into the analysis. In addition, many projections will result in additional financing requirements or may test and even exceed existing debt covenants. Where important, these should be incorporated into the projections model and presentations.

The Value Is in the Planning, Not the Plan

While developing a plan is important, the far greater value is likely in the assessment of factors impacting the organization, critical thinking, and the ability to monitor performance against the plan. While financial projections are an important element of all decisions and plans, it can be argued that there is even more value created by the thinking necessitated in developing the financial projections. For example:

• Identifying critical assumptions that can be tested and monitored (an important management activity).
• Identifying and thinking through different scenarios and developing contingency plans.
• Understanding how critical management decisions impact the financial model and shareholder value.