B. Strategic Financial Budgets/Forecasts What is it? - “If you can’t measure it, you can’t manage it”. A Budget or Financial Forecast is the translation of a business’ strategic plan into measurable quantities over a specified period.
- It takes the form of a Financial Model that presents the financial outcomes of the proposed business strategies over the period of the Plan.
- The Plan may be the annual budget in which case the forecasts are for 12 months or it may be a long term strategy in which case it will be multi-year forecast which usually goes out 3 – 5 years. Multi-year forecasts are usually required for financing, capital raisings and valuations.
Why do it? - It is an essential tool for owners/managers to achieve the business goals because it enables:(a) a rational approach to decision making. The financial implications of the alternative business strategies can be evaluated.
- planning for appropriate resourcing(
- monitoring progress against key performance indicators, and
- timely implementation of corrective actions or alterations to the strategy(ies) to achieve the goals.
Budgeting/Forecasting is a financial management discipline which should be adhered to even if you only intend to adopt a ‘steady as she goes’ strategy. You might not have growth plans but external shocks to the system can derail your strategy. How? Forecasting is NOT about predicting future certainties. No one can do that. Assumptions have to be made about the future and these assumptions should be critically assessed and tested before business plans are finalised. As such, the forecasting process is necessarily both chronological (Step 1 and Step 2) and iterative (moving to and fro between Steps 1 and 2). Step 1: The Building Blocks (a) Establish the strategic goals of the business. The existing and potential changes in economic/industry conditions and the strengths, weaknesses, opportunities and threats of the business should be taken into account. Some examples of issues to be considered in establishing strategic goals: - What revenue growth is being targeted and over what time frame?
- What improvements in profitability are being targeted and over what time frame?
- How are the goals to be achieved?
- Are there any factors that could threaten the achievement of the target(s)?
- Are there any potential changes in the economic or industry environment in the forecast period?
(b) Develop the Operating Budgets of the various functional units of your business eg Sales & Marketing, Production, Distribution, Corporate (Overheads). These are done both in Units (such as staff numbers, product and inventory units, etc) and dollar terms. Production constraints – whether in terms of people or production capacity – must be taken into account in establishing the Operating Budgets. If you need to hire more people or buy new equipment or rent new premises to achieve these targets, then these requirements need to be reflected in the Operating Budgets (and will also flow through to the Financial Budget). If various business strategies are being considered, the inputs which are specific to each of these strategies should be separately identified. Example: The goal is to achieve improved gross margins. Possible Strategies to achieve this goal: Strategy A: Continue to purchase from domestic (possibly different) suppliers on better terms. Can you extract better terms from domestic suppliers?
Strategy B : Source all product from overseas. Who? What does it do to lead times and inventory holding levels?
Strategy C: Introduce a new product line that has higher gross margin potential. What is expected customer take up? Does it open up new markets? Do you need different people or equipment resources to sell and produce this product?
Strategy D: A (defined) combination of A and/or B and/or C.
The Operating Budgets result in a Profit & Loss (excluding finance costs). (c) Develop the Financial Budget. This includes working capital cashflow, capital expenditure and balance sheet that result from the operating budgets. Financing decisions (ie whether to use debt or equity) are NOT made at this stage of the budgeting process. Step 2: The Master Budget. The Master Budget integrates the Operating Budgets and Financial Budget to provide a complete 3 dimensional view of the business - profit and loss, cashflow and balance sheet – that emerge from the assumptions associated with the underlying individual budgets. Alternative financing structures are also considered in the Master Budget. Some things to think about when assessing the Master Budget: - Do the proposed operational strategies deliver the overall goals of the business?
- Is there any “fat” in the individual underlying budgets?
- Will the proposed operational strategies stretch resources too thinly?
- Which strategy delivers the better outcome?
- How should funding be structured to ensure that financial risk is kept at prudent levels?
- Can the funding be achieved or should the strategy(ies) be revised?
- What could go wrong? What is the impact on the financials (especially cashflow) if the assumptions are not realised?
“What If” analysis and assumption testing: this is the iterative part of the process which involves ranging of the key variables within the Building Blocks and possibly making alterations to strategies. - Develop various Scenarios.
- Each Scenario represents certain defined strategies (or combination of strategies).
- Each Scenario and should have a High Case (optimistic but achievable), Base Case (most likely) and Low Case (worst case).
- Assess the implications on the forecast financials under each Scenario in its various Cases and decide the Scenario that will be the Business Plan to be executed.
- The Base Case of that Scenario will be the Budget against which actual performance will be measured. Base Case will be the business strategy to be pursued.
Forecasting Tools: Dynamic 3-Way Financial Models A Tailored Dynamic 3-Way Financial Model which incorporates Scenario modelling capability is essential to undertake the iterative process effectively and efficiently. The iterative process is absolutely critical in forecasting. Anything less than a Dynamic 3-Way Model renders the forecasting process cumbersome, laborious and potentially flawed. The Model must be tailored to the business as each business has its own specific issues and characteristics and no one business will be looking at identical opportunities or undertaking identical strategies at any one point in time. At In-Context Finance, we are experienced in working with businesses in constructing Dynamic 3-Way Financial Models that are tailored specifically to each client’s business. We build models that are: - “Dynamic” as distinct from "Static" because they allow for examination of various Scenarios and Sensitivity Analysis (ie High, Base and Low Cases). A Dynamic model, once constructed, enables changes to key drivers and accomodates new or alterations to strategies with minimal effort and time.
- “3-Way” in that they are based on the inextricable circular linkages between performance (Profit & Loss), Cashflow, and financial position (Balance Sheet). Cashflow, the single most important determinant of business success and survival, is dynamic in a 3-Way Model.
- Practical. The resultant budget can and should be used in monitoring progress and identifying the root cause(s) of any signficiant deviations from the Plan. Early problem identification enables early corrective action.
Contact us to discuss how we can assist you in developing practical financial models to assist your budgeting and business planning processes. | 
