When referring to a Financial Plan as an integral part of a Business Plan, budgeting usually comes to mind. However, financial planning can be much more when done systematically and look at a forecast period beyond 1-2 budget years. Financial plans often focus on forecasting and analysing a company’s financial future. The forecast period typically covers at least five years and many times even longer time horizons.
1.0 Why does my Business need a Financial Plan?
Financial plans are needed to obtain more information about the future financial situation of a company for a forecast period of 5 years or more. Those plans are needed by big and small businesses alike. A financial plan translates a business strategy into measurable expected results. Very often, financial plans are prepared when starting a new business. They are needed to answer important questions which will be of high relevance to the financial future of either a newly planned venture or any business:
- What will be the sources of revenue?
- What will be the expected sales volumes?
- How much production capacity will be needed by when?
- What will be the prices for products and services?
- How is the business expected to grow?
- What will be the breakdown of revenues and profits?
- Which products/services will contribute how much to the expected profits?
- What costs do we have to expect?
- What profits do we predict?
- At what prices/volumes will we reach break-even?
- How much investment will be required?
- How much funding will be required?
- Which financing sources are we going to use?
- Is a business proposition economically viable?
- How attractive is our plan to investors?
- Will our plan be acceptable to banks?
- Should we invest or not?
- What is the value of our business based on this plan?
2.0 What are the Objectives of a Financial Plan?
Financial plans should describe the financial future and the underlying assumptions. The objective of financial plans includes topics such as quantifying revenues, growing a business, predicting financial performance, specifying assumptions, forecasting cash flows and financial ratios, fundraising from investors, bank financing, business valuations, investment analysis, allocating capital, understanding a business, performing financial (feasibility) analysis, financial decision-making and scenario analysis. This list only offers the shared objectives and by no means should be considered as including all potential topics financial plans can cover.
Developing financial plans can become very useful to understand better the financial future of a company or a project. In today’s business world, financial plans are widely used for making capital allocation decisions. They enforce management to quantify their business plans into measurable financial results so that investors can understand the financial implications. Stakeholders can also use financial plans as future references. Years later, the business owners and management can look back, and it allows them to compare how the effective results turned out vs the original expectations. Comparing previous plans to the actual result allows obtaining valuable conclusions to identify planning weaknesses to be taken into account when preparing a new plan.
Financial Plans also can be used to measure management performance. For example, by using the concept of Economic Profit by comparing the created value to the alternative of investing in the stock market. In addition, financial plans form the basis when using the Discounted Cash Flow (DCF) Valuation Method for business valuations.
Financial plans outline how a business is supposed to grow and create sustainable profits. The aim is to create value for shareholders and stakeholders. In addition, a financial plan aims to translate a strategy into a financial forecast so that its capital providers can easily understand it.
3.0 Definition of Financial Plan
Financial plans will differ from business to business, from project to project. Some plans will establish large manufacturing sites and build up distribution or marketing organisations. In contrast, other plans might focus on how to market content via the internet or study the construction of a new solar park. Every financial plan is different from business to business. What we need now is a definition of a financial plan. Here is how we define what a financial plan is:
“The financial plan describes the expected financial performance of a business, a project, or an asset and specifies the underlying assumptions. The plan offers comprehensive insights on what is expected to happen mid-to-long term and is essential in translating business strategies into measurable financial projections.”
As you can see, preparing a financial plan allows one to plan for growth and seeks to obtain deep insights into how a business creates profits and what the financial performance should result. In addition, a financial plan typically serves as the basis for any capital allocation decisions by business owners, investors, and banks.
4.0 Financial Plan vs Business Plan?
What is the difference between a financial plan vs a business plan? You might have noticed that many times in business, the word “business plan” is used simultaneously for a financial plan. The reason is that a financial plan should be part of a business plan. The business plan describes the company’s strategy, its planned positioning in the market, outlines what problem will be solved, the products and services to be delivered, what makes the company unique and how they will be marketed. The business also describes how the company will operate and what team will execute the business plan. The financial plan typically is added at the end and converts the business plan into numbers and projections. This allows capital providers to understand the expected financial performance of the envisaged business proposition. Therefore, investors and banks are often more interested in the financial plan than the business plan itself. Therefore, “business plan” is used as a financial plan proxy.
Read More: 7 Reasons Why Financial Models are Important
5.0 Bottom-up vs Top-Down Financial Planning
Financial plans can either be prepared using a bottom-up or a top-down approach.
- Bottom-up Planning: We talk about a bottom-up plan when forecasting the fundamental parameters of a business which, when combined, define revenues, costs, profits, and cash flows. Bottom parameters are factors that the company can directly influence. Examples are using prices, volumes, and costs per-product basis to prepare a financial forecast. Bottom-up planning looks at the specific situation of a business and uses observable parameters from the “bottom” to prepare the forecast. Bottom-up planning is more detailed and tedious than top-down planning.
- Top-Down Planning: Opposite to analysing the parameters from the bottom, we look at them from the top. Top-down parameters typically refer to parameters that are the results of a company’s actions. E.g., like the market share. So instead of using price x volumes to forecast revenue, we use market size x market share. Again, we use a global perspective in light of the likely results that seem obtainable. Top-down financial planning often is quicker to do. However, top-down planning fails to tell us exactly what we need to do to get the desired results, such as revenues.
The quality of a financial plan depends on which approach is being used. The bottom-up approach typically offers a better financial plan quality as it explicitly answers what we need to do and what parameters to influence to get the desired result. Parameters such as the market share will then be the output rather than the input of the financial plan.
6.0 When do you need to prepare a Financial Plan?
Preparing a financial plan takes time and effort. Therefore, a plan is mainly prepared on an “as needed” basis. Typically, there are several specific events where a financial plan will be needed:
- Starting a new Business
- Fundraising from Investors
- Bank Financing
- Business Valuations
- Sale or purchase of a company
- Shareholder buy-outs
- Investing in a Business
- Turnaround Situation
The one thing these situations have in common is that they require a financial decision. Given that a large amount of capital is at stake, a financial plan will be needed to justify this decision.
A common trap is already making such a decision before even analysing and preparing such a plan. In those cases, what happens is that the plan reflects a decision that has already been taken.
A better way is first to analyse a business proposition, prepare a financial plan, and then based on that plan, conclude. Sometimes we are not aware of this or forget it, but this is very important to be open and properly do the financial analysis before concluding.