Custom Search

FINANCIAL PLANNING IS NOT JUST FORECASTING

Forecasting concentrates on the most likely future outcome. But financial planners are not concerned solely with forecasting. They need to worry about unlikely events as well as likely ones. If you think ahead about what could go wrong, then you are less likely to ignore the danger signals and you can react faster to trouble.

Companies have developed a number of ways of asking ¬what-if ­ questions about both their projects and the overall firm. Often planners work through the consequences of the plan under the most likely set of circumstances and then use sensitivity analysis to vary the assumptions one at a time. For example, they might look at what would happen if a policy of aggressive growth coincided with a recession. Companies using scenario analysis might look at the consequences of each business plan under different plausible scenarios in which several assumptions are varied at once. For example, one scenario might envisage high interest rates contributing to a slowdown in world economic growth and lower commodity prices. A second scenario might involve a buoyant domestic economy, high inflation, and a weak currency. The nearby box describes how Georgia Power Company used scenario analysis to help develop its business plans.

Contingency Planning at Georgia Power Company

The oil price hikes in 1973 Ј1974 and 1979 caused consternation in the planning departments of electric utilities. Planners, who had assumed a steady growth in energy usage and prices, found that assumption could no longer be relied on.

The planning department of the Georgia Power Company responded by developing a number of possible scenarios and exploring their implications for Georgia Power`s business over the following 10 years. In planning for the future, the company was not simply interested in the most likely outcome; it also needed to develop contingency plans to cover any unexpected occurrences.

Georgia Power`s planning process involved three steps: (1) identify the key factors affecting the company`s prospects; (2) determine a range of plausible outcomes for each of these factors; and (3) consider whether a favorable outcome for one factor was likely to be matched by a favorable outcome for the other factors.

This exercise generated three principal scenarios. For example, in the most rosy scenario, the growth in gross national product was expected to exceed 3.2 percent a year. This higher economic growth was likely to be accompanied by high productivity growth and lower real interest rates as the baby boom generation matured. However, high growth was also likely to mean that economic prosperity would be more widely spread, so that the net migration to Georgia and the other sunbelt states was likely to decline. The average price of oil would probably remain below $18 a barrel as the power of OPEC weakened, and this would encourage industry to substitute oil for natural gas. The government was likely to pursue a free-market energy policy, which would tend to keep the growth in electricity prices below the rate of inflation.

Georgia Power`s planners explored the implications of each scenario for energy demand and the amount of investment the company needed to make. That in turn allowed the financial managers to think about how the company could meet the possible demands for cash to finance the new investment.