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FINANCIAL PLANNING

It`s been said that a camel looks like a horse designed by committee. If a firm made all its financial decisions piecemeal, it would end up with a financial camel. Therefore, smart financial managers consider the overall effect of future investment and financing decisions. This process is called financial planning, and the end result is called a financial plan.

New investments need to be paid for. So investment and financing decisions cannot be made independently. Financial planning forces managers to think systematically about their goals for growth, investment, and financing. Planning should reveal any inconsistencies in these goals.

Planning also helps managers avoid some surprises and think about how they should react to those surprises that cannot be avoided. We stress that good financial managers insist on understanding what makes projects work and what could go wrong with them. The same approach should be taken when investment and financing decisions are considered as a whole.

Finally, financial planning helps establish goals to motivate managers and provide standards for measuring performance.

We start by summarizing what financial planning involves and we describe the contents of a typical financial plan. We then discuss the use of financial models in the planning process. Finally, we examine the relationship between a firm`s growth and its need for new financing.

After studying this material you should be able to

_ Describe the contents and uses of a financial plan.

_ Construct a simple financial planning model.

_ Estimate the effect of growth on the need for external financing.

What Is Financial Planning?

Financial planning is a process consisting of:

1. Analyzing the investment and financing choices open to the firm.

2. Projecting the future consequences of current decisions.

3. Deciding which alternatives to undertake.

4. Measuring subsequent performance against the goals set forth in the financial plan.

Notice that financial planning is not designed to minimize risk. Instead it is a process of deciding which risks to take and which are unnecessary or not worth taking. Firms must plan for both the short-term and the long-term. Short-term planning rarely looks ahead further than the next 12 months. It is largely the process of making sure the firm has enough cash to pay its bills and that short-term borrowing and lending are arranged to the best advantage.

Here we are more concerned with long-term planning, where a typical planning horizon is 5 years (although some firms look out 10 years or more). For example, it can take at least 10 years for an electric utility to design, obtain approval for, build, and test a major generating plant.

PLANNING HORIZON

Time horizon for a financial plan.