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Financial Planning Models

Financial planners often use a financial planning model to help them explore the consequences of alternative financial strategies. These models range from simple models, such as the one presented later, to models that incorporate hundreds of equations. Financial planning models support the financial planning process by making it easier and cheaper to construct forecast financial statements. The models automate an important part of planning that would otherwise be boring, time-consuming, and laborintensive. Programming these financial planning models used to consume large amounts of computer time and high-priced talent. These days standard spreadsheet programs such as Microsoft Excel are regularly used to solve complex financial planning problems.

COMPONENTS OF A FINANCIAL PLANNING MODEL

A completed financial plan for a large company is a substantial document. A smaller corporation`s plan would have the same elements but less detail. For the smallest, youngest businesses, financial plans may be entirely in the financial managers` heads. The basic elements of the plans will be similar, however, for firms of any size. Financial plans include three components: inputs, the planning model, and outputs. The relationship among these components is represented in Figure 1.16. Let`s look at these components in turn.

Inputs. The inputs to the financial plan consist of the firm`s current financial statements and its forecasts about the future. Usually, the principal forecast is the likely growth in sales, since many of the other variables such as labor requirements and inventory levels are tied to sales. These forecasts are only in part the responsibility of the financial manager. Obviously, the marketing department will play a key role in forecasting sales. In addition, because sales will depend on the state of the overall economy, large firms will seek forecasting help from firms that specialize in preparing macroeconomic and industry forecasts.

The Planning Model. The financial planning model calculates the implications of the manager`s forecasts for profits, new investment, and financing. The model consists of equations relating output variables to forecasts. For example, the equations can show how a change in sales is likely to affect costs, working capital, fixed assets, and financing requirements. The financial model could specify that the total cost of goods produced may increase by 80 cents for every $1 increase in total sales, that accounts receivable will be a fixed proportion of sales, and that the firm will need to increase fixed assets by 8 percent for every 10 percent increase in sales.

Outputs. The output of the financial model consists of financial statements such as income statements, balance sheets, and statements describing sources and uses of cash. These statements are called pro formas, which means that they are forecasts based on the inputs and the assumptions built into the plan. Usually the output of financial models also include many financial ratios. These ratios indicate whether the firm will be financially fit and healthy at the end of the planning period.

PRO FORMAS Projected or forecasted financial statements.