While companies often have various future plans, financial sketches, and "napkin-level" strategic estimates, a detailed, precise budget, especially a long-term one, is less common. However, regularly developed future operating plans and financial flow forecasts significantly facilitate management and owner decision-making, help achieve intended goals, attract creditor or investor funds, and successfully sell the company.
Surprisingly, many large Latvian companies do not budget for the next year, let alone two, three, or five years ahead. If they do, it's often approximate – created to cover some ad-hoc needs (for example, a bank has requested a financial plan for the next year).
This leads to logical questions in practice:
- Why plan financial flows? What does it provide?
- Why plan beyond the short term or, at most, a year?
- Why plan in detail?
The Significance of Financial Plans in Practice
Financial flow planning serves both external and internal needs. Just as financial statements are prepared to reflect past events in numerical terms, planned financial flows reflect a fact-based management view of revenue, expense forecasts, and resource needs for forecast execution.
Similarly, past actual and future planned cash flows help fulfill business intentions. Even if plans don't materialize as intended, they reflect decisions, resources for generating revenue, funding for plan execution, and results, as well as providing understandable and explainable reasons for deviations.
The Significance of Plans for External Users
In practice, there are several instances where external users need to review a company's financial plan.
- To assure potential buyers of the company's true value:
- Potential buyers need to see if the company has planned its operations (what were the approved budgets) and what results have been achieved. Consistency in plan execution increases the company's value. Why? Because buyers are apprehensive, unfamiliar with the company and its management. Regular planning and plan execution increase confidence that the company's owners and management know what they're doing and are selling a functional, profitable asset.
- For external financiers to understand expectations:
- Banks will want to see the annual budget and medium-term business plan of the company they're lending to. While the loan price – reflecting the company's risk in the financier's eyes – is traditionally assessed globally based on the probability of repayment (e.g., by determining a credit rating or calculating the Altman Z-Score coefficient – using historical financial indicators), quality plans give financiers confidence that the company knows what to expect and how to achieve its goals.
- Audited financial plan for obtaining fund financing:
- While not common practice in Latvia, particularly when seeking funds from European Union funds, such as future innovation funds, the funder may require a financial auditor-reviewed and verified company financial plan. Therefore, a quality plan is needed, which the auditor then audits and provides an opinion on.
The Significance of Plans for Internal Users
Financial plan preparation is also significant for internal users. Inside the company, financial plans:
- Allow for the specification of goals and the allocation of limited resources to achieve those goals – in the short term and strategically.
- There may be grand and ambitious ideas, but planning clarifies whether there are sufficient funds. This opens up options – to change plans or find funds (the deficit can be determined from financial plan calculations) – or, most often, to change plans and find funds. It clarifies who, what, why, and how.
- Reinforce discipline within the company and provide an opportunity to control plan execution.
- When budgets and financial plans are approved within the company, it's clear who is responsible for what. In this case, spending can be evaluated in the context of achieving the goals outlined in the plans, and actual results, compared to the budget, allow not only for the identification of deviations but also for understanding the reasons.
Therefore, a quality financial plan – both annually and over several years – is strategically useful.
How to Plan Financial Flows?
This article won't delve into every element of financial plan creation – thick books have been written on that – but will focus on some essential, perhaps less labor-intensive, aspects that help both create and evaluate a quality financial plan.
Historical Data Analysis
Before future planning, it's essential to understand what's happening in the company and why. The higher the quality of the accounting system, the more reliable and usable the results, and the better the ability to justify near and long-term plans.
It's particularly helpful if the company accounts for its work logically in non-financial units as well – in terms of volume completed/sold. One might even say that every company has that "one number" to which financial results are related to determine efficiency and forecast the future.
Example
A hotel's operations generate revenue both annually and monthly. The number of hotel rooms is known, from which the average revenue per room [1] coefficient can be obtained (revenue divided by the number of rooms). It's also known how many hotel rooms are used out of the potential (out of 100%).
Revenue = number of hotels x average revenue per room x actual room occupancy rate.
Of course, this can be supplemented, for example, hotels also generate revenue from services, catering, and additional services. Revenue can be seasonal – and in seasonal businesses, it's better to analyze data in shorter periods (months, quarters) rather than for the entire year.
Similarly, it's possible to analyze direct costs, such as the direct and indirect maintenance costs of hotel rooms. The difference between revenue and direct costs is gross profit. Fixed costs – both depreciation of fixed assets and sales, administrative costs, and other fixed payments – are then covered from it. In planning, it's crucial to separate fixed and variable costs, and this ratio can vary significantly across different sectors.
Of course, the classification in each case corresponds to the company's operating model, but the essence remains the same.
Even if the company doesn't have this "one number," accounting often occurs at the department, structural unit, or project level – and this analysis is also a good basis for future forecasts.
- Growth that's faster than the economy – whether of a company or an industry – cannot continue indefinitely, because – purely mathematically – the company will eventually outgrow the world, which is not realistic.
Historically, it's also necessary to evaluate the balance sheet and cash flow – how exactly the company has obtained funds for its operations (shareholder funding, retained earnings, loans, deferred payments to suppliers) and how it has used them (fixed assets, current assets), and assess the cost of providing these operations (e.g., loan interest; frozen funds from holding large inventories to secure better prices from suppliers; etc.).
Therefore, analysis should be performed by breaking down the traditional accounting profit and loss statement – separately evaluating long-term investment depreciation and interest costs. In fact, the goal is initially to understand earnings before interest, taxes, depreciation, and amortization (EBITDA) and then analyze other costs.
Similarly – related – "intangible resources" – employees, intellectual property – should be evaluated, as any resource can be expressed in monetary form – reflected in historical financial data and forecasts.
To create a quality financial plan, it's necessary to know what and why is happening today, what and why happened yesterday. Start with analysis.
Profit and Loss Plan
Based on historical data analysis, knowing what the company expects in the near future, what the plans and intentions are, it's possible to create a financial plan – a budget for the next year, a detailed plan for the next 3–5 years, and, preferably, a longer-term plan for the more distant future.
Example
Returning to the hotel example, planning is relatively simple – just plan the same coefficients/indicators that were calculated/obtained from historical data analysis – but for the future.
Accordingly, it's possible to plan the number of hotel rooms, occupancy, and average revenue. At this level, it's also possible to assess the realism of the plans, for example, by comparing them with historical indicators and the market. Historical occupancy rates for hotel operations can be obtained from Latvia's official statistics portal Stat.gov.lv. When planning your hotel's operations, you can compare its historical data with historical data for Riga.
Accordingly, if the hotel has historically performed better than Riga hotels overall, there's a basis for planning such a better result in future forecasts, but it's also clear that planning unrealistic forecasts is pointless – they won't materialize. And unrealistic plans will quickly be revealed by both life itself – the plans won't materialize – and a smart external plan reader – will notice the logical flaws.
Other revenue and expense items can be planned similarly – expressed in monetary terms, they are included in the profit and loss plan.
The future profit and loss plan is also initially created at the EBITDA level and then supplemented with long-term investment depreciation amortization costs and interest costs. Why? More on that later in the text.
Investment Plan
Without resources that generate turnover, profit plans are not executable. Some resources are directly reflected in costs – labor, subcontractors, leased items, raw materials. Some resources become the company's property. For example, premises can be leased, but premises can also be owned. The business can be equivalent in both cases, but the costs are different and their reflection in the financial statements is also different.
Resources acquired as property are traditionally fixed assets and current assets.
Fixed assets – these are resources acquired for a longer period (calendar year) and are gradually reflected in the profit and loss statement – by showing depreciation. Historical financial analysis helps understand whether the company has sufficient fixed assets to support operations or whether investments are needed. These can be divided into two large groups – investments to maintain existing capacity and growth investments – to increase turnover and/or develop new activities, products, markets. It's crucial to plan these investments in the budget and multi-year financial plan, justifying their volume, necessity, and timing.
Therefore, financial plans start with EBITDA calculation and then, for profit calculation purposes, add depreciation costs – as it consists of depreciation from both existing assets and new investments. Moreover, depreciation costs are usually not proportional to turnover changes and are therefore projected as a separate element (although in a standard accounting profit and loss statement, a significant portion of production costs for gross profit calculation is depreciation).
Current assets – this essential resource, which requires financing and generates turnover, is usually overlooked.
Example
A wholesale distributor supplies construction companies with specific components. Although most goods are purchased to order, a significant portion is also kept in stock – the company has purchased inventory for sale – and historical data analysis has shown that the inventory covers an average of 30 days (a month) of the company's operations. In other words, the company's funds are invested in inventory for an average of 30 days a year.
As the goods are sold to construction companies, often specialized subcontractors, the cash flow schedule from the customer is long – from the customer to the general contractor, from the general contractor to the subcontractor, from the subcontractor to the supplier. Historical data analysis has shown that customers pay the company for the delivered goods within an average of 3 months, i.e., 90 days.
Deferred payments reduce current asset needs – the company receives goods on credit from its suppliers (manufacturers). Historical data analysis shows that the average payment period is 30 days.
Thus, the company finances inventory on the balance sheet with deferred payments to the supplier, but it needs to finance current assets from other sources.
And then, when creating financial plans, it's concluded that there's an opportunity to increase turnover by 25% next year. With a historical turnover of EUR 5,000,000, this means a EUR 1,250,000 increase in turnover and – hopefully – profit. But additional turnover will mean additional accounts receivable – profit will be generated from the recognition of sales invoices in the company's accounting, and the company's bank account will receive it only 3 months later. With a 25% increase in turnover, accounts receivable will also increase by 25%, from EUR 411,000 in the previous financial year to EUR 514,000 in the planned financial year. This means that the company will have to find an additional EUR 103,000 to "freeze" in current assets to ensure the planned increase in turnover and profit.
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Even if plans don't materialize as intended, they reflect decisions, resources for generating revenue, funding for plan execution, and results, as well as providing understandable and explainable reasons for deviations.
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The need for current assets doesn't appear directly in the profit and loss statement but indirectly. For example, to reduce it, the company decides to lower prices for customers, asking for faster debt repayment – profit decreases. Or it asks suppliers for a longer deferred debt term – again, profit decreases. Or the owner cannot withdraw dividends because they are used to finance current assets. Or a bank loan has to be taken, thus burdening the company's assets and incurring interest costs – which are directly included in the profit and loss plans.
Cash Flow Forecast Result
The result of compiling all plans in the form of projected financial statements reflects the company's planned operating result – whether the cash balance increases or decreases. In the first case, the cash surplus is included in the projected balance sheet to balance it. In the second case, additional financing – usually investments or loans – is sought and shown in the forecasts.
Of course, business is planned to increase cash flow, but it doesn't happen evenly and immediately.
Budgeting and long-term cash flow planning allow you to see in black and white what is required of the company and its management to achieve the business goal in the long term – profit and, more importantly, a positive cash flow in the aggregate projected future. To reiterate, a quality budget and long-term cash flow forecast help reliably understand where the company is heading, what it can achieve, and what resources – both tools and financial sources – are needed to achieve the goals.
Time Horizon
There's often a question about how long a period to plan cash flow for. The answer depends on the company's market position – whether it's growing with the economy or whether growth is happening faster or slower.
If it's already growing slower than the economy, there are two options in planning – to plan for decline and termination/sale/transformation or to plan for a "rebound" and further growth or stabilization.
If the intended growth is in line with the economy, there's no point in planning long-term cash flows, but a budget is (though it indicates that the company's management has no ideas for long-term growth). In this situation, it's necessary to decide what the expected annual stable growth rate is – usually the long-term economic growth or projected inflation rate. This forecast is used in the capitalization method for valuation and the calculation of the so-called "terminal" or "terminal" value, and it's often used in commercial real estate valuations.
On the other hand, if the company is naturally (on its own, without considering acquisitions of other companies) growing faster than the economy, it can happen based on one of two factors (or a combination of both): the company's operating sphere is growing faster than the economy and/or the company's market share is growing faster than its competitors.
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Growth that's faster than the economy – whether of a company or an industry – cannot continue indefinitely, because – purely mathematically – the company cannot expand beyond global space and time.
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Therefore, the answer is to forecast cash flows forward for as many years as reliably needed to reach the general economic growth rate.
Detailing varies:
- The first year should be forecast very accurately – essentially, a budget should be created;
- 2–5 years should preferably be forecast in considerable detail, indicating the main revenue and expense items – the forecast content is similar to a budget summary;
- If after 5 years there's still no certainty that growth is stabilizing or it's clear that growth can continue, but there's no point in looking at revenue and expense items in detail, then for a certain period, you can plan in broad strokes – plan the annual growth rate to reach the economic growth rate, plan profit as a certain percentage of turnover, and further justified detailing is possible, for example, in fundraising or dividend payout.
[1] In professional international terminology, ARR or RevPAR, or ADR – allows comparison of the efficiency of different hotels.
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