FINANCIAL MODELING:
A KEY PART OF THE STRATEGIC PLANNING PROCESS
Most CEO’s have correctly concluded that success requires constant change in what a business does and how it does it, an ongoing and well thought out response to constant changes in the marketplace. Many CEO’s have also come to recognize the benefit of having a strategic plan in place to help identify the timing and nature of changes needed to succeed. And some CEO’s have come to realize, through experience, that a good strategic plan can make the difference in meeting growth objectives, or surviving the storm.
In developing a strategic plan, it is important, if not critical, to make financial modeling a part of the process.
Strategic Planning – Overview:
Developing a strategic plan is a “top down” process, starting with an analysis of how a business “fits” within its marketplace. Once the business’s current position is defined, it is compared to what is seen as an achievable and better position, the new strategic objective, found through an analysis of market risks and opportunities compared to business strengths and weaknesses. The strategic planning process then lays out the steps that need to be taken, a series of sub-objectives, which represent the path to this new spot on the marketplace map, the strategic objective.
There is more than one way to get from point A to point B, and development of the strategic plan is akin to designing a tower out of blocks. It is important to start with a strong foundation, and to carefully choose the what, when and where as new pieces are progressively added, each block filling an identified need. The choice of blocks, and the choice of when and where to add that block, represents the execution strategy.
Last and certainly not least, the strategic plan must be interpreted and tested in a financial forecast, or business model. If expertly created, this model will provide a detailed picture of the strategy, answering questions about feasibility, and defining the expected business value created by any particular strategic plan. And perhaps most importantly, it also becomes a basis for budgeting, and for monitoring performance as you move toward the objective.
Strategic Objective:
The selection of a strategic objective involves two main types of analysis:
• A market assessment – Identify the broader, big picture risks and opportunities that exist in the marketplace given the nature of customers and competition, who and what they are today, but also who and what they may be tomorrow, how the market may change. The key purpose of the assessment is to identify trends in supply, demand, margins and customer preferences, and other market characteristics that represent either a risk or opportunity, things to be taken advantage of, or avoided, through management choice.
• A business assessment – Identify the strengths and weaknesses of the business, the things that make it unique in comparison to others in its marketplace. Unique characteristics can give a business an edge over the competition, a strength to exploit, or can represent a limitation, things that need to be overcome or avoided when choosing the path forward.
The combination of this market and business assessment provides a strategic framework, a map of the terrain, with a pin stuck into the position a business is in today, and another for where it wants to be tomorrow. The location of that second pin should be reasonably achievable, a “best fit” of a particular business in its marketplace given its unique strengths and weaknesses. And the financial returns promised by achieving that position should be commensurate with risks that must be assumed to reach that position. In comparison to the selected objective, any other position in the market would represent either taking more risk without sufficient additional reward, or a reduction in reward without realizing a sufficient reduction in risk.
The marketplace is fluid, and new risks and opportunities will be presented over time. Having created this strategic mapping, a business has a frame of reference, a tool that helps recognize key marketplace changes, and can help determine how its strategy might need to be changed in response to developments in the market. Management’s ability and willingness to “pivot” can be a key determinant of success.
Execution Strategy:
With an objective defined, the strategic planning process must then identify the best means and method to get from point A to point B, the business’s execution strategy. As if constructing a building, the process begins by defining the foundation of the business, and identifying the building blocks that move the business toward its strategic objective. When adding building blocks, choices on timing and positioning can be as important as selecting the block itself. Decisions to add one block before another, or position a block next to one, or on top of another, can determine the stability of the business, and what the business can become.
Every business is made up of a distinct set of functional characteristics, or critical components, including:
• Brand
• Products and/or Services
• Production
• Distribution
• Customers
• Capital
There are many ways for a business to fulfill each of these critical, functional components. And there will likely be more than one combination of components that could create a business with the desired characteristics. In selecting components, the key is to create a total package of operational, marketing and financial strengths that enable management to generate profits, and successfully react to the inevitable changes they will face in their marketplace.
Assembling the targeted components will not happen overnight. The components needed to create a business reflecting the strategic objective are acquired or developed over time. The execution strategy must therefore give each component a relative prioritization in comparison to all other components. And that prioritization will reflect the position of each component in the “design” of the business, and its relative importance in achieving the end objective.
The result is a set of sub-objectives, laid out in a relative order of both importance and timing. And it is this ordering, and the financial characteristics of the ordering, that define the level of risk assumed in the execution strategy. The optimal ordering of sub-objectives will balance the risks assumed against the rewards expected upon achieving each sub-objective, taking into consideration:
• the time and investment needed to acquire or develop each component,
• the likely reaction from customers and competition to “component building” steps taken
• the impact of having one component on being able to acquire or develop another
Financial Model:
Creating a financial model is the last, but no less critical, step in the process of developing a strategic plan. The model is essential to defining the financial implications of the execution strategy, and in particular, how much risk and reward is inherent in plan.
The process of identifying a strategic objective and defining the execution plan is, by definition, based on somewhat general, broad concepts. But the financial modeling exercise is all about details. Assumptions and expectations that led to a choice of an objective and the design of the execution plan are turned into specifically defined revenues and costs, laid out over time.
In combination with these revenue and cost details, the financial forecast also reflects the business component choices made, and the ordering of sub-objectives. The prioritization and time required to achieve each sub-objective is specifically laid out, enabling a calculation of expected growth rates, funding needs and returns on investment, all based on what profits and cash flow the execution strategy is expected to generate. If not for the financial forecast, it would be impossible to see with any specificity how feasible the execution strategy really is, and whether or not the strategy is likely to meet return objectives.
Results from the initial modeling of the execution strategy may lead to a need to make changes in the plan. For example, the plan may call for offering discounted pricing to gain a foothold in a new market. The model may point out that this will lead to operating losses, and an unacceptably low level of liquidity. In light of this knowledge, management may want to defer the new market entry until internally generated capital is available to support the discounted pricing strategy, or it may want to alter tactics, relying on a more aggressive marketing campaign as opposed discounted pricing. The financial model provides a means to very specifically test this kind of change in execution strategy, and identify the best path forward.
Also, results from the initial modeling might show that the strategy does not meet return objectives. For example, the plan may call for heavy investment in plant and equipment at an early stage. In order to fulfil that sub-objective, a sale of equity may be required to meet the funding need. Control of productive capacity may well be key to the strategy, but the financial model may show that pursuing that objective too early would result in an over-dilution of existing investors, reducing returns to below acceptable levels. As an alternative, management may utilize contracted manufacturing facilities to meet production objectives, and alter the pace of investment in its own plant and equipment, using its own profits as opposed to a sale of equity to fund investments in P & E. The financial model can specifically test how such a change would affect growth rates, profitability and investor returns.
The financial model is uniquely suited to defining and testing how the business will meet its funding needs, the capital component of the execution strategy. Capital comes in the form of internally generated funds (profit), debt (with various lender alternatives available) or equity (which can be offered in combination with debt). The cash flows expected from any given execution strategy are specifically laid out in the model, and if the strategy results in insufficient profits to meet capital needs, the business must meet the need by raising debt or selling equity. The financial model provides a means of testing the risk and return impact inherent in using one capital source vs another, including its form and structure.
And lastly, the financial model provides a means of testing resilience of the strategic plan to changes in market conditions. New competition may place pressure on margins, or a weak economy can cause delays in meeting revenue targets. By changing the amount or timing of revenue and profitability assumptions, market changes can be simulated in the financial model to test how “stress resistant” a given strategy may be. A high degree of sensitivity, be it in terms of liquidity or other financial measures that define financial health, suggests a high degree of risk, and a likely need to adjust one or more component of the strategy.
If the financial model is expertly prepared, it can be the most valuable tool in a CEO’s toolbox. It is essential as a means of testing the feasibility management’s plans, how objectives are to be achieved. It is also essential to identifying changes that may need to be made in the plan to eliminate unacceptable risks, and improve returns. And as the business evolves, the model provides a means of monitoring progress and making adjustments to meet performance targets, and the strategic objective.
With a financial model in hand, a CEO has the information needed to make good decisions, pinpoint potential problems, and make changes in what the business does, and how it does it, before it’s too late.
JCJCo provides outsourced CFO and business consulting services to entrepreneurial and high growth companies. We help our clients develop performance metric measurement and management systems that reflect the client’s strategy, and delivers essential information needed by the business owner or CEO to monitor performance, make business adjustments, and meet growth objectives.
