A financial plan is a product used for guiding people’s actions toward the accumulation of wealth. As a product a financial plan is created from a variety of sources. One source used for creating a financial plan is accounting.
Making projections is one part of an FP&A practitioner’s work. The purpose of projections is to establish expectations on outcomes. How can an FP&A practitioner give meaning to projections?
An FP&A practitioner can give meaning to income projections. When working with entrepreneurs I emphasize a quote from an angel investor: “I don’t care what your idea is, I want to know how I’m going to make money.” Answering the angel investor’s question requires entrepreneurs to go beyond numbers when raising money. One way to go beyond numbers is through descriptive general ledger accounts like Sustainable Materials, LinkedIn Advertising, and Blockchain Training. Another way to go beyond numbers is through executive summaries that describe how startups will create, promote, and support what is sold. General ledgers and executive summaries are not the answer but an answer for giving meaning to income projections. Giving meaning to income projections only can be accomplished when words are used with numbers in a way to establish a story that readers consider credible.
An FP&A practitioner can give meaning to cash flow projections. When helping a startup raise money I found an extremely optimistic assumption about inventory; the assumption was the startup would sell its products on average within 4 days. Immediately I asked questions about this assumption and learned about their production and selling processes. What I learned about these processes was expressed in words rather than numbers. The words used to express these processes helped me not only understand but also highlight the assumption. Highlighting the assumption is important because it establishes a story about cash flow which in this case is cash flow will stand out due to effective inventory management. What one can take away is cash flow is numbers supported by words and words will give meaning to cash flow projections in a way to determine the projections’ usefulness.
An FP&A practitioner can give meaning to earnings per share (EPS) projections. I use EPS in this article because EPS is used by business networks like Bloomberg, CNBC, and Fox Business to educate their audience about quarterly results provided by publicly traded companies. Since EPS is used by business networks an FP&A practitioner has a resource for giving meaning to these projections. How can an FP&A practitioner use this resource? Business networks expand their presentation of EPS by telling stories about sales and/or expenses. The stories in large part are presented in a way that simplifies an understanding of what has happened as well as what will happen. As a result an FP&A practitioner can use content from these stories to enhance the quality of EPS projections in order to make them useful for stakeholders.
Projections are an important part of our lives because we want to know what will happen in the future. Numbers are not enough to help people know about tomorrow. As a result an FP&A practitioner should look to add stories to the numbers in order to give meaning to projections.
As an FP&A practitioner, I am called upon to make predictions on behalf of clients. Two of the more prominent predictions I am asked to make are Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA) and cash flows. I am asked to make these predictions in order to determine valuations and financing requirements.
What I describe above is precise in that it focuses on a specific type of entity, startups. Startups, however, are not the only entities that require predictions. Small businesses require predictions in order to determine the timing of cash flows for paying employees and vendors. Middle market companies require predictions in order to compete against smaller, more agile businesses or larger, wealthier businesses. Large businesses require predictions in order to exploit potential growth opportunities.
Businesses are not the only entities that rely on predictions; we as individuals rely on predictions to conduct tasks like going to work, meeting with friends, or dealing with adverse weather conditions. These examples serve as reasons for why prediction is important however I found other reasons that give it credence in our work as FP&A practitioners.
We Tend not to Take Prediction Seriously...
I found the other reasons in a book written by Nate Silver titled The Signal and the Noise. Nate Silver gained prominence in his work on predictions during the 2008 and 2012 presidential elections in the United States. His book addresses not only elections but topics like finance, sports, and weather. What may seem funny is the other reasons that I’m about the present do not come from the chapters in the book but praise for the book by Bill James; Bill James is most known for his work in transforming the way Major League Baseball games are played through his work with statistics. In his praise of the book, Bill James made two statements that I find relevant to the importance of prediction. The first statement is “Projection, prediction, assumption, trepidation, anticipation, expectation, estimation…we wouldn’t have eighty words like this in the English language if it wasn’t central to our lives.” The second statement is “We tend not to take prediction seriously because, on some level, we know that we don’t know.”
The Uncertainty is Real
Why do I consider Bill James’ statements so important? When we consider the first statement I previously provided a number of examples that support the importance of prediction but there’s one example that makes our work as FP&A practitioners vital. Our work focuses on creating insights into the strengths and weaknesses of the financial health within businesses and without these insights businesses will fail and stakeholders like employees and communities will suffer. When we consider the second statement we as FP&A practitioners must acknowledge that uncertainty is real. We must acknowledge that we don’t know for certain whether one customer or several customers will stay in business and that can mean sales predictions could turn for the worse. We must acknowledge that we don’t know for certain whether a service provider may institute price increases which can turn expense predictions awry or a supplier may discontinue shipments which can cause a ripple effect among production and selling functions. Bill James’ statements give us some food for thought: people want to know what tomorrow will look like but no matter how hard we try giving people a precise tomorrow is impossible.
Making predictions is an important part of our work as FP&A practitioners. Its importance is due to need but need can be hindered due to incomplete knowledge. Our work, therefore, must focus on maximizing the positive and minimizing the negative about prediction.
A Chart of Accounts as an FP&A Framework
In previous articles, I wrote about ways to improve financial reporting through financial planning and financial analysis. A foundation for financial reporting is a chart of accounts. A chart of accounts also can serve as a framework for FP&A.
A chart of accounts serves as a database containing records like account elements, account names, and account numbers. Examples of account elements are assets, liabilities, equity, revenues, and expenses. Examples of account names are cash, accounts payable, common stock, merchandise revenue, and cost of goods sold. Examples of account numbers are assets starting with the number one, liabilities starting with the number two, equity starting with the number three, revenues starting with the number four, and expenses starting with the number five through nine. These records serve as a foundation for the communication of financial statements however these records serve two additional purposes. The first purpose is to establish a framework for financial planning. The second purpose is to establish a framework for financial analysis.
A Framework for Financial Planning through Precision
A chart of accounts establishes a framework for financial planning through precision. Precision within financial planning through a chart of accounts focuses on account names. The use of account names can establish a descriptive manner in how businesses expect to earn income. Earning income from revenues can be described through account names like audit fees, jewelry sales, membership fees, out-of-pocket reimbursements, and smartphone sales. Earning income from expenses can be described through account names like accounting services, fashion show production, freight from drop shipments, LinkedIn advertising, and office stationery. Using precision through account names in financial planning can initiate the proper recording of transactions. Using precision through account names in financial planning also can initiate the proper evaluation of effort toward earning income.
A Framework for Financial Analysis Through the Process
A chart of accounts establishes a framework for financial analysis through the process. The process within financial analysis through a chart of accounts focuses on account names. The use of account names can establish the amount of effort taken. Using account names that describe broadly, for example, miscellaneous expenses will require more effort to learn about the nature of transactions. Using account names that describe narrowly, for example, laboratory equipment, will require less effort to learn about the nature of transactions. Is describing broadly better than narrowly or vice versa? The answer is neither.
Describing Broadly or Narrowly?
Describing broadly establishes a “top-down” approach to solving financial problems. Describing broadly can be used to focus on elements like revenues expenses, assets, liabilities, and equity. Elements like these can establish a starting point for identifying strengths and weaknesses in the financial health of organizations. Describing narrowly establishes a “bottom-up” approach to solving financial problems. Describing narrowly can be used to focus on elements like iPhone sales, Facebook advertising, printer cartridge supplies, California sales taxes payable, and Class A common stock. Elements like these can establish a starting point for making better decisions on specific activities that affect the overall financial health of organizations.
FP&A establishes the foundation for thinking and learning about how processes affect outcomes. These actions can be guided by broad and narrow framing. In order for FP&A to add value toward these actions, it must take an active role in establishing a framework through the chart of accounts.
Financial Planning helps Financial Reporting
Financial reporting is the process of describing how businesses earn revenues, incur expenses, and generate cash flows. An objective of financial reporting is to develop insights into profitability, liquidity, and solvency. One way to improve the ability in achieving this objective is through financial planning.
Financial planning can help financial reporting develop insights into profitability, liquidity, and solvency through a chart of accounts. A chart of accounts is a list of names used to record and communicate transactions. Transactions can be recorded and communicated broadly through assets, liabilities, equity, revenues, and expenses. Transactions can be recorded and communicated narrowly through cash, accounts payable, common stock, merchandise revenue, and cost of goods sold. Recording and communicating transactions broadly are processes dictated by organizations like the Financial Accounting Standards Board (FASB), International Accounting Standards Board (IASB), and Securities and Exchange Commission (SEC). Recording and communicating transactions narrowly are processes influenced by the actions of people within businesses.
Financial Planning guides actions
The actions of people within businesses can be guided by the role of financial planning.
Financial planning can guide actions within businesses based on how revenues will be earned. Financial planning can guide people to think about the types of products that will be delivered. Financial planning can guide people to think about the types of services that will be provided. Thinking about the types of products delivered and services provided can create flexibility within a chart of accounts. A chart of accounts can be organized to communicate revenues broadly, e.g. product revenue and service revenue. A chart of accounts can be organized to communicate revenues narrowly, e.g. food sales and tax services. Creating flexibility within revenues can help people assess strengths and weaknesses within customer relationships.
Financial planning can guide actions within businesses based on how expenses will be incurred. Financial planning can guide people to think about how products will be created, e.g. direct materials, direct labor, and manufacturing overhead. Financial planning can guide people to think about how products or services will be promoted, e.g. public relations, social media, and trade shows. Financial planning can guide people to think about how businesses will be supported, e.g. compliance, communication, and training. A chart of accounts can be organized to communicate these thoughts broadly through production, selling, and administration. A chart of accounts can be organized to communicate these thoughts narrowly through specific initiatives. Creating flexibility within expenses can help people assess strengths and weaknesses within internal processes.
Financial reporting helps people inside and outside businesses to assess financial health. The foundation in this effort is a chart of accounts. The effectiveness of a chart of accounts can be achieved by the role of financial planning.
Framing is how situations are presented to people. How situations are presented affect the decisions that people make. Framing has a role in the work of FP&A practitioners.
FP&A practitioners can work through narrow frames. Narrow frames can appear on income statements through revenues from specific products, executive salaries, and equipment depreciation. Narrow frames can appear on balance sheets through work in process inventory, interest payable, and common stock. Narrow frames provide an opportunity for FP&A practitioners to employ a bottom-up approach to their work. Employing this approach improves the ability to be precise in areas like financial plans.
FP&A practitioners can work through broad frames. Broad frames can appear on income statements through net income. Broad frames can appear on balance sheets through total assets, total liabilities, and total equity. Broad frames provide an opportunity for FP&A practitioners to employ a top-down approach to their work. Employing this approach improves the ability to think and learn about the value proposition that businesses have.
Finance is about wealth. Wealth can be measured in a number of ways. Measuring wealth is based on framing. Narrow frames like revenues from new customers or products, the average collection period, or the average age of inventory can provide insight into the ability of businesses to create wealth. Broad frames like net income, return on assets, and return on equity also can provide insight into the ability of businesses to create wealth. The key for FP&A practitioners is to manage biases, i.e. errors in judgment, when assessing wealth. One way for FP&A practitioners to manage biases when assessing wealth is to know which method of framing, narrow or broad, is more appropriate to use under certain situations.
FP&A is called upon to stimulate thinking and learning about how organizations earn revenues, incur expenses, and generate cash flows. Thinking and learning are processes that are subject to errors. Understanding the concept of framing can help FP&A practitioners minimize the effects of errors in their work.
A financial plan is a product used for guiding people’s actions toward the accumulation of wealth. As a product a financial plan is created from a variety of sources. One source used for creating a financial plan is economics.
The purpose of a statement of cash flows is to describe how businesses receive and spend money. This purpose is seen as an end result of financial planning but this purpose can be seen as a starting point of financial planning. As a starting point of financial planning, people should think about how to accumulate wealth from the receipt and disbursement of cash.