Resource Management: 6 – Managing the Finances 1

Chapter 6

Managing the Finances 1

The Function of Financial Management: Integrated Planning and Control

Making the most of your resources

Before considering the practical elements of effective financial planning and management, we need to remind ourselves yet again that the key economic objective of the organisation is to make the ‘best’ use of its limited resources. From the outset we have stressed that the outcome of any financial transaction has to be judged in terms of its contribution to the declared corporate objectives. We can therefore say that the effective use of resources is the central purpose of financial management.

Focusing on resource (or ‘opportunity’) costs, rather than the more limited notion of monetary costs, helps to emphasise the point that financial management is not concerned with doing things as cheaply as possible; it is about getting value-for-money from limited resources. It also helps to explain why financial management is not simply the responsibility of the treasury or finance section of the organisation. Sound financial management has to be of concern to all those who make decisions that use up valuable resources. This means that it is also part of the remit of those operational managers who have responsibilities for managing departmental budgets.

 

The objectives of financial planning and control

Internal treasury management is concerned to:

  • provide the financial resources necessary for the organization to achieve its purposes;
  • manage the associated risks (organisational and financial) that might threaten its ability to achieve these objectives;
  • manage the financial assets in a way that ensures that they maintain their value;
  • manage the financial liabilities in a way that ensures that they remain affordable.

 

Why is financial planning and control important?

Because most businesses in both the private and public sectors see themselves as ‘permanent’ organisations, effective financial planning has to consider the future consequences as well as the current outcomes of putting money into the enterprise. This means that effective financial management involves:

  • adhering to current regulations and meeting past plans and promises NOW;
  • meeting current proprietary plans and prevailing societal expectations in the NEAR FUTURE;
  • adapting and developing to accommodate changing needs and demands in the INTERMEDIATE FUTURE; and,
  • surviving into the DISTANT FUTURE.

This idea of a series of interrelated time profiles lies at the heart of strategic financial management. Such a series of time profiles is sometimes conceived of as an integrated planning and control cycle that links the organisation’s long-term aspirations to its immediate activities. These financial time frames mirror those of the business planning periods discussed in chapter 1 (i.e. longer term ‘strategic’ and shorter term ‘operational’, see fig.2).

Converting the idea of the cycle into a management process involves asking different types of policy question and creating a cascade of documents differentiated by time, scale and specific detail.

 

The scope of financial management: the integrated planning and control cycle

Although all well run businesses seek to run their affairs strategically, different enterprises can take distinctly different approaches to financial planning and control and fig.6 should be regarded as a broad schema rather than a set framework that is appropriate to all organisations. In particular, the time periods are indicative only and they tend to merge into one another (see fig.5). However, in the discussion that follows the reader is encouraged to keep in mind this model of an integrated planning process. Sound financial management rests on an awareness of the different planning and control time horizons mentioned above and the direction of travel indicated by fig.5.

 

Fig.5 The flight from aspirations to actions

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The idea of an integrated planning and control cycle (fig.6) highlights the need to provide decision-makers with financial information that enables them to assess how current decisions will impact on future aspirations.

 

Fig.6 Financial planning integrated over time: the planning and control cycle

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The distant future period (up to 30+/- years)

Embraces the sorts of questions asked by lenders of long-term capital, the chief executive and management board. E.g. ‘What is our growth strategy?’ and ‘What is our corporate mission?’ This period also poses the question of how to account for the long-term replacement of the organisation’s fixed assets (depreciation).

Requires the production of a strategic plan covering the physical and economic lives of major assets, the period of long-term loans, and beyond. During this period the organisation might be expected to grow or amalgamate, and/or redefine its mission. The primary objective of this period is ‘survival’.

 

The intermediate future period (up to 10 years+/-)

Embraces the sorts of questions asked by investment project managers, lending institutions, and the management board. Includes identifying objectives that need to be achieved to fulfil the mission and how best to acquire funds for development and renewal.

Requires the production of a business plan (strategic), a corporate plan (operational), option appraisals (project planning), and risk registers (risk appraisal and management). The primary objective of this period is ‘adaptation’.

 

The near future period (up to 5 years +/-)

Embraces the sorts of questions asked by shareholders, service users and/or front-line managers about imminent price changes, product development, proposed maintenance and minor works schedules, and sources of short-term finance.

Requires the publication of budgets, cash flow forecasts and work schedules relating to specific projects, and committee minutes confirming policy decisions relating to the business and corporate plans. It also requires the periodic publication of performance indicators that measure trends and outcomes against the organisation’s declared objectives. The primary objective of this period is ‘meeting planned outcomes’ and ‘keeping promises’.

 

The present and recent past periods (annual)

Focuses on the immediate concerns of auditors, the regulator, front-line managers, and shareholders and current stakeholders.

Requires the production of annual accounts, financial statements, and annual performance measures. The primary objective of this period is ‘adherence to legal and good practice obligations’.

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Financial profiling and long-term financial planning

The system of financial management must give a high priority to the presentation of relevant financial data to management committees in ways that allow informed decisions to be made about current management issues, prospective projects and longer-term strategic aspirations.

 

Financial profiling

The strategic approach to financial planning involves establishing a ‘rolling’ analysis of current and future revenues, costs and investment needs that is termed ‘financial profiling’. A financial profile is a projection. It is a projection of the near and distant future seen from the perspective of the present. It charts anticipated costs and revenues based on present knowledge and current assumptions about the future. It provides a present day ‘snapshot’ of the anticipated financial future. The projection has to be based on a range of assumptions about such things as known and planned debt servicing charges, appropriate gearing ratios, building cost inflation, interest rates, expected maintenance, repairs and renewal needs (of the tangible assets and other fixed assets), planned rental and revenue flows, and other anticipated sources of income. As the projection moves further into the future it moves away from a zone of relative certainty into zones of increasing uncertainty. We have to be more and more circumspect about our assumptions as we move away from a relatively certain present towards an increasingly uncertain future.

The profiling approach seeks to enable managers and decision-makers at a particular moment to:

  • be certain about the immediate financial needs of the organisation, based on accurate information about the past, and firm assumptions about the current and near future accounting periods;
  • be clear about the intermediate financial needs of the organisation, based on provisional estimates of incomes and costs relating to that period;
  • have some conditional ideas about the long-term financial needs of the organisation, based on tentative assumptions about the distant future.

This static profile of the future, the ‘snapshot’, is made dynamic by establishing procedures that periodically check the assumptions. In this way, as time passes and we roll towards the future, financial plans can gradually firm up and become more concrete. At any point in time, different futures can be anticipated through appraisal techniques such as discounting and sensitivity analysis. (More about these later).

Although they do not normally describe detailed financial arrangements, projected plans should make some reference to how current loans are to be serviced, when fixed capital assets will need renewing or replacing, and how general institutional growth and change are to be paid for. Although the strategic plan takes the long view (± 30 years) it should be regularly revisited and revised in the light of operational experiences and changing circumstances. The act of reviewing creates a rolling process of change and modification (a moving film rather than a single snapshot) that we can call ‘profiling’. In this way a static projection becomes a dynamic process.

 

Long term financial planning

The long-term strategic planning period is sometimes called the ‘business planning period’. This is the time frame that a business needs to bear in mind when planning how to look after its tangible assets and pay off its long-term debts. Tangible assets are those property and other real assets that the organisation needs in order to run its affairs. In a retail chain, for example, the main tangible assets will be the stock of shops and associated offices. In a university they will include such things as teaching rooms, laboratories, common rooms, offices, etc. For accounting purposes, tangible assets have to be distinguished from investment assets. Investments assets comprise money reserves and any land bank that the enterprise might possess. Accounting conventions require tangible assets to be depreciated through time (unlike investment assets) to ensure that proper account is taken of their long-run refurbishment and replacement needs.

In a commercial business, the long-term planning period will be determined by the board of management and the executive team. In local authorities and arms-length management organizations (ALMOs) the regulator tends to set the long-term planning period at thirty years because this is seen as an appropriate period for the authority to develop its services and manage its tangible assets effectively. In many small businesses, the planning period is much the same because start-up loans tend to be negotiated over such a term (25-30 years). Clearly, any institution lending relatively large sums of money for such a period will want to see in place some form of business plan that covers the full length of this loan term. So we can say that long term financial plans are largely concerned with questions of long-run viability, overall asset management and renewal, and long-term debt management.

 

Intermediate term financial planning

Intermediate-term decisions about specific projects and policy initiatives (such as acquisitions and mergers, major repairs of tangible assets, or new building works) should be based on some form of financial planning that typically begins with the presentation of an option appraisal report and culminates with budgeting and cash-flow forecasting. An option appraisal report can be produced internally but is sometimes commissioned from external consultants who will have had experience of working on similar projects with other organisations.

Option appraisals are usually presented in a cost-benefit format that identifies, and in some way quantifies, all the relevant advantages and disadvantages of following one course of action as against others. The ‘costs’ and ‘benefits’ should encompass everything that is judged to be relevant to the corporate mission and strategy. This may mean that some rather intangible costs and benefits have to be included, such as staff morale, company reputation, and client or customer satisfaction. Because costs and benefits come on stream at different times, the report has to be put into a clear time profile that discounts the value of future costs and benefits back to a present value. There are many difficulties and problems associated with the production of a cost-benefit report and over the years a number of techniques and conventions have been developed to standardise their production.[1]

When commissioning a cost-benefit analysis (CBA), the housing practitioner, or the management board, needs to be aware of the strengths and limitations of this kind of appraisal. They also have to be clear that they, and not their consultants, have to be responsible for making the final decision. This means that such reports should not ‘make’ the decision about which option to follow, but rather act as a guide and source of information and analysis. A CBA should be regarded as a management tool that guides those who carry the ultimate responsibility for taking the option decision. Once decided upon, the selected option has to be budgeted for and cash flows have to be estimated.

 

Budgeting and planning for the near future

Budgets are intended to help the organisation ensure that, over a specified budgetary period, expenditure is met by income. The budgetary period may cover more than one financial year. Budgets are used to monitor and authorise expenditure and the collection of income. The budget process also enables the organisation to set and declare priority spending and to establish a rational sequence of spending events. More broadly, budgets can be used to co-ordinate different functions and activities, set targets, and provide a recorded basis for measuring performance and reviewing the organisation’s strategy.

There are a number of recognised approaches to budgeting. These include incremental budgeting, planning programming budgeting systems (PPBS), and zero-base budgeting. The incremental approach is commonly used in the preparation of revenue budgets. It involves making incremental adjustments to the previous period’s budget by focusing on those items that need to be altered because of changing circumstances, like inflation, new service agreements, salary increases, withdrawal of revenue grants. This is a largely conservative approach to budgeting as it assumes that, although circumstances will change, the basis of the business will continue much as before. It concentrates on making provision for changes in the external environment.

In contrast, PPBS focuses on the internal objectives of the organisation and identifies alternative ways of achieving these objectives. This approach is more relevant for capital budgeting where particular investment and reinvestment plans might be achieved by a variety of different spending programmes.

Zero-based budgeting takes a cost-benefit approach by comparing estimated outcomes with the costs of producing those outcomes. It extends the PPBS approach into a more overtly value-for-money analysis: as such, it is particularly appropriate where a commercial business is about to change direction. It would also be appropriate in a social business context where various levels of provision are possible for a variety of functions. It takes a strictly opportunity cost approach to spending by seeking to make explicit what would be gained or lost by spending ‘more here’ and ‘less there’. By giving a priority to value-for-money outcomes, this approach may point to the need to make significant changes to previous spending patterns. Although in line with the philosophy of resource accounting and budgeting (RAB), zero-based budgeting can be relatively expensive and time-consuming to establish and operate. As with any CBA approach, it also involves making value judgments about the value of one course of action as against another, and is open to a degree of political manipulation.

Budgets can be set at different levels (corporate, departmental, section). Once an organisation has reached a certain size, experience shows that some resource use decisions are best made by those who have direct managerial responsibility for the spending outcomes. A cost centre is a sub-division of the organisation that is used for planning and accounting purposes. Typically the manager of the cost centre will be the budget holder and, as such, will be held responsible for controlling and justifying the devolved budget. The principle here is that devolved responsibility produces more informed decisions and a more intelligent and flexible use of limited resources, and is therefore less bureaucratic.

Controlling budgets involves the management of cash flows. Because cash management is such an important aspect of financial planning and control, we will discuss it in more detail when we analyse the key elements of effective treasury management (see below).

 

Managing the present and the immediate past: standard accounts and financial statements

Shorter term financial information is presented in the audited accounts, appended notes, and accompanying financial statements. Two key accounts have to be kept by all businesses: these are an Income and Expenditure Account and a Balance Sheet.

A standard Income and Expenditure Account is a ‘real’ transactions account that records the movement of money into and out of the books. Unlike the financial accounts, it does not reflect ‘book’ transactions like depreciation, nor does it distinguish between capital and revenue transactions. The account is prepared on an ‘accruals basis’ which means that if some expenditure has been incurred and a bill is on its way, it will be included in the account. The same accruals approach is taken to income owed but not yet received. However, a prudent approach is taken and only sums known with certainty are included. The purpose of the accruals approach is to try and present as accurate a picture of the financial position as is possible.

A balance sheet is a statement featured in the annual accounts that indicates the value of the organisation’s assets and liabilities at the end of the accounting period, and the ways in which these have been financed. The main purpose of the balance sheet is to show the state of affairs of the enterprise at the year end date.

 

Financial statements

In addition to the two main accounts, the business has to produce a set of financial statements that give an indication to the management committee, and other interested parties, of the year’s transactions and how the organisation has fared financially over the accounting period. Among other things, these will explain how the current cash flow was generated and spent and how surpluses or deficits were dealt with in the accounting period.

The information presented in the accounts and their accompanying financial statements are necessarily detailed. The detailed requirements, should be published in a format recommended by the Financial Accounting Standards Board.[2] What the general reader needs to bear in mind is that the presentation of all this information is designed to guarantee accountability (transparency) and to allow informed decision-making to occur. Later we will consider the important question of risk management. It is worth making the point straightaway that the production and presentation of deficient, misleading or inaccessible information is bound to add to the risks of running a business.

[1] For a fuller discussion of these see Garnett, D. (1994), The Theory and Practice of Cost-Benefit Analysis, Bristol: University of the West of England. Reprinted in Housing and Society, leapingfrogpublications.co.uk (2017)

[2] The mission of the Financial Accounting Standards Board is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information

 

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