The Business Roundtable, a group of Chief Executive Officers of nearly 200 major U.S. corporations, recently issued a statement with a new definition of the “purpose of a corporation”. The reimagined idea of a corporation drops the age-old notion that they function first and foremost to serve their shareholders and maximize profits. Investing in employees, delivering value to customers, dealing ethically with suppliers and supporting outside communities are now at the forefront of American business goals. Adopting the financial planning and reporting processes to this new reality does not require reinventing the wheel since many value-based concepts are readily available.
This is the time of the year where many corporations are spending significant time and effort preparing and debating their annual financial budgets. Most budgets (and for that matter, the associated forecasts as well) are prepared using well-known instruments such as driver-based planning, zero-based planning and factor-based planning.
Driver-based planning is a great instrument for revenue and direct cost. It is used extensively in production companies as it utilizes anticipated production volumes and sale & purchase prices to determine the revenue, direct costs and thus the gross profit.
Zero-based planning is a great instrument for variable indirect cost. It allows for a stringent cost control and a proper debate about where and why money is spent. A typical example is a marketing budget, where the planning of individual marketing campaigns enables a transparent decision for which one(s) to approve.
Factor-based planning is generally used for fixed indirect cost or the more immaterial components of a cost budget. Third-party services, for example those related to an outsourced company canteen, generally are subject to an inflation adjustment year on year. Most planners would apply such a straightforward inflation factor to arrive to their cost budget.
A budget organized around income statement does not necessarily contribute to value-based corporate financial planning
Existing planning instruments mostly apply to the income statement. Corporations should ask themselves if their financial planning process is really value-based. Value-based corporate financial planning focuses on what matters most – enhancing the corporation’s net worth for all its stakeholders. Having a budget process organized around income statement does not contribute to that objective. Successful value-based corporate financial planning introduces two additional elements: a (better) understanding of the underlying non-financial value drivers and (better) cash flow planning capabilities required for resource allocations.
Non-financial value drivers
The most relevant of all probably is establishing a good understanding of the underlying non-financial value drivers, or ‘pre-financials’ as they are sometimes called. While volumes and prices explain the basic mechanics behind income and expenses, companies should really be asking themselves what determines their success both in the short and the long term. The Integrated Reporting framework offers a handy toolkit to channel the search for, discussion about and reporting of non-financial value drivers. It presents human capital, intellectual capital, social & relationship capital and natural capital in addition to the classic financial capital (the funds provided to the company) and manufactured capital (the net assets employed by the company). There are merits in the understanding of how non-financial capitals fuel the company’s performance and as such, why companies should allocate resources towards the improvement of those non-financial capitals. This includes the Business Roundtable objectives related to investing in employees, delivering value to customers, dealing ethically with suppliers and supporting outside communities.
Cash flow planning
Cash flow planning is important to understand and decide on resource allocations in the short term for the benefit of value creation in the long term – like it or not, but cash still is king for commercial enterprises. Surprisingly, successful cash flow planning is heavily dependent on a more business-oriented view on balance sheet. Where most companies tend to stick to the ‘GAAP’ format for balance sheet, a ‘Capital Employed’ format provides for a more natural presentation of working capital and other operating activities, tangible assets and other investing activities, and equity & net debt as representatives of financing activities. The biggest challenge therein is the definition and management of working capital. It is important to getting to the bottom of the logical correlation between income and expenses on the one hand, and receivables and payables on the other hand. This often leads to more enhanced definitions of working capital, for example by breaking down into ‘primary’ or ‘trade’ working capital (directly influenced by the degree of operating activities) and ‘secondary’ or ‘non-trade’ working capital (not influenced by the degree of operating activities).
Value-based corporate financial planning is not a myth. There are good examples of companies that successfully apply value-based concepts. It entails a broader view on performance management – with the Executive Board leading by example. If companies choose to dilute their focus on operating profit in favor of non-financial value drivers and cash flow, a much richer debate on corporate performance management is the logical consequence. Those nearly 200 CEOs whose Business Roundtable recently announced their new definition of the “purpose of a corporation” do not have to search long for the planning instruments to help achieve their ambitions!
Casper van Leeuwen is Executive Partner at Satriun, an international Corporate Performance Management consultancy with offices in the Netherlands, Belgium, Switzerland, France, Germany, Romania and Israel. Satriun advises large corporations in the areas of financial consolidation, budgeting & planning, and management reporting.
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Please contact Casper on +31 6 13 08 49 72 and Casper.van.Leeuwen@satriun.com