Lecture Notes - Financial Planning

Financial planning means deciding in advance, the financial activities to be carried on to achieve the basic objective of the firm. The basic objective of the firm is to get maximum profits out of minimum efforts.

So, the basic purpose of the financial planning is to make sure that adequate funds are raised at the minimum cost (optimal financing) and that they are used wisely. Thus planners of financial policies must see that adequate finance is available with the concern, because an inadequate supply of funds will hamper operations and laid to difficulties. Too much capital, on the other hand, means lower earnings to the unit holders. A proper planning is therefore necessary.

Main Aspects of Financial Planning

There are three main aspects:

Determining Financial Objectives 

The main aspect of financial planning is to determine the long-term and the short-term financial objectives. Determining of financial objectives is necessary to achieve the basic objectives of the firm. Financial objectives guide the financial authorities in performing their duties well. 

Financial objectives may be long-term and short-term. The long-term financial objective of the firm should be to utilise the productive resources of the firm effectively and economically. The effective utilisation of all other productive factors is possible only if there is a regular supply of funds at minimum cost. Thus long term financial objectives include 

(a) Proper capitalisation, i.e., to estimate the amount of capital to be raised 

(b) Determining the capital structure, i.e., the form, relationship and proportionate amount of securities to be issued.

Formulating Financial Policies

The second aspect of financial planning is to formulate certain policies to be followed by the financial authorities with regard to the administration of capital to achieve the long-term and the short-term financial objectives of the firm. The following financial policies maybe important in regard to-

                                     i.        Policies regarding estimation of capital requirements.

                                   ii.        Policies regarding relationship between the company and creditors.

                                  iii.        Policies regarding the form and proportionate amount of securities to be issued.

                                  iv.        Policies and guidelines regarding sources of raising capital.

                                    v.        Policies regarding distribution of earnings. 

Developing Financial Procedures

The third aspect of financial planning is to develop the procedure for performing the financial activities. For this purpose, financial activities should be sub-divided into smaller activities and powers, duties and responsibilities be delegated to the sub-ordinate officers. Proper control on financial performance should also be administered. 

Financial control is possible by establishing standards for evaluating the performance and comparing the actual performance with the standard so established. Stern steps should be taken to control any deviations from or inconsistencies in predetermined objectives, policies and programmes. Various methods are used for this purpose such as budgetary control, cost-control, analysis and interpretation of financial accounts etc.

Characteristics of a sound financial plan

The success of a business very much depends upon a financial plan (capital plan) based upon certain basic principles of corporation finance.

The essential characteristics of an ideal capital plan ae as follows:-

 Simplicity

 The capital plan of a company should be as simple as possible. By 'simplicity' we mean that the plan should be easily understandable to all and it should be free from complications, and/or suspicion-arising statements.

At the time of formulating capital structure of a company or issuing various securities to the public, it should be borne in mind that there would be no confusion in the mind of investors about their nature and profitability.

 Foresight

The planner should always keep in mind not only the needs of 'today' but also the needs of 'tomorrow' so that a sound capital structure (financial plan) may be formed. Capital requirements of a company can be estimated by the scope of operations and it must be planned in such a way that needs for capital may be predicted as accurately as possible.

Although, it is difficult to predict the demand of the product yet it cannot b an excuse for the promoters to use foresight to the best advantage in building the capital structure of the company.

Flexibility

The capital structure of a company must be flexible enough to meet the capital requirements of the company. The financial plan should be chalked out in such a way that both increase and decrease in capital may be feasible. The company may require additional capital for financing scheme of modernisation, automation, betterment of employees etc. It is not difficult to increase the capital.

It may be done by issuing fresh shares or debentures to the public or raising loans from special financial institutions, but reduction of capital is really a ticklish problem and needs statesman like dexterity.

Intensive use

Effective use of capital is as much necessary as its procurement. Every resource should be used properly for the prosperity of the enterprise. Wasteful use of capital is as bad as inadequate capital. There must be 'fair capitalisation' i.e., company must procure as much capital as requires nothing more and nothing less. 

Over-capitalisation and under capitalisation are both danger signals. Hence, there should neither be surplus nor deficit capital but procurement of adequate capital should be aimed at and every effort be made to make best use of it.

Liquidity

Liquidity means that a reasonable amount of current assets must be kept in the form of liquid cash so that business operations may be carried on smoothly without any shock to term due to shortage of funds. 

This cash ratio to current ratio to current assets depends upon a number of factors, e.g., the nature and size of the business, credit standing, goodwill and money market conditions etc.

 

Economy

The cost of capital procurement should always be kept in mind while formulating the financial plan. It should be the minimum possible. Dividend or interests to be paid to share holder (ordinary and preference) should not be a burden

Financial objectives - overview

From the first day of trading, a business should set itself financial objectives.

For a start-up, the relevant financial objective is likely to be focused initially on survival - i.e. not running out of cash.  

After a while (hopefully sooner rather than later) the business aims to breakeven and then start generating a profit.  

Even better would be to generate positive cash flows out of those profits.  Medium-term financial objectives for the start-up might then also include making a return for the investors and growing the capital value of the business.

Importantly, those early financial objectives of the start-up never really disappear completely.  The many well-established businesses that became insolvent in 2008-09 during the recession would certainly have given their all to have achieved survival and emerged intact from the economic downturn. The profit objective continues to be a vitally important aim for private sector businesses of all sizes.

However, as a business becomes well-established and its products and operations become more complex, the nature of its financial objectives changes.

Why set financial objectives?  It is quite simply because the performance of a business is traditionally measured in financial

Internal and external influences on financial objectives

The main internal and external influences which are likely to affect the financial objectives include:

Internal Influences	External Influences
Business ownership The nature of business ownership has a significant impact on financial objectives.  A venture capital investor would have quite a different approach to a long-standing family ownership.	Economic conditions As demonstrated by the Credit Crunch.  The economic downturn forced many businesses to reappraise their financial objectives in favour of cost minimisation and maximising cash inflows and balances. Significant changes in interest rates and exchange rates also have the potential to threaten the achievement of financial targets like ROCE.
Size and status of the business E.g. start-ups and smaller businesses tend to focus on survival, breakeven and cash flow objectives.  Quoted multinational businesses are much more focused on growing shareholder value	Competitors Competitive environment directly affects the achievability of financial objectives.  E.g. cost minimisation may become essential if a competitor is able to grow market share because it is more efficient

Budgeting

A budget is a financial plan for the future concerning the revenues and costs of a business. However, a budget is about much more than just financial numbers.

Budgetary control is the process by which financial control is exercised within an organisation.  

Budgets for income/revenue and expenditure are prepared in advance and then compared with actual performance to establish any variances.

Managers are responsible for controllable costs within their budgets and are required to take remedial action if the adverse variances arise and they are considered excessive.

There are many management uses for budgets.  For example, budgets are used to:

• Control income and expenditure (the traditional use)
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• Establish priorities and set targets in numerical terms
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• Provide direction and co-ordination, so that business objectives can be turned into practical reality
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• Assign responsibilities to budget holders (managers) and allocate resources
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• Communicate targets from management to employees
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• Motivate staff
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• Improve efficiency
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• Monitor performance

Whilst there are many uses of budgets, there are a set of guiding principles for good budgetary control in a business.

In an effective budget system:

• Managerial responsibilities are clearly defined – in particular the responsibility to adhere to their budgets
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• Individual budgets lay down a plan of action
• Performance is monitored against the budget
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• Corrective action is taken if results differ significantly from the budget
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• Departures from budgets are permitted only after approval from senior management
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• Unaccounted for variances are investigated

Limitations of budgets

Whilst budgets are widely used to in business, you should appreciate that they have some important limitations.  In particular:

• Budgets are only as good as the data being used to create them.  Inaccurate or unreasonable assumptions can quickly make a budget unrealistic
• Budgets can lead to inflexibility in decision-making
• Budgets need to be changed as circumstances change
• Budgeting is a time consuming process – in large businesses, whole departments are sometimes dedicated to budget setting and control
• Budgets can result in short term decisions to keep within the budget rather than the right long term decision which exceeds the budget
• Managers can become too preoccupied with setting and reviewing budgets and forgetting to focus on the real issues of winning customers

Budgets can also create some behavioural challenges in a business

• Budgeting has behavioural implications for the motivation employees
• Budgets are de-motivating if they are imposed rather than negotiated
• Setting unrealistic targets adds to de-motivation
• Budgets contribute to departmental rivalry - battles over budget allocation
• Spending up to budget: it can result in a “use it or lose it” mentality - spend up to the budget  to preserve it for next year
• Budgetary slack occurs if targets are set too low
• A “name, blame and shame” culture can develop - but managers should be answerable only for variations that were under their control

Source: Wikipedia