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Financial Management

Unit 2

Unit 2

Financial Planning

Structure: 2.1 Introduction Objectives Objectives of financial planning Benefits of financial planning Guidelines for financial planning 2.2 Steps in Financial Planning Forecast of income statement Forecast of balance sheet Computerised financial planning system 2.3 Factors Affecting Financial Planning 2.4 Estimation of Financial Requirements of a Firm 2.5 Capitalisation Cost theory Earnings theory Over-capitalisation Under-capitalisation 2.6 Summary 2.7 Glossary 2.8 Terminal Questions 2.9 Answers 2.10 Case Study

2.1 IntroductionIn the previous unit, you have learnt about the meaning and definition of financial management, goals of financial management, functions of finance, and the interface between finance and other business functions. In this unit, we will discuss the steps in financial planning, factors affecting financial planning, estimation of financial requirements of a firm, and the concept of capitalisation. Liberalisation and globalisation policies initiated by the government have changed the dimension of business environment. Therefore, for survival and growth, a firm has to execute planned strategies systematically. To execute

Sikkim Manipal University

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Financial Management

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any strategic plan, resources are required. Resources may be manpower, plant and machinery, building, technology, or any intangible asset. To acquire all these assets, financial resources are essentially required. Therefore, the finance manager of a company must have both long-range and short-range financial plans. Integration of both these plans is required for the effective utilisation of all the resources of the firm. The long-range plans must include: Funds required for executing the planned course of action Funds available at the disposal of the company Determination of funds to be procured from outside sources Objectives: After studying this unit, you should be able to: explain the steps involved in financial planning analyse the factors affecting financial planning estimate the financial requirements of a Firm explain the effects of capitalisation 2.1.1 Objectives of financial planning Financial planning is a process by which funds required for each course of action is decided. 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 profit with minimum losses or risk. 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 lead to crisis. Too much capital, on the other hand, means lower earnings to the unit holders. A proper planning is therefore necessary. A financial plan has to consider capital structure, capital expenditure, and cash flow. Decisions on the composition of debt and equity must be taken. Highest earnings can be assured only through sound financial plans. A faulty financial plan may ruin the business completely. So, sound financialSikkim Manipal University Page No. 31

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Financial Management

Unit 2

planning is necessary to achieve the long-term and the short-term objectives of the firm and to protect the interest of all parties concerned, i.e., the firm, the creditors, the shareholders, and the public. Financial planning or financial plan indicates: The quantum of funds required to execute business plans Composition of debt and equity, keeping in view the risk profile of the existing business, new business to be taken up, and the dynamics of capital market conditions Formulation of policies, giving effect to the financial plans under consideration 2.1.2 Benefits of financial planning Financial planning also helps firms in the following ways: A financial plan is at the core of value creation process. A successful value creation process can effectively meet the benchmarks of investors expectations. Financial planning ensures effective utilisation of the funds. To manage shortage of funds, planning helps the firms to obtain funds at the right time, in the right quantity, and at the least cost as per the requirements of finance emerging opportunities. Surplus is deployed through wellplanned treasury management. Ultimately, the productivity of assets is enhanced. Effective financial planning provides firms the flexibility to change the composition of funds that constitute its capital structure in accordance with the changing conditions of the capital market. Financial planning helps in formulation of policies and instituting procedures for elimination of wastages in the process of execution of strategic plans. Financial planning helps in reducing the operating capital of a firm. Operating capital refers to the ratio of capital employed to the sales generated. Maintaining the operating capability of the firm through the evolution of scientific replacement schemes for plant and machinery and other fixed assets will help the firm in reducing its operating capital. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital.

Sikkim Manipal University

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Financial Management

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Operating capital = Capital employed/Sales generated

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Activity-1: Review the annual report of Dell computers for the year 2008 and 2009. Find out how does it minimize the operating capital to support sales Hint: A study of annual reports of Dell computers will throw light on how Dell strategically minimised the operating capital required to support sales. Such companies are admired by investing community. 2.1.3 Guidelines for financial planning The following are the guidelines of a financial plan: Never ignore the cardinal principle that fixed asset requirements must be met from the long-term sources. Make maximum use of spontaneous source of finance to achieve highest productivity of resources. Maintain the operating capital intact by providing adequately out of the current periods earnings. Give due attention to the physical capital maintenance or operating capability. Never ignore the need for financial capital maintenance in units of constant purchasing power. Employ current cost principle wherever required. Give due weightage to cost and risk in using debt and equity. Keeping the need of finance for expansion of business, formulate plough back policy of earnings. Exercise thorough control over overheads. Seasonal peak requirements to be met from short-term borrowings from banks. A strategic financial plan of a firm spells out its corporate purpose, scope, objectives, and strategies. As a financial manager, one must: Sensitise the strategic planning group to the financial implications of various choices Ensure that the chosen strategic plan is financially feasible Translate the plan that is finally adopted into a long-range financial plan Coordinate the development of the budgetSikkim Manipal University Page No. 33

Financial Management

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2.2 Steps in Financial PlanningThere are six steps involved in financial planning. Figure 2.1 depicts the steps involved in financial planning.Formatted: Font color: Black Formatted: Font color: Black

Figure 2.1: Steps in Financial Planning

Let us now study the steps in detail. Establish corporate objectives The first step in financial planning is to establish corporate objectives. Corporate objectives can be grouped into two: o Qualitative and quantitative objectives o Short-term, medium-term, and long-term objectives For example, a companys mission statement may specify create economic value added. However this qualitative statement has to be stated in quantitative terms such as a 25% ROE or a 12% earnings growth rates. Since business enterprises operate in a dynamic environment, there is a need to formulate both short-term and long-term objectives. Formulate strategies The next stage in financial planning is to formulate strategies for attaining the defined objectives. Operating plans help to achieve the purpose. Operating plans are framed with a time horizon. It can be a five-year plan or a ten-year plan. Assign responsibilities Once the plans are formulated, responsibility for achieving sales target, operating targets, cost management benchmarks, and profit targets are to be fixed on respective executives.

Sikkim Manipal University

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Forecast financial variables The next step is to forecast the various financial variables such as sales, assets required, flow of funds, and costs to be incurred. These variables are to be translated into financial statements. Financial statements help the finance manager to monitor the deviations of actual from the forecasts and take effective remedial measures. This ensures that the defined targets are achieved without any overrun of time and cost.

Develop plans This step involves developing a detailed plan of funds required for the plan period under various heads of expenditure. From the plan, a forecast of funds that can be obtained from internal as well as external sources during the time horizon is developed. Legal constraints in obtaining funds on the basis of covenants of borrowings are given due weightage. There is also a need to collaborate the firms business risk with risk implications of a particular source of funds. A control mechanism for allocation of funds and their effective use is also developed in this stage. Cre