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Financial Management Unit 2

Sikkim Manipal University Page No. 30

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 Introduction

In 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



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 financial

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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 investor’s

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 well-

planned 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.



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 budget

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.

Operating capital = Capital employed/Sales generated





2.2 Steps in Financial Planning

There are six steps involved in financial planning. Figure 2.1 depicts the

steps involved in financial planning.

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 company’s 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.





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 firm’s 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.

Create flexible economic environment – While formulating the plans,

certain assumptions are made about the economic environment. The

environment, however, keeps changing with the implementation of plans.

To manage such situations, there is a need to incorporate an in-built

mechanism which would scale up or scale down the operations

accordingly.

Forecasting of financial statements:

Following are some basic points that would help you to understand the

importance of financial forecasting before we study the methods of

forecasting and income statement/balance sheet.

Financial forecasting is the process of estimating future business

performance (sales, costs, earnings).

Corporations and companies employ forecasting to do financial planning

which includes an assessment of their future financial needs.

Forecasting is also important for production planning, human resource

planning, etc.

Forecasting is also used by outsiders to value companies and their

securities.



Financial planning is enabled by creating pro forma income statements and

balance sheets. These are forecasted financial statements. As we have

discussed, financial planning is a continuous process of directing and

allocating financial resources to meet strategic goals and objectives. The

output from financial planning takes the form of budgets. The most widely

used form of budgets is pro forma or budgeted financial statements.

The pro forma statements help to have a comprehensive look at the likely

future financial performance. While the pro forma income statement

represents the operational plan for the whole organisation, the pro forma

balance sheet reflects the cumulative impact of anticipated future decisions.

Budgets include:

Cash budget

Operating budget

Sales budget

Production budget

Sales and distribution expenses budget

Administrative overheads budget

2.2.1 Forecast of income statement

There are three methods of forecasting income statement:

Percent of sales method or constant ratio method

Expense method

Combination of the above two

Percent of sales method

This is the most basic method of forecasting a financial statement. It

assumes that certain expenses, assets, and liabilities maintain a constant

relationship to the level of sales.

Basically, this method assumes that future relationship between various

elements of cost to sales will be similar to their historical relationships.

These cost ratios are generally based on the average of previous two or

three years. For example, cost of goods sold may be expressed as a

percentage of sales.

Therefore, the key driver of this method is the sales forecast and based on

this, pro forma financial statements (i.e., forecasted) can be constructed and

the firm’s needs for external financing can be identified.



Since sales have a significant effect on the financial needs of a business,

different items of assets, liabilities, revenue, and expenses can be

expressed as a percentage of sales.

The first step is to express the income statement accounts which vary

directly with sales as percentages of sales. This is calculated by dividing the

balance for these accounts for the current year by sales revenue for the

current year.

The accounts which generally vary closely with sales are cash accounts,

receivable, inventory, and accounts payable.

On the income statement, costs are expressed as a percentage of sales.

Since we are assuming that all costs remain at a fixed percentage of sales,

net income can be expressed as a percentage of sales. This indicates the

profit margin.

Caselet:

Raw material cost is 40% of sales revenue for the year ended 31.03.2007.

However, this method assumes that the ratio of raw material cost to sales

will continue to be the same in 2008 also. Such an assumption may not

look good in most of the situations.

If in case, raw material cost increases by 10% in 2008 but selling price of

finished goods increases only by 5%. In this case raw material cost will be

44/105 of the sales revenue in 2008. This can be solved to some extent by

taking the average for the same representative years. However, inflation,

change in government policies, wage agreements, and technological

innovation totally invalidate this approach on a long run basis.



Illustration:

The Profit and Loss statement of Biotech Ltd. for the years 2000 and 2001

are given below. If the sales for the year 2002 are estimated at

Rs. 22,00,000, prepare a pro forma income statement for the year 2002

using the percent of sales method.

(Rs. ‘000) 2000 2001

Total sales

Cost of goods sold

Gross profit

Selling and administration expenses

Depreciation

Operating profit

Non-operating surplus

EBIT

Interest

Tax

Profit after tax

Dividends

Retained earnings

1,200

700

500

180

50

270

40

310

160

60

90

30

60

1,800

1,100

700

220

80

400

80

480

160

100

220

60

160

Solution:

Average percent of sales

Pro forma income statement for 2002

(in Rs. ’000)

Net sales

Cost of goods sold

Gross profit

Selling and administration expenses

Depreciation

Operating profit

Non-operating surplus

EBIT

Interest

Tax

Profit after tax

Dividends

Retained earnings

100

60

40

13.33

4.3

22.36

4

26.4

10.67

5.3

10.33

3

7.33

2,200

1,320

880

293

95

492

88

580

235

117

228

66

162



Working notes:

Total cost of goods sold for 2000 and 2001 = Rs 18,00,000.

Total sales for the year 2000 and 2001 = Rs. 30,00,000.

Hence, percentage of total cost of goods sold relative to sales = 18,00,000 /

30,00,000 X 100 = 60

The other items are also computed in a similar manner.

Budgeted expense method

Expenses for the planning period are budgeted on the basis of anticipated

behaviour of various items of cost and revenue.

The value of each item is estimated on the basis of expected developments

in the future period for which the pro forma P&L account is being prepared.

It calls for greater effort on the part of management since they have to

define the likely happenings. This also demands effective database for

reasonable budgeting expenses.

Combination of both these methods

The combination of both these methods is used because some expenses

can be budgeted by the management. This is done taking into account the

expected business environment while some other expenses could be based

on their relationship with the sales revenue expected to be earned.

The budgeted income statement will pull together all revenue and expense

estimates from previously prepared detail budgets. Once this statement is

prepared, the budgeted balance sheet can be prepared.

2.2.2 Forecast of balance sheet

The following steps discuss the forecasting of the balance sheet:

Compute the sales revenue, having a close relationship with the items of

certain assets and liabilities, based on the forecast of sales and the

historical database of their relationship.

Determine the equity and debt mix on the basis of funds requirements

and the company’s policy on capital structure.

Projections for Balance sheet can be made as listed below:

Employ percent of sales method to project items on the asset side,

except “Investments” and “Miscellaneous Expenses and Losses”.



Expected values for “Investments” and “Miscellaneous Expenses and

Losses” can be estimated using specific information.

Use percent of sales method to project values of current liabilities and

provisions.(also referred to as ‘spontaneous liabilities’).

Projected values of reserves and surplus can be obtained by adding

projected retained earnings from P&L pro forma statement.

Projected value for equity and preferential capital can be set tentatively

equal to their previous values.

Projected values for loan funds will be tentatively equal to their previous

level, less repayments or retirements.

Compare the total of asset side with that of liabilities side and determine

the balancing figure. (If assets exceed liabilities, the balancing figure

represents external funding requirement. If liabilities exceed assets, the

balancing item represents surplus available funds).

The budgeted balance sheet will provide an estimate of how much external

financing is required to support estimated sales.

The main link between the income statement and the balance sheet is

retained earnings. Therefore, preparation of the budgeted balance sheet

starts with an estimate of the ending balance for retained earnings. In order

to estimate ending retained earnings, one has to project future dividends

based on current dividend policies and what management expects to pay in

the next planning period.

Once the budgeted balance sheet is prepared, it will show either a surplus

(excess financing over assets) or a deficit (additional financing needed to

cover assets). This difference is derived from the accounting equation:

Assets = Liabilities + Equity.

We can also calculate External Financing Required (EFR) based on the

relationships between assets, liabilities, and sales.



Caselet

The following details have been extracted from the books of X Ltd.

Table 2.1 and table 2.2 depict the income statement and balance sheet

respectively.

Table 2.1: Income Statement

2006 2007

Sales less returns 1000 1300

Gross profit 300 520

Selling expenses 100 120

Administration 40 45

Deprecation 60 75

Operating profit 100 280

Non-operating income 20 40

EBIT (Earnings Before Interest and Tax) 120 320

Interest 15 18

Profit before tax 105 302

Tax 30 100

Profit after tax 75 202

Dividend 38 100

Retained earnings 37 102

Table 2.2: Balance Sheet

Liabilities 2006 2007 Assets 2006 2007

Shareholder’s fund Fixed assets 400 510

Share capital Less depreciation 100 120

Equity 120 120 300 390

Preference 50 50 Investments 50 50

Reserves and surplus

122 224

Secured loans 100 120 Current assets, loans, and advances

Unsecured loans 50 60 Cash at bank 10 12

Receivables 80 128



Current liabilities Inventories 200 300

Trade creditors 210 250 Loans and advances

50 80

Provisions Miscellaneous expenditure

10 24

Tax 10 60

Proposed dividend 38 100

700 984 700 984

Forecast the income statement and balance sheet for the year 2008 based on the following assumptions:

Sales for the year 2008 will increase by 30% over the sales value for 2007

Use percent of sales method to forecast the values for various items of income statement using the percentage for the year 2007

Depreciation is charged at 25% of fixed assets

Fixed assets will increase by Rs. 100 million

Investments will increase by Rs. 100 million

Current assets and current liabilities are to be decided based on their relationship with the sales in the year 2007

Miscellaneous expenditure will increase by Rs. 19 million

Secured loans in 2008 will be based on its relationship with the sales in the year 2007

Additional funds required, if any, will be met by bank borrowings

Tax rates will be 30%

Dividends will be 50% of the profit after tax

Non-operating income will increase by 10%

There will be no change in the total amount of administration expenses to be spent in the year 2008

There is no change in equity and preference capital in 2008

Interest for 2008 will maintain the same ratio as it has in 2007 with the sales of 2007

Table 2.3 and table 2.4 depict the forecast of the income statement and the balance sheet for the year 2008 respectively.

Table 2.3: Income Statement

Particulars Basis Working Amount (Rs.)

Sales Increase by 30% 1300 x 1.3 1690

Cost of sales Increase by 30% 780 x 1.3 1014

Gross profit Sales-cost of sales 1690-1014 676



Selling expenses 30% increase 120 x 1.3 156

Administration No change 45

Depreciation % given

4

100390

123 (Rounded off)

Operating profit C - (D + E + F) 352

Non-operating income Increase by 10% 1.1 x 40 44

Earnings Before Interest and Taxes (EBIT)

396

Interest Salesof

1300

18

1300

169018

23

(Decimal

ignored)

Profit before tax 373

Tax 112

Profit after tax 261

Dividends 130

Retained earnings 131


Particulars Basis Working Amount (Rs.)

Assets

Fixed assets Given 510

Add: Addition 100

610

Depreciation 120 + 123 243

1. Net fixed assets 367

2. Investments 150

3. Current assets, loans, and advances

Cash at bank

1300

12

1300

169012

16

(Rounded off)

Receivables

1300

128

1300

1690128

166



Inventories

1300

300

1300

1690300

390

Loans and advances

1300

80

1300

169080

104

4. Miscellaneous

Expenditure Given 24 + 19 43

Total 1236

Liabilities

1. Share capital

Equity 120

Preference 50

2. Reserves and surplus Increase by current year’s retained earnings

355

3. Secured loan

1300

60

1300

169060

78

Bank borrowings 40 (Difference –

Balancing figure)

4. Unsecured loan 60 60

5. Current liabilities and provision

Trade creditors

1300

250

1300

1690250

325

Provision for tax

1300

60

1300

169060

78

Proposed dividend Current year given

130

Total liabilities 1236

2.2.3 Computerised financial planning system

All corporate forecasts use computerised forecasting models. Additional

funds required to finance the increase in sales could be ascertained using a

mathematical relationship based on the following:



Additional Funds Required = Required Increase in Assets – Spontaneous

Increase in Liabilities – Increase in Retained Earnings

(This formula has been recommended by Eugene F. Brigham and Michael

C. Earnhardt in the book Financial Management – Theory and Practice)

Prof. Prasanna Chandra, in his book Financial Management, (6th edition -

Manohar Publishers and Distributors) has given a comprehensive formula

for ascertaining the external financial requirements.

Here

(ΔΔsS

A = Expected increase in assets, both fixed assets and current

assets required for the expected increase in sales in the next year.

(ΔΔsS

L = Expected spontaneous finance available for the expected

increase in sales.

MS1 (1-d) = It is the product of profit margin, expected sales for the next

year, and the retention ratio.

Retention ratio = 1 – payout ratio.

Payout ratio refers to the ratio of the dividend paid to the earnings per

share.

1m = Expected change in the level of investments and miscellaneous

expenditure.

SR = It is the firm’s repayment liability on term loans and debenture for

the next year.

The formula described above has certain features:

Ratios of assets and spontaneous liabilities to sales remain constant

over the planning period.

Dividend payout and profit margin for the next year can be reasonably

planned in advance.

Since external funds requirements involve borrowings from financial

institution, the formula rightly incorporates the management’s liability on

repayments.

EFR =S

)s(L

S

)s(A

– MS1 (1-d) – (1m + SR)



Solved Problem

X Ltd. has given the following forecasts: “Sales in 2008 will increase from

Rs. 1000 to Rs. 2000 in 2007”. Table 2.5 depicts the balance sheet of the

company as on December 31, 2007.


Liabilities Rs. Assets Rs.

Share capital Net fixed assets 500

Equity (Shares of Rs.10 each)

100 Inventories 200

Reserves and surplus 250 Cash 100

Long term loan 400 Bills receivable 200

Creditors for expenses outstanding

50

Trade creditors 50

Bills payable 150

1000 1000

Taking into account the following information, the external funds

requirements for the year 2008 has to be ascertained:

The company’s utilisation of fixed assets in 2007 was 50% of capacity but

its current assets were at their proper levels.

Current assets increase at the same rate as sales.

Company’s after-tax profit margin is expected to be 5%, and its payout

ratio will be 60%.

Creditors for expenses are closely related to sales.

(Adapted from IGNOU MBA).

Solution:

Preliminary workings:

A = Current assets = Cash + Bills receivables + Inventories

= 100 + 200 +200 = 500



500.Rs10001000

500)s(

S

A

L = Trade creditors + Bills payable + Expenses outstanding

= 50 + 150 + 50 = Rs. 250

250.Rs10001000

250)s(

S

L

M (Profit margin) = 5 / 100 = 0.05

S1 = Rs.2000

1-d = 1 – 0.6 = 0.4 or 40 %

1m = NIL

SR = NIL

Therefore: sS

L

S

)s(AEFR

- ms1 (1-d) – (1m + SR)

= 500 – 250 – (0.05 x 2000 x 0.4) – (0 + 0)

= 500 – 250 – 40 - (0 + 0)

= Rs. 210

Therefore, external fund requirements for 2008 will be Rs. 210. This

additional fund requirement will be procured by the firm based on its

policy on capital structure.

Self Assessment Questions

1. Corporate objectives could be grouped into ___ and ___.

2. Control mechanism is developed for _____ and their effective use.

3. Seasonal peak requirements to be met from __________________

from banks.

2.3 Factors Affecting Financial Planning

Figure 2.2 depicts the various factors affecting financial plan.



Figure 2.2: Factors Affecting Financial Plan

Let us now discuss these factors in detail.

Nature of the industry – The first factor affecting the financial plan is

the nature of the industry. Here, we must check whether the industry is a

capital-intensive or labour-intensive industry. This will have a major

impact on the total assets that a firm owns.

Size of the company – The size of the company greatly influences the

availability of funds from different sources. A small company normally

finds it difficult to raise funds from long-term sources at competitive

terms.

On the other hand, large companies like Reliance enjoy the privilege of

obtaining funds both short-term and long-term at attractive rates.

Status of the company in the industry – A well-established company

enjoys a good market share, because its products normally command

investor’s confidence. Such a company can tap the capital market for

raising funds in competitive terms for implementing new projects to

exploit the new opportunities emerging from changing business

environment.



Sources of finance available – Sources of finance could be grouped

into debt and equity. Debt is cheap but risky whereas equity is costly. A

firm should aim at optimum capital structure that would achieve the least

cost capital structure. A large firm with a diversified product mix may

manage higher quantum of debt because the firm may manage higher

financial risk with a lower business risk. Selection of sources of finance is

closely linked to the firm’s capability to manage the risk exposure.

The capital structure of a company – The capital structure of a

company is influenced by the desire of the existing management

(promoters) of the company to retain control over the affairs of the

company. The promoters who do not like to lose their grip over the

affairs of the company normally obtain extra funds for growth by issuing

preference shares and debentures to outsiders.

Matching the sources with utilisation – The prudent policy of any

good financial plan is to match the term of the source with the term of the

investment. To finance fluctuating working capital needs, the firm resorts

to short-term finance. All fixed-asset investments are to be financed by

long-term sources which is a cardinal principle of financial planning.

Flexibility – The financial plan of a company should possess flexibility

so as to effect changes in the composition of capital structure whenever

the need arises. If the capital structure of a company is flexible, there will

not be any difficulty in changing the sources of funds. This factor has

become a significant one today because of the globalisation of capital

market.

Government policy – SEBI guidelines, finance ministry circulars,

various clauses of Standard Listing Agreement and regulatory

mechanism imposed by FEMA, and Department of Corporate Affairs

(government of India) influence the financial plans of corporates today.

Management of public issues of shares demands the compliances with

many statutes in India. They are to be complied with a time constraint.


4. ______ has a major impact on the total assets that the firm owns.

5. Sources of finance could be grouped into ______ and _____.



6. ___________ of any good financial plan is to match the term of the

source with the term of the investment.

7. _____ refers to the ability to _____ whenever needed.

2.4 Estimation of Financial Requirements of a Firm

A company should be properly capitalised and the actual capital should be

neither more nor less than the amount which is needed and which can be

gainfully employed. It is, therefore, necessary for a concern to estimate its

requirements of funds properly. The financial requirements of a company

may be outlined under the following heads:

Cost of fixed assets including land and buildings, plant and machinery,

furniture, etc. The amount invested in these items is called fixed capital.

Cost of current assets including cash, stock of goods (also called

inventory of merchandise), book debts, bills, etc.

Cost of promotion including the expenses on preliminary investigation in

case of a new company, accounting, marketing, legal advice, etc.

Cost of establishing the business, i.e., the operating losses which have

generally to be sustained in the initial periods of a company.

Cost of financing including brokerage on securities, commission on

underwriting, etc.

Cost of intangible assets like goodwill, patents, etc.

Of the various items of financial requirements listed above, the first two

deserve special consideration as the successes of any concern will depend

largely on them.

The estimation of capital requirements of a firm involves a complex process.

Even with expertise, managements of successful firms could not arrive at

the optimum capital composition in terms of the quantum and the sources.

As indicated above, capital requirements of a firm could be grouped into

fixed capital and working capital.

The long-term requirements such as investments in fixed assets will have to

be met out of funds obtained on long-term basis.



Fixed capital of an industrial concern is invested in fixed assets like plant

and machinery, land, buildings, furniture, etc. These assets are not fixed in

value. In fact, their value may record an increase or decrease in course of

time.

Variable working capital requirements which fluctuate from season to

season will have to be financed only by short-term sources.

The working capital is required for the purchase of raw materials and for

meeting the day-to-day expenditure on salaries, wages, rents, advertising,

etc.

Any departure from this well-accepted norm causes negative impact on the

firm’s finances. We will look at assessing these requirements in detail in the

upcoming pages.

Activity 2

Select 2 companies each from FMCG, Software and Manufacturing on the

mission statement. What is your observation on financial requirements?

Hint: All the finance requirements are to be discussed.


4.8. Capital requirement of a firm could be grouped into ____ and _____.

5.9. Variable working capital will have to be financed only by _______.

2.5 Capitalisation

Capitalisation of a firm refers to the composition of its long-term funds and

its capital structure. It has two components – Debt and Equity.

After estimating the financial requirements of a firm, the next decision that

the management has to take is to arrive at the value at which the company

has to be capitalised.

There are two theories of capitalisation for the new companies:

Cost theory

Earnings theory



Figure 2.3 depicts the two theories of capitalisation.

Figure 2.3: Theories of Capitalisation

Let us now discuss these theories in detail.

2.5.1 Cost theory

Under this theory, the total amount of capitalisation for a new company is

the sum of:

Cost of fixed assets

Cost of establishing the business

Amount of working capital required

Merits of cost approach

It helps promoters to estimate the amount of capital required for

incorporation of company, conducting market surveys, preparing detailed

project report, procuring funds, procuring assets both fixed and current,

running a trial production, and successfully producing, positioning, and

marketing its products or rendering of services.

If done systematically, it will lay the foundation for successful initiation of

the working of the firm.

Demerits of cost approach

If the firm establishes its production facilities at inflated prices, the

productivity of the firm will become less than that of the industry.

Net worth of a company is decided by the investors and the earnings of a

company. Earning capacity based on net worth helps a firm to arrive at

the total capital in terms of industry-specified yardstick (operating capital

based on benchmarks in that industry). Cost theory fails in this respect.



2.5.2 Earnings theory

Earnings are forecasted and capitalised at a rate of return, which actually is

the representative of the industry. Earnings theory involves two steps. They

are:

Estimation of the average annual future earnings.

Estimation of the normal earning rate of the industry to which the

company belongs.

Merits of earnings theory

Earnings theory is superior to cost theory because of its lesser chances

of being either under or over capitalisation.

Comparison of earnings approach to that of cost approach will make the

management to be cautious in negotiating the technology and the cost of

procuring and establishing the new business.

Demerits of earnings theory

The major challenge that a new firm faces is deciding on capitalisation

and its division thereof into various procurement sources.

Arriving at the capitalisation rate is equally a formidable task because the

investor’s perception of established companies cannot be really unique

of what the investor’s perceive from the earning power of the new

company.

Due to this problem, most of the new companies are forced to adopt the

cost theory of capitalisation. Ideally, every company should have normal

capitalisation, which is a utopian way of thinking.

Changing business environment, role of international forces, and dynamics

of capital market conditions force us to think in terms of ‘what is optimal

today need not to be so tomorrow’.

Even with these constraints, management of every firm should continuously

monitor its capital structure to ensure and avoid the bad consequences of

over and under capitalisation.

2.5.3 Over-capitalisation

A company is said to be over-capitalised when its total capital (both equity

and debt) exceeds the true value of its assets.



It is wrong to identify over-capitalisation with excess of capital because most

of the over-capitalised firms suffer from the problems of liquidity. The correct

indicator of over-capitalisation is the earnings capacity of the firm.

If the earnings of the firm are less than that of the market expectation, it will

not be in a position to pay dividends to its shareholders as per their

expectations. This is a sign of over-capitalisation. It is also possible that a

company has more funds than its requirements based on current operation

levels and yet have low earnings.

Over-capitalisation may be considered on the account of:

Acquiring assets at inflated rates

Acquiring unproductive assets

High initial cost of establishing the firm

Companies which establish their new business during boom condition

are forced to pay more for acquiring assets, causing a situation of over-

capitalisation once the boom conditions subside

Total funds requirements have been over estimated

Unpredictable circumstances (like change in import/export policy,

change in market rates of interest, and changes in international

economic and political environment) reduce substantially the earning

capacity of the firm. For example, rupee appreciation against US dollar

has affected the earning capacity of the firms engaged mainly in the

export business because they invoice their sales in US dollar

Inadequate provision of depreciation adversely affects the earning

capacity of the company leading to over-capitalisation of the firm

Existence of idle funds

Effects of over-capitalisation

Decline in earnings of the company

Fall in dividend rates

Loss of goodwill

Market value of the company’s share falls, and the company loses

investors’ confidence

Company may collapse at any time because of anaemic financial

conditions which affect its employees, society, consumers, and

shareholders. Employees will lose jobs. If the company is engaged in the



production and marketing of certain essential goods and services to the

society, the collapse of the company will cause social damage

Remedies of over-capitalisation

Over-capitalisation often results in a company becoming sick. Restructuring

the firm helps to avoid such a situation. Some of the other remedies of over-

capitalisation are:

Reduction of debt burden

Negotiation with term lending institutions for reduction in interest

obligation

Redemption of preference shares through a scheme of capital reduction

Reducing the face value and paid-up value of equity shares

Initiating merger with well–managed, profit-making companies interested

in taking over ailing company

2.5.4 Under-capitalisation

Under-capitalisation is just the reverse of over-capitalisation. A company is

considered to be under-capitalised when its actual capitalisation is lower

than the proper capitalisation as warranted by the earning capacity.

Symptoms of under-capitalisation

The following points describe the symptoms of under-capitalisation:

Actual capitalisation is less than the warranted earning capacity

Rate of earnings is exceptionally high in relation to the return enjoyed by

similar situated companies in the same industry

Causes of under-capitalisation

The following points describe the causes of under-capitalisation:

Under estimation of the future earnings at the time of the promotion of

the company

Abnormal increase in earnings from the new economic and business

environments

Under estimation of total funds requirement

Maintaining very high efficiency through improved means of production

of goods or rendering of services

Companies which are set up during the recession period will start

making higher earning capacity as soon as the recession is over

Purchase of assets at exceptionally low prices during recession



Effects of under-capitalisation

The following points describe some of the effects of under-capitalisation:

Under-capitalisation encourages competition by creating a feeling that

the line of business is lucrative

It encourages the management of the company to manipulate the

company’s share prices

High profits will attract higher amount of taxes

High profits will make the workers demand higher wages. Such a feeling

on the part of the employees leads to labour unrest

High margin of profit may create an impression among the consumers

that the company is charging high prices for its products

High margin of profits and the consequent dissatisfaction among its

employees and consumer may invite governmental enquiry into the

pricing mechanism of the company

Remedies

The following points describe the remedies of under-capitalisation:

Splitting up of the shares, which will reduce the dividend per share

Issue of bonus shares, which will reduce both the dividend per share and

the earnings per share

Both over-capitalisation and under-capitalisation are detrimental to the

interests of the society.


10. _____ of a firm refers to the composition of its long-term funds.

11. Two theories of capitalisation for new companies are ______ and

earnings theory.

12. A company is said to be ________, when its total capital exceeds the

true value of its assets.

10.13. A company is considered to be _______, when its actual

capitalisation is lower than its proper capitalisation as warranted by its

earning capacity.



2.6 Summary

Let us recapitulate the important concepts discussed in this unit:

Financial planning deals with the planning, the execution, and the

monitoring of procurement and utilisation of funds. Financial planning

process gives birth to financial plan. It could be thought of as a blueprint

explaining the proposed strategy and its execution.

There are many financial planning models. All these models forecast the

future operations and then translate them to income statements and

balance sheets. It will also help the finance managers to ascertain the

funds to be procured from the outside sources. The essence of all these

is to achieve a least cost capital structure which would match with the

risk exposure of the company.

Failure to follow the principle of financial planning may lead a new firm to

over or under-capitalisation when the economic environment undergoes

a change.

Ideally, every firm should aim at optimum capitalisation or it might lead to

a situation of over or under-capitalisation. Both are detrimental to the

interests of the society. There are two theories of capitalisation - cost

theory and earnings theory.

2.7 Glossary

Accounting equation: Assets = Liabilities + Equity.

Capitalisation of a firm: Refers to the composition of its long-term funds

and its capital structure. It has two components – Debt and Equity.

Financial planning: Process by which funds required for each course of

action is decided.

2.8 Terminal Questions

1. Explain the steps involved in Financial Planning.

2. Explain the factors affecting Financial Plan.

3. List out the causes of over-capitalisation.

4. Explain the effects of under-capitalisation.



2.9 Answers


1. Qualitative, Quantitative

2. Allocation of funds

3. Short-term borrowings

4. Nature of the industry

5. Debt, equity

6. The prudent policy

7. Flexibility in capital structure, effect changes in the composites of

capital structure

8. Fixed capital, working capital

9. Short-term sources

10. Capitalisation

11. Cost theory

12. Over-capitalised

12.13. Under-capitalised

Terminal Questions

1. There are six steps involved in financial planning. Refer to 2.2

2. There are various factors affecting financial plan. Refer to 2.3

3. A company is said to be over-capitalised when its total capital (both

equity and debt) exceeds the true value of its assets. Refer to 2.5.3

4. A company is considered to be under-capitalised when its actual

capitalisation is lower than the proper capitalisation as warranted by the

earning capacity. Refer to 2.5.4



2.10 Case Study: Financial Planning

Firms need to plan their future activities keeping in view the expected

changes in the economic, social, technical, and competitive environment.

The top and middle-level managers plan their business activities in terms of

financial projections keeping in view the various factors that will affect the

business.

Financial planning is enabled by creating pro forma income statements and

balance sheets. These are forecasted financial statements. As we have

discussed in the unit, financial planning is a continuous process of directing

and allocating financial resources to meet strategic goals and objectives. he

output from financial planning takes the form of budgets. The most widely

used form of budgets is pro forma or budgeted financial statements.

Given below is the profit and loss account statement and balance sheet

synopsis of Reliance Industries for the last five years. Study the statements

in detail.

Profit and Loss Account (Rs. in Crores)

Mar '11 Mar '10 Mar '09 Mar '08 Mar ‘07

Income

Sales Turnover 2,58,651.15 2,00,399.79 1,46,328.07 1,39,269.46 1,18,353.71

Excise Duty 10,515.09 8,307.92 4,369.07 5,463.68 6,654.68

Net Sales 2,48,136.06 1,92,091.87 1,41,959.00 1,33,805.78 1,11,699.03

Other Income 3,358.61 3,088.05 1,264.03 6,595.66 236.89

Stock Adjustments 3,243.05 3,947.89 427.56 -1,867.16 654.60

Total Income 2,54,737.72 1,99,127.81 1,43,650.59 1,38,534.28 1,12,590.52

Expenditure

Raw Materials 1,98,076.21 1,53,689.01 1,09,284.34 98,832.14 80,791.65

Power and Fuel Cost 2,255.07 2,706.71 3,355.98 2,052.84 2,261.69

Employee Cost 2,621.59 2,330.82 2,397.50 2,119.33 2,094.09

Other Manufacuring Expenses 2,915.44 2,153.67 1,162.98 715.19 1,112.17

Selling and Admin Expenses 7,207.83 5,756.44 4,736.60 5,549.40 5,478.10

Miscellaneous Expenses 500.52 651.96 562.42 412.66 321.23

Preoperative Exp Capitalised -30.26 -1,217.92 -3,265.65 -175.46 -111.21

Total Expenses 2,13,546.40 1,66,070.69 1,18,234.17 1,09,506.10 91,947.72



Operating Profit 37,832.71 29,969.07 24,152.39 22,432.52 20,405.91

PBDIT 41,191.32 33,057.12 25,416.42 29,028.18 20,642.80

Interest 2,328.30 1,999.95 1,774.47 1,162.90 1,298.90

PBDT 38,863.02 31,057.17 23,641.95 27,865.28 19,343.90

Depreciation 13,607.58 10,496.53 5,195.29 4,847.14 4,815.15

Other Written Off 0.00 0.00 0.00 0.00 0.00

Profit Before Tax 25,255.44 20,560.64 18,446.66 23,018.14 14,528.75

Extra-ordinary items 0.00 0.00 0.00 48.10 0.51

PBT (Post-Extra-ord items) 25,255.44 20,560.64 18,446.66 23,066.24 14,529.26

Tax 4,969.14 4,324.97 3,137.34 3,559.85 2,585.35

Reported Net Profit 20,286.30 16,235.67 15,309.32 19,458.29 11,943.40

Balance Sheet (Rs. in Crores)

Mar ‘11 Mar ‘10 Mar ‘09 Mar ‘08 Mar ‘07

Sources of Funds

Total Share Capital 3,273.37 3,270.37 1,573.53 1,453.39 1,393.21

Equity Share Capital 3,273.37 3,270.37 1,573.53 1,453.39 1,393.21

Share Application Money 0.00 0.00 69.25 1,682.40 60.14

Preference Share Capital 0.00 0.00 0.00 0.00 0.00

Reserves 1,42,799.95 1,25,095.97 1,12,945.44 77,441.55 59,861.81

Revaluation Reserves 5,467.00 8,804.27 11,784.75 871.26 2,651.97

Networth 1,51,540.32 1,37,170.61 1,26,372.97 81,448.60 63,967.13

Secured Loans 10,571.21 11,670.50 10,697.92 6,600.17 9,569.12

Unsecured Loans 56,825.47 50,824.19 63,206.56 29,879.51 18,256.61

Total Debt 67,396.68 62,494.69 73,904.48 36,479.68 27,825.73

Total Liabilities 2,18,937.00 1,99,665.30 2,00,277.45 1,17,928.28 91,792.86

Application of Funds

Gross Block 2,21,251.97 2,15,864.71 1,49,628.70 1,04,229.10 99,532.77

Less: Accum. Depreciation 78,545.50 62,604.82 49,285.64 42,345.47 35,872.31

Net Block 1,42,706.47 1,53,259.89 1,00,343.06 61,883.63 63,660.46

Capital work-in-progress 12,819.56 12,138.82 69,043.83 23,005.84 7,528.13

Investments 33,019.27 19,255.35 20,268.18 20,516.11 16,251.34

Inventories 29,825.38 26,981.62 14,836.72 14,247.54 12,136.51

Sundry Debtors 17,441.94 11,660.21 4,571.38 6,227.58 3,732.42

Cash and Bank Balance 604.57 362.36 500.13 217.79 308.35

Total Current Assets 47,871.89 39,004.19 19,908.23 20,692.91 16,177.28

Loans and Advances 17,320.60 10,517.57 13,375.15 18,441.20 12,506.71

Fixed Deposits 31,162.56 17,073.56 23,014.71 5,609.75 1,527.00

Total CA, Loans and Advances 96,355.05 66,595.32 56,298.09 44,743.86 30,210.99

Deferred Credit 0.00 0.00 0.00 0.00 0.00



Current Liabilities 61,399.87 48,018.65 42,664.81 29,228.54 24,145.19

Provisions 4,563.48 3,565.43 3,010.90 2,992.62 1,712.87

Total CL and Provisions 65,963.35 51,584.08 45,675.71 32,221.16 25,858.06

Net Current Assets 30,391.70 15,011.24 10,622.38 12,522.70 4,352.93

Miscellaneous Expenses 0.00 0.00 0.00 0.00 0.00

Total Assets 2,18,937.00 1,99,665.30 2,00,277.45 1,17,928.28 91,792.86

Contingent Liabilities 41,825.13 25,531.21 36,432.69 37,157.61 46,767.18

Book Value (Rs.) 446.25 392.51 727.66 542.74 439.57

Discussion Questions:

Prepare pro forma financial statements for the year 2012 with the following

considerations:

1. The sales for the year 2012 are to be increased by 30% over the value of sales for the year 2011.

2. Use percent of sales method to forecast the values for various items of income statement using the percentage for the year 2011.

3. Secured loans in 2012 will be based on its relationship with the sales in the year 2011.

4. Additional funds required, if any, will be met by bank borrowings.

5. Selling and administration expenses expected to increase by 5%.

(Hint: Refer proforma financial statements)

(Source: http://www.moneycontrol.com/financials

References:

Prasanna Chandra, Financial Management, 6th edition - Manohar

Publishers and Distributors

Brigham. Eugene F. and Houston. Joel F.(2007). Fundamentals of

Financial Management, 11th Edition, Cengage Learning

E-References:

http://www.moneycontrol.com/financials) retrieved on 10/12/ 2011

http://www.moneycontrol.com/financials

http://www.moneycontrol.com/financials

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