1. Meaning of Financial Planning
Financial planning has been defined as “the advance programming of all plans of financial management and the integration and coordination of these plans with the operating plans of the enterprise.” There is hardly any aspect of a business which does not have both financial requirements and financial consequences. Financial planning deals with both sources and uses of funds.
There must be someone in the enterprise who pulls together, reviews, analyses, interprets and plans these requirements and consequences. The person who does all this is one who is the chief executive officer in charge of finance of the enterprise; no matter by whatever name or designation he is called.
Financial planning includes the following:
1. Determination of the financial resources required to meet the operating programme of the company.
2. To work out as to how much of these requirements are to be met by generating funds internally by the company and how much is to be obtained from outside the company.
3. To develop the best possible plans for obtaining the funds needed from the external sources.
4. To establish and maintain a system of financial controls for governing the allocation and the use of funds.
5. To formulate a programme for the provision of the most effective relationships between product-cost-profit.
6. To analyse the financial results of all operations.
7. To report these analysed facts to the top management of the enterprise.
8. To make recommendations relating to future operations.
2. Need for Financial Planning
Financial planning is an essential and significant financial process. All aspects of financial plans—short-term, medium-term and long-term—affect the earning capacity, profitability and solvency of the business concern.
A rational financial planning is the key to successful business. In view of the complex nature of the business enterprise today, management places a great emphasis upon financial planning.
For the success and progress of any corporate body, it is essential that available resources be utilised in an optimal way and as far as possible the capital should not be misused.
This is possible only when correct estimates of present and future capital requirements are made through financial planning. More is the rationality in these estimates; less will be the possibilities of problems of excessive capital or inadequate capital.
History indicates that many business concerns in the past years met failures simply because their financial planning was defective. Defective planning does not ensure correct estimates of capital requirements.
As a result, either the concern does not avail adequate funds as per the needs or avails too much funds leading to misuse/wastage of funds. In both the cases, profitability of the concern is adversely affected.
Likewise, financial planning also acts as a guide in designing the capital structure. While deciding the ratio/proportion of various securities in total amount of required capital, the financial executive has to consider a capital structure where the cost of capital is the minimum with no additional risk. Even a slight default in this regard may prove fatal to the concern in the long-run.
The success of a business concern depends to a greater extent upon the comprehensive financial planning. All plans relating to promotion, future expansion and development depend upon the soundness of the financial planning only.
Generally, the need and importance of financial planning are due to following factors:
(i) Successful promotion of business,
(ii) Success of entire firm,
(iii) Economy and coordination in operations,
(iv) Conservation of Capital,
(v) Expansion and development of business,
(vi) Changes in price level, and
(vii) Adequate liquidity in the business.
It may be inferred from the above discussion that financial planning is an indispensable tool for the success of various plans right from promotion to expansion and development programmes as well as for economical operations of various activities of the business entity.
One more advantage comes in the form of fair and adequate return on invested capital. J. Batty holds- adequate amount of cash and its continuous flows are must in the business.
Business firm must be able to pay its liabilities at every moment, whether the case is that of expansion or is a competitive environment or the case is of producing a new product or there is the question of modernization. Firm needs finance and for making arrangements of adequate finance at the right time, financial planning is essential.
3. Objectives of Financial Planning
The main objectives of Financial Planning are:
(1) To make available the adequate funds for business so that they can be used upto the optimum point.
(2) To collect the funds at a time when the cost of capital is minimum, considering the investors who are willing to bear risk.
(3) To bring flexibility in planning so that adjustment in the capital structure can be made with the changing circumstances.
(4) To make the financial plan simplified according to the objectives of the plan.
These objectives act as standards on the basis of which financial decisions can be evaluated. Which object is more important and which is less important, depends upon the actual circumstances. Financial plan should be evaluated from time to time so that an equilibrium in its main objectives is maintained.
4. Characteristics of a Sound Financial Plan
The financial plan of a business should be prepared carefully because the achievement of the business objectives and its long-term success depend on the financial plan along with other factors.
The basic principle of a financial plan should be the availability of adequate finance for business activities on the one hand and profitable use of the available funds on the other.
A sound financial plan should be based on the following characteristics:
The financial plan of the business should be foresighted. It should take into account not only the present requirements of the business but also the future ones. It should have the provision to fulfil the requirements of fixed and working capital.
It should be prepared, keeping in view the technological changes, changes in demand, availability of resources and other factors.
(2) Intensive Use:
Financial plans should make possible the intensive use of all available resources of finance. The misuse of capital decreases the profitability of business. There should be the balance between the long-term and short-term finances of business. It is possible when the capital requirements are correctly estimated and financial control is used.
The financial plan of the firm should be flexible too. It should be such as to make necessary adjustments regarding the changes in the scope of business and other circumstances like recession, boom time, etc. Financial plans should be prepared in a manner so that at times of less profits, business may not have to bear fixed expenses.
The financial plan should be prepared in such a manner as to maintain the necessary liquidity. Liquidity means the capacity of the business to pay its operating expenses and other short-term debts in time.
To operate the business successfully, it is necessary to pay off the creditors in time. In absence of liquidity, the business will not be able to pay its liabilities in time and consequently the goodwill of the firm is adversely affected.
Financial plan should help curtail the different expenses on issues of capital like underwriting commission, brokerage, discount, printing expenses, etc. The average cost of capital should also be minimum. The burden of fixed expenses should also be minimum. This is possible when proper balance between debt funds and owned capital is maintained.
The financial plan of a business should also be prepared considering the contingencies of business. These contingencies should be forecasted and adequate funds should be provided for to face them.
Financial plan should be prepared in accordance with the organisation structure of the firm.
While determining the financial plan, such sources of funds should be determined which can help in the availability of funds in actual practice.
5. Main Elements
Main Elements of Financial Planning are as follows:
A closure analysis of the definition given by Walker and Baughn, suggests that there are three main elements/components of financial planning:
1. Determination of Financial Objectives,
2. Formulation of Financial Policies, and
3. Developing Financial Procedures.
1. Determination of Financial Objectives:
The first element of financial planning is the setting up both long-term and short-term financial objectives of the enterprise. These objectives are in consonance with the fundamental goals of the enterprise and they serve as a guide to personnel engaged in finance functions. Long-term financial objectives are in terms of maximum, efficient and economical use of factors of production.
The maximum use of all factors of production except capital is possible only when the enterprise gets capital in required quantity, at the right time and at reasonable cost. The appropriate capitalisation and capital structure are determined and designed after due consideration of long-term financial objectives.
Short-term objectives include the arrangement of adequate cash for each activity/function of the enterprise. This requires the arrangement of working capital or inflow and outflow of funds.
2. Formulation of Financial Policies:
Formulation of financial policies in accordance with financial objectives is the second element of financial planning. These policies are formulated by various executives working in the finance department. It has to be clearly spelled out as what policies would have to be adopted for achieving the financial objectives.
Normally, such policies are formulated in respect of the following:
(i) Determining the required amount of capital;
(ii) Establishing relationship between providers of Capital and the enterprise;
(iii) Determining the ratio between debt and owners’ capital (equity);
(iv) Selecting the sources of capital;
(v) Distribution or disposal of income;
(vi) Management of working capital; and
(vii) Management of all types of assets.
3. Developing Financial Procedures:
In order to implement the financial policies formulated in accordance with financial objectives, it is imperative to develop financial procedures as well. Thus, developing financial procedure is the third element of financial planning.
Dividing the various finance functions in smaller sub-departments, delegating them (with responsibility) to employees, arranging the financial performance and control etc., are included in the development of financial procedures.
Setting the standards of performance and to reach the correct result by comparing the actual performance with standards and checking all the discrepancies have also become the elements of financial planning.
Cohen and Robbins are of the opinion that financial planning should:
i. Determine the financial resources required to meet the company’s operating programme;
ii. Forecast the extent to which these requirements will be met by internal generation of funds and to what extent they will be met from external sources;
iii. Develop the best plans to obtain the required external funds;
iv. Establish and maintain a system of financial controls governing the allocation and use of funds;
v. Formulate programmes to provide the most effective profit-volume-cost relationships;
vi. Analyse the financial results of operations; and
vii. Report the facts to the top management and make recommendations on future operations of the firm.
6. Components of Financial Planning
According to the views of Robins & Cohen’s, a financial plan should consist of mainly three components, namely:
(a) Capital Structure planning – comprises rising different forms of capital i.e., Debt & Equity mix (known as Capital mix decision)
(b) Capital Expenditure planning – deals with Capital project evaluation investment on Fixed Assets & Current Assets (known as Asset mix decision).
(c) Cash flow analysis- deals with assessing the Present value of Cash inflows & cash outflows to determine the cost-benefit of investment on different projects.
7. Types of Financial Planning
On the basis of time, financial plans can be short-term, medium-term or long-term.
(1) Short-Term Financial Planning:
The financial plans which are normally made for a one-year period are called short-term financial plans. Short-term financial plans are prepared for the efficient use of working capital. With its help, the total amount of working capital and its different sources, etc. are determined.
The main objective of a short-term financial plan is to maintain liquidity of business. Under it, different budgets like sales budget, cash budget, projected profit and loss statement, cash flow statement, etc. are prepared.
(2) Medium-Term Financial Planning:
The plans prepared for more than one year but less than five or seven years are called medium-term financial plans. Medium-term financial plan provides for medium-term funds for the business.
Medium-term funds are required for replacement of assets, purchase of additional equipment and tools, major repairs on assets, research and development activities, and fulfilling the special requirements of additional working capital.
(3) Long-Term Financial Planning:
The financial plan prepared approximately for 5 to 7 years or more is called a long-term financial plan. Long-term financial plan is prepared to fulfil the long-term objectives of business.
The programmes and policies relating to capitalisation, capital structure, replacement of fixed assets and expansion and growth of business are covered under it.
8. Steps in Financial Planning Process
For the purposes of financial planning, an organisation should take the following steps:
(1) Laying Down Financial Objectives:
In order to make an effective financial plan, first of all the financial objective of the corporation should be laid down. The financial objectives of a business help in determining policies and procedures. In the changing circumstances, the business must determine its short-term and long-term objectives in present times.
Short-term objectives should be determined in a manner that they help in the achievement of long-term objectives. The objectives should be clear and definite so that they can be used as guidelines by the executives and the activities of the organisation could be performed in an organised and coordinated manner.
The long-term financial objective of business should stress the maximum and economical use of the financial resources so that value of assets could be maximised. The liquidity of funds is maintained only when the adequate cash for each transaction is maintained. For this purpose, there is a need for effective management of working capital.
(2) Formulating Financial Policies:
The formulation of policies is the second step in financial planning. These policies act as guidelines for the procurement of funds, their utilisation and control. These help in achieving the financial goals. Policies should be based on predetermined objectives and practicable so that they can be implemented easily and effectively.
The policies should be determined at the top level of management. Normally the advice of a financial manager is sought in determining the policies and his role is decisive. These policies can relate to determination of capital structure, capitalisation, sources of funds, realisation of debt, management of capital, distribution of profit, management of working capital, management of inventory, etc.
(3) Developing Financial Procedures:
To implement the policies, it is necessary that detailed financial procedures be determined which explain all rules and sub-rules. The subordinates will come to know what work they have to do and how they have to do it. Performance can be determined effectively. It will increase the efficiency of the employees and their tasks can be coordinated.
In order to implement the predetermined objectives, policies and programmes and to control the deviations, financial control are essential under the financial plan. For this purpose, a budgetary control and cost control system is adopted.
Under it, standards are determined for financial performance. Actual performance is compared with the standards to ascertain deviations and their causes. Efforts are made to prevent the deviations.
(4) Preparation of Financial Plan:
Under this process, total capital requirement is determined. It is called capitalisation. To determine the capitalisation, fixed assets, current assets, preliminary expenses, and other expenses are determined to make the correct estimate of necessary funds.
After determining the total fund requirements, it is determined in what proportion the funds will be raised from different sources. It is called capital structure.
(5) Reviewing of Financial Planning:
Financial planning is a continuous process of business. The financial objectives, policies, procedures, capitalisation and capital structure should be modified according to the changing internal and external circumstances.
9. Factors Affecting Financial Planning
It is important for finance managers to understand aspects of the business environment because it can affect the firm and its operations. Prior to drafting financial plans, understanding the business environment is essential to discover the opportunities and threats that are evolving and that need to be addressed by the enterprise.
The external and internal factors provide managers with the foundation to create a budget, which works in tandem with financial planning. The following are the key factors to be considered while formulating and implementing a financial plan.
1. Nature of Business:
The nature of an organisation’s business directly influences its fund requirements, for example manufacturing industries require large investments in plant, machinery, warehouses and others. While, trading concerns need relatively lesser investment in such assets.
These assets continue to generate income and profits over an extended period of time. Also, funds which are once invested in fixed assets cannot be withdrawn and put to some other use.
2. Risk Appetite:
Risk appetite refers to the level of risk that an organization is willing to undertake in its normal course of business. It represents a balance between the potential benefits of new actions that a business organization undertakes and the threats that change inevitably brings.
When deciding on its risk appetite for each category of risk in its financial plan, the board of directors should consider the risk capacity of the company. This includes the amount and type of risk it is able to support in pursuit of its business objectives, taking into account its capital structure and access to financial markets.
3. Position of the Firm:
Position of the firm implies market share, goodwill, reputation of the management and financial performance of the business enterprise.
If a company is in a good position it becomes easy for it to raise funds from various sources, further it can also avail credit facilities from various suppliers at ease. Therefore a finance manager has to assess the position of the company before formulating a financial plan.
4. Study of Financial Markets:
Businesses often need to raise capital in order to fund its fixed and working capital requirements, therefore a comparative study should be undertaken to study various sources of finance critically.
Funds can be obtained through financial markets, organized forums in which the suppliers and demanders of various types of funds can make transactions.
Financial markets offer a variety of financing to meet the requirements of the organization. Therefore study of the financial market is necessary to strike out a balance between cost and risk involved in financing decisions and its impact on profitability.
5. Economic Conditions:
Economic condition means the state of the economy that is determined by numerous macroeconomic and micro economic factors, including monetary and fiscal policy, the state of the global economy, unemployment levels, productivity, exchange rates, inflation, business cycles and so on as an economy goes through expansion and contraction.
Economic conditions are considered to be sound or positive when an economy is expanding, and are considered to be adverse or negative when an economy is contracting. These micro and macro-economic factors influence the working of a business enterprise, therefore a financial plan should be designed keeping in mind these factors.
6. Future Plans:
Most of the organizations have ambitious plans of expansion, capturing wider market share and also going international.
Whatever may be the future ambition, if the financial plan adopted fails to provide sufficient capital to meet the requirement of fixed and fluctuating capital and particularly if it fails to assume the obligations by the corporations without establishing earning power, the business cannot be carried on successfully.
Hence assumption of future plans which financial planning is very necessary for the success of all future endeavours of the organization.
7. Government Policies and Control:
Governments create the rules and frameworks in which businesses operate. From time to time the government will change these rules and frameworks forcing businesses to change the way they operate.
For example government regulatory bodies such as RBI and SEBI periodically frame regulations pertaining to issue of debentures, shares, payment of dividend, mergers and acquisitions and rate of interest etc. Therefore while preparing financial plans the financial managers should take into consideration these policies.
Companies will have varying needs for financial planning and budgeting depending on the type of business and its size. Some will need detailed financial plans, with hierarchical goals and a rigid budgeting process that is established and monitored frequently.
Small, independent businesses may need just a bare-bones plan of where they hope to go and how they plan to manage expenses to continue to stay in business.
10. Significance of Financial Planning
The success of a business is based on the fact how carefully and foresightedly financial planning has been made. The future modernisation, development and growth depend on the soundness of financial planning.
The significance of financial planning can be explained as under:
(1) Optimum Utilisation of Resources:
Financial planning helps in optimum utilisation of resources because it facilitates to correctly estimate present and future capital requirements and to prevent the problems of over-capitalisation and under-capitalisation.
Various business institutions fail only due to wrong financial plans. Both excess capital and deficit capital more than required are harmful. Due to efficient financial planning, fair return on capital can be achieved.
(2) Helpful in Optimum Capital Structure:
Under the financial plan, optimum capital structure can be determined. In the capitalisation of a firm, different components of sources of finance are mixed in a manner so that cost of capital is minimum and value of the firm is maximum.
(3) Efficient Operation of Business:
The efficiency of the activities of business like production, marketing, etc. depends upon adequate availability of funds. Financial planning helps in providing adequate funds in time. In absence of financial planning, management has to make changes in the policies and procedures. It causes loss of goodwill and resources of business.
(4) Expansion of Business:
Financial plan helps make a forecast about the required capital for the future expansion of business. It helps combat the financial difficulties. The growth and expansion of firms is needed due to change in internal and external circumstances. Project planning is made under long-term financial plan.
(5) Adequate Liquidity:
Liquidity is related to the debt paying capacity of the business in short-term. To maintain the liquidity position, liquid funds are needed. In a financial plan, adequate provision of funds is made for the payment of these debts in time.
11. Limitations of Financial Planning
Financial planning is not without limitations. It works effectively only when they are overcome while formulating it.
The important limitations of this are as follows:
1. Inadaptability of plans:
Plans are decisions and decisions require facts. Facts about the future are non-existent, consequently, assumptions concerning the future must be substituted.
Since future conditions cannot be forecast accurately, the adaptability of plans is seriously limited. This is particularly true of plans which cover several years in advance, since reliability of forecasting decreases with time.
2. Reluctance of management to change:
A plan once it has been made, there are several reasons for its opposition. First, plans relating to capital expenditures often involve thousands of rupees, and commitments for funds are made months in advance and cannot readily be changed.
Secondly in addition to advance arrangements regarding capital, management often makes commitments for raw material and equipment and even starts training programs for personnel prior to the time when the plan is to be initiated.
These commitments, if broken, may result in serious problems. Thirdly, management personnel are psychologically against change, which creates rigidity.
3. Lack of coordination:
Financial planning affects each function in the organisation and to be effective, each function should be coordinated in order to ensure consistency of action. Poor coordination also disturbs limiting and sequence of events, thus making the plan ineffective. Indecision on the part of executives is often harmful to the plans.
4. Heavy investments in specialised equipment:
Mechanical evolution has brought about an increased use of specialised buildings, machinery and equipment which has resulted in an increase in the amount of capital tied up in fixed assets.Many firms cannot afford to make new plans which include the employment of these assets even though the present plan may not be the best for existing circumstances.