MB0045 - Financial Management Unit-2 Financial PlanningProgram Semester Subject Code Book Id Subject Name Unit number Unit Title : MBA :I : MB0045 : B1134 : Financial Management :2 : Financial Planning 1 HOME Confidential NEXT MB0045 - Financial Management Unit-2 Financial Planning Introduction • 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 longrange and short-range financial plans. Integration of both these plans is required for the effective utilisation of all the resources of the firm. Financial planning is a process by which funds required for each course of action is decided. 2 PREVIOUS HOME Confidential NEXT • • • • • MB0045 . Effects of under-capitation. Cases of over-capitation. The steps involved in financial planning. 3 PREVIOUS HOME Confidential NEXT .Financial Management Unit-2 Financial Planning Objectives Session Objectives: To • • • • understand. The factors effecting financial planning. new business to be taken up and the dynamics of capital market conditions – Formulation of policies. Financial planning or financial plan indicates: – The quantum of funds required to execute business plans • • – Composition of debt and equity.MB0045 . giving effect to the financial plans under consideration 4 PREVIOUS HOME Confidential NEXT . Decisions on the composition of debt and equity must be taken.Financial Management Unit-2 Financial Planning Objectives • A financial plan has to consider capital structure. keeping in view the risk profile of the existing business. capital expenditure and cash flow. • 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. • • 5 PREVIOUS HOME Confidential NEXT . It helps in formulation of policies and instituting procedures for elimination of wastages in the process of execution of strategic plans.Financial Management Unit-2 Financial Planning Benefits • • A financial plan is at the core of value creation process. It ensures effective utilisation of the funds.MB0045 . Financial planning helps in reducing the operating capital of a firm. Employ current cost principle wherever required. Make maximum use of spontaneous source of finance to achieve highest productivity of resources. Exercise thorough control over overheads. Give due attention to the physical capital maintenance or operating capability.MB0045 . Never ignore the need for financial capital maintenance in units of constant purchasing power. • • • • • • • 6 PREVIOUS HOME Confidential NEXT .Financial Management Unit-2 Financial Planning Guidelines for Financial Planning • • Never ignore the coordinal principle that fixed asset requirements be met from the long term sources. formulate plough back policy of earnings. Maintain the operating capital intact by providing adequate out of the current periods earnings. Seasonal peak requirements to be met from short term borrowings from banks. Keeping the need of finance for expansion of business. Give due weight age to cost and risk in using debt and equity. flow of funds and costs to be incurred. assets required. • Developing a detailed plan of funds required for the plan period under various heads of expenditure. • Formulate strategies for attaining the defined objectives.Financial Management Unit-2 Financial Planning Steps in Financial Planning Establish Corporate Objectives Formulate Strategies • Corporate objectives can be grouped into qualitative and quantitative. Operating plans helps achieve the purpose. profit targets is to be fixed on respective executives.MB0045 . operating targets. • Incorporate an inbuilt mechanism which would scale up or scale down the operations accordingly. 7 Confidential NEXT Delegate responsibilities Forecast Financial Variables Develop Plans Create flexible economic environment PREVIOUS HOME . • Forecast the various financial variables such as sales. • Responsibility for achieving sales target. cost management bench-marks. This demands effective database for reasonable budgeting of expenses. Budgeted expense method Expenses for the planning period are budgeted on the basis of anticipated behaviour of various items of cost and revenue. • • 8 PREVIOUS HOME Confidential NEXT .MB0045 . Combination of both these methods The combination of both these methods is used because some expenses can be budgeted by the management 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.Financial Management Unit-2 Financial Planning Income Statement Methods of preparing Income Statement • Percent of sales method or constant ratio method This approach is based on the assumptions that each element of cost bears some constant relationship with the sales revenue. • Compute the sales revenue.Financial Management Unit-2 Financial Planning Balance Sheet The following steps discuss the forecasting of the balance sheet. 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 • 9 PREVIOUS HOME Confidential NEXT . having a close relationship with the items of certain assets and liabilities.MB0045 . MB0045 . 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 • ^Following is a comprehensive formula for ascertaining the external financial requirements. 10 PREVIOUS HOME Confidential NEXT .Financial Management Unit-2 Financial Planning Computerised Financial Planning System • • All corporate forecasts use computerised forecasting models. • Size of the company . This will have a major impact on the total assets that a firm owns.a company with good reputation can tap the capital market for raising funds in competitive terms.Financial Management Unit-2 Financial Planning Factors Affecting Financial Plan • Nature of the industry .MB0045 . for implementing new projects.Selection of sources of finance is closely linked to the firm’s capability to manage the risk exposure. • • 11 PREVIOUS HOME Confidential NEXT .The size of the company greatly influences the availability of funds from different sources. to exploit the new opportunities emerging from changing business environment. Sources of finance available .check whether the industry is a capital intensive or labour intensive industry. Status of the company in the industry . They are to be complied with a time constraint.Financial Management Unit-2 Financial Planning Factors Affecting Financial Plan • Capital structure of a company . Flexibility – Plan should possess flexibility so as to effect changes in the composition of capital structure whenever need arises.prudent policy of any good financial plan is to match the term of the source with the term of the investment. • Matching the sources with utilisation .influenced by the desire of the existing management (promoters) of the company to retain control over the affairs of the company.Management of public issues of shares demands the compliances with many statues in India. • • 12 PREVIOUS HOME Confidential NEXT .MB0045 . Government policy . Capital requirements of a firm could be grouped into fixed capital and working capital.MB0045 . • 13 PREVIOUS HOME Confidential NEXT . – The long term requirements such as investments in fixed assets will have to be met out of funds obtained on long term basis – Variable working capital requirements which fluctuate from season to season will have to be financed only by short term sources • Any departure from this well accepted norm causes negative impact on firm’s finances.Financial Management Unit-2 Financial Planning Estimations of Financial Requirements • The estimation of capital requirements of a firm involves a complex process. It has two components – Debt and Equity.MB0045 .Financial Management Unit-2 Financial Planning Capitalisation • Capitalisation of a firm refers to the composition of its long term funds and its capital structure. which actually is the representative of the industry.Earnings are forecasted and capitalised at a rate of return. There are two theories of capitalisation for the new companies: Cost 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 • Earnings Theory . Earnings theory involves two steps: •Estimation of the average annual future earnings •Estimation of the normal earning rate of the industry to which the company belongs 14 PREVIOUS HOME Confidential NEXT . Over-capitalisation may be considered on the account of: – Acquiring assets at inflated rates – Acquiring unproductive assets – High initial cost of establishing the firm – Total funds requirements have been over estimated – Inadequate provision of depreciation. when its total capital (both equity and debt) exceeds the true value of its assets.Financial Management Unit-2 Financial Planning Capitalisation Over-Capitalisation • A company is said to be over-capitalised. leading to over-capitalisation of the firm – Existence of idle funds – New businesses established in boom period. adversely effects the earning capacity of the company. forced to pay more for acquiring assets.MB0045 . interest rates) reduce substantially the earning capacity of the firm. – Unpredictable circumstances (like change of policies. 15 PREVIOUS HOME Confidential NEXT • . MB0045 . Remedies: – 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 16 PREVIOUS HOME Confidential NEXT • . consumers and its shareholders.Financial Management Unit-2 Financial Planning Capitalisation • Effects of over-capitalisation: – Decline in earnings of the company – Fall in dividend rates – Market value of the company’s share falls. society. and the company loses investors confidence – Company may collapse at any time because of anaemic financial conditions which affect its employees. Causes: – 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 17 PREVIOUS HOME Confidential NEXT • .MB0045 .Financial Management Unit-2 Financial Planning Capitalisation Under-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. MB0045 .Financial Management Unit-2 Financial Planning Capitalisation • Symptoms: – Actual capitalisation is less than the warranted by its earning capacity – Rate of earnings is exceptionally high in relation to the return enjoyed by similar situated companies in the same industry Effects: – 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 • 18 PREVIOUS HOME Confidential NEXT . 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. which will reduce the dividend per share – Issue of bonus shares. • 19 PREVIOUS HOME Confidential NEXT .Financial Management Unit-2 Financial Planning Capitalisation – 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.MB0045 . may invite governmental enquiry into the pricing mechanism of the company • Remedies: – Splitting up of the shares. MB0045 . benefits Steps in financial planning Factors that affect financial planning Capitalisation – causes. effects and remedies PREVIOUS HOME Confidential 20 .Financial Management Unit-2 Financial Planning Summary You have learnt: • • • • • What is financial planning Its objectives.