MB0045 Slides Unit 02

C o n f i d e n t i a l

MB0045 - Financial Management

Unit-2 Financial Planning

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Program : MBA

Semester : I

Subject Code : MB0045

Book Id : B1134

Subject Name : Financial Management

Unit number : 2

Unit Title : Financial Planning

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• 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.

• Financial planning is a process by which funds required for each course of action is decided.

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Introduction

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Session Objectives:

To understand,

• The steps involved in financial planning.

• The factors effecting financial planning.

• Cases of over-capitation.

• Effects of under-capitation.

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Objectives




• A financial plan has to consider capital structure, capital expenditure and cash flow.

• Decisions on the composition of debt and equity must be taken.

• 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

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Objectives

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• A financial plan is at the core of value creation process.

• It ensures effective utilisation of the funds.

• 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.

• It 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.

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Benefits

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• Never ignore the coordinal principle that fixed asset requirements 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 adequate 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 weight age 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.

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Guidelines for Financial Planning

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• Corporate objectives can be grouped into qualitative and quantitative.

Establish Corporate Objectives

• Formulate strategies for attaining the defined objectives. Operating plans helps achieve the purpose.

Formulate Strategies

• Responsibility for achieving sales target, operating targets, cost management bench-marks, profit targets is to be fixed on respective executives.

Delegate responsibilities

• Forecast the various financial variables such as sales, assets required, flow of funds and costs to be incurred.

Forecast Financial Variables

• Developing a detailed plan of funds required for the plan period under various heads of expenditure.

Develop Plans

• Incorporate an inbuilt mechanism which would scale up or scale down the operations accordingly.

Create flexible economic environment

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Steps in Financial Planning

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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.

• Budgeted expense method

Expenses for the planning period are budgeted on the basis of anticipated behaviour of various items of cost and revenue. This demands effective database for reasonable budgeting of expenses.

• 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.

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Income Statement

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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

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Balance Sheet

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• 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

• ^Following is a comprehensive formula for ascertaining the external financial requirements.

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Computerised Financial Planning System

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• Nature of the industry - 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.

• Status of the company in the industry - a company with good reputation 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 - Selection of sources of finance is closely linked to the firm’s capability to manage the risk exposure.

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Factors Affecting Financial Plan

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• Capital structure of a company - influenced by the desire of the existing management (promoters) of the company to retain control over the affairs of the company.

• Matching the sources with utilisation - prudent policy of any good financial plan is to match the term of the source with the term of the investment.

• Flexibility – Plan should possess flexibility so as to effect changes in the composition of capital structure whenever need arises.

• Government policy - Management of public issues of shares demands the compliances with many statues in India. They are to be complied with a time constraint.

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Factors Affecting Financial Plan

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

• 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

– 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.

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Estimations of Financial Requirements

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• Capitalisation of a firm refers to the composition of its long term funds and its capital structure. It has two components – Debt and Equity.

• There are two theories of capitalisation for the new companies:

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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 are forecasted and capitalised at a rate of return, which actually is the representative of the industry. 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

Capitalisation

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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.

• 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, adversely effects the earning capacity of the company, leading to over-capitalisation of the firm

– Existence of idle funds

– New businesses established in boom period, forced to pay more for acquiring assets.

– Unpredictable circumstances (like change of policies, interest rates) reduce substantially the earning capacity of the firm.

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Capitalisation

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• Effects of over-capitalisation:

– Decline in earnings of the company

– Fall in dividend rates

– 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 its shareholders.

• 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

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Capitalisation

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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.

• 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

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Capitalisation

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• 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

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Capitalisation

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– 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:

– 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.

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Capitalisation

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You have learnt:

• What is financial planning

• Its objectives, benefits

• Steps in financial planning

• Factors that affect financial planning

• Capitalisation – causes, effects and remedies

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Summary

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MB0045 Slides Unit 02

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