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Meaning and Characteristics of Financial Planning
Meaning and Characteristics of Financial Planning
business enterprise;
Simplicity
The financial plan should be as simple as possible so that it can be
easily understood even by a layman, property executed and
administered. A complicated financial plan creates unnecessary
complications and confusion.
Based
on
Clear-cut
Objectives
The financial plan should be based on the clear-cut objectives of the
company. It should aim to procure adequate funds at the lowest cost
so that the profitability of the business is improved.
Flexibility
The financial plan should not be rigid, but rather flexible enough to
accommodate the changes which may be introduced in it as and when
necessary. The rigid composition of the financial plan may cause
unnecessary irritation and may limit the future development of the
business unit.
Solvency
an
Liquidity
The financial plan should ensure solvency and liquidity of the business
enterprise. solvency requires that short-term and long-term payments
should be made on due dates positively. This will ensure credit
worthiness and good will to the business enterprise. Liquidity means
maintenance of adequate cash balance in hand. Sometimes
insufficiency of cash may make a business enterprise bankrupt.
Planning
Foresight
Financial planning should have due foresight and vision to access the
future needs, scope and scale of operation of the business enterprise.
On the basis, financial planning should be done in such a manner that
any adjustment needed in the future may be made without much
Some authors have given it a broad meaning while others have used it in a
narrow sense. According to first school of thought, capitalisation has been
defined to include the amount of capital to be raised; the securities through
which it is to be raised and the relative proportions of various classes of
securities to be issued, and also the administration of capital.
The analysis of this definition clearly shows that capitalisation is synonymous
with financial planning. Besides the amount of capital required in a business, it
decides about the determination of the form and the relative proportions of the
various classes of securities to be issued and administration of policies
concerning capital.
Lillin Doris, Gilbert Harold and Charles Gerstenberg have given narrow
interpretation of the term capitalisation. They feel that the term capitalisation
refers to the amount at which a companys business can be valued.
Some of the important definitions are discussed below:
Capitalisation of a corporation comprises the ownership capital and the
borrowed capital as represented by long-term, indebtness. It may also mean
the total accounting value of capital stock, surplus in whatever form it may
appear and funded long-term debt Lillin Doris. Capitalisation comprises (i)
ownership capital which includes capital stock and surplus in whatever form it
may appear ; and (ii) borrowed capital which consists of bonds or similar
evidences of long term debt.
Gerstenberg Capitalisation of a corporation is the sum of the par value of the
stocks and bonds outstanding Guthman and Dougall. Capitalisation is
equivalent to the valuation placed upon the fixed capital by the corporation
measured by stocks and bonds outstanding, floagland.
From these definitions it can be concluded that capitalisation is the sum-total
of all long-term securities issued by a company and surplus not meant for
distribution. In other sense, Bonneville and others defined capitalisation as the
act or process of fixing the value of an enterprise for the purpose of
determining the capital liabilities that the company may assume in exchange
for the property.
An accountant may, however, use the concept of capitalisation in a different
way. When dividends or retained earnings in the form of stock or bonus
shares are issued to the existing shareholders, capital stock is increased and
surplus decreased, the surplus is said to be capitalised and this process is
known as capitalisation.
Again, in finance, capitalisation of income means the process of estimating
the present investment value of a property by discounting the present worth,
the anticipated stream of future income. In other words, when total earnings
along with the current rate of interest are used for calculating the total capital,
the process is called capitalisation of earnings.
In this book, capitalisation has been used in the narrow sense to include the
aggregate of all types of long-term securities and surpluses not meant for
distribution. A separate term capital gearing or structure has been used to
denote the forms and proportion of various securities to be issued.
We shall discuss first the basis of capitalisation and then the different aspects
of capital structure. The separation of these two topics for the purposes of this
Over- Capitalization:
A company is said to be over-capitalized when its earnings are not sufficient
to justify a fair return on the amount of capital raised through equity and
debentures.
It is said to be over capitalized when the total of owned and borrowed
capital exceeds its fixed and current assets. This happens when it shows
accumulated losses on the assets side of the balance sheet.
An over capitalized company is like a bulky person who is not able to carry
his weight properly. Such a person is prone to many diseases and is
definitely not likely to be requisite active life. Unless the condition of
overcapitalization is rectified, the company may suffer from many
difficulties.
Causes of Over Capitalization:
The important reasons of over-capitalization are:
1. Idle funds:
The company may have unused funds lying idle in banks or in the form of
low yield investments, and there is no likelihood of using it properly in the
near future.
2. Over-valuation of acquired assets:
The fixed assets, particularly goodwill, might have been bought at a much
higher cost than warranted by the services to be rendered.
3. Fall in value of fixed assets:
Fixed assets might have been acquired at a time when prices were high and
now the prices have corrected substantially. But in the balance sheet the
assets are yet shown at their book value less depreciation written off.
4. Inadequate depreciation provision:
If proper and adequate depreciation has not been provided on the fixed
assets the result would be more profits in the Profit & Loss Account. This
book profit might have been distributed as dividend and leaving no funds
with which to replace the assets at the right time.
Remedies of over-capitalization:
The process of remedying overcapitalization is very painful. It can be
remedied through following measures:
1. Reduction in its capital so as to obtain a satisfactory relationship between
proprietary funds and net profit.
2. If over-capitalization is because of result of over-valuation of assets then
it can be remedied by bringing down the values of assets to their proper
values.
3. Reduction of debt burden. For which negotiations with the big lenders
may be made to reduce the interest obligation.
4. Preference shares may be redeemed through capital reduction scheme.
5. Reducing face value and paid up value of equity shares.
Under- Capitalization:
If the owned capital of the firm is disproportionate to the size of business
operations and the firm has to depend upon borrowed money and trade
creditors it is a sufficient indicator of undercapitalization. It may also be
because of over-trading, trading beyond capacity. It must be noted that
undercapitalization is different from high capital gearing.
In capital gearing there is a comparison between equity capital and fixed
interest bearing capital (which includes preference share capital and
excludes trade creditors) whereas in the case of under capitalization,
comparison is made between total owned capital (both equity and
preference share capital) and total borrowed capital (which includes trade
creditors as well). Under capitalization is signaled by low proprietary ratio,
high current ratio, and high return on equity capital.
Causes of Undercapitalization:
1. Under-estimation of future earnings in the beginning and also later
stages of the company.
2. Extraordinary increase in earnings.
3. Lower estimation of total fund requirements.
4. Being highly efficient through improved technology.
5. Companies established during recession make higher earnings as and
when the recession is over.
6. Companies following conservative dividend policy will in due course find
themselves gradually rising profits.
7. Purchase of assets at exceptionally low prices.
Financial plan
In business, a financial plan can refer to the three primary financial
statements (balance sheet, income statement, and cash flow statement)
created within a business plan.Financial forecast or financial plan can
also refer to an annual projection of income and expenses for a company,
division or department.[2] A financial plan can also be an estimation of cash
needs and a decision on how to raise the cash, such as through borrowing
or issuing additional shares in a company.[3]
A financial plan may be contain prospective financial statements which
are similar, but different, than a budget. Financial plans are the ENTIRE
financial accounting overview of a company. Complete financial plans
contain all periods and transaction types. Its a combination of the financial
statements which independently only reflect a past, present, or future state
of the company. Financial plans are the collection of the historical, present,
and future financial statements; for example, a (historical & present) costly
expense from an operational issue is normally presented prior to the
issuance of the prospective financial statements which propose a solution
to said operational issue.
Some period specific financial statement examples include pro
forma statements (historical period) and prospective statements (current &
future period). Compilations are a type of service which involves
"presenting, in the form of financial statements, information that is the
representation of management".[4] There are two types of "prospective
financial statements": financial forecasts & financial projections and both
relate to the current/future time period. Prospective financial statements are
a time period-type of financial statement which may reflect the
current/future financial status of a company using three main
reports/financial statements: cash flow statement, income statement, and
balance sheet. "Prospective financial statements are of two
types- forecasts and projections. Forecasts are based on management's
expected financial position, results of operations, and cash flows" [5] Pro
Forma statements take previously recorded results, the historical financial
data, and present a "what-if"; "what-if" a transaction had happened sooner.
[6]
While the common usage of the term "financial plan" often refers to a
formal and defined series of steps or goals, there is some technical
confusion about what the term "financial plan" actually means in the
industry. For example, one of the industry's leading professional
organizations, the Certified Financial Planner Board of Standards, lacks
any definition for the term "financial plan" in its Standards of Professional
Conduct publication. This publication outlines the professional financial
planner's job, and explains the process of financial planning, but the term
"financial plan" never appears in the publication's text. [7]
The accounting and finance industries have distinct responsibilities and
roles. When the products of their work are combined it produces a
complete picture, a financial plan. A financial analyst studies the data and
facts (regulations/standards) which are processed, recorded, and
presented by accountants. Normally,finance personnel study the data
results meaning- what has happened or what might happen- and propose a
solution to an inefficiency. Investors and financial institutions must see both
the issue and the solution to make an informed decision. Accountants and
financial planners are both involved with presenting issues and resolving
inefficiencies, so together, the results and explanation is provided in
a financial plan.
4. Procurement of Funds:
The financial manager takes steps to procure the funds required for the
business. It might require negotiation with creditors and financial institutions,
issue of prospectus, etc. The procurement of funds is dependent not only
upon cost of raising funds but also on other factors like general market
conditions, choice of investors, government policy, etc.
5. Utilisation of Funds:
The funds procured by the financial manager are to be prudently invested in
various assets so as to maximise the return on investment: While taking
investment decisions, management should be guided by three important
principles, viz., safety, profitability, and liquidity.
7. Management of Cash:
Management of cash and other current assets is an important task of financial
manager. It involves forecasting the cash inflows and outflows to ensure that
there is neither shortage nor surplus of cash with the firm. Sufficient funds
must be available for purchase of materials, payment of wages and meeting
day-to-day expenses.
8. Financial Control:
Evaluation of financial performance is also an important function of financial
manager. The overall measure of evaluation is Return on Investment (ROI).
The other techniques of financial control and evaluation include budgetary
control, cost control, internal audit, break-even analysis and ratio analysis.
The financial manager must lay emphasis on financial planning as well.