UNIT 2 FINANCIAL PLANNING

PRPARED BY
Prof. Preksha Dattani
UNIT 2 FINANCIAL PLANNING
Introduction:

For any organization it is very necessary to prepare proper
financial planning. If planning is not done properly then other
activities will not completed properly. There are chances of
mismanagement of finance.

The basic meaning of planning means what to do? How to do?
When to do? Where to do? So this planning now linked with
finance. It consists following.
(i)Determination of amount of finance needed by an enterprise to carry out its
operations smoothly.

(ii) Determination of sources of funds, i.e., the pattern of securities to be issued.

(iii) Determination of policy for utilizing finance effectively and effectively.

Objectives of Financial Planning:
Financial planning is done to achieve the following two objectives:

1) To ensure availability of funds whenever these are required:

The main objective of financial planning is that sufficient fund should be available
in the company for different purposes such as for purchase of long term assets, to
meet day-to- day expenses, etc. It ensures timely availability of finance. Along
with availability financial planning also tries to specify the sources of finance.

2) To see that firm does not raise resources unnecessarily:

Excess funding is as bad as inadequate or shortage of funds. If there is surplus

money, financial planning must invest it in the best possible manner as keeping
financial resources idle is a great loss for an organization.

Financial Planning includes both short term as well as the long term planning.
Long term planning focuses on capital expenditure plan whereas short term
financial plans are called budgets. Budgets include detailed plan of action for a
period of one year or less.

3) Estimating the time and source of funds:

Time is a game-changing factor in any business venture. Delivering the funds at the
right time at the right place is very much crucial. It is as vital as the generation of
the amount itself. While time is an important factor, the sources of these funds are
necessary as well.

4) Generating capital structure:

The capital structure is the composition of the capital of a company, that is, the kind
and proportion of capital required in the business. This includes planning of debt-
equity ratio both short-term and long-term.
Financial planning for an organization is the process of determining how they
will fund their activities to ensure they meet their strategic goals and objectives. In
the financial plan, activities are matched with the resources, equipment, and
materials needed for it to be achieved and a time frame is also listed.

5) Counter strategies for Risks:

Financial planning identifies the risks and issues associated with the business plan.
Once the issues are identified at the planning stage, the counter strategies are
prepared to counter the identified issues. This ensures the smooth completion of
the project and saves a lot of money and time.

Capitalization

 Capitalization refers to the valuation of the total business. It is the sum total of
owned capital and borrowed capital. Thus it is nothing but the valuation of
long-term funds invested in the business.

 It refers to the way in which its long-term obligations are distributed between
different classes of both owners and creditors. In a broader sense it means the
total fund invested in the business and includes owner’s funds, borrowed
funds, long term loans, any other surplus earning, etc. Symbolically:

 Capitalization = Share Capital + Debenture + Long term borrowing

+ Reserve + Surplus earnings.
  According to Guthmami and Dougall, ‘capitalization is the sum of the par
value of the outstanding stocks and the bonds’.

 The objective of every business is to maximize the value of the business. In

this respect the finance manager, as well as individual investors, want to know
the value created by the business. The value of business relates to the
capitalization of the business.

 The need for capitalization arises in all the phases of a firm’s business cycle.
Virtually capitalization is one of the most important areas of financial man-
agement.

OVER CAPITALIZATION


A company is said to be overcapitalized when its total capital (both equity
and debt) exceeds the true value of its assets.

It is wrong to identify over capitalization with excess of capital because
most of the overcapitalized firms suffer the problem of the liquidity.

The correct indicator of over capitalization is earning capacity of the firm. If
the earnings of the firm is less than the market expectation.

It will not be in the position to pay dividends to shareholders as per their
expectations.

This is the sign of overcapitalization. It is also possible that company has
more funds than its requirements based on current operation levels and yet
have low earnings.
Debt and equity > net asset

Company A Company B
Investment 5 lakh 6 lakh
Return 5000 5000
Rate of return 10% - proper capitalized 8% - over capitalized
causes
Over –capitalization 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
- Total funds requirentment has been over estimated
- Unpredictable circumstances (like change in import/export policy, change in
markets rates of interest, and changes in international economic, political
environment) reduce substantially 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 be overcapitalized firm.
- Existence of idle funds

Effects of overcapitalization

- Decline in earning of the company

- Fall in dividend rates
- Loss of goodwill
- Market value of the company’s share falls and the company loses its
investors. Company may collapse at any time because of anemic (Poor
/weak) financial conditions which effects its employees, society, consumers,
and share holders, employees will lose their jobs, if the company 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

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 earning
per share

Splitting of shares example

before After 2:1 – spilt of ratio

Rs 1000 1OOshares Rs.500 shares 200

100000 100000
Under – Capitalization

 Under capitalization is just considered opposite to the over-capitalization. A

company is considered to be undercapitalized when its actual capitalization
is lower than the proper capitalization.

 Undercapitalization occurs when a company does not have sufficient capital

to conduct normal business operations and pay creditors.

 This can occur when the company is not generating enough cash flow or is
unable to access forms of financing such as debt or equity.

 Undercapitalized companies also tend to choose high-cost sources of capital,

such as short-term credit, over lower-cost forms such as equity or long-term
debt.

 Investors want to proceed with caution if a company is undercapitalized

because the chance of bankruptcy increases when a company loses the
ability to service its debts.

Key points

 Undercapitalized companies do not have enough capital to pay creditors and

often need to borrow more money.

 Young companies that do not fully understand initial costs are sometimes
undercapitalized.

 If a company can't generate capital over time, chances of going bankrupt

increase, as it loses the ability to service its debts.

.
Causes of undercapitalization

- Under estimation of the future earnings at the time of the promotion of the
company.
- Abnormal increases in earnings from the new economic and the business
environments
- Under estimation of the total funds requirentment.
- 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 undercapitalization

- Under-capitalization encourages competition for increase the great number

of profit.
- It encourages the management of the company to manipulate the company’s
share price.
- High profits will attract higher amount of taxes.
- High profits will make the workers demand higher wages. such as 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 higher prices for its products.
- High margin of profits and the consequent dissatisfaction among its
employees and consumer may invite government enquiry into pricing
mechanism of the company.

Remedies

- Splitting up to the shares which will reduce the dividend per share

- Issues of debentures and shares

- Bonus share issues

Difference

Points Over-Capitalization Under-Capitalization

1. Rate of dividend Rate of dividend is lesser Rate of dividend is higher

in over-capitalization in under capitalization
2. competition It discourages competition It encourage the cut throat
competition
3. Goodwill Goodwill looses in over Increase the goodwill in
capitalization undercapitalization
4. Earnings per share Earnings per share Earnings per share
decreases. increases
5. Misuse of capital Capital is not misused in Capital is misused in this
this situation situation
6. market value of Market value of share is Market value of share
share reduced increased
7. clause This situation is arise due It arises due to
to over capital issue undercapitalization of
requirentment capital
8. Opposition of Due to less income Workers believe that
workers ,enterprise reduce the salary will increase due to
salary of workers more income.