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Financial Management Unit 2
Sikkim Manipal University Page No. 30
Unit 2 Financial Planning
Structure:
2.1 Introduction
Objectives
Objectives of financial planning
Benefits of financial planning
Guidelines for financial planning
2.2 Steps in Financial Planning
Forecast of income statement
Forecast of balance sheet
Computerised financial planning system
2.3 Factors Affecting Financial Planning
2.4 Estimation of Financial Requirements of a Firm
2.5 Capitalisation
Cost theory
Earnings theory
Over-capitalisation
Under-capitalisation
2.6 Summary
2.7 Glossary
2.8 Terminal Questions
2.9 Answers
2.10 Case Study
2.1 Introduction
In the previous unit, you have learnt about the meaning and definition of
financial management, goals of financial management, functions of finance,
and the interface between finance and other business functions. In this unit,
we will discuss the steps in financial planning, factors affecting financial
planning, estimation of financial requirements of a firm, and the concept of
capitalisation.
Liberalisation and globalisation policies initiated by the government have
changed the dimension of business environment. Therefore, for survival and
growth, a firm has to execute planned strategies systematically. To execute
Financial Management Unit 2
Sikkim Manipal University Page No. 31
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.
The long-range plans must include:
Funds required for executing the planned course of action
Funds available at the disposal of the company
Determination of funds to be procured from outside sources
Objectives:
After studying this unit, you should be able to:
explain the steps involved in financial planning
analyse the factors affecting financial planning
estimate the financial requirements of a Firm
explain the effects of capitalisation
2.1.1 Objectives of financial planning
Financial planning is a process by which funds required for each course of
action is decided.
Financial planning means deciding in advance the financial activities to be
carried on to achieve the basic objective of the firm. The basic objective of
the firm is to get maximum profit with minimum losses or risk.
So, the basic purpose of the financial planning is to make sure that
adequate funds are raised at the minimum cost (optimal financing) and that
they are used wisely. Thus planners of financial policies must see that
adequate finance is available with the concern, because an inadequate
supply of funds will hamper operations and lead to crisis. Too much capital,
on the other hand, means lower earnings to the unit holders. A proper
planning is therefore necessary.
A financial plan has to consider capital structure, capital expenditure, and
cash flow. Decisions on the composition of debt and equity must be taken.
Highest earnings can be assured only through sound financial plans. A
faulty financial plan may ruin the business completely. So, sound financial
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Financial Management Unit 2
Sikkim Manipal University Page No. 32
planning is necessary to achieve the long-term and the short-term objectives
of the firm and to protect the interest of all parties concerned, i.e., the firm,
the creditors, the shareholders, and the public.
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
2.1.2 Benefits of financial planning
Financial planning also helps firms in the following ways:
A financial plan is at the core of value creation process. A successful
value creation process can effectively meet the benchmarks of investor’s
expectations.
Financial planning ensures effective utilisation of the funds. To manage
shortage of funds, planning helps the firms to obtain funds at the right
time, in the right quantity, and at the least cost as per the requirements
of finance emerging opportunities. Surplus is deployed through well-
planned treasury management. Ultimately, the productivity of assets is
enhanced.
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.
Financial planning 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.
Operating capital refers to the ratio of capital employed to the sales
generated. Maintaining the operating capability of the firm through the
evolution of scientific replacement schemes for plant and machinery and
other fixed assets will help the firm in reducing its operating capital.
Along with fixed assets such as plant and equipment, working capital is
considered a part of operating capital.
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2.1.3 Guidelines for financial planning
The following are the guidelines of a financial plan:
Never ignore the cardinal principle that fixed asset requirements must 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 adequately 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 weightage 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.
A strategic financial plan of a firm spells out its corporate purpose,
scope, objectives, and strategies. As a financial manager, one must:
Sensitise the strategic planning group to the financial implications of
various choices
Ensure that the chosen strategic plan is financially feasible
Translate the plan that is finally adopted into a long-range financial
plan
Coordinate the development of the budget
Activity-1:
Review the annual report of Dell computers for the year 2008 and 2009.
Find out how does it minimize the operating capital to support sales
Hint: A study of annual reports of Dell computers will throw light on how
Dell strategically minimised the operating capital required to support
sales. Such companies are admired by investing community.
Operating capital = Capital employed/Sales generated
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Financial Management Unit 2
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2.2 Steps in Financial Planning
There are six steps involved in financial planning. Figure 2.1 depicts the
steps involved in financial planning.
Figure 2.1: Steps in Financial Planning
Let us now study the steps in detail.
Establish corporate objectives – The first step in financial planning is
to establish corporate objectives. Corporate objectives can be grouped
into two:
o Qualitative and quantitative objectives
o Short-term, medium-term, and long-term objectives
For example, a company’s mission statement may specify “create
economic – value added.” However this qualitative statement has to be
stated in quantitative terms such as a 25% ROE or a 12% earnings
growth rates. Since business enterprises operate in a dynamic
environment, there is a need to formulate both short-term and long-term
objectives.
Formulate strategies – The next stage in financial planning is to
formulate strategies for attaining the defined objectives. Operating plans
help to achieve the purpose. Operating plans are framed with a time
horizon. It can be a five-year plan or a ten-year plan.
Assign responsibilities – Once the plans are formulated, responsibility
for achieving sales target, operating targets, cost management
benchmarks, and profit targets are to be fixed on respective executives.
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Financial Management Unit 2
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Forecast financial variables – The next step is to forecast the various
financial variables such as sales, assets required, flow of funds, and
costs to be incurred. These variables are to be translated into financial
statements.
Financial statements help the finance manager to monitor the deviations
of actual from the forecasts and take effective remedial measures. This
ensures that the defined targets are achieved without any overrun of
time and cost.
Develop plans – This step involves developing a detailed plan of funds
required for the plan period under various heads of expenditure. From
the plan, a forecast of funds that can be obtained from internal as well as
external sources during the time horizon is developed. Legal constraints
in obtaining funds on the basis of covenants of borrowings are given due
weightage. There is also a need to collaborate the firm’s business risk
with risk implications of a particular source of funds. A control
mechanism for allocation of funds and their effective use is also
developed in this stage.
Create flexible economic environment – While formulating the plans,
certain assumptions are made about the economic environment. The
environment, however, keeps changing with the implementation of plans.
To manage such situations, there is a need to incorporate an in-built
mechanism which would scale up or scale down the operations
accordingly.
Forecasting of financial statements:
Following are some basic points that would help you to understand the
importance of financial forecasting before we study the methods of
forecasting and income statement/balance sheet.
Financial forecasting is the process of estimating future business
performance (sales, costs, earnings).
Corporations and companies employ forecasting to do financial planning
which includes an assessment of their future financial needs.
Forecasting is also important for production planning, human resource
planning, etc.
Forecasting is also used by outsiders to value companies and their
securities.
Financial Management Unit 2
Sikkim Manipal University Page No. 36
Financial planning is enabled by creating pro forma income statements and
balance sheets. These are forecasted financial statements. As we have
discussed, financial planning is a continuous process of directing and
allocating financial resources to meet strategic goals and objectives. The
output from financial planning takes the form of budgets. The most widely
used form of budgets is pro forma or budgeted financial statements.
The pro forma statements help to have a comprehensive look at the likely
future financial performance. While the pro forma income statement
represents the operational plan for the whole organisation, the pro forma
balance sheet reflects the cumulative impact of anticipated future decisions.
Budgets include:
Cash budget
Operating budget
Sales budget
Production budget
Sales and distribution expenses budget
Administrative overheads budget
2.2.1 Forecast of income statement
There are three methods of forecasting income statement:
Percent of sales method or constant ratio method
Expense method
Combination of the above two
Percent of sales method
This is the most basic method of forecasting a financial statement. It
assumes that certain expenses, assets, and liabilities maintain a constant
relationship to the level of sales.
Basically, this method assumes that future relationship between various
elements of cost to sales will be similar to their historical relationships.
These cost ratios are generally based on the average of previous two or
three years. For example, cost of goods sold may be expressed as a
percentage of sales.
Therefore, the key driver of this method is the sales forecast and based on
this, pro forma financial statements (i.e., forecasted) can be constructed and
the firm’s needs for external financing can be identified.
Financial Management Unit 2
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Since sales have a significant effect on the financial needs of a business,
different items of assets, liabilities, revenue, and expenses can be
expressed as a percentage of sales.
The first step is to express the income statement accounts which vary
directly with sales as percentages of sales. This is calculated by dividing the
balance for these accounts for the current year by sales revenue for the
current year.
The accounts which generally vary closely with sales are cash accounts,
receivable, inventory, and accounts payable.
On the income statement, costs are expressed as a percentage of sales.
Since we are assuming that all costs remain at a fixed percentage of sales,
net income can be expressed as a percentage of sales. This indicates the
profit margin.
Caselet:
Raw material cost is 40% of sales revenue for the year ended 31.03.2007.
However, this method assumes that the ratio of raw material cost to sales
will continue to be the same in 2008 also. Such an assumption may not
look good in most of the situations.
If in case, raw material cost increases by 10% in 2008 but selling price of
finished goods increases only by 5%. In this case raw material cost will be
44/105 of the sales revenue in 2008. This can be solved to some extent by
taking the average for the same representative years. However, inflation,
change in government policies, wage agreements, and technological
innovation totally invalidate this approach on a long run basis.
Financial Management Unit 2
Sikkim Manipal University Page No. 38
Illustration:
The Profit and Loss statement of Biotech Ltd. for the years 2000 and 2001
are given below. If the sales for the year 2002 are estimated at
Rs. 22,00,000, prepare a pro forma income statement for the year 2002
using the percent of sales method.
(Rs. ‘000) 2000 2001
Total sales
Cost of goods sold
Gross profit
Selling and administration expenses
Depreciation
Operating profit
Non-operating surplus
EBIT
Interest
Tax
Profit after tax
Dividends
Retained earnings
1,200
700
500
180
50
270
40
310
160
60
90
30
60
1,800
1,100
700
220
80
400
80
480
160
100
220
60
160
Solution:
Average percent of sales
Pro forma income statement for 2002
(in Rs. ’000)
Net sales
Cost of goods sold
Gross profit
Selling and administration expenses
Depreciation
Operating profit
Non-operating surplus
EBIT
Interest
Tax
Profit after tax
Dividends
Retained earnings
100
60
40
13.33
4.3
22.36
4
26.4
10.67
5.3
10.33
3
7.33
2,200
1,320
880
293
95
492
88
580
235
117
228
66
162
Financial Management Unit 2
Sikkim Manipal University Page No. 39
Working notes:
Total cost of goods sold for 2000 and 2001 = Rs 18,00,000.
Total sales for the year 2000 and 2001 = Rs. 30,00,000.
Hence, percentage of total cost of goods sold relative to sales = 18,00,000 /
30,00,000 X 100 = 60
The other items are also computed in a similar manner.
Budgeted expense method
Expenses for the planning period are budgeted on the basis of anticipated
behaviour of various items of cost and revenue.
The value of each item is estimated on the basis of expected developments
in the future period for which the pro forma P&L account is being prepared.
It calls for greater effort on the part of management since they have to
define the likely happenings. This also demands effective database for
reasonable budgeting expenses.
Combination of both these methods
The combination of both these methods is used because some expenses
can be budgeted by the management. This is done 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.
The budgeted income statement will pull together all revenue and expense
estimates from previously prepared detail budgets. Once this statement is
prepared, the budgeted balance sheet can be prepared.
2.2.2 Forecast of balance sheet
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.
Projections for Balance sheet can be made as listed below:
Employ percent of sales method to project items on the asset side,
except “Investments” and “Miscellaneous Expenses and Losses”.
Financial Management Unit 2
Sikkim Manipal University Page No. 40
Expected values for “Investments” and “Miscellaneous Expenses and
Losses” can be estimated using specific information.
Use percent of sales method to project values of current liabilities and
provisions.(also referred to as ‘spontaneous liabilities’).
Projected values of reserves and surplus can be obtained by adding
projected retained earnings from P&L pro forma statement.
Projected value for equity and preferential capital can be set tentatively
equal to their previous values.
Projected values for loan funds will be tentatively equal to their previous
level, less repayments or retirements.
Compare the total of asset side with that of liabilities side and determine
the balancing figure. (If assets exceed liabilities, the balancing figure
represents external funding requirement. If liabilities exceed assets, the
balancing item represents surplus available funds).
The budgeted balance sheet will provide an estimate of how much external
financing is required to support estimated sales.
The main link between the income statement and the balance sheet is
retained earnings. Therefore, preparation of the budgeted balance sheet
starts with an estimate of the ending balance for retained earnings. In order
to estimate ending retained earnings, one has to project future dividends
based on current dividend policies and what management expects to pay in
the next planning period.
Once the budgeted balance sheet is prepared, it will show either a surplus
(excess financing over assets) or a deficit (additional financing needed to
cover assets). This difference is derived from the accounting equation:
Assets = Liabilities + Equity.
We can also calculate External Financing Required (EFR) based on the
relationships between assets, liabilities, and sales.
Financial Management Unit 2
Sikkim Manipal University Page No. 41
Caselet
The following details have been extracted from the books of X Ltd.
Table 2.1 and table 2.2 depict the income statement and balance sheet
respectively.
Table 2.1: Income Statement
2006 2007
Sales less returns 1000 1300
Gross profit 300 520
Selling expenses 100 120
Administration 40 45
Deprecation 60 75
Operating profit 100 280
Non-operating income 20 40
EBIT (Earnings Before Interest and Tax) 120 320
Interest 15 18
Profit before tax 105 302
Tax 30 100
Profit after tax 75 202
Dividend 38 100
Retained earnings 37 102
Table 2.2: Balance Sheet
Liabilities 2006 2007 Assets 2006 2007
Shareholder’s fund Fixed assets 400 510
Share capital Less depreciation 100 120
Equity 120 120 300 390
Preference 50 50 Investments 50 50
Reserves and surplus
122 224
Secured loans 100 120 Current assets, loans, and advances
Unsecured loans 50 60 Cash at bank 10 12
Receivables 80 128
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Current liabilities Inventories 200 300
Trade creditors 210 250 Loans and advances
50 80
Provisions Miscellaneous expenditure
10 24
Tax 10 60
Proposed dividend 38 100
700 984 700 984
Forecast the income statement and balance sheet for the year 2008 based on the following assumptions:
Sales for the year 2008 will increase by 30% over the sales value for 2007
Use percent of sales method to forecast the values for various items of income statement using the percentage for the year 2007
Depreciation is charged at 25% of fixed assets
Fixed assets will increase by Rs. 100 million
Investments will increase by Rs. 100 million
Current assets and current liabilities are to be decided based on their relationship with the sales in the year 2007
Miscellaneous expenditure will increase by Rs. 19 million
Secured loans in 2008 will be based on its relationship with the sales in the year 2007
Additional funds required, if any, will be met by bank borrowings
Tax rates will be 30%
Dividends will be 50% of the profit after tax
Non-operating income will increase by 10%
There will be no change in the total amount of administration expenses to be spent in the year 2008
There is no change in equity and preference capital in 2008
Interest for 2008 will maintain the same ratio as it has in 2007 with the sales of 2007
Table 2.3 and table 2.4 depict the forecast of the income statement and the balance sheet for the year 2008 respectively.
Table 2.3: Income Statement
Particulars Basis Working Amount (Rs.)
Sales Increase by 30% 1300 x 1.3 1690
Cost of sales Increase by 30% 780 x 1.3 1014
Gross profit Sales-cost of sales 1690-1014 676
Financial Management Unit 2
Sikkim Manipal University Page No. 43
Selling expenses 30% increase 120 x 1.3 156
Administration No change 45
Depreciation % given
4
100390
123 (Rounded off)
Operating profit C - (D + E + F) 352
Non-operating income Increase by 10% 1.1 x 40 44
Earnings Before Interest and Taxes (EBIT)
396
Interest Salesof
1300
18
1300
169018
23
(Decimal
ignored)
Profit before tax 373
Tax 112
Profit after tax 261
Dividends 130
Retained earnings 131
Table 2.4: Balance Sheet
Particulars Basis Working Amount (Rs.)
Assets
Fixed assets Given 510
Add: Addition 100
610
Depreciation 120 + 123 243
1. Net fixed assets 367
2. Investments 150
3. Current assets, loans, and advances
Cash at bank
1300
12
1300
169012
16
(Rounded off)
Receivables
1300
128
1300
1690128
166
Financial Management Unit 2
Sikkim Manipal University Page No. 44
Inventories
1300
300
1300
1690300
390
Loans and advances
1300
80
1300
169080
104
4. Miscellaneous
Expenditure Given 24 + 19 43
Total 1236
Liabilities
1. Share capital
Equity 120
Preference 50
2. Reserves and surplus Increase by current year’s retained earnings
355
3. Secured loan
1300
60
1300
169060
78
Bank borrowings 40 (Difference –
Balancing figure)
4. Unsecured loan 60 60
5. Current liabilities and provision
Trade creditors
1300
250
1300
1690250
325
Provision for tax
1300
60
1300
169060
78
Proposed dividend Current year given
130
Total liabilities 1236
2.2.3 Computerised financial planning system
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:
Financial Management Unit 2
Sikkim Manipal University Page No. 45
Additional Funds Required = Required Increase in Assets – Spontaneous
Increase in Liabilities – Increase in Retained Earnings
(This formula has been recommended by Eugene F. Brigham and Michael
C. Earnhardt in the book Financial Management – Theory and Practice)
Prof. Prasanna Chandra, in his book Financial Management, (6th edition -
Manohar Publishers and Distributors) has given a comprehensive formula
for ascertaining the external financial requirements.
Here
(ΔΔsS
A = Expected increase in assets, both fixed assets and current
assets required for the expected increase in sales in the next year.
(ΔΔsS
L = Expected spontaneous finance available for the expected
increase in sales.
MS1 (1-d) = It is the product of profit margin, expected sales for the next
year, and the retention ratio.
Retention ratio = 1 – payout ratio.
Payout ratio refers to the ratio of the dividend paid to the earnings per
share.
1m = Expected change in the level of investments and miscellaneous
expenditure.
SR = It is the firm’s repayment liability on term loans and debenture for
the next year.
The formula described above has certain features:
Ratios of assets and spontaneous liabilities to sales remain constant
over the planning period.
Dividend payout and profit margin for the next year can be reasonably
planned in advance.
Since external funds requirements involve borrowings from financial
institution, the formula rightly incorporates the management’s liability on
repayments.
EFR =S
)s(L
S
)s(A
– MS1 (1-d) – (1m + SR)
Financial Management Unit 2
Sikkim Manipal University Page No. 46
Solved Problem
X Ltd. has given the following forecasts: “Sales in 2008 will increase from
Rs. 1000 to Rs. 2000 in 2007”. Table 2.5 depicts the balance sheet of the
company as on December 31, 2007.
Table 2.5: Balance Sheet
Liabilities Rs. Assets Rs.
Share capital Net fixed assets 500
Equity (Shares of Rs.10 each)
100 Inventories 200
Reserves and surplus 250 Cash 100
Long term loan 400 Bills receivable 200
Creditors for expenses outstanding
50
Trade creditors 50
Bills payable 150
1000 1000
Taking into account the following information, the external funds
requirements for the year 2008 has to be ascertained:
The company’s utilisation of fixed assets in 2007 was 50% of capacity but
its current assets were at their proper levels.
Current assets increase at the same rate as sales.
Company’s after-tax profit margin is expected to be 5%, and its payout
ratio will be 60%.
Creditors for expenses are closely related to sales.
(Adapted from IGNOU MBA).
Solution:
Preliminary workings:
A = Current assets = Cash + Bills receivables + Inventories
= 100 + 200 +200 = 500
Financial Management Unit 2
Sikkim Manipal University Page No. 47
500.Rs10001000
500)s(
S
A
L = Trade creditors + Bills payable + Expenses outstanding
= 50 + 150 + 50 = Rs. 250
250.Rs10001000
250)s(
S
L
M (Profit margin) = 5 / 100 = 0.05
S1 = Rs.2000
1-d = 1 – 0.6 = 0.4 or 40 %
1m = NIL
SR = NIL
Therefore: sS
L
S
)s(AEFR
- ms1 (1-d) – (1m + SR)
= 500 – 250 – (0.05 x 2000 x 0.4) – (0 + 0)
= 500 – 250 – 40 - (0 + 0)
= Rs. 210
Therefore, external fund requirements for 2008 will be Rs. 210. This
additional fund requirement will be procured by the firm based on its
policy on capital structure.
Self Assessment Questions
1. Corporate objectives could be grouped into ___ and ___.
2. Control mechanism is developed for _____ and their effective use.
3. Seasonal peak requirements to be met from __________________
from banks.
2.3 Factors Affecting Financial Planning
Figure 2.2 depicts the various factors affecting financial plan.
Financial Management Unit 2
Sikkim Manipal University Page No. 48
Figure 2.2: Factors Affecting Financial Plan
Let us now discuss these factors in detail.
Nature of the industry – The first factor affecting the financial plan is
the nature of the industry. Here, we must 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. A small company normally
finds it difficult to raise funds from long-term sources at competitive
terms.
On the other hand, large companies like Reliance enjoy the privilege of
obtaining funds both short-term and long-term at attractive rates.
Status of the company in the industry – A well-established company
enjoys a good market share, because its products normally command
investor’s confidence. Such a company 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.
Financial Management Unit 2
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Sources of finance available – Sources of finance could be grouped
into debt and equity. Debt is cheap but risky whereas equity is costly. A
firm should aim at optimum capital structure that would achieve the least
cost capital structure. A large firm with a diversified product mix may
manage higher quantum of debt because the firm may manage higher
financial risk with a lower business risk. Selection of sources of finance is
closely linked to the firm’s capability to manage the risk exposure.
The capital structure of a company – The capital structure of a
company is influenced by the desire of the existing management
(promoters) of the company to retain control over the affairs of the
company. The promoters who do not like to lose their grip over the
affairs of the company normally obtain extra funds for growth by issuing
preference shares and debentures to outsiders.
Matching the sources with utilisation – The prudent policy of any
good financial plan is to match the term of the source with the term of the
investment. To finance fluctuating working capital needs, the firm resorts
to short-term finance. All fixed-asset investments are to be financed by
long-term sources which is a cardinal principle of financial planning.
Flexibility – The financial plan of a company should possess flexibility
so as to effect changes in the composition of capital structure whenever
the need arises. If the capital structure of a company is flexible, there will
not be any difficulty in changing the sources of funds. This factor has
become a significant one today because of the globalisation of capital
market.
Government policy – SEBI guidelines, finance ministry circulars,
various clauses of Standard Listing Agreement and regulatory
mechanism imposed by FEMA, and Department of Corporate Affairs
(government of India) influence the financial plans of corporates today.
Management of public issues of shares demands the compliances with
many statutes in India. They are to be complied with a time constraint.
Self Assessment Questions
4. ______ has a major impact on the total assets that the firm owns.
5. Sources of finance could be grouped into ______ and _____.
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6. ___________ of any good financial plan is to match the term of the
source with the term of the investment.
7. _____ refers to the ability to _____ whenever needed.
2.4 Estimation of Financial Requirements of a Firm
A company should be properly capitalised and the actual capital should be
neither more nor less than the amount which is needed and which can be
gainfully employed. It is, therefore, necessary for a concern to estimate its
requirements of funds properly. The financial requirements of a company
may be outlined under the following heads:
Cost of fixed assets including land and buildings, plant and machinery,
furniture, etc. The amount invested in these items is called fixed capital.
Cost of current assets including cash, stock of goods (also called
inventory of merchandise), book debts, bills, etc.
Cost of promotion including the expenses on preliminary investigation in
case of a new company, accounting, marketing, legal advice, etc.
Cost of establishing the business, i.e., the operating losses which have
generally to be sustained in the initial periods of a company.
Cost of financing including brokerage on securities, commission on
underwriting, etc.
Cost of intangible assets like goodwill, patents, etc.
Of the various items of financial requirements listed above, the first two
deserve special consideration as the successes of any concern will depend
largely on them.
The estimation of capital requirements of a firm involves a complex process.
Even with expertise, managements of successful firms could not arrive at
the optimum capital composition in terms of the quantum and the sources.
As indicated above, 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.
Financial Management Unit 2
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Fixed capital of an industrial concern is invested in fixed assets like plant
and machinery, land, buildings, furniture, etc. These assets are not fixed in
value. In fact, their value may record an increase or decrease in course of
time.
Variable working capital requirements which fluctuate from season to
season will have to be financed only by short-term sources.
The working capital is required for the purchase of raw materials and for
meeting the day-to-day expenditure on salaries, wages, rents, advertising,
etc.
Any departure from this well-accepted norm causes negative impact on the
firm’s finances. We will look at assessing these requirements in detail in the
upcoming pages.
Activity 2
Select 2 companies each from FMCG, Software and Manufacturing on the
mission statement. What is your observation on financial requirements?
Hint: All the finance requirements are to be discussed.
Self Assessment Questions
4.8. Capital requirement of a firm could be grouped into ____ and _____.
5.9. Variable working capital will have to be financed only by _______.
2.5 Capitalisation
Capitalisation of a firm refers to the composition of its long-term funds and
its capital structure. It has two components – Debt and Equity.
After estimating the financial requirements of a firm, the next decision that
the management has to take is to arrive at the value at which the company
has to be capitalised.
There are two theories of capitalisation for the new companies:
Cost theory
Earnings theory
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Figure 2.3 depicts the two theories of capitalisation.
Figure 2.3: Theories of Capitalisation
Let us now discuss these theories in detail.
2.5.1 Cost theory
Under this 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
Merits of cost approach
It helps promoters to estimate the amount of capital required for
incorporation of company, conducting market surveys, preparing detailed
project report, procuring funds, procuring assets both fixed and current,
running a trial production, and successfully producing, positioning, and
marketing its products or rendering of services.
If done systematically, it will lay the foundation for successful initiation of
the working of the firm.
Demerits of cost approach
If the firm establishes its production facilities at inflated prices, the
productivity of the firm will become less than that of the industry.
Net worth of a company is decided by the investors and the earnings of a
company. Earning capacity based on net worth helps a firm to arrive at
the total capital in terms of industry-specified yardstick (operating capital
based on benchmarks in that industry). Cost theory fails in this respect.
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2.5.2 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. They
are:
Estimation of the average annual future earnings.
Estimation of the normal earning rate of the industry to which the
company belongs.
Merits of earnings theory
Earnings theory is superior to cost theory because of its lesser chances
of being either under or over capitalisation.
Comparison of earnings approach to that of cost approach will make the
management to be cautious in negotiating the technology and the cost of
procuring and establishing the new business.
Demerits of earnings theory
The major challenge that a new firm faces is deciding on capitalisation
and its division thereof into various procurement sources.
Arriving at the capitalisation rate is equally a formidable task because the
investor’s perception of established companies cannot be really unique
of what the investor’s perceive from the earning power of the new
company.
Due to this problem, most of the new companies are forced to adopt the
cost theory of capitalisation. Ideally, every company should have normal
capitalisation, which is a utopian way of thinking.
Changing business environment, role of international forces, and dynamics
of capital market conditions force us to think in terms of ‘what is optimal
today need not to be so tomorrow’.
Even with these constraints, management of every firm should continuously
monitor its capital structure to ensure and avoid the bad consequences of
over and under capitalisation.
2.5.3 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.
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It is wrong to identify over-capitalisation with excess of capital because most
of the over-capitalised firms suffer from the problems of liquidity. The correct
indicator of over-capitalisation is the earnings capacity of the firm.
If the earnings of the firm are less than that of the market expectation, it will
not be in a position to pay dividends to its shareholders as per their
expectations. This is a sign of over-capitalisation. It is also possible that a
company has more funds than its requirements based on current operation
levels and yet have low earnings.
Over-capitalisation 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 acquiring assets, causing a situation of over-
capitalisation once the boom conditions subside
Total funds requirements have been over estimated
Unpredictable circumstances (like change in import/export policy,
change in market rates of interest, and changes in international
economic and political environment) reduce substantially the earning
capacity of the firm. For example, rupee appreciation against US dollar
has affected 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 over-capitalisation of the firm
Existence of idle funds
Effects of over-capitalisation
Decline in earnings of the company
Fall in dividend rates
Loss of goodwill
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
shareholders. Employees will lose jobs. If the company is engaged in the
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production and marketing of certain essential goods and services to the
society, the collapse of the company will cause social damage
Remedies of over-capitalisation
Over-capitalisation often results in a company becoming sick. Restructuring
the firm helps to avoid such a situation. Some of the other remedies of over-
capitalisation are:
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
2.5.4 Under-capitalisation
Under-capitalisation is just the reverse of over-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.
Symptoms of under-capitalisation
The following points describe the symptoms of under-capitalisation:
Actual capitalisation is less than the warranted earning capacity
Rate of earnings is exceptionally high in relation to the return enjoyed by
similar situated companies in the same industry
Causes of under-capitalisation
The following points describe the causes of under-capitalisation:
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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Effects of under-capitalisation
The following points describe some of the effects of under-capitalisation:
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
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
The following points describe the remedies of under-capitalisation:
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.
Self Assessment Questions
10. _____ of a firm refers to the composition of its long-term funds.
11. Two theories of capitalisation for new companies are ______ and
earnings theory.
12. A company is said to be ________, when its total capital exceeds the
true value of its assets.
10.13. A company is considered to be _______, when its actual
capitalisation is lower than its proper capitalisation as warranted by its
earning capacity.
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2.6 Summary
Let us recapitulate the important concepts discussed in this unit:
Financial planning deals with the planning, the execution, and the
monitoring of procurement and utilisation of funds. Financial planning
process gives birth to financial plan. It could be thought of as a blueprint
explaining the proposed strategy and its execution.
There are many financial planning models. All these models forecast the
future operations and then translate them to income statements and
balance sheets. It will also help the finance managers to ascertain the
funds to be procured from the outside sources. The essence of all these
is to achieve a least cost capital structure which would match with the
risk exposure of the company.
Failure to follow the principle of financial planning may lead a new firm to
over or under-capitalisation when the economic environment undergoes
a change.
Ideally, every firm should aim at optimum capitalisation or it might lead to
a situation of over or under-capitalisation. Both are detrimental to the
interests of the society. There are two theories of capitalisation - cost
theory and earnings theory.
2.7 Glossary
Accounting equation: Assets = Liabilities + Equity.
Capitalisation of a firm: Refers to the composition of its long-term funds
and its capital structure. It has two components – Debt and Equity.
Financial planning: Process by which funds required for each course of
action is decided.
2.8 Terminal Questions
1. Explain the steps involved in Financial Planning.
2. Explain the factors affecting Financial Plan.
3. List out the causes of over-capitalisation.
4. Explain the effects of under-capitalisation.
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2.9 Answers
Self Assessment Questions
1. Qualitative, Quantitative
2. Allocation of funds
3. Short-term borrowings
4. Nature of the industry
5. Debt, equity
6. The prudent policy
7. Flexibility in capital structure, effect changes in the composites of
capital structure
8. Fixed capital, working capital
9. Short-term sources
10. Capitalisation
11. Cost theory
12. Over-capitalised
12.13. Under-capitalised
Terminal Questions
1. There are six steps involved in financial planning. Refer to 2.2
2. There are various factors affecting financial plan. Refer to 2.3
3. A company is said to be over-capitalised when its total capital (both
equity and debt) exceeds the true value of its assets. Refer to 2.5.3
4. A company is considered to be under-capitalised when its actual
capitalisation is lower than the proper capitalisation as warranted by the
earning capacity. Refer to 2.5.4
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2.10 Case Study: Financial Planning
Firms need to plan their future activities keeping in view the expected
changes in the economic, social, technical, and competitive environment.
The top and middle-level managers plan their business activities in terms of
financial projections keeping in view the various factors that will affect the
business.
Financial planning is enabled by creating pro forma income statements and
balance sheets. These are forecasted financial statements. As we have
discussed in the unit, financial planning is a continuous process of directing
and allocating financial resources to meet strategic goals and objectives. he
output from financial planning takes the form of budgets. The most widely
used form of budgets is pro forma or budgeted financial statements.
Given below is the profit and loss account statement and balance sheet
synopsis of Reliance Industries for the last five years. Study the statements
in detail.
Profit and Loss Account (Rs. in Crores)
Mar '11 Mar '10 Mar '09 Mar '08 Mar ‘07
Income
Sales Turnover 2,58,651.15 2,00,399.79 1,46,328.07 1,39,269.46 1,18,353.71
Excise Duty 10,515.09 8,307.92 4,369.07 5,463.68 6,654.68
Net Sales 2,48,136.06 1,92,091.87 1,41,959.00 1,33,805.78 1,11,699.03
Other Income 3,358.61 3,088.05 1,264.03 6,595.66 236.89
Stock Adjustments 3,243.05 3,947.89 427.56 -1,867.16 654.60
Total Income 2,54,737.72 1,99,127.81 1,43,650.59 1,38,534.28 1,12,590.52
Expenditure
Raw Materials 1,98,076.21 1,53,689.01 1,09,284.34 98,832.14 80,791.65
Power and Fuel Cost 2,255.07 2,706.71 3,355.98 2,052.84 2,261.69
Employee Cost 2,621.59 2,330.82 2,397.50 2,119.33 2,094.09
Other Manufacuring Expenses 2,915.44 2,153.67 1,162.98 715.19 1,112.17
Selling and Admin Expenses 7,207.83 5,756.44 4,736.60 5,549.40 5,478.10
Miscellaneous Expenses 500.52 651.96 562.42 412.66 321.23
Preoperative Exp Capitalised -30.26 -1,217.92 -3,265.65 -175.46 -111.21
Total Expenses 2,13,546.40 1,66,070.69 1,18,234.17 1,09,506.10 91,947.72
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Operating Profit 37,832.71 29,969.07 24,152.39 22,432.52 20,405.91
PBDIT 41,191.32 33,057.12 25,416.42 29,028.18 20,642.80
Interest 2,328.30 1,999.95 1,774.47 1,162.90 1,298.90
PBDT 38,863.02 31,057.17 23,641.95 27,865.28 19,343.90
Depreciation 13,607.58 10,496.53 5,195.29 4,847.14 4,815.15
Other Written Off 0.00 0.00 0.00 0.00 0.00
Profit Before Tax 25,255.44 20,560.64 18,446.66 23,018.14 14,528.75
Extra-ordinary items 0.00 0.00 0.00 48.10 0.51
PBT (Post-Extra-ord items) 25,255.44 20,560.64 18,446.66 23,066.24 14,529.26
Tax 4,969.14 4,324.97 3,137.34 3,559.85 2,585.35
Reported Net Profit 20,286.30 16,235.67 15,309.32 19,458.29 11,943.40
Balance Sheet (Rs. in Crores)
Mar ‘11 Mar ‘10 Mar ‘09 Mar ‘08 Mar ‘07
Sources of Funds
Total Share Capital 3,273.37 3,270.37 1,573.53 1,453.39 1,393.21
Equity Share Capital 3,273.37 3,270.37 1,573.53 1,453.39 1,393.21
Share Application Money 0.00 0.00 69.25 1,682.40 60.14
Preference Share Capital 0.00 0.00 0.00 0.00 0.00
Reserves 1,42,799.95 1,25,095.97 1,12,945.44 77,441.55 59,861.81
Revaluation Reserves 5,467.00 8,804.27 11,784.75 871.26 2,651.97
Networth 1,51,540.32 1,37,170.61 1,26,372.97 81,448.60 63,967.13
Secured Loans 10,571.21 11,670.50 10,697.92 6,600.17 9,569.12
Unsecured Loans 56,825.47 50,824.19 63,206.56 29,879.51 18,256.61
Total Debt 67,396.68 62,494.69 73,904.48 36,479.68 27,825.73
Total Liabilities 2,18,937.00 1,99,665.30 2,00,277.45 1,17,928.28 91,792.86
Application of Funds
Gross Block 2,21,251.97 2,15,864.71 1,49,628.70 1,04,229.10 99,532.77
Less: Accum. Depreciation 78,545.50 62,604.82 49,285.64 42,345.47 35,872.31
Net Block 1,42,706.47 1,53,259.89 1,00,343.06 61,883.63 63,660.46
Capital work-in-progress 12,819.56 12,138.82 69,043.83 23,005.84 7,528.13
Investments 33,019.27 19,255.35 20,268.18 20,516.11 16,251.34
Inventories 29,825.38 26,981.62 14,836.72 14,247.54 12,136.51
Sundry Debtors 17,441.94 11,660.21 4,571.38 6,227.58 3,732.42
Cash and Bank Balance 604.57 362.36 500.13 217.79 308.35
Total Current Assets 47,871.89 39,004.19 19,908.23 20,692.91 16,177.28
Loans and Advances 17,320.60 10,517.57 13,375.15 18,441.20 12,506.71
Fixed Deposits 31,162.56 17,073.56 23,014.71 5,609.75 1,527.00
Total CA, Loans and Advances 96,355.05 66,595.32 56,298.09 44,743.86 30,210.99
Deferred Credit 0.00 0.00 0.00 0.00 0.00
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Current Liabilities 61,399.87 48,018.65 42,664.81 29,228.54 24,145.19
Provisions 4,563.48 3,565.43 3,010.90 2,992.62 1,712.87
Total CL and Provisions 65,963.35 51,584.08 45,675.71 32,221.16 25,858.06
Net Current Assets 30,391.70 15,011.24 10,622.38 12,522.70 4,352.93
Miscellaneous Expenses 0.00 0.00 0.00 0.00 0.00
Total Assets 2,18,937.00 1,99,665.30 2,00,277.45 1,17,928.28 91,792.86
Contingent Liabilities 41,825.13 25,531.21 36,432.69 37,157.61 46,767.18
Book Value (Rs.) 446.25 392.51 727.66 542.74 439.57
Discussion Questions:
Prepare pro forma financial statements for the year 2012 with the following
considerations:
1. The sales for the year 2012 are to be increased by 30% over the value of sales for the year 2011.
2. Use percent of sales method to forecast the values for various items of income statement using the percentage for the year 2011.
3. Secured loans in 2012 will be based on its relationship with the sales in the year 2011.
4. Additional funds required, if any, will be met by bank borrowings.
5. Selling and administration expenses expected to increase by 5%.
(Hint: Refer proforma financial statements)
(Source: http://www.moneycontrol.com/financials
References:
Prasanna Chandra, Financial Management, 6th edition - Manohar
Publishers and Distributors
Brigham. Eugene F. and Houston. Joel F.(2007). Fundamentals of
Financial Management, 11th Edition, Cengage Learning
E-References:
http://www.moneycontrol.com/financials) retrieved on 10/12/ 2011