Meaning and Importance
Planning business finances and carrying out financial plans is a continuous process in the day to day administration of a business. It is essentially concerned with the economical procurement and profitable use of funds - a use which is determined by realistic investment decisions. Financial planning is deciding in advance the course or line of action of business in respect of the financial management of a concern. The aim is to match the needs of the company with those of investors with a sensible gearing of short-term and long-term fixed interest securities. In view of the complex nature of a business enterprise today, management places a great emphasis upon financial planning.
The primary advantage of financial planning is the elimination of waste resulting from complexity of operation. Example: Technological advancement, higher taxes, increasing cost of social legislation, fluctuation of interest rates and pressures resulting from increasing competition tend to cause the management to exert wasteful effort. It helps to avoid waste by providing policies and procedures which make possible a closer coordination between various functions of the business enterprise. It aids the company in preparing for the future. A firm which has no financial planning, depends upon past experience for the establishment of its objectives, policies and procedures. Since the economy in which the firm operates is dynamic in character, past experience cannot be relied upon in dealing with future condition. To plan effectively requires that forecasts be made of future trends, and when these are used as a basis for plans, many unprofitable ventures are eliminated
The success or failure of production and distribution functions of firms depend upon the manner in which the finance function is performed and in many instances, a single financial decision at the policy procedure level determines the success or failure of the firm. It is therefore essential that each financial act be carefully planned before any action is taken. Whatever the financial plans, their ultimate objective is to enable a firm to take such decisions as would make it possible for it to accomplish goals and objectives. Financial planning should achieve a total integration and coordination of all the plans of the other functions of the firm.
A financial plan states :
1. The total amount of funds or capital needed by a concern for financing its business.
2. The form and the proportion of the securities to be issued to raise the required funds.
3. The financial objectives of the concern and the financial policies and financial procedures to be followed for raising distribution and administration of funds.
According to Cohen and Robbins, financial planning should
1. Determine the firm's resources required to meet the company's operating programme.
2. Forecast the extent to which these requirements will be met by internal generation of funds and to what extent they will be met from the external sources.
3. Develop the best plans to obtain the required external funds.
4. Establish and maintain a system of financial control governing the allocation and use of funds.
5. Formulate programme to provide the most effective profit volume-cost relationship.
6. Analyze the firm's results of operations.
7. Report the facts of top management and make recommendations on future operations of the firm.
Financial planning is the responsibility of top management. Financial planning is a part of a large planning process in an organization. It is in a way, an indication of the overall plan of a firm in financial terms.
A financial plan is a statement estimating the amount of capital and determining its composition. The quantum of funds needed will depend upon the assets requirement of the business. The time at which the funds will be needed should be carefully decided so that finances are raised at a time when these are needed. The next aspect of a financial plan is to determine the pattern of financing. There are a number of ways for raising funds. The selection of various securities should be done carefully. The funds may be raised by issuing shares, debentures, etc. Once a pattern of financing is selected, then it becomes very difficult to modify it. A financial plan also spells out the policies to be pursued for the floatation of various corporate securities, particularly regarding the time of their floatation.
Steps in Financial Planning
Whether the business is big or small, existing or a new business, this function has to be performed. At the time of promotion, this function is performed by the promoter.
1. Establishing objectives : Business enterprise operate in a dynamic society and in order to take advantage of the changed economic conditions, financial planning should establish both short-term and long run objectives. Financial objective of any business enterprise is to employ capital in whatever proportion necessary to increase the productivity of remaining factors of production over the long run. The long run goal of any firm is to use capital in correct proportion. The financial objective should be clearly defined. The concern should take advantage of prevailing economic situation.
2. Formulating financial
policies : Financial policies are guides to all action which deals with
procuring, administrating and distributing the funds of business firms. These
policies may be classified into several broad categories :
(a) Policies governing the amount of capital required by the firm to achieve their financial objectives.
(b) Policies to achieve and determine control by the parties who furnish the capital.
(c) Policies which act as a guide in the use of debt or equity capital.
(d) Policies which guide management in the selection of sources of funds.
(e) Policies which govern credit and collection activities of an enterprise. These should be clear cut plans of raising the required funds and their possible uses. The current and future needs for funds should be considered in the financial plans.
3. Forecasting : A fundamental requisite is the collection of facts. However, where financial plans concern the future and facts are not available, financial management is required to forecast the future in order to predict the variability of factors influencing the type of policies the enterprise formulates. This involves a thorough study of the company's past performance to identify trends. These trends are projected into the future and modified taking into account events or trends expected to occur in the future.
4. Formulation of Procedures : Financial planning are broad guides which to be executed properly, must be translated into detailed procedures. If a policy is to raise short-term funds from banks, then a procedure should be laid to approach the lenders and the persons authorized to initiate such action. Financial planning is the work of top management. Financial planning is a part of a larger planning process in an organization.
5. Providing for flexibility : The financial planning should ensure proper flexibility in objectives, policies and procedures to adjust according to the changing economic situations. The changing economic environment may offer new opportunities. The business should be able to make use of such situations for the benefits of the concern. A rigid financial planning will not let the business use new opportunities.
Every concern had to formulate a financial plan that would suit the specific circumstances in which it is operating. A concern should bear in mind certain considerations or principles while formulating or devising its financial plan :
1. Simplicity of purpose : Financial plan should be drafted in terms of the purpose for which the enterprise is organized. It should contain a simple financial structure that can be implemented and managed easily and understood clearly by all. In short the number of securities should be the minimum possible.
2. Optimum use or intensive use : A wasteful use of capital is almost as bad as inadequate capital. A financial plan should be such that it will provide for an intensive use of funds. Funds should not remain idle nor should there be any paucity of it. The financial planners should keep in view the proper utilization of funds in the context of overall objective of maximization of wealth. Again they should see that there is a proper balance in maintenance between long-term and short-term funds, since the surplus of one will not be able to offset the shortage of the other.
3. Based on clear-cut objectives : Financial planning should be done by keeping in view the overall objectives of the company. It should aim to procure funds at the lowest cost so that profitability of the business is improved.
4. Long-term view : Financial planning should be formulated keeping in view the long-term requirements and not just the immediate or short-term requirements of the concern. This is because financial planning originally formulated would continue to operate for a long time after the formation of the concern.
5. Flexibility : The financial planning should be such that it can be modified or changed according to the changing needs of the business with minimum possible delay. There may be scope for raising additional funds if fresh opportunities occur. Flexibility in a plan will be helpful in coping with the demands of the future. Management should be ready to revise or completely change the firm's short-run objectives, policies and procedures in order to take advantage of changing conditions.
6. Planning foresight : Foresight is essential for any plan of business operations so that capital requirements may be assessed as accurately as possible. Accurate forecasts are required to be made regarding the future scope of operations of the concern, technological developments, etc. The making of accurate forecasts require foresight on the part of financial planners. A financial plan visualized without foresight may fail to meet the present as well as the future requirements of funds and bring disaster to the concern.
7. Financial contingencies : The financial planning should make adequate provisions of funds for meeting the contingencies likely to arise in the future. This principle does not mean that large amount of funds should be kept idle as reserves for unforeseen contingencies. It simply means that while formulating the financial plans, the financial planners should make proper forecasts of the contingencies likely to arise in the future and make adequate provisions for funds for meeting the future contingencies.
8. Solvency \ Liquidity : The plan should take proper care of solvency because many of the companies have failed by reason of insolvency. There should be adequate liquidity in the financial plans. Liquidity means the availability of cash for the concern whenever required, for making payments on dates when they are due. This will ensure credit worthiness and goodwill to the concern and funds become available to it on very reasonable terms. It acts as a shock absorber in the event of business operations deviating from the normal course. It gives the financial plan a certain degree of flexibility. Above all, it will help in avoiding embarrassment to the management and a loss of reputation of the concern in the eyes of the public. Proper forecasting of future payments will be helpful in planning liquidity.
9. Profitability : A financial plan should maintain the required proportion between fixed charge obligations and the liabilities in such a manner that the profitability or the organization is not adversely affected. The most crucial factor in financial planning is the forecast of sale, for sales almost invariably represent the primary source of income and cash receipts. Besides, the operations of a business are geared to the anticipated volume of sales.
10. Economy : The financial plan should also ensure economy. It should ensure that the cost of raising funds is minimum. This is possible by having a proper debt-equity mix in the capital structure. The cost of capital is an important element in the formulation of a financial plan. An excessive burden of fixed charges on its earnings might inflate its cost of capital.
11. Conservative : A financial plan should be conservative, in the sense that the debt capacity of the plan should not be exceeded.
12. Varying risks : The financial plan should provide for ventures with varying degrees of risks so that it might enable a company to achieve substantial earnings from risky ventures.
13. Practical : A plan should be such that it should serve a practical purpose. It should be realistic and capable of being put to use.
14. Availability : The source of finance which a corporation may select, may be available at a given point of time. If certain sources are not available, the corporation may even prefer to violate the principle of suitability. Availability sometimes bears no relation to cost. A corporation cannot always choose its source of funds. Availability of different kinds of funds often plays an important part in a firm's decision to use a debt or equity. This aspect may be considered while formulating a plan.
15. Investor's preference or temperament : Preferences of investors are different. Some who are bold and venturesome prefer equity shares. Some investors who are cautious go for debentures. As such, the financial plan should keep in mind the temperament or the preference of investors, i.e. the financial plan should be formulated in accordance with preferences of investors.
16. Timing : A sound financial planning involves effective timing in the acquisition of funds. The key to effective timing is correct forecasting. This would depend upon the understanding of the management as to how business cycles behave during different phases of business operations.
17. Communication : With outside parties including investors and other suppliers of funds, communication is an essential prerequisite. The outside parties would then know that the management is trying to control its business effectively and what it is doing.
18. Implementation : A firm should see to it that plans are actually carried out. The data should be available at any level in detail and in certain frequency. This would enable a firm to take timely and corrective action whenever necessary.
19. Control : The capital structure of a firm may be such as to ensure that control does not pass in the hands of outsiders. For this purpose the use of debt financing may be encouraged. However stock should be broadly distributed to facilitate the maintenance of control.
20. Less dependence on outside sources : Long-term financial planning should aim to reduce dependence on outside sources. This can be possible by retaining a part of profits for ploughing back. The generation of own funds is the best way of financing operations. In the beginning, outside funds may be a necessity but financial planning should be such that dependence on such funds may be reduced in due course of time.
21. Nature of industry : The needs for funds are different for various industries. The asset structure, element of seasonality, stability of earnings, are not common factors for all industries. These variables will influence or determine the size and structure of financial requirements.
22. Standing of the concern : This will influence a decision about the financial plan. The goodwill of the concern, credit rating in the market, past performances, attitude of the management are some of the factors which will be considered in formulating a financial plan.
23. General economic conditions : The prevailing economic conditions at the national level and international level will influence a decision about financial plan. These conditions should be considered before taking any decisions about sources of funds. A favourable economic environment will help in raising funds without any difficulty. On the other hand, uncertain economic conditions may make it difficult for even a good concern to raise sufficient funds.
24. Government control : The government policies regarding issue of shares and debentures, payment of dividend and interest rates, entering into foreign collaborations, etc. will influence a financial plan. The legislative restrictions on using certain sources, limit of dividends, etc. will make it difficult to raise funds. So Government controls should be properly considered while selecting a financial plan.
Limitations of Financial Planning
1. Difficulties in forecasting : Plans are decisions and decisions require facts about the future. Financial plans are prepared by taking into account the expected situations in the future, which is always uncertain. Since future conditions cannot be forecasted accurately, the adaptability of planning is seriously limited. One way to offset the limitation is to improve forecasting techniques. Another way to overcome this limitation is to revise plans periodically. The development of variable plans, which take changing conditions into consideration, will go a long way in eliminating this limitation.
2. Difficulty in change : Another serious difficulty in planning is the reluctance or inability of the management to change a plan once it has been made, for several reasons. Assets may have to be purchased again, raw materials and cost may have to be incurred.
3. Rapid change : The growing mechanism of industry is bringing rapid changes in industrial processes. The methods of production, marketing devices, consumer preferences, create new demand every time. The incorporation of new changes require a change in financial plan every time. Once investments are made in fixed assets, then these decisions cannot be reversed. It becomes very difficult to adjust the financial plan for incorporating fast changing solutions. Unless a financial plan helps the adoption of new techniques, its utility becomes limited.
4. Problem of coordination : Financial functions is the most important of all functions. Other functions also influence a decision about financial plan. While estimating financial means, production policy, personnel requirements, marketing possibilities are all taken into account. Unless there is proper coordination among all the functions, preparing of financial plan becomes difficult. Often there is a lack of coordination among different functions. Even indecision among personnel disturbs the process of financial planning.
Estimating Long-term and Short-term Financial Needs
Before raising capital, it is essential to make estimates for long-term and short-term financial needs. In the absence of correct estimates, the business may suffer either from inadequate or from excess capital. If there is a shortage of funds then this will continue to struggle for existence. On the other hand, if capital is in excess of needs, then it will remain idle and may reduce earnings in comparison to investment. So, the estimates should be such that all financial needs are properly satisfied. The finances required for a business can be broadly classified into two main categories :
1. Fixed capital requirements, and
2. Working capital requirements
The term 'fixed capital' stands for that amount of capital which is required for long-term to create production facilities through purchase of fixed assets such as plant, machinery, land, building, furniture, etc. These assets represent that part of firm's capital which is blocked on a permanent or fixed basis. The business does not intend to dispose off these assets and for this reason fixed capital is also known as 'Block Capital'.
The fixed assets are neither fixed or attached in all cases, to a particular place nor are they fixed in value. There may be increase or decrease in their value in the course of time; yet, they are regarded as fixed assets as they are to be retained in business for carrying out regular operations and without them the business of the concern cannot be carried out. Investment in non-current assets such as long-term receivables, advance to subsidiary or affiliate concerns, goodwill, patents, copyrights, long-term investments etc. also form part of fixed capital. Fixed capital is required not only for the acquisition of fixed and non-current assets at the start of the business, but is also required for development, expansion and permanent working capital.
Some important definitions of fixed capital are as follows
In the words of P.M. Chiuminatoo, "Fixed capital comprises of fixed assets and other non-current assets."
Shubin has defined fixed capital as, "the funds required for the acquisition of those assets that are to be used over and over for a long-period such assets as land, building, machinery, equipment and tools."
According to Hoagland, "Fixed capital is comparatively easily defined to include land, building machinery and other assets having a relatively permanent existence."
In the words of Wheeler, "Fixed Capital is invested in the fixed or long-term assets. The amount of fixed capital needs, therefore, varies directly with the amount of fixed assets owned or used by a business."
From the above definitions, it is clear that fixed capital is the amount invested in various fixed or permanent assets which are necessary for conducting the operations of a business.
Importance of Fixed Capital
Capital is the life blood and nerve center of a business. Just as circulation of blood is essential in the human body for maintaining life, capital is very essential to maintain the smooth running of the business. Every business needs some amount of capital to be invested in fixed or non-current assets so as to create production or business facilities. No business can be started without an adequate amount of fixed capital. Right from the very beginning i.e. conceiving an idea to do business, capital is needed to promote or establish the business, acquire fixed assets, make investigations such as market surveys etc. Even an existing concern may require fixed capital for making improvements or expanding the business. Thus it is very essential to have adequate fixed capital in a business.
Assessment of Fixed Capital Requirements
Fixed capital is required to finance the cost of acquisition of permanent assets such as land, building, plant and machinery, etc.; and to fund the cost of intangible assets like promotion expenses, organization expenses, operating losses, costs of financing, patents, copyrights and goodwill, etc. Hence, the assessment of the total amount of fixed capital required in a business involves :
A. Estimation of fixed assets requirements
B. Estimation of intangible assets requirements.
Estimation of Fixed Assets Requirements
Fixed assets requirements are estimated usually at the time of promotion of a new enterprise. However, existing firms may also need it at the time of expansion, growth, replacement and improvement of the existing facilities. It is important not only to estimate the investments needed for these assets, but also the time at which these amounts are required.
The promoters and managers of the business can determine various fixed assets required by them from their own experience in the business or by making a study of similar units or by taking advice from technical experts in that line of business or from the manufactures or suppliers of these assets. Estimation of the cost of land usually poses no problems and the cost of building can be estimated by taking help from building engineers and contractors. Further, the cost of installation of plant and machinery and other equipment's should also be made. A sufficient margin for non-firm costs should, however, be made to meet the exigencies. The requirement of fixed assets varies from business to business. There are a number of factors that determine the requirements of fixed assets in a business.
Factors Affecting the Estimation of Fixed Assets Requirements
Various factors which affect the estimation of fixed assets requirements in a business can be studied under two heads :
1. Internal factors; and
2. External factors.
(a) Nature or character of business. The fixed assets requirements of a business basically depends upon the nature of its business. Public utility undertakings such as electricity, water supply and railways require huge funds to be invested in fixed assets. On the other hand, trading and financial firms have very less requirements for fixed assets but have to invest large amounts in current assets. Manufacturing concerns also require sizable fixed capital as they have to set up production facilities and invest large funds in fixed assets such a land and building, plant and machinery, etc. Thus, the nature of business determine the requirements of fixed assets \ capital to a large extent.
(b) Size of business. The fixed assets \ capital requirements of concern are also influenced by the size of its business which may be determined in terms of scale of operations. Generally, larger the size of a business unit, greater is the requirement of fixed assets needed to set up the business operations.
(c) Activities undertaken by the enterprise or scope of business. The requirement of fixed capital also depends upon number of activities undertaken by the enterprise. For example, if a concern manufactures and markets its products itself, it needs more fixed capital as compared to a concern that undertakes only manufacturing activities or only marketing activities. Similarly, if a concern is engaged in production of all parts of a product, it will require more capital than a concern which is engaged in assembling parts manufactured by other units.
(d) Production techniques. Another factor that influences the requirements of fixed capital in a business is the production technique that is to be adopted in the enterprise. For example, use of automatic machinery calls for larger investment in the fixed assets. On the other hand, if production methods are simple, which do not require such equipment's, lesser amount of fixed capital shall be needed.
(e) Mode of acquisition of fixed assets (extent of lease or hire). Fixed assets may be purchased outrightly or acquired on lease or hire basis. If an outright purchase of fixed assets is to be made, larger amount of fixed capital shall be required in comparison to the acquisition of fixed assets on leasehold basis or on hire. It is, therefore essential to decide in advance as to which assets are to be acquired on leasehold basis and which are to be purchased outrightly. In the same manner, if some of the fixed assets are available on hire or rent, decision has to be taken in regard to the purchase of these assets on outright or hire basis.
(f) Acquisition of old equipment and plant. In certain industries, old plant and machinery or equipment's may be available at prices much below the prices of the new plant and machinery. If old plant and machinery could be satisfactorily used in the business, especially in the areas where the technological change in production method is moderate or slow, it would substantially reduce the required investment in fixed assets.
(g) Decision as regards ancillary units. In certain industries, there may be a possibility of carrying out certain processes through ancillary units or subcontracts without compromising with the quality and cost of the product. If it is so, the requirements of fixed assets can be decreased.
(h) Availability of fixed assets at concessional rates. In some areas, the Government provides land and other materials \ facilities at concessional rates to promote balanced industrial growth and regional development of industries. Further, plant and machinery may be made available on instalment basis. Such concessions induce the promoters to establish business in these areas reducing their investment in fixed assets.
The decisions relating to investment in fixed assets involve large amount of funds and are of irreversible nature. Such decisions have a long-term and significant effect on the profitability of a concern. Thus, such decisions have to be carefully taken after considering the various factors affecting future requirements of fixed assets, as given below :
(a) International conditions and economic outlook. While taking decision relating to investment in fixed assets, particularly in a large concern, the general economic and international conditions also play an important role. For example, if the level of business activity is expected to increase, the needs for fixed assets and funds to finance their acquisition will also grow. In the same manner, companies expecting war, may commit large investment in fixed assets before there is a shortage of such material.
(b) Population trends and its composition. If a firm is planning for national market for its products, national population trends must be evaluated while forecasting for fixed assets requirements. In India, certain promoters are encouraged to expand business because the population is increasing at a fast rate. The age and sex composition of the population may also be important for certain businesses.
(c) Shift in consumer preferences. Another factor that affects the future requirements of fixed assets is shift in consumer preferences. Fixed assets requirements should be planned in a manner so as to provide goods or services that consumers will accept.
(d) Competitive factors. The decision making process on planning future requirements of fixed assets is also influenced by competitive factors. For example, if an existing company shifts to a particular line of business, then others may also follow the lead.
(e) Shift in technology. Future improvements and shifts in technology have also to be considered while deciding about the future requirements of fixed assets. The financial plan should allow a scope for adjustments as and when new situations emerge.
(f) Government regulations. There may be certain Government regulations affecting the size and the direction of a business enterprise. Hence, these should also be considered while assessing requirements of fixed assets. Although, it may not be possible to forecast changes in the Government policy, a margin should be provided to absorb the impact of such changes.
Estimation of Intangible Assets Requirements
The expenses of promotion, incorporation, organization or establishment of business, cost of financing and the amount to be invested in intangible assets such as goodwill, patents, copyrights, etc. also form part of fixed capital and hence influence the requirements of fixed capital of a concern. The estimation of fund requirements for intangible assets, except for organization expenses such as legal fees and taxes, etc. is a difficult task. However, these are discussed below:
1. Promotion expenses. The expenses incurred by the promoter to make preliminary investigation, study marketing possibilities, enquiries about the technical aspects of production processes and assembling the elements of business are called promotion expenses. These are to be paid to the promoter as compensation for the services rendered by him in promoting the business. Although, it is very difficult to determine the remuneration of the promoter for his personal efforts, time and skill in promoting the business, sufficient provision should be made for the same while estimating the requirements of intangible assets for the purpose of assessing the fixed capital requirements of a business.
2. Incorporation and organization expenses. Expenses incurred in setting up the business such as legal counselling, stamp duty, registration fees, filing fees, incorporation taxes, printing, etc. form part of incorporation or organizational cost. It is very essential to make an estimate of such expenses while determining the requirements of fixed capital in a business.
3. Costs of financing. The expenses incurred for arranging the funds required for a business are called costs of financing. These include the remuneration of underwriters, brokers, investment bankers as well as the expenses to be incurred in preparation of a registration statement and prospectus for making capital issues. These costs would also be estimated while assessing the requirements of intangible assets forming part of the fixed capital.
4. Initial operating losses. Every enterprise needs some time to stabilize the production and reach the self supporting stage. Until that time, it incurs certain cash losses and funds drain out of the business. Such losses are most prolonged in business requiring huge initial investment, complex production techniques and marketing or developing a novel product. While planning for capital, it is very essential to estimate and provide for such operating initial losses.
5. Cost of acquisition of patents, copyrights, goodwill, etc. If a company is considering to purchase patents, copyrights, goodwill, etc. then it is very essential to make an estimate of the cost of these intangible assets and include the same in the fixed capital requirements of a business. After preparing estimates of fixed assets and intangible assets requirements separately, we can determine the total fixed capital requirements of an enterprise by simply adding the funds needed for fixed assets and intangible assets.
Management of Fixed Assets \ Capital
The selection of various fixed assets required to create the desired production facilities and the decision as regards determination of the level of fixed assets is primarily the task of the production \ technical people. However there are certain financial considerations also involved in the same. As the decisions relating to fixed assets involve huge funds for a long-period of time and are generally of irreversible nature affecting the long-term profitability of a concern, an unsound investment decision may prove to be fatal to the very existence of the organization Thus, management of fixed assets is of vital importance to any organization
The process of fixed assets management involves :
(i) selection of most worthy projects or alternatives of fixed assets, and
(ii) arranging the requisite funds \ capital for the same. The sources of fixed capital include issue of shares and debentures, public deposits, ploughing back of profits and loan from specialized financial institutions.
The first important consideration to be kept in mind is to acquire only that much amount of fixed assets which will be just sufficient to ensure smooth and efficient running of the business. However, in some cases it may be economical to buy certain assets in a lot size.
Another important consideration to be kept in mind is the possible increase in demand of the firm's products necessitating expansion of its activities. Hence, a firm should have that much amount of fixed assets which could adjust to the increased demand.
The third aspect of fixed assets management is that a firm must ensure buffer stocks of certain essential equipment \ services to ensure uninterrupted production in the event of emergencies. Sometimes, there may be a breakdown in some of the equipment's or services affecting the entire production. It is always better to have some alternative arrangement to deal with such situations. But at the same time the cost of carrying such buffer stocks should also be evaluated. Efforts should also be made to minimize the level of buffer stocks of fixed assets by encouraging their maximum utilization during lean periods, transferring a part of peak period and hiring additional capacity.
The fourth aspect of management of fixed assets is to consider the cost of capital to be invested.
Principles of Fixed Capital Management
The main objective of fixed capital management is to make sound investment and to retain intact the investment in fixed assets such as land, building, plant, machinery, etc.
The following are the main principles in the fixed capital
(i) Selection of most appropriate and suitable fixed assets.
(ii) Financing and acquisition of fixed assets.
(iii) Proper accounting of fixed assets.
(iv) Sound depreciation policy.
(v) Proper upkeep and maintenance of fixed investments.
(vi) Periodical appraisal of fixed investments.
Working capital refers to that part of the firm's capital which is required for financing short-term or current assets such as cash, marketable securities, debtors and inventories. Funds thus invested in current assets keep revolving fast and are being constantly converted into cash and this cash flows out again in exchange for other current assets. Hence, it is also known as revolving or circulating capital or short-term capital.
The working capital requirements of a concern depend upon
a large number of factors such as:
1. Nature or character of business
2. Size of business \ Scale of operations
3. Production policy
4. Manufacturing process \ Length of production cycle
5. Seasonal variations
6. Working capital cycle
7. Rate of stock turnover
8. Credit policy
9. Business cycles
10. Rate of growth of business
11. Earning capacity and dividend policy
12. Price level changes
13. Other factors
To avoid the shortage of working capital, an estimate of working capital requirements should be made in advance so that arrangements can be made to procure adequate working capital. The working capital should be determined by estimating the investment in current assets minus moneys expected from current liabilities.
The following factors should be taken into consideration
while making an estimate of working capital requirements :
1. Total costs incurred on material, wages and overheads
2. The length of time for which raw materials are to remain in stores before they are issued for production
3. The time taken for conversion of raw material into finished goods
4. The length of sales cycle during which finished goods are to be kept waiting for sales
5. The average period of credit allowed to customers
6. The amount of cash required to pay day-to-day expenses of the business
7. The average amount of cash required to make advance payments, if any
8. The average credit period expected to be allowed by suppliers
9. Time lag in payment of wages and other expenses.
From the total amount blocked in current assets estimated on the basis of the first seven items given above, the total of the current liabilities, i.e. the last two items is deducted to find out the requirements of working capital.
Limitations of Financial Planning
Some of the limitations of financial planning are discussed as follows :
1. Difficulty in forecasting. Financial plans are prepared by taking into account the expected situations in the future. Since, the future is always uncertain and things may not happen as these are expected, the utility of financial planning is limited. The reliability of financial planning is uncertain and very much doubted.
2. Difficulty in change. Once a financial plan is prepared then it becomes difficult to change it. A changed situation may demand change in financial plan but managerial personnel may not like it. Even otherwise, assets might have been purchased and raw material and labour costs might have been incurred. It becomes very difficult to change financial plan under such situations.
3. Problem of coordination. Financial function is the most important of all the functions. Other functions influence a decision about financial plan. While estimating financial needs, production policy, personnel requirements, marketing possibilities are all taken into account. Unless there is a proper coordination among all the functions, the preparation of a financial plan becomes difficult. Often there is a lack of coordination among different functions. Even indecision among personnel disturbs the process of financial planning.
4. Rapid changes. The growing mechanization of industry is bringing rapid changes in industrial process. The methods of production, marketing devices, consumer preferences create new demands every time. The incorporation of new changes require a change in financial plan every time. Once investments are made in fixed assets, then these decisions cannot be reversed. It becomes very difficult to adjust a financial plan for incorporating fast changing situations. Unless a financial plan helps the adoption of new techniques, its utility becomes limited.
A. Objective Type
1. State whether the following statements are true or false :
(a) Planning and finance functions make financial planning.
(b) Financial planning is concerned with present financial estimation only.
(c) Financial planning is concerned with procurement and not with use of funds.
(d) Excess capital is good for a sound financial plan.
(e) Financial planning depends upon future estimations.
[Ans.True: (a), (e); False: (b), (c), (d)]
whether each of the following statements are true or false :
(i) Fixed capital is also known as block capital.
(ii) Fixed assets are fixed to a particular place and are fixed in value.
(iii) Even an existing firm may require fixed capital.
(iv) Mode of acquisition of fixed assets may affect the requirements of fixed capital.
(v) Promotion expenses do not affect the planning for fixed capital.
[Ans. (i) True; (ii) False; (iii) True; (iv) True; (v) False]
B. Short Answer Type
1. What is financial planning ?
2. How is financial planning concerned with future ?