CHAPTER 26

FINANCIAL PLANNING AND STRATEGY

Q-1
A-1

Q-2
A-2

What is a financial planning? How does it differ from financial forecasting?

The process of estimating the funds requirements of a firm; to finance its current and fixed assets
to meet the expected growth in business; and determining the sources of funds is called financial
planning. Financial forecasting is an integral part of financial planning. Forecasting uses past
data to estimate the future financial requirements.
Forecasts are merely estimates based on the past data; planning means what a company would
like to happen in the future, and includes necessary action plans for realizing the predetermined
intensions. Financial planning is a means for achievement of growth and profitability objectives
by making planned investment and financing decisions.
Explain the steps involved in preparing a financial plan. What are the merits of a financial
planning?
The following steps are involved in preparing a financial plan.
(1) Analyze the firms past performance and establish relationships between financial variables.
(2) Analyze the firms strength with respect to operating characteristics like product, market
competition, production, operating risks, etc.
(3) Workout the firms investment needs and its capacity to generate cash flows from operations.
(4) Also workout the appropriate means to raise the external funds, based on investment and
dividend policies; and also the long-term financial health and survival plan.
Financial planning supports the management to ascertain the need of assets to sustain the higher
growth in sales, by taking proper investment and financing decision, based on long-term
projections (normally of three or five years).

Q-3
A-3

Is there a relationship between strategic planning and financial planning? Explain.

Financial planning of a company has close links with strategic planning. Strategic planning
considers all markets, including product, labour and capital, as imperfect and changing.
Strategies are developed to manage the business firm in uncertain and imperfect market
conditions and environment and exploit opportunities. The companys strategy establishes an
effective and efficient match between its resources, opportunities and risks. Firms develop
financial plan within the overall framework of strategic plan.

Q-4

What is a financial model? Illustrate the development of a simple financial model. What are the
advantages and limitations of a financial model?
A financial planning model establishes the relationship between financial variables and targets,
and facilitates the financial forecasting and planning process. A model makes it easy for the
financial managers to prepare financial forecasts. It makes financial forecasting automatic and
saves the financial managers time and efforts performing a tedious activity. Financial planning
models help in examining the consequences of alternative financial strategies. A financial
planning model has three components Inputs, Model and Output.

A-4

Q-5
A-5

What is meant by sustainable growth? Explain sustainable growth models with illustrations.
Sustainable growth may be defined as the annual percentage growth in sales that is consistent
with the firms financial policies (assuming no issue of fresh equity). The following model can
be used to determine the sustainable growth (gs) in sales:

net margin retention leverage

assets - to - sales (net margin retention leverage)
The net asset to sales ratio determines the requirement of funds for investing in assets to support
a given level of sales. The requirement for funds would increase with expanding sales. The net
profit minus the dividends is an internal source of funds. Thus, the product of net profit to sales
ratio and retained profit to net profit (net margin retention ratio) gives an idea of the funds
available internally to support the growth of the firm. Retained earnings increase the debt raising
capacity of the firm. Thus, given the target capital structure, the total funds would be equal to
retained earnings plus debt supported by the retained earnings. Net assets or capital employed
(viz. debt plus equity) to equity is a leverage measure, and is equal to one plus debtequity ratio.
Suppose the following for a firm: PAT = Rs 100; sales = Rs 5000; dividends = Rs 400; NA=
Debt + NW (equity) = Rs 2500; NW = Rs 1250. The sustainable growth is:
sustainable growth =

100/5000 60/100 2500/1250

2500/5000 (100/5000 60/100 2500/1250)
0.02 0.6 2
=
= 0.05 = 5%
0.5 (0.02 0.6 2)

sustainable growth =

A more general method of determining the sustainable growth rate in the case of multi-product
or multi-division company is to calculate the sustainable growth rate at the corporate level in
terms of growth in assets.
Sustainable growth = asset turnover profit margin income leverage

retention ratio financial leverage

S PBIT PAT RE NA
gs =

NA
S
PBIT PAT NW