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Meaning and Characteristics of Financial planning.

Finance is the life blood of business. No business can run successfully

without adequate finance. Finance is required to bring a business into
existence, to keep it alive and also to see it growing and prospering.

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Meaning of Financial Planning:

Finance is an important function of business. The application of
planning to this function is called financial planning. Financial
planning is mainly concerned with the economical procurement and
profitable use of funds. According to Gutlman and Dougall, Financial
planning is concerned with raising, controlling and administering of
funds used in business. In the words of Bouneville and Dewey,
Financial planning consists in the raising, providing and managing of
all the money, capital of funds of any kind to be used in connection
with the business. Financial planning is an important element of the
overall planning of business enterprise. Financial planning includes
the following:

Estimating the amount of capital required for financing the

business enterprise;

Determining capital structure;

Laying down policies for the administration of capital;

Formulating the programmes to provide the most effective use of

Characteristics of a Good/ Sound Financial Planning:
The main characteristics of a good financial planning are as follows:

The financial plan should be as simple as possible so that it can be
easily understood even by a layman, property executed and
administered. A complicated financial plan creates unnecessary
complications and confusion.
The financial plan should be based on the clear-cut objectives of the
company. It should aim to procure adequate funds at the lowest cost
so that the profitability of the business is improved.
The financial plan should not be rigid, but rather flexible enough to
accommodate the changes which may be introduced in it as and when
necessary. The rigid composition of the financial plan may cause
unnecessary irritation and may limit the future development of the
business unit.
The financial plan should ensure solvency and liquidity of the business
enterprise. solvency requires that short-term and long-term payments
should be made on due dates positively. This will ensure credit
worthiness and good will to the business enterprise. Liquidity means
maintenance of adequate cash balance in hand. Sometimes
insufficiency of cash may make a business enterprise bankrupt.
Financial planning should have due foresight and vision to access the
future needs, scope and scale of operation of the business enterprise.
On the basis, financial planning should be done in such a manner that
any adjustment needed in the future may be made without much

difficulty. As the business proceeds, the financial adjustments become

necessary which should be adjustable properly as and when desired.
The financial plan should be able to anticipate various contingencies
which may arise in the near future. The financial plan should make
adequate provision for meeting the challenge of unforeseen events.
A long-term financial planning should aim at minimum dependence
on outside resources. This can be possible by retaining a part of the
profits for ploughing back.
Financial planning should ensure intensive use of capital. As far as
possible, a proper balance between fixed and working capital should
be maintained.
A financial plan should be drafted in such a way that the profitability
of the business enterprise is not adversely affected.
The financial plan should be quite economical i.e., the cost burden of
raising various types of capital should be minimum.
The financial policy should be prepared in accordance with the
government financial policy and regulation. It should not violate it
under any circumstances.

Financial Planning - Definition,

Objectives and Importance
Definition of Financial Planning
Financial Planning is the process of estimating the capital required and
determining its competition. It is the process of framing financial policies in
relation to procurement, investment and administration of funds of an

Objectives of Financial Planning

Financial Planning has got many objectives to look forward to:
a. Determining capital requirements- This will depend upon factors like
cost of current and fixed assets, promotional expenses and longrange planning. Capital requirements have to be looked with both
aspects: short- term and long- term requirements.
b. Determining capital structure- The capital structure is the composition
of capital, i.e., the relative kind and proportion of capital required in
the business. This includes decisions of debt- equity ratio- both shortterm and long- term.
c. Framing financial policies with regards to cash control, lending,
borrowings, etc.
d. A finance manager ensures that the scarce financial resources are
maximally utilized in the best possible manner at least cost in order to
get maximum returns on investment.

Importance of Financial Planning

Financial Planning is process of framing objectives, policies, procedures,
programmes and budgets regarding the financial activities of a concern.
This ensures effective and adequate financial and investment policies. The
importance can be outlined as-

1. Adequate funds have to be ensured.

2. Financial Planning helps in ensuring a reasonable balance between
outflow and inflow of funds so that stability is maintained.
3. Financial Planning ensures that the suppliers of funds are easily
investing in companies which exercise financial planning.
4. Financial Planning helps in making growth and expansion
programmes which helps in long-run survival of the company.
5. Financial Planning reduces uncertainties with regards to changing
market trends which can be faced easily through enough funds.
6. Financial Planning helps in reducing the uncertainties which can be a
hindrance to growth of the company. This helps in ensuring stability
an d profitability in concern.

Capitalisation: Meaning and Definition of Capitalisation!

The term capitalisation is derived from the word capital; hence it would be
appropriate to understand the meaning of capital. Capital in business usage
is mostly taken to mean total assets required to operate in a business and the
money needed to acquire such assets.
The term capital in accounting literature means the net worth of the company.
Net worth means assets minus liabilities. Economists use the term capital to
mean all the accumulated wealth used to produce additional wealth. The
debtors and similar accounting claims, the intangible assets like goodwill are
excluded from the economists version of capital.
Capital, in the legal parlance of the term, is the amount received in return for
securities (shares allotted to the investors). The total amount of share values
paid as shown in the companys books of accounts is legally known as its
The term capitalisation is used in relation to companies and not in respect of
sole proprietorships and partnership firms. Different views have been
expressed on the concept and definition of capitalisation by various authors in
the context of corporate sector.

Some authors have given it a broad meaning while others have used it in a
narrow sense. According to first school of thought, capitalisation has been
defined to include the amount of capital to be raised; the securities through
which it is to be raised and the relative proportions of various classes of
securities to be issued, and also the administration of capital.
The analysis of this definition clearly shows that capitalisation is synonymous
with financial planning. Besides the amount of capital required in a business, it
decides about the determination of the form and the relative proportions of the
various classes of securities to be issued and administration of policies
concerning capital.
Lillin Doris, Gilbert Harold and Charles Gerstenberg have given narrow
interpretation of the term capitalisation. They feel that the term capitalisation
refers to the amount at which a companys business can be valued.
Some of the important definitions are discussed below:
Capitalisation of a corporation comprises the ownership capital and the
borrowed capital as represented by long-term, indebtness. It may also mean
the total accounting value of capital stock, surplus in whatever form it may
appear and funded long-term debt Lillin Doris. Capitalisation comprises (i)
ownership capital which includes capital stock and surplus in whatever form it
may appear ; and (ii) borrowed capital which consists of bonds or similar
evidences of long term debt.
Gerstenberg Capitalisation of a corporation is the sum of the par value of the
stocks and bonds outstanding Guthman and Dougall. Capitalisation is

equivalent to the valuation placed upon the fixed capital by the corporation
measured by stocks and bonds outstanding, floagland.
From these definitions it can be concluded that capitalisation is the sum-total
of all long-term securities issued by a company and surplus not meant for
distribution. In other sense, Bonneville and others defined capitalisation as the
act or process of fixing the value of an enterprise for the purpose of
determining the capital liabilities that the company may assume in exchange
for the property.
An accountant may, however, use the concept of capitalisation in a different
way. When dividends or retained earnings in the form of stock or bonus
shares are issued to the existing shareholders, capital stock is increased and
surplus decreased, the surplus is said to be capitalised and this process is
known as capitalisation.
Again, in finance, capitalisation of income means the process of estimating
the present investment value of a property by discounting the present worth,
the anticipated stream of future income. In other words, when total earnings
along with the current rate of interest are used for calculating the total capital,
the process is called capitalisation of earnings.
In this book, capitalisation has been used in the narrow sense to include the
aggregate of all types of long-term securities and surpluses not meant for
distribution. A separate term capital gearing or structure has been used to
denote the forms and proportion of various securities to be issued.
We shall discuss first the basis of capitalisation and then the different aspects
of capital structure. The separation of these two topics for the purposes of this

explanation is not intended to give the impression that management arrives at

total amount of capitalisation and then determines its capital structure.
Actually what happens is that management estimates the amount of capital
that will be required and then tries to figure out how to raise that amount of
capital. In making its deal with those who supply the capital, it arrives at the
capitalisation and capital structure

Over- Capitalization and Under Capitalization of Company!

The capital structure of a company should be fair, neither overcapitalized,
nor undercapitalized. The availability of funds should be neither too much
nor too low.

Over- Capitalization:
A company is said to be over-capitalized when its earnings are not sufficient
to justify a fair return on the amount of capital raised through equity and
It is said to be over capitalized when the total of owned and borrowed
capital exceeds its fixed and current assets. This happens when it shows
accumulated losses on the assets side of the balance sheet.
An over capitalized company is like a bulky person who is not able to carry
his weight properly. Such a person is prone to many diseases and is
definitely not likely to be requisite active life. Unless the condition of
overcapitalization is rectified, the company may suffer from many
Causes of Over Capitalization:
The important reasons of over-capitalization are:
1. Idle funds:

The company may have unused funds lying idle in banks or in the form of
low yield investments, and there is no likelihood of using it properly in the
near future.
2. Over-valuation of acquired assets:
The fixed assets, particularly goodwill, might have been bought at a much
higher cost than warranted by the services to be rendered.
3. Fall in value of fixed assets:
Fixed assets might have been acquired at a time when prices were high and
now the prices have corrected substantially. But in the balance sheet the
assets are yet shown at their book value less depreciation written off.
4. Inadequate depreciation provision:
If proper and adequate depreciation has not been provided on the fixed
assets the result would be more profits in the Profit & Loss Account. This
book profit might have been distributed as dividend and leaving no funds
with which to replace the assets at the right time.
Remedies of over-capitalization:
The process of remedying overcapitalization is very painful. It can be
remedied through following measures:
1. Reduction in its capital so as to obtain a satisfactory relationship between
proprietary funds and net profit.
2. If over-capitalization is because of result of over-valuation of assets then
it can be remedied by bringing down the values of assets to their proper
3. Reduction of debt burden. For which negotiations with the big lenders
may be made to reduce the interest obligation.
4. Preference shares may be redeemed through capital reduction scheme.
5. Reducing face value and paid up value of equity shares.

6. Initiating merger with well managed profit making companies interested

in taking over ailing company.
Many Indian companies have resorted to remedying overcapitalization
through the measures mentioned above.

Under- Capitalization:
If the owned capital of the firm is disproportionate to the size of business
operations and the firm has to depend upon borrowed money and trade
creditors it is a sufficient indicator of undercapitalization. It may also be
because of over-trading, trading beyond capacity. It must be noted that
undercapitalization is different from high capital gearing.
In capital gearing there is a comparison between equity capital and fixed
interest bearing capital (which includes preference share capital and
excludes trade creditors) whereas in the case of under capitalization,
comparison is made between total owned capital (both equity and
preference share capital) and total borrowed capital (which includes trade
creditors as well). Under capitalization is signaled by low proprietary ratio,
high current ratio, and high return on equity capital.
Causes of Undercapitalization:
1. Under-estimation of future earnings in the beginning and also later
stages of the company.
2. Extraordinary increase in earnings.
3. Lower estimation of total fund requirements.
4. Being highly efficient through improved technology.
5. Companies established during recession make higher earnings as and
when the recession is over.
6. Companies following conservative dividend policy will in due course find
themselves gradually rising profits.
7. Purchase of assets at exceptionally low prices.

How does Undercapitalization affect?

Undercapitalization affects different stakeholders in the different ways:
Undercapitalization brings in greater reputation, greater earnings and
greater market share. Higher rate of return leads to higher competition in
the market. Higher profit means better products to follow. There would be
excessive interest on borrowed capital. However, the employees would
demand higher salaries, and the government may impose heavy tax.
Due to increase in market share and profitability, the company enjoys
better reputation. The company's equity shares valuation goes up in the
stock market. The shareholders can expect better dividends.
Consumers often feel that they are being overcharged, and thus feel being
on the receiving end.
High earnings, high profitability, and high market valuation of shares
affects society in an adverse manner. Public feels being overcharged on the
one hand, and expects such firms to raise innovations, on the other. In the
stock market for such firms often unhealthy things get into currency.
Remedies of undercapitalization:
1. To reduce the dividend per share split up at the shares; Many Indian
companies, including Luxmi Machine Works, have done it.
2. Issue of bonus share will reduce both the dividend per share and
earnings per share.

Undercapitalization and Overcapitalization - Both

are bad!

The conclusion is that neither undercapitalization, nor overcapitalization is

desirable, as both are evils. However, if one has to choose between the two,
undercapitalization would be the right choice:
(a) Overcapitalization leads to the conclusion that capital is ineffectively
used and the earnings are less than being fare.
(b) Undercapitalization, whereas, means that the rate of profit on capital
invested is higher than the normal return (enjoyed by similar companies in
the same industry or when the value of assets is more than the amount of
(c) Undercapitalization has its own evil consequences but it is not as fatal as
in the case of over capitalization. Undercapitalization cannot continue
indefinitely because more profitability means more competition, more
government intervention, and the environment pulls and pressures.
(d) Overcapitalization being a serious problem, later or sooner the company
will have to be reorganized and the consequences of the same will have to
be borne by the shareholders and creditors.

Financial plan
In business, a financial plan can refer to the three primary financial
statements (balance sheet, income statement, and cash flow statement)
created within a business plan.Financial forecast or financial plan can
also refer to an annual projection of income and expenses for a company,
division or department.[2] A financial plan can also be an estimation of cash
needs and a decision on how to raise the cash, such as through borrowing
or issuing additional shares in a company.[3]
A financial plan may be contain prospective financial statements which
are similar, but different, than a budget. Financial plans are the ENTIRE
financial accounting overview of a company. Complete financial plans
contain all periods and transaction types. Its a combination of the financial
statements which independently only reflect a past, present, or future state

of the company. Financial plans are the collection of the historical, present,
and future financial statements; for example, a (historical & present) costly
expense from an operational issue is normally presented prior to the
issuance of the prospective financial statements which propose a solution
to said operational issue.
Some period specific financial statement examples include pro
forma statements (historical period) and prospective statements (current &
future period). Compilations are a type of service which involves
"presenting, in the form of financial statements, information that is the
representation of management".[4] There are two types of "prospective
financial statements": financial forecasts & financial projections and both
relate to the current/future time period. Prospective financial statements are
a time period-type of financial statement which may reflect the
current/future financial status of a company using three main
reports/financial statements: cash flow statement, income statement, and
balance sheet. "Prospective financial statements are of two
types- forecasts and projections. Forecasts are based on management's
expected financial position, results of operations, and cash flows" [5] Pro
Forma statements take previously recorded results, the historical financial
data, and present a "what-if"; "what-if" a transaction had happened sooner.

While the common usage of the term "financial plan" often refers to a
formal and defined series of steps or goals, there is some technical
confusion about what the term "financial plan" actually means in the
industry. For example, one of the industry's leading professional
organizations, the Certified Financial Planner Board of Standards, lacks
any definition for the term "financial plan" in its Standards of Professional
Conduct publication. This publication outlines the professional financial
planner's job, and explains the process of financial planning, but the term
"financial plan" never appears in the publication's text. [7]
The accounting and finance industries have distinct responsibilities and
roles. When the products of their work are combined it produces a
complete picture, a financial plan. A financial analyst studies the data and
facts (regulations/standards) which are processed, recorded, and
presented by accountants. Normally,finance personnel study the data
results meaning- what has happened or what might happen- and propose a
solution to an inefficiency. Investors and financial institutions must see both

the issue and the solution to make an informed decision. Accountants and
financial planners are both involved with presenting issues and resolving
inefficiencies, so together, the results and explanation is provided in
a financial plan.

The functions of Financial Manager are

discussed below:
1. Estimating the Amount of Capital Required:
This is the foremost function of the financial manager. Business firms require
capital for:
(i) purchase of fixed assets,
(ii) meeting working capital requirements, and
(iii) modernisation and expansion of business.
The financial manager makes estimates of funds required for both short-term
and long-term.

2. Determining Capital Structure:

Once the requirement of capital funds has been determined, a decision
regarding the kind and proportion of various sources of funds has to be taken.
For this, financial manager has to determine the proper mix of equity and debt
and short-term and long-term debt ratio. This is done to achieve minimum cost
of capital and maximise shareholders wealth.

3. Choice of Sources of Funds:

Before the actual procurement of funds, the finance manager has to decide
the sources from which the funds are to be raised. The management can raise
finance from various sources like equity shareholders, preference
shareholders, debenture- holders, banks and other financial institutions, public
deposits, etc.

4. Procurement of Funds:
The financial manager takes steps to procure the funds required for the
business. It might require negotiation with creditors and financial institutions,
issue of prospectus, etc. The procurement of funds is dependent not only
upon cost of raising funds but also on other factors like general market
conditions, choice of investors, government policy, etc.

5. Utilisation of Funds:
The funds procured by the financial manager are to be prudently invested in
various assets so as to maximise the return on investment: While taking
investment decisions, management should be guided by three important
principles, viz., safety, profitability, and liquidity.

6. Disposal of Profits or Surplus:

The financial manager has to decide how much to retain for ploughing back
and how much to distribute as dividend to shareholders out of the profits of
the company. The factors which influence these decisions include the trend of
earnings of the company, the trend of the market price of its shares, the
requirements of funds for self- financing the future programmes and so on.

7. Management of Cash:
Management of cash and other current assets is an important task of financial
manager. It involves forecasting the cash inflows and outflows to ensure that
there is neither shortage nor surplus of cash with the firm. Sufficient funds
must be available for purchase of materials, payment of wages and meeting
day-to-day expenses.

8. Financial Control:
Evaluation of financial performance is also an important function of financial
manager. The overall measure of evaluation is Return on Investment (ROI).
The other techniques of financial control and evaluation include budgetary
control, cost control, internal audit, break-even analysis and ratio analysis.
The financial manager must lay emphasis on financial planning as well.