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Financial Planning
Short-term, medium term, & long Sugandha Muduli- Faculty PIMR
term planning
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Sugandha Muduli- Faculty PIMR

Finance is defined as the provision of

money at the time when it is required.
• Capital required for a business can be classified under
two main categories:
▫ Fixed Capital (for long-term purposes)
▫ Working Capital (for short-term purposes)

• Long term funds are required for fixed assets like

plant, machinery, land, building, furniture etc.
• Short term funds are required for purchase of raw
materials, wages, other day-to-day expenses, etc.
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Sugandha Muduli- Faculty PIMR

Financial Plan
• 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 requirements of business.

• The time, the pattern, no. of ways, selection of

securities are also decided under financial plan.
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Sugandha Muduli- Faculty PIMR

Objectives of financial plan

• Adequate funds
• Balancing of costs and risk
• Flexibility
• Simplicity
• Long-term view
• Liquidity
• Optimum use
• Economy (the cost of raising funds should be min.)
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Sugandha Muduli- Faculty PIMR

Characteristics of a financial plan

• Simplicity
• Based on clear-cut objectives
• Less dependence on outside sources
• Flexibility
• Solvency and Liquidity
• Cost
• Profitability
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Sugandha Muduli- Faculty PIMR

Limitations of financial planning

• Difficulty in forecasting (because of uncertain future)
• Difficulty in change
• Problem of coordination
• Rapid changes
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Sugandha Muduli- Faculty PIMR

Steps in financial planning

1. Establishing financial objectives:
▫ The financial objectives of a company should be
clearly determined.
▫ Both short & long term objectives should be carefully
prepared.
▫ The main purpose of financial planning should be to
utilise financial resources in the best possible manner.
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Sugandha Muduli- Faculty PIMR

2. Formulating Financial Policies:

▫ The financial policies of a concern deal with
procurement, administration and distribution of
business funds in a best possible way.
▫ There should be clear-cut plans of raising required
funds and their possible uses.
▫ The current and future needs for funds should be
considered while formulating financial policies.
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Sugandha Muduli- Faculty PIMR

3. Formulating Procedures:
▫ The procedures are formed to ensure consistency of
actions.
▫ The procedure follow the formulation of policies.
▫ If a policy is to raise short-term funds from banks, then
a procedure should be laid to approach the lenders and
the persons authorised to initiate such actions.
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Sugandha Muduli- Faculty PIMR

4. Providing for flexibility:

▫ The financial planning should ensure proper flexibility
in objective, policies and procedures so as to adjust
according to changing economic situations.
▫ The changing economic environment may offer new
opportunities.
▫ The business should be able to make use of such
situations for the benefit of the concern.
▫ A rigid financial planning will not let the business use
new opportunities.
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Sugandha Muduli- Faculty PIMR

Short term financial planning

• Short-term finance
• Definition: Short term refers to the time period of less than 12
months – the current fiscal year.
• Examples: Examples of external short-term finance include
family and friends, overdraft, trade credit, debt factoring and
microfinance providers.
• Amount: Short-term finance deals with rather small amounts
of money.
• Purpose: Mainly for Revenue Expenditure. Most short-term
finance is used to help a business maintain positive cash flow,
and help manage cash-flow problems. It will be used to
purchase raw materials, pay wages to production workers, pay
trade credit, TAXes, interest on a bank loan, etc.
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Sugandha Muduli- Faculty PIMR

• Short-term financial planning is about solving

immediate problems and developing strategies
that will lead to results, usually within one year.
Short-term goals should be achievable and adaptable
to emerging circumstances.
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Sugandha Muduli- Faculty PIMR

Medium term financial planning

• Medium-term finance

• Definition: Medium term refers to the time period of

more than 12 months but less than five years.
• Examples: Examples of external medium-term finance
include hire purchase, leasing and sale-and-leaseback.
• Amount: Medium-term finance deals with fairly larger
amounts of money.
• Purpose: Mainly for lower Capital Expenditure. Most
medium-term finance is used to purchase cheaper Fixed
Assets such as machinery, equipment, vehicles, etc.
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Sugandha Muduli- Faculty PIMR

• The Medium Term Financial Planning looks at

financial planning and management for a three-
year period. It helps us to develop a sustainable
budget over the medium term.
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Sugandha Muduli- Faculty PIMR

Long term financial planning

• Long-term finance
• Definition: Long term, either debt or equity, refers to
the time period of more than five years.
• Examples: Examples of external long-term finance
include equity shares, long-term bank loans,
mortgage and debentures (bonds). Borrowing
for long-term means that the business does not expect
to repay this debt in less than five years.
• Amount: Long-term finance deals with very larger
amounts of money.
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Sugandha Muduli- Faculty PIMR

• Purpose: Mainly for higher Capital Expenditure. Most long-

term finance is used to purchase expensive Fixed Assets such
as land, buildings, assembly lines, etc. The longer the time
period, the harder it becomes to plan effectively. Some
business activities need huge amounts of money and the
business will invest this money over several years,
e.g. building a new factory, international expansion, or
acquiring or taking over another business.
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Financial Planning 2.0

Capitalisation Sugandha Muduli- Faculty PIMR
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Sugandha Muduli- Faculty PIMR

Meaning
• Capitalization refers to the process of determining the quantum
of funds that a firm needs to run its business.

• Capitalization is only the par value of share capital and debenture

and it does not include reserve and surplus.

• According to Guthman and Dougall, “capitalization is the sum of

the par value of stocks and bonds outstanding”.

• “Capitalization is the balance sheet value of stocks and bonds

outstanding”. — Bonneville and Dewey

• According to Arthur. S. Dewing, “capitalization is the sum total of

the par value of all shares”.
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Sugandha Muduli- Faculty PIMR

• Capitalisation includes:
▫ Estimating the total amount of capital to be raised;
▫ Determining the type of securities to be issued; and
▫ Determining the composition or proportion of the
various securities to be issued.
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Sugandha Muduli- Faculty PIMR

Capital v/s Capitalisation

• Capitalisation is used only in relation to companies
and not in relation to partnership firms or sole-
proprietory organisations.

• Capital refers to the total investment of a company in

money, tangible and intangible assets.
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Sugandha Muduli- Faculty PIMR

Theories of Capitalisation
• 1. Cost Theory:
▫ The amount of capitalisation is arrived at by adding up the
cost of fixed assets, working capital required for the
continuous operations of the company, the cost of
establishing the company and the promotional expenses.
Capitalisation= Total fixed assets= total fixed liabilities.
▫ Limitation:
 Not satisfactory as it ignores the earning capacity of the
business.
 The amount of capitalisation is based on a figure which will
not change with the earning capacity of the business.
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Sugandha Muduli- Faculty PIMR

• 2. Earnings Theory:
▫ Capitalisation of a company depends upon its earnings and
the expected fair rate of return on its capital invested.

▫ Capital * rate of return(%)= Expected Annual Earnings or

Net profit
▫ Capitalisation= Estimated Annual Earnings/r%

▫ Suppose the Est. Annual Earning of XYZ ltd. is Rs.3,00,000

and fair rate of return is 12%.
Capitalisation= 3,00,000/12%
=3,00,000/.12
=Rs. 25,00,000/-
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Sugandha Muduli- Faculty PIMR

Types of Capitalisation
• Over-Capitalisation
• Under-Capitalisation
• Watered-Capitalisation
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Sugandha Muduli- Faculty PIMR

Over-Capitalisation
• Over capitalization refers to the company which possesses an
excess of capital in relation to its activity level and
requirements.

• In simple means, over capitalization is more capital than

actually required and the funds are not properly used.

• According to Bonneville, Dewey and Kelly, over

capitalization means, “when a business is unable to earn fair
rate on its outstanding securities”.

• Conditions: 1. If Total Fixed Liabilities > Total Fixed Assets

2. If Actual capitalisation > Fair Capitalisation
3. If Actual rate of return < Fair rate of return
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Sugandha Muduli- Faculty PIMR

• A firm earns Rs.4,80,000/- annually after paying all

expenses and interest. The total amount of capital
employed is Rs.60,00,000/- and fair rate of return
expected by investors is 12%. Is the firm over-
capitalised? If so, by how much?

• Capitalisation= Est. Annual earnings/r%

= 4,80,000/.12
=Rs. 40,00,000/- (fair capitalisation)
Since the actual cap. > fair cap. clearly the firm is
over capitalised.
Also if actual rate of return < Fair rate of return, it is
over capitalised.
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Sugandha Muduli- Faculty PIMR

• Extent of over-capitalisation
=Actual capitalisation-Fair Capitalisation
=60,00,000 - 40,00,000
=Rs. 20,00,000
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Sugandha Muduli- Faculty PIMR

Over-capitalisation v/s Excess of

capital
• These two terms are not same.
• Excess of capital can be one of the reason of over-
capitalisation, but it is not the only reason.
• Over-capitalisation arises when the existing capital of
a firm is not effectively utilized, resulting to fall in
the earning capacity of the company.
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Sugandha Muduli- Faculty PIMR

Causes of Over-Capitalisation
1. Over-issue of capital
2. Promotion, Formation or Development during inflation
3. Buying assets of lower value at higher prices
4. High promotion costs
5. Inadequate depreciation
6. Liberal Dividend Policy
7. Taxation Policy
8. Inadequate Demand
9. Payment of High rate of Interest
10. Under-estimation of capitalisation of rate.
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Sugandha Muduli- Faculty PIMR

Remedies for Over-Capitalisation

• To have efficient management
• Redemption of preference shares.
• Reduction of funded debts.
• Reorganization of equity share capital.
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Sugandha Muduli- Faculty PIMR

Under Capitalisation
• When company’s actual capitalisation is lower than
its fair capitalisation.

• Conditions:
1. If Total Fixed Liabilities < Total Fixed Assets
2. If Actual capitalisation < Fair Capitalisation
3. If Actual rate of return > Fair rate of return

• It is just opposite of over-capitalisation.

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Sugandha Muduli- Faculty PIMR

Causes of Under-capitalisation
1. Under-estimation of capital requirements
2. Under-estimation of future earnings
3. Promotion during depression
4. Conservative Dividend Policy
5. Very Efficient Management
6. Desire of control and trading on equity.
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Sugandha Muduli- Faculty PIMR

Remedies for Under-capitalisation

• Fresh issue of shares
• Issue of bonus shares
• Increasing the par value of shares
• Splitting stock
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Sugandha Muduli- Faculty PIMR

Watered Stock
• Hoagland- A stock is said to be Watered when its true
value is less than its book value.

• If the stock or capital of the company is not

mentioned by assets of equivalent value, it is called
as watered stock.
• In simple words, watered capital means that the
realizable value of assets < its book value.
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Sugandha Muduli- Faculty PIMR

Causes of Watered Stock

• Generally watered capital arises at the time of
incorporation of a company but it also arises during the
life time of the business.

• The following are the main causes of watered capital:

1. Acquiring the assets of the company at high price.
2. Adopting ineffective depreciation policy.
3. Worthless intangible assets are purchased at higher
price
4. Valuing the services of promoters at unduly high
values and paying them in form of stocks.
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Types of Securities
Sugandha Muduli- Faculty PIMR
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Sugandha Muduli- Faculty PIMR

Securities
• The term 'securities’ is broadly used to refer to
financial instruments that hold some kind of
monetary value. The term encompasses debt and
equity instruments, as well as hybrid instruments that
combine elements of both.
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Sugandha Muduli- Faculty PIMR

Finance sources in detail

1. Bank Credit: Bank credit is usually referred to as a
loan given for business requirements or personal
needs to its customers, with or without a guarantee
or collateral, with an expectation of earning
periodic interest on the loan amount.

2. Customer Advances: It means those advances by

customers to seller for operations related to the
business which are to be refunded either wholly or
in part.
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Sugandha Muduli- Faculty PIMR

3. Trade Credit: Trade credit is the loan extended by

one trader to another when the goods and services
are bought on credit. Trade credit facilitates the
purchase of supplies without immediate payment.

4. Factoring: Factoring is a type of finance in which a

business would sell its accounts receivable (invoices)
to a third party to meet its short-term liquidity needs.

5. Accruals: Accruals are treated as “cost free” source

or finance, since it does not involve any payment of
interest. Accruals represent a value a firm has
received, but not yet paid.
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Sugandha Muduli- Faculty PIMR

6. Deferred Incomes: Deferred income is income received

in advance by the firm for supply of goods or services in
future period. This income increases the firm’s liquidity
and constitutes an important source of short-term finance.

7. Commercial paper: It represents a short-term unsecured

promissory note issued by firms that have a fairly high
credit (standing) rating.

8. Installment Credit: Installment credit is a loan that offers

a borrower a fixed, or finite, amount of money over a
specified period of time. It involves a loan that is repaid
over time with a set number of scheduled payments.
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Sugandha Muduli- Faculty PIMR

9. Issue of shares: Share issue is a source of finance that is only

available to private or public limited companies. Such
businesses can decide to issue more shares in the company
and obtain finance from their sale.

10. Issue of Debentures: Debentures are loans given to the

business by individuals. Interest is paid annually and the loan
is paid back in full at an agreed date in the future.
Unlike shareholders, debenture holders are guaranteed their
interest payment each year but do not hold a share of the
company.

11. Issue of Preference shares: Preference shares are shares that

represent part of capital issued by a company. The shares thus
issued usually carries a definite rate of dividend, which
generally is lower than that, is declared on ordinary shares.
It is a hybrid security.
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Sugandha Muduli- Faculty PIMR

12. Bank loans: A bank loan is a long term source of finance. It

is a fixed amount of money that is given to a business by the
bank that has to be repaid over time with interest, usually in
monthly instalments.

13. Public Deposits: The deposits that are raised by

organisations directly from the public are known as public
deposits. Rates offered on public deposits are higher than of
bank deposits. But, there is higher risk in public deposits.
Public deposits cater to both short term and medium term
finance requirements.

14. Retained Earnings: . It is a source of internal financing or

self-financing or ‘ploughing back of profits’. The profit
available for ploughing back in an organisation depends on
many factors like net profits, dividend policy and age of the
organisation.
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Sugandha Muduli- Faculty PIMR

15. Lease Financing: A lease is a contractual agreement

whereby one party i.e., the owner of an asset grants
the other party the right to use the asset in return for a
periodic payment. In other words it is a renting of an
asset for some specified period.
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Sugandha Muduli- Faculty PIMR

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