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Financial Planning

1. Definition

Financial Planning is the process of estimating the capital required for business operations and determining the sources and uses of these funds, ensuring adequate funds are available at the right time for the right purpose.

2. Types of Financial Planning

2.1 Based on Time Period

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2.2 Based on Nature

1. Strategic Planning

  • Long-term objectives
  • Overall direction
  • Major investments
  • Example: Entering new market

2. Tactical Planning

  • Medium-term (1-3 years)
  • Specific departmental plans
  • Resource allocation
  • Example: Marketing budget for new product

3. Operational Planning

  • Short-term (daily, weekly, monthly)
  • Routine operations
  • Cash management
  • Example: Daily cash requirements

3. Financial Planning Process

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4. Estimation of Financial Requirements

Method 1: Percentage of Sales Method

Assumption: Certain assets and liabilities vary directly with sales.

Formula:

Formula

Additional Funds Needed (AFN) =
(Assets/Sales) × ΔSales - (Liabilities/Sales) × ΔSales - (Profit Margin × New Sales × Retention Ratio)

Where:

  • ΔSales = Change in sales
  • Retention Ratio = 1 - Dividend Payout Ratio

Problem 1: Calculate additional funds needed.

Given:

Current Sales = ₹10,00,000
Projected Sales = ₹12,00,000
Assets that vary with sales = ₹6,00,000
Liabilities that vary with sales = ₹2,00,000
Net Profit Margin = 10%
Dividend Payout Ratio = 40%

Formula:

AFN = (A*/S) × ΔS - (L*/S) × ΔS - (PM × S1 × RR)

Solution:

Step 1: Calculate change in sales (ΔS)

ΔS = New Sales - Current Sales
ΔS = ₹12,00,000 - ₹10,00,000
ΔS = ₹2,00,000

Step 2: Calculate asset increase required

Asset increase = (Assets/Sales) × ΔSales
= (₹6,00,000 / ₹10,00,000) × ₹2,00,000
= 0.60 × ₹2,00,000
= ₹1,20,000

Step 3: Calculate spontaneous liability increase

Liability increase = (Liabilities/Sales) × ΔSales
= (₹2,00,000 / ₹10,00,000) × ₹2,00,000
= 0.20 × ₹2,00,000
= ₹40,000

Step 4: Calculate retained earnings from new sales

Retention Ratio = 1 - 0.40 = 0.60

Retained Earnings = PM × New Sales × RR
= 0.10 × ₹12,00,000 × 0.60
= ₹72,000

Step 5: Calculate AFN

AFN = Asset Increase - Liability Increase - Retained Earnings
AFN = ₹1,20,000 - ₹40,000 - ₹72,000
AFN = ₹8,000

Answer: Additional funds needed = ₹8,000

Interpretation: Company needs to raise ₹8,000 externally (through equity or debt) to support the sales increase.

Method 2: Pro Forma Financial Statements

Approach: Prepare projected income statement and balance sheet.

Example - Simplified:

Given:

Current Year Sales: ₹10,00,000
Next Year Sales (expected): ₹12,00,000 (20% increase)
Current Assets: ₹6,00,000 (60% of sales)
Current Liabilities: ₹2,00,000 (20% of sales)
Net Profit Margin: 10%
Dividend Payout: 40%

Pro Forma for Next Year:

Step 1: Project Assets

Assets should be 60% of new sales
Required Assets = 0.60 × ₹12,00,000 = ₹7,20,000
Increase needed = ₹7,20,000 - ₹6,00,000 = ₹1,20,000

Step 2: Project Liabilities Spontaneously (increase with sales)

Liabilities should be 20% of new sales
Spontaneous Liabilities = 0.20 × ₹12,00,000 = ₹2,40,000
Increase = ₹2,40,000 - ₹2,00,000 = ₹40,000

Step 3: Project Retained Earnings Addition

Net Profit = 10% × ₹12,00,000 = ₹1,20,000
Retained = 60% × ₹1,20,000 = ₹72,000

Step 4: Calculate External Financing Needed

AFN = Required Asset Increase - Spontaneous Liability Increase - Retained Earnings
AFN = ₹1,20,000 - ₹40,000 - ₹72,000 = ₹8,000

Answer: External financing needed = ₹8,000 (matches Method 1)

5. Importance of Financial Planning

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Exam Pattern Questions and Answers

Question 1: "Distinguish between short-term and long-term financial planning." (4 Marks)

Answer:

Short-term Financial Planning (2 marks): Covers period up to one year, focusing on working capital needs for day-to-day operations. Uses tools like cash budget and sales forecasts to estimate monthly or quarterly fund requirements for inventory, receivables, and operational expenses.

Long-term Financial Planning (2 marks): Covers period exceeding one year (typically 3-5 years), focusing on fixed assets and expansion needs. Uses capital budgets and pro forma financial statements to plan major investments in plant, machinery, technology, and strategic initiatives requiring substantial capital commitment.

Question 2: "Calculate additional funds needed using percentage of sales method." (6 Marks)

Given:

Current Sales: ₹5,00,000
Projected Sales: ₹6,00,000
Assets varying with sales: ₹3,00,000
Liabilities varying with sales: ₹1,00,000
Profit Margin: 12%
Retention Ratio: 50%

Formula:

AFN = (A/S) × ΔS - (L/S) × ΔS - (PM × S1 × RR)

Solution:

Step 1: Calculate ΔS

ΔS = ₹6,00,000 - ₹5,00,000 = ₹1,00,000

Step 2: Asset increase

= (₹3,00,000 / ₹5,00,000) × ₹1,00,000
= 0.60 × ₹1,00,000 = ₹60,000

Step 3: Liability increase

= (₹1,00,000 / ₹5,00,000) × ₹1,00,000
= 0.20 × ₹1,00,000 = ₹20,000

Step 4: Retained earnings

= 0.12 × ₹6,00,000 × 0.50 = ₹36,000

Step 5: Calculate AFN

AFN = ₹60,000 - ₹20,000 - ₹36,000 = ₹4,000

Answer: Additional Funds Needed = ₹4,000

Summary

Financial Planning:

  • Definition: Estimating capital needs and determining sources
  • Types: Short-term (< 1 year), Long-term (> 1 year)
  • Process: Objectives → Sales Forecast → Estimate Requirements → Identify Sources → Plans → Control

Methods for Estimating Requirements:

  1. Percentage of Sales Method: Quick estimate based on sales-asset relationship
  2. Pro Forma Statements: Detailed projected financial statements

AFN Formula:
AFN = (A/S) × ΔS - (L/S) × ΔS - (PM × S1 × RR)

Exam Tip

For numerical problems on AFN: (1) Clearly write "Given", (2) State formula, (3) Show 5 steps: ΔS calculation, asset increase, liability increase, retained earnings, final AFN, (4) Write answer with interpretation. This ensures full marks!

Quiz Time! 🎯

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