Financial Planning and Its Importance - Assignment Example

Managing Financial Resources and Decisions Table of Contents Task 3 Report on the sources of finance highlighting the Short-term, Medium-term and Long-term sources. 3 Task 2 5 a)Importance of internal and external sources of financing and their implication on a company’s financial statements. 5 b)Financial planning and its importance 7 Task 3 8 a)Identify and discuss the objectives of a budget and assess its importance generally with special emphasis on small and medium size enterprises. 8 b)Short note on investment appraisal techniques and importance of NPV in determining viability of a project. 9 Task 4 11 Ratio analysis of British Airways for 2011 and 2012- 11 Reference list 14 Task 1 Report on the sources of finance highlighting the Short-term, Medium-term and Long-term sources. Investment is considered as the life blood of any business. So, financial arrangements form one of the most important activities in a business. This section of the paper discusses various short-term, medium-term and long-term sources of finance employed by a firm. Short-term sources of financing a) Bank overdraft: Bank O/D is a credit extension facility that banks provide to customers who can withdraw money above their credit limit. It is provided mainly to enterprises and business owners for a limited period, usually less than a year. The customer is supposed to pay interest only on the amount excess to the credit limit. b) Accounts payable: Accounts payable are current liabilities of a firm. It includes creditors and unpaid bills, such as, telephone bills, electricity bills and so on. These accounts are needed to be paid within a year, although some bills are paid after a month. c) Factoring: It is a transaction method adopted by firms to have quick cash. In factoring, a firm sells its accounts receivables to a third-party financial company, who pays them 80-95 percent of the total value immediately. The third party company later collects the amount from company’s debtors. Factoring is also known as accounts receivable financing. d) Business angels: Business angels are affluent individuals who invest their disposable income in new business ventures during the initial stage of start-up in form of equity financing. They are also known as informal investors. Angel investors often make individual investment or form a part of group investing. e) Sale of fixed assets: Firms often generate fund by selling off fixed asset that no longer is in use, such as, machinery, old factory location and commercial vehicles. It is an important internal source of financing and is a good way of generating fund, only when the firm has surplus idle fixed assets. f) Government gilts: Gilts are considered to be the safest form of investment as they are issued by the national government. The gilt promises to pay back a specific amount on maturity and is not subject to market fluctuation. The return on the gilt-edge security is less, but firms invest in them to earn a fixed return and avoid risk (Pour, 2011). Medium-term sources of financing a) Leasing: Leasing is an alternate term for renting assets for a certain period of time. Many a times, companies lease buildings, vehicles and machineries when they either do not have sufficient fund to purchase the asset or require it only for a limited time period. Leasing is considered cost efficient in short-run, but is an expensive source in long-run. b) Bank loans: Bank loans as medium-term source of financing are granted for a period of 1-5 years. This a secured source of financing where the bank provides loan at a specific interest rate for a specific repayment period. Medium-term bank loans are granted only on personal guarantee and mortgage is provided by the firm as an assurance. c) Venture capitals: Venture capitalists are investors who make investment in nascent, but highly potential, industries with a possibility of immense growth. This kind of financing is made generally while starting up the business. The investors become a major equity holder. They also bring along their experience and knowledge. d) Government grants: Government from time to time provide cash grants and other forms of direct assistance as a part of its economic development policy. These grants are generally available to technology-oriented industries and high unemployment sectors. Moreover, the grants are also made available to self-help groups, micro, small and medium enterprises (MSME) and indigenous industries (Pour, 2011). Long-term sources of financing a) Long-term bank loans: Long-term loans are generally granted for a period exceeding 5 years. These loans are taken by a firm to meet heavy capital expenditure including expansion of operations, purchase of new asset, acquiring new business and refurbishment. b) Share capital: A major source of a company’s capital is equity capital. A major advantage for equity financed companies is that in case of solvency, they do not have any liabilities to take care of beyond company assets. Equity capital is raised by issuing shares in stock market, where shareholders invest and are treated as owners of company. Through equity capital financing, risk is reduced as the company does not have any mandatory obligation to pay the shareholders. c) Preference capital: Preference capital is known as hybrid instrument as they have properties of both equity share as well as debentures. Preference shares are usually owned by promoters of a firm and are given preference over equity shares. The preference shareholders enjoy a certain percentage of fixed dividends like, debenture holders and have a claim on company’s assets. d) Retained earnings: Every company retains a certain percentage of their profit as retained earnings to invest back in business. The retained earnings are mainly used to finance new projects, addition, modification and expansion of old projects and so on. High retained earnings result in low percent of dividend paid to individuals. e) Debentures: Debentures are long-term debt capitals with fixed/floating rate of interest. This is also known as debt financing and debenture holders are regarded as long-term creditors of a firm. Since debentures require regular payment of interest, they are considered risky. f) Eurobonds: Eurobonds are international bonds that can be issued by any company in any currency and country, apart from the native country. It is a very attractive financial source as it is highly liquid and provides issuer the liberty to select the country, in terms of norms and policies (Pour, 2011). Task 2 a) Importance of internal and external sources of financing and their implication on a company’s financial statements. Every business requires financing for running its operations. The sources of financing can be internal as well as external. The internal sources of finance are equity share capital, right shares, retained profit and capital earned from sale of assets. The internal financing is relatively inexpensive as it does not bear any transactional cost. Moreover, a firm does not have any obligation towards external liabilities. From time to time, along with equity, firms also issue right shares to raise fund. Right shares are issued by offering the same to existing shareholders at a price less than the market price. The shareholder can either accept or decline the offer. Issue of right shares also helps in preventing the cost of fresh issue (Pour, 2011). The external sources of finance can be classified in three categories, namely short-term, medium-term and long-term sources. The short-term financing sources are bank overdraft, accounts payable, factoring and government gilts. These sources provide immediate cash necessary for running day-to-day operations. Funds through these sources are available only for a period as short as a year. These sources are useful in funding working capital management. The medium-term and long-term financing involve bank loans, leasing, creditors and debt financing. In these kinds of financing, firm has a mandatory obligation of paying back the borrowed fund. Such external sources are taken in consideration when the firm wants to expand its business through heavy expenditure and is in a position to pay back all obligations (Pour, 2011). Impact of internal and external sources on financial statements of a firm: Balance sheet: In a balance sheet, factoring of accounts receivable, short-term investments such as, gilt securities and cash or cash equivalents are considered as current asset, while bills payable, bank overdraft and interest payable are known as current liabilities. It is important for a firm to have current asset twice the current liabilities to manage its liquidity (Subramanyam and Wild, 2009). Building, plants and machinery are considered as long-term assets, whereas debentures, preference capital and loans are long-term liabilities as they are to be paid over a certain number of years. The total asset should always be more than total liabilities. Usually, the difference of total assets and liabilities is equivalent to company’s net worth. The net worth comprises share capital and retained earnings. For a profitable business, net worth continues to grow (Penman, 2007). Profit and loss account: The impact of various elements of the balance sheet on the profit and loss statement can be analysed by applying financial tools such as, ratio analysis. There are liquidity ratios, solvency ratios, efficiency ratios and profitability ratios that determine relationship between components of balance sheet (sources of financing) and the income statement. The liquidity ratios such as, current and liquid ratios, indicate the relationship between current asset and liabilities, besides determining liquidity of a firm. The solvency ratios consider long-term sources of financing and their relations. For instance, debt equity ratio explains that the share of equity financing should always be higher than debt financing; the interest coverage ratio shows whether a firm has earned enough profit to meet all the interest charges to be paid and so on (Penman, 2007). The efficiency ratios are useful in determining effectiveness of firm’s policies related to credit and operations. Lastly, profitability ratio relates profit to the overall turnover and investment. For example, the return on investment explains amount of return that a firm has earned with respect to the fund invested (Will, Subramanyam and Robert, 2001). Cash flow statement: The cash flow statement is classified in three major activities: operating activities, investing activities and financing activities. The cash inflow and outflow take in account operating activities such as, sale and purchase of securities such as, gilt; cash receipts from sale of assets bills receivable and factoring; and cash payment in case of bills payable. The investment activities involve purchase and sale of fixed assets and dividend and interest earned. The financing activities takes in account earnings from issuance of share capital and debt capital; repayment of loans and debentures and payment of dividend and interest (Gruca and Rego, 2005). b) Financial planning and its importance Financial planning is an important management tool in the decision making process of a firm. Planning is the process of deciding in advance about activities, resource allocation and method of monitoring (Nugus, 2009). Financial planning is defined as a process of calculating the amount of financing necessary in order to continue a firm’s operations (Booker, 2006). The financial objectives that are to be achieved in future are pre-established by financial planning. A financial plan is of paramount importance for a firm and hence, is prepared with great caution. Financial plans are prepared for different periods and can vary from 1 year to 10 years and more (Stovall and Maurer, 2011). Financial planning is important as it systematically organises various financial activities of a firm and helps in achieving set goals and objectives. Financial planning adds meaning and direction to affairs of a firm. It helps in prioritizing the activities and determining the amount of investment required. Financial planning helps in reducing a firm’s debt and increasing net worth. Moreover, this ensures maximization of shareholders’ wealth and profit. With proper financial planning, a firm can lower cost and meet exigencies (Van Horne James, 2002). Cash management: Cash management is the method of efficiently managing inflow and outflow of cash in a business. It optimises cash flow, balance and various short-term investments. In cash management, cash is defined as cash or cash equivalents such as, draft, deposits, marketable securities and bills (Maness and Zietlow, 2004). It deals with all liquid assets that can easily be converted in cash. Cash management is considered important because liquid cash is often required to meet cash transactions such as, payment of bills and wages. Furthermore, cash reserves facilitate immediate purchase of raw materials, in case of reduction in price. Another important aspect of cash management is management of working capital for day-to-day operations (Padachi, 2006). Task 3 a) Identify and discuss the objectives of a budget and assess its importance generally with special emphasis on small and medium size enterprises. Budget is defined as monetary expression of a business plan. It is an outline or estimation of revenue and expenditure for a given period, generally a month, quarter and year. Budgets are prepared by every company to define specifically their short and long run goals for a financial year. Budgeting is also done for long time period, such as, 5 and 10 years. Budgets can be of different kinds depending on need of a firm. A firm generally prepares functional budgets such as, cash budget, sales budget and production budget and a master budget that encompasses details of all other budgets (Schleifer, Sullivan and Murdough, 2014). The main objectives of a budget are: 1. The basic purpose of budgeting is to prevent overspending by a firm and facilitate appropriate allocation of monetary and human resources. 2. A budget is necessary while planning and forecasting for a long period of time so as to meet uncertainty and risks. 3. A budget reflects realistic estimation of income and expenditure as well as financial position of a firm for a given period. 4. Budget helps in coordinating various action plans to achieve the estimation and any deviations can be easily recognized and corrected. 5. Budget provides guidance to the management in decision making and helps them to adjust their plans and objectives as per a given situation. Budget is a necessity for small and medium sized enterprises as it helps planning, forecasting and controlling firm’s activities. It reflects a firm’s goals and objectives in financial terms. In addition, a budget is helpful in determining strategies related to cost allocation. It communicates business priorities to individuals. Budgeting provides a set of targets, which are to be achieved at functional, strategic and corporate levels (Schleifer, Sullivan and Murdough, 2014). b) Short note on investment appraisal techniques and importance of NPV in determining viability of a project. Investment appraisal or capital budgeting techniques are employed by companies to evaluate and determine viability of long-term projects that require significant investment of capital. The main techniques that are applied for this purpose are- Net Present Value, Internal Rate of Return, Payback Period and Annual Rate of Return. NPV: The NPV method evaluates a project by considering all the inflows and outflow of cash over a given period of time and calculating net worth by applying a certain discounting rate. In case of positive NPV, the project is accepted; whereas, negative NPV results in rejection of the project. Positive NPV represents that the project will be profitable. IRR: The internal rate of return is an interest rate at which the net present value of a project is zero. IRR method is useful to rank various prospective projects on the basis of expected return. The most desirable project is the one that has highest internal rate of return. The acceptance criterion in IRR is that return rate should be higher than the cost of capital. Payback (PB) period: The payback period is the minimum period within which initial outlay in the project is recovered through the inflows. It is an important method of evaluation as projects with long payback period is not suitable from a firm’s financial point of view. Therefore, the only criterion in PB period is to select the project with shortest recovery time. ARR: ARR is a non-discounting technique of project evaluation. It does not take into consideration the time value of money. It is a straight-line calculation method where the annual profit is divided by initial investment. This is not a very useful method as it lacks sophistication and can be misleading (Kruschwitz and Löffler, 2006). Importance of NPV: The NPV method is a discounted cash flow technique that evaluates future inflows of cash by considering their present value at a given discounting rate. The techniques consider the time value of money, which ensures viability of the project. Moreover, discounting rate is usually the cost of capital. The NPV method always considers shareholders’ value maximisation as its priority (Kruschwitz and Löffler, 2006). The following example represents NPV calculation method and project evaluation: (Refer to excel sheet for calculation) The above example is of ABC Company, presenting evaluation of three projects viz. Alpha, Beta and Gamma for five years and the cost of capital is 15%. The calculated net present values for the projects are £ 10,806.76, £1564.97 and £ 2640.47 respectively. All the projects have positive NPV, but project Alpha has the highest NPV. Hence, it is the most suitable project for the company. Task 4 Ratio analysis of British Airways for 2011 and 2012- (Refer to excel sheet for calculation) The ratio analysis has been done in order to access the performance of the British Airways in terms of profitability, liquidity and efficiency: Liquidity ratio Current ratio: The ratio conveys the relationship between the current assets and liabilities. The ratio for 2011 and 2012 shows that the adversity of the company has increased over the year as the current ratio has reduced from 0.75 to 0.59 and is nowhere near to the ideal ratio which is 2:1. It represents that the company may face difficulties while meeting its current obligations. Acid test ratio: this ratio is considered ideal for measuring liquidity. It takes into account only those current assets that can be converted in cash or equivalents immediately hence overlooks inventory. The benchmark ratio is 1:1, whereas that of British Airways is 0.57 in 2012 while it was 0.71 in 2011. The company’s illiquidity can be explained as either negative working capital or inventories that are waiting to be sold (Alexander, 2001). Efficiency ratio Stock turnover period: the stock turnover period has decreased by 2 days from 2011 to 2012 which shows that the consumption of inventory has increased and as a result, firm’s efficiency has improved. Debtor settlement period: the debtor settlement period should be less. With quick debtor turnover period, the possibility of bad debt is eliminated. The debtor collection period has been more or less same for both the years and 16 to 17 days as settlement period is quite a positive sign. Creditor settlement period: the creditor settlement period determines the credit worthiness of a firm. It shows that the creditors trust the firm with the credit amount. The credit period has increased from 126 days in 2011 to 130 days in 2012, which clearly express that the creditors are satisfied with the performance of the firm and ready to extend the credit period (Drake, n.d.). Profitability ratio Operating profit ratio: The operating profit is the profit earned by a firm after deducting all direct as well as indirect costs from sales turnover. The ratio present the proportion of revenue left after the variable costs have been paid. The operating profit margin is considerer better when it is continuously increasing; whereas in case of British Airline the profit value has decline, which can be justified by considering high operating cost. ROCE: The data of British Airways for 2011 and 2012 shows that there has been a sharp rise in the return on capital employed. While the amount of capital has declined, the net profit has increased consistently. It is a good sign that even with marginal change in the capital the company was able to increase its profit and hence the return. Gross Profit ratio: The gross profit has decline by a substantial margin of about 3%. The various reasons for this can be the increase in direct cost of material and labour. Since the revenue growth has not declined hence this is just a temporary situation and the company is expected to have a quick rebound (Alexander, 2001). Reference list Alexander, C., 2001. Market models: a guide to financial data analysis. New Jersey: John Wiley & Sons. Booker, J., 2006. Financial Planning Fundamentals. Canada: CCH Canadian Limited. Drake, P. P., no date. Financial ratio analysis. [pdf] JMU. Available at: [Accessed 19 May 2014]. Gruca, T. S. and Rego, L. L., 2005. Customer satisfaction, cash flow, and shareholder value. Journal of Marketing, 69(3), pp. 1-130. Kruschwitz, L. and Löffler, A., 2006. Discounted cash flow: a theory of the valuation of firms. New Jersey: John Wiley & Sons. Maness, T. S. and Zietlow, J. T., 2004. Short Term Financial Management. USA: South-Western Educational Publishing. Nugus, S., 2009. Financial Planning Using Excel: Forecasting, Planning and Budgeting Techniques. United Kingdom: Butterworth-Heinemann. Padachi, K., 2006. Trends in working capital management and its impact on firms’ performance: an analysis of Mauritian small manufacturing firms. International Review of business research papers, 2(2), pp. 45-58. Penman, S. H., 2007. Financial statement analysis and security valuation. [pdf] IFM. Available at: [accessed 19 May 2014]. Pour, N.M., 2011. Identifying different sources of finance to PLC advantages and limitations. [online] Available at: [accessed 19 May 2014]. Schleifer, T. C., Sullivan, K. T. and Murdough, J. M., 2014. Projection and Budgets. Managing the Profitable Construction Business: The Contractors Guide to Success and Survival Strategies, pp. 181-194. Stovall, J. and Maurer, T., 2011. The Ultimate Financial Plan: Balancing Your Money and Life. New Jersey: John Wiley & Sons. Subramanyam, K. R. and Wild, J. J., 2009. Financial statement analysis. New York, NY: McGraw-Hill. Van Horne James, C., 2002. Financial Management & Policy. India: Pearson Education. Will, I., Subramanyam, K. R. and Robert, F. H., 2001. Financial statement analysis. New York: McGraw-Hill International. Read More