The Importance of Financial Planning - Essay Example

The Importance of Financial Planning Teacher’s Institute The Importance of Financial Planning What is financial planning? Financial planning concept may relate to both private life and company business. This assignment discusses this concept related to a company or corporate business. Financial planning is a tool used to meet the goals of the company through the proper management of its finance (Michigan State University n.d.,). The following paragraphs present an evaluation on interpretation of financial planning of the company and its requirement in the business. Why is it needed? A company generates products or services, and then it sells in the market. These are the company’s principal activities. These activities are called company operations, and it requires money. Money for company operations is arranged through financing. Financing may be arranged through different sources; however, the principal sources are owner(s) and creditor(s). In order to arrange financing both owner and creditor want to understand how the funds will be spent; if the funds will generate profit to pay off the interest and principal back. This is why a financial planning is required in the business. It was mentioned earlier that credit is one of the sources in arranging financing. Credit, from the viewpoint of maturity is termed as short-term, mid-term, and long-term. Short-term credit has a maturity of one or less year while long-term has maturity more than one year. For financial managers, it is important to plan how to distribute short-term, medium-term, and long-term financing so to produce maximum benefit for the company. For example, most long-term funds are used in fixed assets, such as land and buildings, plant and equipment. These assets generate profit during their productive economic lives. On the other hand, short-term funds are used to buy raw materials, make utility payments, and pay employees’ salaries. In order to conduct said activities, a company needs plan its funds; it is also called planning of company financial operations. A good planning of the company’s financial operations can bring favorable results. An inadequate planning bring heavy losses; a company even can sustain bankruptcy. Who needs it? Several parties need to understand company’s financial planning. These parties are lenders, investors, and company managers. All of the above parties in a group is called as decision makers. The decision makers need to study information about financial planning. The information about financial planning is expressed through various financial information. Not all information play same importance to all decision makers. A group of the decision maker may show interest on some information, which may not be relevant to another group. For example, a long-term lender wants to know the gearing ratio of a company; a short-term lender wants to know about the liquidity ratio, company manager wants to know information about profitability, solvency, and managerial effectiveness. How to find and interpret financial information? Decision makers can get information from company’s financial statements. There are three basic financial statements; the income statement, balance sheet, and cash flow statement. Professional company accountants prepare these statements. These financial statements contain information that can be used to conduct horizontal analysis, vertical analysis, trend analysis, and ratio analysis of company’s operational activities. Among them, information of financial ratios plays significant importance to the decision makers. In fact, financial ratios illustrate company’s financial health and shows its position in the business landscape. Financial ratios are tools that help to interpret a company’s financial planning, and its performance during the existence of the business. It allows the company to compare own activities with respect to previous years as well as among competitors. Financial ratios enable to understand operating performance and financial condition of the company through profitability ratio, liquidity ratio, activity ratio, financial leverage ratio, and shareholders’ ratio. A financial ratio shows the relationship between two relevant variables of financial statements. Ratios can be expressed as a percentage or number. Profitability ratios are gross profit margin, operating profit margin, and net profit margin; they are expressed as a percentage of sales. In other words, profitability ratios demonstrate the percentage of profit a company was able to generate at the different points of its operational activities. Activity ratios measure how well the company uses the assets. It is expressed through inventory turnover, total asset turnover, and fixed assets turnover. These ratios demonstrate how efficiently a company is putting its investment to work. These ratios are expressed in numbers. Total and fixed asset turnover ratios state how many times these assets were used in generating company’s sales in the fiscal year; inventory turnover informs how many times the inventory was created and sold in the fiscal year. Liquidity ratios inform the company’s ability to meet its liability; current and quick ratios are two popular liquidity ratios. The current ratio indicates a company’s ability to satisfy its current liabilities with its current assets. The quick ratio or acid test ratio indicates its current liability through its liquid assets. A company finances its assets through equity, debt; , or both. Debt financing involves risks; that is why lenders are interested to know the company’s financial leverage ratios. They are expressed through total debt to assets ratio, long-term debt to assets ratio, and debt to equity ratio. Total debt to assets ratio indicates company’s portion of total debt that are financed through the assets; long-term debt to assets ratio states percentage of company’s assets that are financed through long-term debt; debt to equity ratio indicates relative use of debt and equity as sources for financing company assets. Impacts of Financing on Financial Statements The above paragraphs demonstrated the concept of the financial planning and its importance in the business. Financing can be arranged from the different sources, such as from personal savings, sale of assets, issuance of shares and debentures and others. These activities of the company are recorded in the balance sheet and income statement.. Different sources of financing affect differently the company income statement and balance sheet. This section studies these impacts. Personal Savings. It is accounted as long-term liabilities in the balance sheet; interest payments are noted in the profit and loss section of the income statement.. Sale of Assets. On the balance sheet, it reduces the value of the fixed assets. The profit and loss made on the sale is recorded in the profit and loss section of the income statement. The depreciation along with its original value is removed from the income statement and balance sheet. Ordinary shares and Preferred Shares. Issuance of both types of shares increases the equity in the balance sheet. The balance sheet shows the number of shares; if applicable records share premium and documents rate of dividend for preferred shares. Dividend payment is deducted from the net profit only and is shown on the income statement. Debentures. It is considered as debt capital. Its value, rate of interest, and maturity are recorded in the liability and equity section of the balance sheet. Interest payment is reduced from profits before taxes and is recorded in the income statement. Bank overdraft. It is a short-term debt, and on the balance sheet, it is shown as a current liability. Interest and banking charges are recorded in the profit and loss section of the income statement is noted before tax is charged. Loan. It is considered as long-term debt and is entered in the liability section of the balance sheet. Interest on the loan is recorded in the company income statement. Venture Capital. It is considered as equity capital and is recorded in the balance sheet. The return for venture capital is considered as profit payment. Factoring and Invoice discounting. It is not recorded in the balance sheet; however, fund received increases cash balance. The interest and fee are recorded in the income statement section. Conclusion The above discussion demonstrates that the financial planning can be visualized as managing financial decision of the company. At the same time, management of financial decision requires comprehensive understanding of activities that rotate around the cash management of the company. The above discussion also shows that financial planning must be given priority. It is, therefore, important that the managers responsible for organizing financial planning of a company must be highly educated and equipped with the adequate knowledge that will assist them to take the right decision. The managers must acknowledge that their decisions will affect the fate of the business and many stakeholders. At the same time, financial planning of a company must be transparent, and that is why it is essential to involve all interested parties in the financial planning. The company management should always remember that cornerstone of company’s success depends on healthy financial planning and its successful implementation. Reference List Michigan State University n.d., The importance of Financial Planning. [ONLINE] Available at: http://www.law.msu.edu/clinics/sbnp/resources/FinPlan.pdf. [Accessed 20 June 14]. Read More