Importance of Financial Planning - Essay Example

Financial Management 1 Introduction Financial Management is the efficient and effective management ofbusiness funds in such conduct as to bring about realization of the purpose of the business that is, profit making. This function is concentrated directly to the top management of any organisation. The importance of this task is not only visible in the Line but moreover in the capacity of Staff in the general administration of the corporation. The duty includes decisions on how to raise the capital, as well as the allocation of the funds to the various projects i.e. capital budgeting. 1.2 sources of business finance It is of great help for the business owner or investors to critically consider the diverse forms of business organization. These forms of businesses are; sole proprietorship, partnership, and corporation (Davidsson, 2003). Investors will evaluate which organizational form is most appropriate to venture into. Their decisions are influenced by financial concerns, tax issues, legal issues, and personal concerns. Debt and equity are the main sources of funding investment. Government grants are also potential areas of sourcing business funds. 1.3 implications of financial sources Financial needs of every single venture will differ depending on the type and size of the venture. For instance, processing businesses are such as, capital intensive, which necessitates huge amounts of investment. Retail businesses, on the other hand, are typically required much less capital. Sole proprietorship will need less capital to start while a limited company will require much more funds to start its operations. Equity financing refers to the substitute of a share of the business ownership for a financial investment in the industry. The share of ownership foregone because of the equity investment allocates the investor to share in the company’s profits. An equity share in a firm can be a unit membership; this is evident in Limited Liability Company or the form of ordinary or preferred share, like that in a company. Debt financing entails the borrowing funds from creditors with the condition of paying back the borrowed funds in addition to the interest earned for a specified time. The financial institutions are offering finances to the business benefit from the interest on the amount lent to the borrower. 1.4 appropriate sources of financing a business project Debt financing offering of loans can be short term or long term in terms of the repayment periods. Commonly, short-term debt is used to finance existing projects such as operations while long-term debt is used to fund major projects that are expected to take long before completion and generation of revenue. Friends and Relatives Entrepreneurs may source funds from private financing resource such as parents or friends. The funds may be of equity financing whereby the friend or relative will them receive a share of ownership or interest in the company. A business faces three major issues when selecting an appropriate source of finance for a new project: 1. Can the finance be raised from internal resources or will new finance have to be raised outside the business? 2. If finance needs to be raised externally, should it be debt or equity? 3. If external debt or equity is to be used, where should it be raised from and in which form? If the necessary finance cannot be provided internally then the company has to consider raising funds externally the company‘s management will need to consider; 2.1 The cost of finance; Debt finance is usually cheaper than equity finance, because it is safer from a lender’s point of view. Interest incurred from the debt can be paid before the payment of dividend. In the happening of insolvency, debt finance could paid off prior to equity. It, therefore, facilitates debt financing a more secure source of finance than equity. Security available; Many lenders will require pledging their assets as security against loans. Fixed assets grant security for accessing funds. Indefinable assets such as capitalized research and development expenditure do not act as security for loans. Lack of good asset securities will incapacitate further borrowing. Business risk; This refers to the instability of operating profit of the enterprise. Businesses with high, unpredictable operating profit should stay away from high levels of borrowing. It is difficult to predetermine their future position and more often unable to meet the interest earned from debt financing. Risky investment projects could acquire finance through equity financing since the companies are not obligated as to pay equity dividend. After consideration of the above points, the company will be in a position to decide the most appropriate source of financing it project between debt or equity sources of finance. 2.2 importance of financial planning Financial planning is a sequence of steps or goals used by a business; the planning process designed to accomplish a financial goal or the company’s objectives, e.g. elimination of debt and retirement preparedness. This often includes a budget, which organizes the steps for resource allocation in an organization. A financial plan helps the management to visualize and set long and short-term business goals, it is a vital step in drawing the expected future financial position of the organization. With a defined financial plan, it makes it easier to make and implement financial decisions. Financial plan also helps in evaluating and ensuring the organization stays on track to meet its goals. Financial planning is vital in the following areas: 1. Income: It is possible to manage the business revenues more effectively through planning. Managing income helps one understand how much money they may need for tax payments, other monthly, and the areas of income generation, expenditures and investments. 2. Cash Flow: planning is essential in observation of cash flows, by carefully monitoring the expenditure’s patterns of the organization. Taxation planning, cautious expenditures and vigilant budgeting will be of assistance to the organization. 3. Capital: A rise in cash flow, on the other hand, leads to a rise in capital. The increase in the business principal funds will allow the management to consider investments to improve the overall financial well-being of the company, thus the need of financial planning. 4. Investment: A proper financial plan performs a guide in helping select the most appropriate types of investments to fit the business objectives, and goals. 5. Financial Understanding: understanding the business finances will give a completely new approach to budgeting and improving control over the business financial strategy. 2.3 information needs for different decision makers Information about any company is very essential to the stakeholders who are interested in that company. Diverse shareholders see the organizations from diverse angles. Shareholders are extremely interested about the company sales, gross profits, expenses incurred and profits earned and any dividend paid all through a specified period. Potential investors are interested about the current earnings per share and new investments that the company implements. The human resources are very keen about the additional benefit earned, enticements, series and wages and possible endurance of the business to guarantee their job security. Government regulators are looking for information about profits and business operation to collect tax payments and other duties imposing on the nature of the business. As such, different king of information about the company serves the stakeholders to make decisions that maximize their value. 2.4 Impact of finance on financial statements Capital structure decision is imperative for the success of a business project. The reason being, the question of where is the optimal mix of capital and debt, which businesse venture, should attempt to accomplish. If a business is opting to obtain debt Capital, the Company should be able to earn enough profits from the project to cover its interest charges on the debt. On the other hand, if borrowed funds were to be used to invest in projects that provide returns in excess of the cost of debt capital, then the shareholders will enjoy the increased return on their equity. General cost of debt of each source as discussed in above is greater than the cost of equity financing. However, saving of taxes can be relieving to the company in the cash of interest payments on debt financing. In the case of issuing shares to the public company, has to incur a considerable amount of expenses that are not tax deductible. Debt in capital financing can seem very attractive as a means of acquiring finances. However, it may not be so as the interests accumulated tend to decrease profits and the corporate taxes too 3.1 Budget analysis and decision-making It is the process of evaluating the effectiveness of finance allocation. When scrutinizing a budget, managers focus on problem areas and evaluate the achievement of the financial goals. It involves looking for areas where finances are overspent constantly and agreeing on whether to increase or decrease the budgeted amount. It checks for success in attaining the financial objectives of the business. As the organizational goals change, the budget will also change similarly. This allows aligning of priorities with business spending. 3.2 calculations of unit cost and pricing decisions The point where the total costs equals total revenue is the breakeven point. For a business to generate profits, the company’s income must be greater than its incurred costs. The cumulative cost is equally variable and fixed (Brigham, 1995). Businesses incur fixed costs irrespective of its level of production or sales made in the period. These costs may include equipment-leasing fees, advertising fees, insurance and rent. Change in level of production and sales unit causes rise in variable costs. Examples include; Raw materials, labour, and units sold (Main prize 2003). Prices charged on commodities will depend on the cost incurred to produce and distribute the goods to the intended consumers. 3.3 Viability of a project using investment appraisal technique: The basic purpose of systematic appraisal is to achieve better spending decisions for capital and current expenditure on schemes, projects. Understanding discounts and NPV computations are essential for appropriate appraisal of business projects. The suggested analytical techniques for appraisal of business projects are commonly the discounted cash flow model. This technique takes into consideration the value of money at a certain time, as used to fund the project. This perception of time preference is indispensable for proper appraisal and so it is crucial to compute the present values of all expenses and returns. When evaluating a capital project it is anticipated, that the costs and to be calculated beyond its predictable life. This means that approximations of prospective costs and benefits require long-term forecasting. 4.1 main financial statements There are four main types of financial statements; they include a statement of financial position, statement of comprehensive income, the statement of changes in equity, and the statement of cash flow. Statement of financial position reports on assets and liabilities; an income sheet reports on income, expenses and profits; an equity statement reports on equity changes; and a cash flow statement reports on operations, investments and financial cash flow activities. 4.2 appropriate formats of financial statements for different types of businesses: The financial statements collect the financial records from the sales and purchases produce, the net taxable profit or loss for each month. Diverse organizations use special formats of financial statements depending on their purposes. For single traders, the financial statement should simple: The reason being that the report only serves the proprietor of the company. A public limited liability company will have to prepare financial statements about international financial reporting standard and the accepted accounting principle. In partnership, the financial statement emphasizes on the interests and profits of the business. It is crucial to the assets’ contributors within the business. When preparing financial statements, income statement is prepared first because the net income or otherwise becomes a component of the statement of partners’ capital. The statement of partners’ capital comes second because the ending partners’ capital balances are elements of the statement of financial position. Financial statement for a limited company is obliged to reveal the current, non-current assets, liabilities, sales, profits, cost of income tax payable and earnings per share. This, therefore, becomes more complex than the other statements prepared by other organizations. 4.3 interpret financial statements using appropriate ratios: Financial performance has changed over a period is compared using financial ratios. Quick ratio: Done by taking the existing properties less the inventories, and then dividing them over the liabilities. The ratios visualize the Target’s capacity to meet its responsibility exclusive of selling off inventory; the higher the result, the better placed the companies’ financial position. Current ratio: This is another test of short-term liquidity, determined by dividing current assets by current liabilities Debt-to-equity ratio: calculated as total debt divided by total equity of the business. A high debt to equity ratio exceeding 68percent it becomes worrying to the shareholders of the company. Working capital: This refers to the ready money available for day-to-day tasks of the business. Computed by subtracting the existing liabilities from the existing assets. The higher the working capital the stable the company, the business can receive funds with ease from the creditors because of the high working capital. References: 1. Brigham, Eugene F (1995), Fundamentals of Financial Management 2. Commission, Regional Policy, Guide to Cost -Benefit Analysis of Investment Projects, July 2008 Edition. 3. HM Treasury, ‘The Green Book’, Appraisal and Evaluation in Central Government, HMSO, 2003 4. Klofsten, and David, (2003). The Business Platform: Developing an Instrument to Gauge and to assist the Development of Young Firms, Journal of Small Business Management. Vol. 10, p.12-34. 5. Main prize and Hindle (2003). Toward the standardization of venture capital investment evaluation: decision criteria for rating investee business plan. Frontiers for Entrepreneurship Research 2002 Xiii, Venture capital 23, Boston: Babson College. Read More