Unit 7: Financial Planning and Control

Conceptual Framework

The economic entities, which are public, corporate and individuals, have specific financial and operational goals and they should act rationally and work systematically to attain those goals. e financial plans provide direction to the e orts of the departments within an organization and also give the details of the division of work, labor and responsibilities.

Financial planning is the process of creating a picture of future given the assumptions of today as determined by the prevailing market and corporate circumstances as well as strategies. It is process of framing objectives, policies, procedures, programmes and budgets regarding the financial activities of a concern. e results of financial planning activities give direction to the company and they can be considered as financial targets for which the organizational e orts are focused to achieve.

Financial Planning has got many objectives to look forward to, but mainly it serves for determining capital requirements in short and long term and proper capital structure for the relevant time frame. It constitutes a framing tool for the financial policies with regards to cash control, lending, borrowings, etc. In this framework, financial planning

• helps in ensuring a reasonable balance between out ow and in ow of funds so that stability is maintained.
• ensures that the supply of funds is easily and effectively invested
• helps in making growth and expansion programmes which helps in long-run survival of the company
• reduces uncertainties with regards to changing market trends which can be faced easily through enough funds, and
• helps in reducing the uncertainties which can be a hindrance to growth of the company. is helps in ensuring stability and profitability in concern.

Main Constituents of Financial Planning

The process of financial planning includes the following financial analysis and aspects:

• Cash Flows: The cash flows convey the liquidity performance, flexibility and risk concepts to the financial planning as supported by the accounting data and financial reports,
• Departmental analysis : For large companies and conglomerates, the targets produced by financial planning for each individual department generated by taking into account its own investment finance and cash flow requirements serves as benchmarks of success,
• Scenario Analysis: The flexibility of financial planning by the use of the capabilities of information technology enables to realize scenario analysis to evaluate the effects of the possible financial and environmental changes on corporate activities in the future.
• Short and Long-term Time Frame: The financial plans can be prepared for short (less than 1 year) and long term (more than 1 year). They can also be prepared as monthly, quarterly and semiannually, each of which are used for control purposes. In the short-term, the basic motivation is to determine the funding needs or surplus and the method to secure or invest the relevant amounts. In the long run, financial planning is used as a strategic tool in order to maximize the return under different risk estimations.

Assumptions of Financial Planning

In order to prepare financial plans, some assumptions should be made in relation with the variables including, but not limited to inflation, economic growth, sales growth, foreign exchange rates etc. It is a fact that during the planning horizon those assumptions may fail. The planning process should be designed to be revised periodically to reflect the effects of those changes to the financial plans.

The Data Set Used for Financial Planning

The required data mainly includes Break- even Analysis, Ratio Analysis and the Investment Projects Evaluations. Additionally, the following operational and financial data is required for the financial planning process:

• Short and long term pro t targets,
• Divisional financial reports,
• Transactions creating cash flow for the divisions and the company,
• Divisional proforma and realized budgets,
• Cost accounting data on product basis,
• Special financial analysis in relation with profitability by product, logistics costs and other expenditure,
• Analysis of security portfolio and subsidiaries,
• Labor productivity reports,
• Internal control reports.

The Outputs of Financial Planning

The material goal of the financial planning is to generate a set of reports, budgets and strategy documents to be used in the managerial decision making. The outputs of financial planning process are:

• Cash Flow Estimations
• Working Capital Strategy
• Short and Long Term Capital Budgets
• Funding Requirements

The Dimensions of Financial Planning

The first dimension of financial planning is the time horizon. There exist two time horizons as short and long term. In the course of financial planning, one of the first tasks is to determine total investment amount by bringing together all the approved projects of the individual divisions. This is the second dimension of planning and specified as collection. After the specification of the dimensions of time horizon and collection, the data input grouped under alternative assumption sets. The alternative plans reflect three degree of expectations specified as worst case scenario, normal case scenario and best case scenario.

Process of Financial Planning

The basic two components of the financial planning are cash and pro t planning. e cash planning is realized by the formulating the cash budget of the company, whereas pro t planning requires the proforma financial statements. The financial planning commences with the development of strategic long term financial plans and these plans give direction to the development of short-term operational plans and budgets. Generally, many operational plans are figured out for different divisions within an organization in order to accomplish the strategic plan. The process of financial planning is summarized in the figure on page 194.

Budgeting

The budget is defined as the numerical report or set of reports addressing the future policy and activities in order to achieve predetermined set of targets. e company budget eases the operational decision making and provides a framework for control as it contains all the operational details such as cost figures and production plans. The budget control is specified as the process of periodic monitoring and evaluations of the results of the activities carried out and taking corrective actions when required. e system of budgeting specifies the principals and techniques to prepare the budgets as well as the application and control mechanisms.

Types of Business Budgets

These are sales budget, production plan, cost of goods sold budget which incorporates direct materials budget, direct labor budget, manufacturing overhead budget and cash budget.

The sales budget is the core of the overall budgeting e orts within an organization. In order to determine the future activity level and the attached revenue and costs, the sales budget should be prepared with great care by taking into account market research and relevant market estimations. The responsibility to prepare the sales budget is generally belongs to sales division managers however depending on the size of the company and organizational structure it may change. The most proper sales forecast method for a company depends on the peculiarities of the company, as well as on the appropriateness of the expected sales growth and on the education provided to the relevant personnel. Regression method, managerial assessment method, special purpose methods, and combined methods are used for sales forecast.

The production budget should include the planning of the main production input of direct materials, direct labor and manufacturing overhead. e major target of the production budget to secure the optimum balance between sales budgets, inventory level and production process requirements without stagnant inventory level. The productivity of the production inputs and the effective use of them depend on effective production budgeting. The responsibility of preparing the production plan belongs to production managers with the support of sales managers.

The direct materials budgets have three interrelated sections, which are the volume, the procurement and inventory of direct materials. The time frame of direct materials budget should be the same with that of sales and production budgets. e budget for the procurement of direct materials is prepared by the procurement managers after finalizing the volume of direct materials budget. This budget should contain the existing amount of direct materials inventory and also pricing level including storage and loading/uploading costs.

The direct labor budget is used to determine the required labor hours in order to produce the volume of products as stipulated in the production budget. The responsibility to prepare the direct labor budget belongs to production managers together with cost accounting, human resources and budget control divisions. In order to achieve the production targets, the required number of labor can easily be determined. The direct labor budget also provides input to the preparation of cash budget of the company.

Manufacturing overhead budget consist of any expenses directly related with the production except direct materials and direct labor. Structurally manufacturing overhead may be in the form of fixed or variable costs. The fixed manufacturing overhead costs include, but not limited to amortization, taxes, insurance. The variable costs are the ones that directly change as parallel to change in the production volume. e responsibility of the manufacturing overhead costs is not under a specific division as it is the case for many types of direct production costs. Instead responsibility for those kinds of costs belongs to many different managers of different divisions where those costs are incurred. For this reason, for each division, a separate manufacturing overhead budget is prepared.

After the preparation of the budgets for the production costs of direct materials, direct labor and manufacturing overhead, the costs of goods sold budget should be figured out.

Cash Budgets

Cash budget is a management plan for the most important factor of a company’s viability — its cash position. A company’s cash position determines how suppliers will be paid, how a banker will respond to a loan request, how fast a company can grow, as well as directly influencing dividends, increases to owner’s equity and profitability. e cash budget involves the cash inflows and outflows forecasts and the planning to manage the shortfalls.

Term of Cash Budgets

The cash budgets can be prepared for short and long term depending on the cash conversion terms of the company. The long-term cash budgets help to define the cash requirements in order to realize the long-term strategies and to clarify the relevant funding activities. The shortterm cash budgets is an important management tool in order to address the future cash inflows and out flows and to sustain the payment capability of the company.

Structure of Cash Budgets

The cash budgets are prepared in cash terms and this is the main differential attribute of the cash budgets as compared to other budgets. e cash budgets mainly consist of three parts; the cash in ow, cash out ow and budget.

Cash Budget Preparation

The cash budgets are generally prepared by the methodology of daily and detailed cash flow statement. By that way, the availability term of the excess cash or the durability of cash shortfall can be determined. This information provides main inputs for cash management in the case of excess cash. The excess cash can be deposited in a bank or a repo transaction can be realized depending on the term of availability. There exist two main methods for preparing the cash budgets: direct estimation of cash inflows and outflows, adjusted net profit method.

Proforma Financial Reports

The proforma financial reports, balance sheet and income statement, contain all the information generated by the budgets on operational level and exhibit the financial situation of the company under the assumptions. Proforma financial statements are the complete set of financial reports issued by an entity incorporating assumptions or hypothetical conditions about events that may have occurred in the past or which may occur in the future which is usually used to present a view of corporate results to insiders to run the operation smoothly as per plan and to outsiders as part of an investment or lending proposal. In order to prepare the proforma financial reports, the existing financial reports are used as starting point. The preparation of proforma balance sheet requires detailed historical data about the company and it is not easy to visualize the formation process.

Preparation of a proforma balance sheet involves four basic steps:

• The forecast of sales and distribution of the sales proceeds to financial accounts,
• Determining the amount of funds intrinsically generated,
• Determining the equity of the company,
• Balancing the total of projected asset and liabilities

The methods of preparation of the proforma balance sheet are Percentage of Sales Method, Ratio Method and Regression Method.

Financial Control

Financial controls are the means by which an organization’s resources are directed, monitored, and measured. It is fact that budgets and proforma financial statements are the major tools of financial control. e financial control can be defined as the analysis of a company’s realized financial results compared to its short, medium and long-term objectives and business plans, as well as budgets. These analyses require control and adjustment processes to ensure that the business plans which are the core ideas under budgets are being followed.

Financial Control Implementation Strategies

Although there are many different types and methodologies, an accepted router to establish a financial control infrastructure within a company involves the following steps:

1. Analysis of the Initial Situation
2. Preparation of Forecasts and Simulations
3. Detection of Deviations in the Basic Financial Statements
4. Correction of Deviations

The Benefits of Financial Control

Financial control generates information flow to the decision makers and managers with regards to the operational results of the company. e budgets are generally prepared quarterly and each quarter the decision makers evaluate the realizations and they compare the actual results with the figures proposed by the budgets such as sales, direct materials flow, direct labor and expenses. In this framework, with the contributions of the financial planning and budgets, the control activities became formal, operating targets are revised and decisionmaking processes prospers.

Financial control may also serve to implement preventive measures. Occasionally, early diagnosis of specific problems detected by financial control makes corrective actions unnecessary, as they are replaced by solely preventive actions. It also serves to communicate with and motivate employees. Last but not the least, financial planning and control create an environment of responsiveness. Financial control must be designed on the basis of very well defined strategies to enable the decision makers to determine the deviations from the budgeted financial and operational figures.