Shawn has a masters of public administration, JD, and a BA in political science.
Financial planning is essential for the success of any business. In this lesson, you'll learn about the financial planning process that businesses perform, including preparation of a master budget, capital budget and cash budget.
Financial Planning Process
Meet Melissa. She's a financial manager for her company. One of her most important roles in the company is helping with the company's financial planning. Financial planning is a part of the overall business planning process; it's a piece of the puzzle that all businesses must figure out in order to achieve their objectives. Financial planning is the process of allocating financial resources to maximize the profitability and wealth of the company.
Three Essential Questions
Melissa starts the planning process by asking three essential questions. First, what is the company's current state of affairs? You can consider this the starting point where Melissa analyzes the current situation of the company. For example, let's say that the company's leading product, a smartphone, has lost significant market share from a new smartphone on the market from a competitor.
Second, where does Melissa's company want to go? This is the ending point or the goal. For example, the president of Melissa's company wants a new smartphone developed so that it not only takes back the lost market share but also to improve upon its market share to increase the company's profit.
Third, how does the company get to its ending point or goal? Here is where financial planning kicks in because financial planning helps provide the course to take the company from where it is to where it wants to be from a financial standpoint.
Cash and Profit Planning
Melissa needs to pay attention to two important aspects of financial planning for a business. First, she needs to ensure that her company has sufficient liquidity and cash flow to operate. Liquidity is the ability to convert assets into cash quickly, and cash flow is simply the flow of cash into and out of the company.
Second, Melissa must consider profit planning in her overall analysis. For example, if the resources to be allocated to the new smartphone development can't produce a return, or profit, then the resources should be allocated elsewhere. Remember, the overall objective of a business is to earn a profit for its owners, and financial planning is a means to allocate resources to achieve that objective.
Other Factors to Consider
Melissa needs to factor in different variables when developing a successful financial plan. Each of these considerations may involve their own detailed analysis, but we'll paint with a broad brush and just give an overview.
Melissa helps her company determine whether getting from where it is to where it wants to be is feasible. Financial feasibility is an analysis whereby you determine if a particular venture is financially viable by taking into account the total costs of it and the probable revenues generated from it. For example, if it will cost more to make the new smartphone than the company can sell it for, then the project is not financially feasible.
Melissa also needs to determine the method of financing. Will the project be funded with the company's retained earnings, an offering of stock or bonds to investors, a loan from a bank or a combination of all these sources? If a combination will be utilized, what will the percentage mix of each type of financing be?
Just because a project is financially feasible doesn't necessarily mean it should be pursued. Melissa needs to consider the financial return compared to financial risk. In our example, do the anticipated profits justify the investment in the new smartphone? What will the company lose if the smartphone flops? How much will the company lose if it does flop? Are there alternative investments with a better risk/reward assessment?
Of course, a core purpose of planning is resource allocation, which is determining where the company's resources go. The financial plan will show how all the company's resources are allocated either on a project basis, a divisional basis, a product basis or some other organizational method. For example, Melissa's company may show resources allocated by project, such as the new smartphone project. Looking at the allocation of resources will give you a clue about a company's priorities and strategy.
Every good plan should include financial controls during implementation. Financial control is a system developed to allow the business to control and monitor the acquisition, allocation and utilization of the financial resources to ensure they are done in accordance with the plan. Of course, there may be regulatory reasons for financial controls as well.
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One of the primary tools used in financial planning is budgets. A budget is a financial document that provides an estimate of expenses and revenue over a specific period of time. Financial management often involves several different types of budgets, including capital budgets, cash budgets and master budgets. Let's take a quick look at each of these types of budgets.
A capital budget is a plan for financing capital investments. Capital investments are long-term investments of fixed assets, such as a plant and equipment, or a business venture where the cost of investment is expected to be recovered through revenues it generates over more than one year. For example, Melissa's company may be planning to build a new operations facility to manufacture its cellphones. The new facility will generate revenue for the company. However, it may take years of revenue generation before the company recoups the initial cost of building the new facility.
Cash is often the lifeblood of a business. A cash budget is an estimate of the flow of cash into and out of the business for a specific period of time. Melissa can use a cash flow budget to determine if the company will have sufficient money on hand for operations, or if there is too much money on hand that could be more productively used elsewhere.
Many companies will produce a master budget, which is a budget prepared by a company that consists of a number of separate budgets that are nevertheless interdependent. This means that the estimates in one budget may influence the estimates of another budget. For example, Melissa's company's investment in a new production facility will show up on the capital budget, which may affect the cash budget.
You can think of the separate budgets as pieces of a company's financial picture with the master budget being the complete financial picture. If done correctly, the master budget will tell you about the company's plans for the future and how those plans will be accomplished.
Let's review what we've learned. Financial planning is part of the overall strategic planning of a company wherein a company determines where it is, where it wants to be and how it will get there. The financial planning process is about allocating resources held or obtainable by the company to their maximum effectiveness. This involves ensuring that the company has sufficient cash flow and liquidity to pursue its objectives to maximize profitability.
Other considerations in the financial planning process include financial feasibility, method of financing, analysis of financial risk and return, resource allocation and financial controls.
Budgets are an important tool used by financial managers in financial planning. A capital budget helps a company estimate the costs of making capital investments. A cash budget helps plan for the company's cash needs for operating. A master budget consists of all the separate budgets a company creates and is interdependent. It gives a comprehensive picture of the company's plans for the future.
After completing this lesson, you should be able to:
Define a financial plan for a business and the three vital questions in planning
Identify the various considerations and process for any financial plan
Understand what the variety of budgets could mean to the present and future
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