Financial Planning in the Firm

By Albach, Horst | Management International Review, Annual 1992 | Go to article overview

Financial Planning in the Firm


Albach, Horst, Management International Review


I. Traditional Methods of Financial Planning

1. Short-term Financial Planning

Planning we understand to be the anticipation of future events, with a view to making the most reasonable adaptation to those events in the light of the goals of the firm. Hence financial planning is the attempt to construct a picture of the future cash flows through the firm. This form of planning is of particular importance because it is vital for the existence of the firm to know whether payments can be kept in balance at all times(1). The problem of financial planning, of providing for the maintenance of financial balance has continually received special attention in the literature of business economics(2). During recent years new possibilities of financial analysis have been developed(3). This paper will attempt to compare the traditional and modern methods of financial planning within the context of the problems they raise.

Traditional methods of financial planning have two characteristics: they are usually concerned with a short term, and take as given by the production sphere certain financial deficiencies or surpluses. In this type of financial planning, then, the firm's production decisions are used as data(4). Financial planning is only carried out at the second stage of the firm's overall planning, after the production planning is complete and the flows of revenue and expenditure which are involved have been determined. Thus traditional financial planning is marked by having two stages(5). Orth has stated this feature of financial planning with particular clarity: "With the forecast of the future cash flows one obtains at the same time the precise statement of the problem of financial planning. If the forecasted expenditures exceed the revenue then the problem put to financial planning is indicated as follows: how can the funds necessary to cover the deficit be raised optimally? At the second stage of financial planning, the financial planning of alternatives is carried out."(6) Figure 1 demonstrates the procedure of traditional financial planning. The first step is to make the financial forecast. Here it is a matter of determining the anticipated revenue and expenditure from the sales in the immediate future. The financial forecast leads to information about the function over time of income and expenditure, as shown in Figure 1. In the case assumed here, it will be seen that up to the point in time |t.sub.2~ the expenditure exceeds income. The diagonally shaded area thus represents the funds required. Traditional methods of financial planning consider this demand for funds as given. It is the task of financial planning to determine those possibilities of financing by which these funds can best be raised. In this context, two considerations are vital: the total amount of the funds required to meet the demand of the firm for capital should be burdened with the minimum possible rates of interest; that is, they should have favourable effects on profit-making. Moreover, the composition of the borrowed capital should harmonised with the loan periods of the capital. Financial theory describes the first principle as the principle of maximum possible profitability, and the second, as the principle of loan-period correspondence(7).

The other property of traditional forms of financial planning is defined by its short-term nature. In the literature, discussions are mainly of financial plans for one year. Long-term considerations are dismissed as pointless, in view of the uncertainty of the future. Exact long-term financial planning is replaced by the application of rules of thumb.

It is evident that any form of financial planning cannot solve the problem of the harmonisation of profitability and financial balance in the firm. According to the principle of profitability, all funds with low interest rates are suitable for the financing of capital requirements. But according to the principle of loan-period correspondence no short-term funds should be used to finance long-term investments(8). …

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