Financial Planning: Process, Concepts, Advantages, Objectives, and Importance

  • Post last modified:14 January 2022
  • Reading time:16 mins read

What is Financial Planning?

Financial planning is the process of estimation of capital necessary for accomplishing the organization’s business activities. That is a process of formulation of financial policy in relation to the provision of assets, investments and organization’s funds management.

Financial planning is the process of formulation of goals, policies, procedures, programs and budgets that refer to an organization’s financial activities. Financial planning means

  • providing appropriate funds,
  • providing appropriate balance between the incoming and outgoing funds,
  • preparation of growing and development programs which ensure long-term sustainability of the organization,
  • decrease of uncertainty regarding to market changes which the organization may face with,
  • decrease of the uncertainty which could affect the organization’s growth,
  • helping to provide stability and profitability

Process of Financial Planning

The process of financial planning is a logical, six-step procedure:

  1. Determining the Current Financial Situation
  2. Developing Financial Goals
  3. Identifying Alternative Courses of Action
  4. Evaluating Alternatives
  5. Creating and Implementing a Financial Action Plan
  6. Reevaluating and Revising the Plan

Determining the Current Financial Situation

Determining the current financial situation means a determination of the situation with regard to incomes, costs, liabilities, loans, receivables.

Developing Financial Goals

Firstly, an analysis should be performed and the needs for achieving what is wanted should be determined, and it is followed by specifying goals and determining how the current income will be spent in order to provide funds for investments for securing future financial security.

Identifying Alternative Courses of Action

Identifying alternative courses of action means determining the factors which will affect the continuity of actions, expansion of the current situation, new courses of action, creativity in decision making and considering the possible alternative solutions which can lead to more effective decisions.

Evaluating Alternatives

Evaluating alternatives means taking into consideration the conditions in which the business activities will be performed, the values of the organization and current economic conditions in the environment. It needs to be evaluated where will the assets be invested, what kind of costs will be made for production, also to evaluate the risks, and which information will be used in order to make relevant decisions.

Creating and Implementing a Financial Action Plan

Creating and implementing a financial action plan means developing a plan, i.e. to choose a way to achieve the financial goals. The financial action plan needs to be implemented by all employees, to provide assets, to invest, to maintain inventory, to provide shares or bonds or mutual funds.

Reevaluating and Revising the Plan

Reevaluating and revising the plan means dynamic following of the plan implementation, assessing the financial decisions and adapting to the new changes of personal, social and economic factors. The review of the implementation of the financial plan enables priority adjustments that will enable the organization to achieve its financial goals.


Concepts of Financial Planning

  1. Diversification
  2. Asset Allocation
  3. The Risk Planning Spectrum
  4. Time Horizon
  5. Tax Planning
  6. Monitoring and Rebalancing

Diversification

Diversifying the investments you hold can help mitigate the risks you face. The value of diversification is often underscored by events in the financial markets, such as sharp drops in stock prices. Every type of investment responds differently to changes in the economy.

So if you own a variety of assets, a decline in one can potentially be balanced by stability or increased value in another. Bear in mind, however, that diversification does not ensure a profit or protect against a loss. Nevertheless, it can help as you work toward achieving your financial goals.

Asset Allocation

Asset allocation is a long-term strategy designed to help investors achieve their financial goals without assuming undue risk. It’s based on the premise that various types of investments have different characteristics that often prompt them to respond differently to economic and financial developments.

Higher risk assets such as common stocks are options to consider in a long-term financial plan, however, they will fluctuate in value and expose your portfolio to more risk. Fixed income investments, by contrast, are considered less risky but tend to provide more conservative returns.

The Risk Planning Spectrum

Generally, the rule of thumb is that the greater the risk assumed, the greater the potential return on that investment. One of the best ways to potentially lower a portfolio’s risk and still potentially earn attractive returns is by diversifying investments across the spectrum of asset classes.

Time Horizon

As a general rule, the longer time you have to invest, the greater the risk exposure you may wish to undertake. For example, someone who is just starting out in a career may have a long time ahead of them and can use the power of compounding effectively to accumulate significant potential wealth through regular, disciplined, automatic investing.

Through careful planning, this person may be willing to assume greater investment risk as a trade-off for potentially higher returns given the longer time frame available to offset potential losses.

Tax Planning

After choosing your asset allocation, it is important to consider whether to place assets in a taxable or tax-deferred account. After all, what you actually keep after taxes is what matters now. A taxable account, such as a stock portfolio, is where you place contributions for which you have already paid income taxes.

A tax-deferred account, such as a pension plan or RRSP by contrast, enables you to contribute money on which you have not paid income taxes. Tax-deferred accounts enable your money to grow faster without the burden of annual taxes on earnings or capital gains.

Monitoring and Rebalancing

It’s not enough to just establish an asset allocation strategy designed to meet your financial goals. You must then execute and monitor your allocations, making periodic adjustments or rebalancing assets to retain the original allocation percentages.

Market conditions have been known to grow some assets substantially while reducing others. It’s important to review your investment portfolio with your advisor on a regular basis to ensure it is aligned with your risk tolerance and on track to meet your financial objectives


Advantages of Financial Planning

Followings are the advantages of financial planning:

  1. Upgraded Living
  2. Money Management
  3. Consumption
  4. Securing Future
  5. Building Wealth
  6. Spend Freely
  7. Healthy Standard of Living

Upgraded Living

A person can maintain income and expenditure if he knows his financial plan. Due to the increase in income and consumption patterns, the standard of living is increasing.

Money Management

Any income can be either saved for future purposes or consumed for the current needs financial planning helps in guiding the person when to invest and when to consume.

Consumption

Consumption includes spending money on basic necessities like food, shelter, and clothing. It also includes buying luxury and semi-luxury products. Normally, the average propensity to consume (the average inclination of an individual to spend rupee of income on the current needs than to save for the future needs) decreases when the income increases.

This results in increased savings and so, financial planning helps the person in chalking out the plans for the future.

Securing Future

As we have seen in the above point that the propensity to consume decreases when the income increases resulting in increased savings. This increased saving is invested in different financial and real as- sets. The idea is to give higher returns on these investments to safeguard from increasing prices (inflation) and from rainy days.

Building Wealth

Financial planning helps a person to create a plan for the future by investing in assets and keeping the current income intact. There are many luxurious products like car, which, in long term may not give any returns; however, it provides convenience to the person.

There is another asset like real estate which gives higher returns to the person by capital appreciation.

Spend Freely

Who wouldn’t want a lavish life and spend freely over vacations? It is possible if you plan your monthly budget and maintain your expenses on a regular basis. Planning helps in avoiding unnecessary expenses. Plan ahead and spend freely knowing that your savings are not going to be hampered in any way.

Healthy Standard of Living

How do you plan to support your current, if not an improved lifestyle in the future? People who plan ahead and save money as per their requirements are able to accumulate enough wealth to lead a comfortable life. Having a financial goal and a plan which supports your goal will help you grow your money in a logical way.


Objectives of Financial Planning

The main objectives of financial planning are:

  1. To ascertain the amount of fixed capital as well as the working capital required in a given period.
  2. To determine the amount to be raised through various sources using a judicious debt-equity mix.
  3. To ensure that the required amount is raised on time at the lowest possible cost.
  4. To ensure adequate liquidity so that there are no defaults in payments and all contingencies (any unforseen expenditure) are met without difficulty.
  5. To ensure optimal use of funds so that the business is neither starved of funds nor has unnecessary surplus funds at any point of time.

Importance of Financial Planning

  • It helps to estimate accurate requirement of funds.
  • It facilitates in developing a sound capital structure which gives maximum returns to shareholders.
  • It helps in proper utilisation of funds.
  • It tries to avoid the shortage of funds and surplus of funds.
  • It provides policies and procedures for coordinating different departments of an enterprise.
  • It acts as a basis to control the financial activities of an organisation.
  • It helps to face unforeseen financial situations in the business.

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