Financial Planning and Capital Structure
Financial Planning
Just as a household needs to plan its finances, a business also needs to plan how much funds it will need, from where it will raise these funds, and how it will use them effectively. This process is called Financial Planning.
Financial Planning is the process of estimating the fund requirements of a business and specifying the sources of funds. It is the process of preparing a financial blueprint of an organisation's future operations.
It involves two main aspects:
1. Determining the financial objectives: What are the overall goals related to finance (e.g., profit targets, return on investment targets)?
2. Developing financial policies and procedures: Laying down guidelines for procurement, investment, and administration of funds.
A comprehensive financial plan includes:
a) Estimation of the amount of capital required.
b) Determining the form of capital (e.g., equity, debt).
c) Laying down policies for the administration of assets.
d) Laying down policies for the distribution of profits.
Importance
Financial planning is essential for the smooth and successful functioning of any business. Its importance can be seen in the following points:
1. Helps in Forecasting: Financial planning helps in forecasting future financial needs (both long-term and short-term) and predicting potential shortages or surpluses of funds.
2. Helps in Avoiding Business Shocks and Surprises: By anticipating future needs and conditions, financial planning helps the business to be prepared for potential shocks or surprises in the market.
3. Helps in Coordinating Different Business Functions: Financial planning provides a framework for coordinating the activities of different departments (e.g., production plans must align with the finance available, marketing plans must consider the budget). Budgets prepared under financial planning act as coordinating devices.
4. Helps in Reduction of Waste and Duplication of Efforts: By clearly defining resource allocation and activities, financial planning helps in avoiding unnecessary expenditure and overlapping of work.
5. Links Planning with Doing: Financial planning provides a basis for control. Planned expenditure and revenues serve as standards against which actual performance can be measured and controlled.
6. Evaluation of Performance: By setting clear targets and benchmarks, financial planning helps in evaluating the performance of individuals, departments, and the entire organisation.
7. Helps in Obtaining Funds: A well-prepared financial plan increases the confidence of investors and lenders, making it easier for the company to raise funds from the market.
Example 1. A textile company in Surat plans to double its production capacity in the next three years. This requires significant investment in new machinery and factory space. The financial manager estimates the total funds required, considers different sources like bank loans and issue of shares, and prepares a detailed budget outlining expected expenses and revenues over the next three years. What is the significance of this exercise for the company?
Answer:
This exercise represents Financial Planning, and its significance lies in:
1. Helping in Forecasting the future financial needs (for expansion).
2. Assisting in Obtaining Funds by presenting a clear plan to potential lenders/investors.
3. Helping in Coordinating Different Business Functions like production and finance.
4. Providing a basis for Evaluation of Performance against the budget and targets.
Capital Structure
Capital Structure refers to the mix or proportion of long-term sources of funds used by a firm. It is the composition of the sources of funds on the liabilities side of the balance sheet, excluding current liabilities.
It essentially indicates how the assets of the company are financed, i.e., what proportion of funds comes from shareholders (owners) and what proportion comes from creditors (borrowed funds).
$$ \text{Capital Structure} = \text{Long-term Debt} + \text{Preference Share Capital} + \text{Equity Share Capital} + \text{Reserves \& Surplus} $$
A company's capital structure is often expressed as the debt-equity ratio:
$$ \text{Debt-Equity Ratio} = \frac{\text{Long-term Debt}}{\text{Shareholders' Funds}} $$
Shareholders' Funds include Equity Share Capital and Reserves & Surplus (Owner's Funds).
The choice of capital structure is a critical financial decision because it affects both the profitability and the financial risk of the company.
Leverage or Gearing is a related concept. Financial leverage is the extent to which a company uses debt financing. A high debt-equity ratio means high financial leverage, which can magnify returns when earnings are high but also magnify losses when earnings are low (increases financial risk).
$$ \text{Financial Leverage} = \frac{\text{Earnings Before Interest and Taxes (EBIT)}}{\text{Earnings Before Taxes (EBT)}} $$
Or a simpler measure:
$$ \text{Financial Leverage Ratio} = \frac{\text{Total Debt}}{\text{Total Assets}} $$
Optimal capital structure is the mix of debt and equity that maximises the market value of the firm's shares.
Factors Affecting The Choice Of Capital Structure
Selecting the appropriate mix of debt and equity is influenced by several factors:
1. Cash Flow Position: The ability of the company to generate sufficient cash flow is a major factor. A strong and stable cash flow allows the company to service its debt obligations (pay interest and principal) easily. Companies with poor or unstable cash flow should avoid high levels of debt.
2. Interest Coverage Ratio (ICR): This ratio measures the company's ability to meet its interest payments. It is calculated as: $$ \text{ICR} = \frac{\text{Earnings Before Interest and Taxes (EBIT)}}{\text{Interest Expense}} $$. A higher ICR indicates that the company can cover its interest obligations more easily, making debt financing less risky.
3. Debt Service Coverage Ratio (DSCR): This ratio indicates the ability to cover both interest and principal repayment obligations. It is calculated as: $$ \text{DSCR} = \frac{\text{Profit After Tax + Depreciation + Interest}}{\text{Preference Dividend + Interest + Repayment Obligation}} $$. A higher DSCR indicates a better ability to service total debt burden, suggesting more debt can be used.
4. Cost of Debt: The interest rate at which debt can be raised is a key consideration. Debt is generally cheaper than equity, especially because interest is tax-deductible. If debt is available at a low rate, the company might prefer using more debt.
5. Tax Rate: Interest on debt is a tax-deductible expense. This tax shield makes debt a cheaper source of finance compared to equity (dividends are paid from after-tax profits). A higher corporate tax rate makes debt more attractive.
6. Cost of Equity: The expected return required by equity shareholders influences the cost of equity. Using more debt increases financial risk, which in turn increases the expected return (and cost) demanded by equity shareholders.
7. Floatation Costs: Expenses incurred in raising funds (e.g., underwriting commission, brokerage, advertising, legal fees). Floatation costs are usually lower for raising debt than equity.
8. Risk Consideration: The overall risk comprises business risk (risk associated with operations) and financial risk (risk due to debt). Companies with high business risk should ideally use less debt to keep the total risk at an acceptable level.
9. Flexibility: The capital structure should be flexible enough to be adjusted when needed. Too much debt can restrict the company's ability to borrow further in the future if unexpected needs arise.
10. Control: Issuing equity shares can dilute the voting power and control of existing shareholders. Debt financing does not dilute control.
11. Regulatory Framework: Rules and regulations by authorities like SEBI, RBI, and provisions of the Companies Act, 2013, affect the design of the capital structure.
12. Stock Market Reaction: The impact of the chosen capital structure on the company's share price and market value is important for wealth maximisation.
Example 2. Company X and Company Y operate in the same industry with similar operating profits (EBIT). Company X has a high proportion of debt in its capital structure, while Company Y is financed mostly by equity. Explain how the earnings per share (EPS) of both companies might differ if there is a significant increase in their operating profits.
Answer:
This relates to the concept of Financial Leverage, which is part of the Capital Structure decision.
When operating profits increase, the Earnings Before Tax (EBT) for both companies will increase. However, Company X has fixed interest payments on its debt. These interest payments do not change with increased operating profits. Therefore, the increase in EBT for Company X will be proportionally higher than for Company Y (since Y has little or no interest expense).
Since Earnings Per Share (EPS) is calculated from profits after tax, the higher proportional increase in EBT for Company X (due to fixed interest) will lead to a proportionally larger increase in its profits after tax compared to Company Y (assuming similar tax rates). This results in a higher increase in Earnings Per Share (EPS) for Company X.
This demonstrates how a high debt component (high financial leverage) can magnify the increase in EPS when operating profits rise, but it also magnifies the decrease in EPS when operating profits fall.