Financial planning is important for businesses today. By preparing the financial plan, an organization is able to determine what kind of objectives the firm would like to achieve. There are different aspects that are covered in a financial plan and some of the important aspects of financial planning include; estimating the profits that the firm would like to generate, the types of resources that would be required to accomplish these objectives, identify the changes in the business environment, analyzing the risk and return of investment, calculating the budget and costs that would be incurred, estimating sales from different departments or products etc. Therefore financial planning helps the organization to know the funds that would be received and that would be invest or used (Besley, & Brigham, 2007). Thus it helps in identifying an estimated value of the profits that the firm would generate.
The process of financial planning comprises of six logical steps. So when an organization is estimating asset investment requirement then it can follow these six steps which have been discussed below :
- Identifying the existing financial position of the company
- Identifying and formulating financial goals of the organization or the goals of the investment
- Identifying different alternative ways and actions through which these goals can be achieved
- Evaluating the pros and cons of these alternatives
- Preparing how to achieve the objectives from the selected alternative or preparing the action plan on how to achieve the objectives
- Analyzing and reevaluating the plan according to the situation (Besley, & Brigham, 2007)
Working capital is defined as the difference between the current assets of the firm and the current liabilities. It is important for firms to have sufficient working capital in order to meet their current liabilities. Working capital should be managed properly. Too low working capital can result in hurting the liquidity position of the firm. Too much current assets in comparison to current liabilities is not a good idea because the firm can invest this current asset and receive earnings from this investment (McLaney, 2009). Therefore in order to capitalize on the opportunities from excessive cash that the company has, firms try to invest in different marketable securities. Some of the most used marketable sectaries in which firms invest the excessive cash include; bonds, shares of other companies, debentures, forwards and future contracts, warrants, preferred shares, money market instruments or government bonds such as t-bills, etc.
When the firm is raising capital; it has two options i.e. either it can raise funds from equity or from debt. It is important for the firm to identify the debt to equity ratio that it would like to achieve and then identify the source of capital accordingly. If the firm has sufficient debt already raised, then raising further debt will not only hurt the debt to equity ratio but it will also increase the risk of the firm. However if the firm has too much equity and debt is very low then it is beneficiary for the firm to raise debt than equity (Leary, and Roberts, 2005). Raising of debt would also allow the firm to take advantage of leverage and thus Return on equity will be multiplied. However the disadvantage of raising debt is that it would increase the risk. According to Pecking order theory, firms should first use the internal funds available i.e. Retained earnings and then go for other sources of capital. If the firm does not have sufficient funds or retained earnings, then it should go for raising debt. However if there is sufficient funds already raised through debt, then the last option that the firm should use is to raise equity (Miglo, 2010). When the economy is going through recession, then it is recommended to raise funds through debt rather than equity (Mizen, 2008)
Firms in order to raise capital use different sources. One of the sources that have been used by firms is to raise capital from foreign investors. Raising capital from foreign investors allow the firms to attract additional funds even at a time when the funds from the local market cannot be raised. Moreover, foreign investors are looking to diversify their risk therefore they are ready to make investment in other counties as well. So the risk of the investors are diversified by investing in another country as the market risk, political risk, country risk, currency risk and interest rate risk of the investors are reduced. The reward for businesses is that they are able to raise capital.
It has been said that the higher the risk of an investment, higher is the return. When an investor is investing in the common stocks, it has a higher risk than the risk of corporate bonds. In corporate bonds, investors are able to receive a fixed amount of return (Gitman, 2003). However in the case of common stock, the income will be received by the shareholders after the bond holders are paid from the earnings of the company. Therefore the income from the common stock would fluctuate however the returns of the corporate bond holders would be more or less fixed. So it can be said that common stock holders take a higher risk and therefore they have a chance of receiving higher income. On the other hand, bond holders take less risk as they are paid first and therefore they receive a fixed return. The following image shows the relationship between different investment options i.e. bonds, equities, cash and property as it defines the return on making investment in different investment options.
(Vanguard Asset Management, 2013)
The above image clearly shows the returns of bonds and equities from 1993 to 2012. The return from equity has been high and positive from 1993 to 1999. However these returns have decreased in 2000 to 2002 but then it increased again. Then in 2003 the returns of common stock again increased till 2006. Then in 2008 and 2011 there were negative returns. On the other hand, the bond returns have been more or less constant from 1993 to 2012 with slight fluctuations (Vanguard Asset Management, 2013). Therefore it is acknowledging the fact that the common stock shareholders are taking a higher risk as their earrings are fluctuating. However at times their returns are too high than others thus they take higher returns. On the other hand, bond holders have received more stable returns (Vanguard Asset Management, 2013).
It is important for investors to diversify their portfolio and include a combination of both bonds and common stock. Inclusion of different investment reduces the risk of the investors. At the same time, it results in more stable returns to the investors. If the above returns from common stock and bonds are included in the portfolio then the risk can be minimized and more stable returns can be achieved. For instance, from 2000 to 2002 as the returns of common stock were negative, bond holders were still able to receive good returns.
References
Besley, S., & Brigham, E. (2007). Essentials of Managerial Finance, 14 edn. USA: Thomson Higher Education.
Gitman, L. (2003). Principles of Managerial Finance. Boston: Addison-Wesley Publishing.
Leary, T. and Roberts, M. (2005). Do firms rebalance their capital structures?. Journal of Finance, 60, 2575-2619.
McLaney, E. (2009). Business Finance: Theory and Practice. Pearson Education: New Jersey.
Miglo, A. (2010). The Pecking Order, Trade-off, Signaling, and Market-Timing Theories of Capital Structure: a Review. Retrieved May 1, 2013 from http://www1bpt.bridgeport.edu/~amiglo/ReviewCapStrSSRN.pdf
Mizen, P. (2008). The Credit Crunch of 2007 -2008: A Discussion of the Background, Market Reactions, and Policy Responses. Federal Reserve Bank of St. Louis Review, 90 (5), 531– 567.
Vanguard Asset Management. (2013). Investment risk: Balancing investment risk and potential reward. Retrieved May 1, 2013 from https://www.vanguard.co.uk/documents/portal/literature/investment-risk-guide.pdf
