Five Limitations of Financial Planning

Planning is the road map to achieving an organization’s short and long term goals. Financial planning is the core part of every business plan as it estimates the needs of total funds and identifies the resources needed for the generation of funds.

Financial planning should be carried out with extreme care and prudence because a little mistake at the planning stage can be a cause of project failure at the time execution.

Limitations of Financial Planning:

Financial planning is mainly based on estimation and forecasting techniques like future assumptions and past records.

The uncertainty associated with the future along with other factors that are not in the control of the management are limitations of financial planning.

After all the hard work, these limitations may force you to change your estimates as the execution of the project goes on. So you should be aware of that.

Following are the common limitation of financial planning:

Uncertain Future:

Financial planning is based on the assumption about the future factors associated with the project.

The nature of the future is uncertain, and most of the times things do not come as expected. The uncertainty of future events greatly decreases the reliability of financial planning.

Lack of Accuracy in Based Data:

Financial planning is the future estimates based on past or researched data coming from different sources.

The results of financial planning may go wrong if the based data itself is inaccurate. Authenticity and accuracy of based data are most important as all the estimates may go wrong.

Rapid Changes in Environment and Policies:

Drastic changes in government rules and regulations about the economic environment can affect financial plans adversely.

If the plan does not possess the flexibility to adjust to the changing environment, a perfect plan may change to a fail financial plan. 

External Factors:

External factors that are not directly stakeholders of your business plan but may affect your planning adversely for example war, natural disaster, etc are extremely difficult or impossible to predict.

To overcome these types of limitations, you should include proper steps like insurance to avoid the loss arises due to these kinds of issues.

Time Consuming and Expensive Process:

Financial planning is a time-consuming activity. It also requires the use of new technologies and expertise of different experts which makes this process expensive also.

Most of the time, either businesses do not want to invest in planning or they do not have that much time to plan properly, which leads to inaccurate and incomplete planning. This limitation can be overcome by dividing the project into phases and then plan for every phase individually.

Methods to Overcoming Financial Planning:

Limitations of financial planning can be dealt with through proper planning and techniques, which are:

  1. The planner should be given sufficient time and tools.
  2. Gather information and data from a very reliable source. The base data should be cross-checked with other sources to make it more reliable.
  3. Involve concerns persons to make the planning more accurate and error-free.
  4. The information system should be properly implemented, which gathers, processes and makes reports of relevant data.
  5. You should be aware of current political and economic signals coming from government sectors to base your predictions more accurately.

Five Purposes / Objectives of Financial Planning:

Financial Planning:

Financial planning is the process of estimating future needs of a business or project in terms of required investment, resources for generating funds, and efficient administration of these funds.

Financial planning is usually done for long term projects whose estimated life is 4-5 years or more.

Financial planning includes:

  1. Planning for the amount of capital or investment required for a business to carry out its operations in a smooth way.
  2. Determining and comparing sources of funds both internally and externally.
  3. Making of suitable rules and policies for administration and utilization of funds.
  4. Identify risks and issues with all the estimations.

5 Objectives of Financial Planning:

The most prominent five objectives of financial planning are the following:

Estimating the total capital required:

The first step in financial planning is to determine the actual investment or capital required. The capital requirement can be further divided into two categories, i.e. short term requirements and long term requirements. Capital required depends on a number of factors like the requirement of current and fixed assets advertisement and operation expenses.

Determining the sources, availability, and timing of funds:

Determining the sources and timing of funds is as tricky as anything else. The required amount of funds should be available at the right time according to business needs. Financial planning helping in determine the inexpensive source of funds and make sure that funds are available at the right time.

Determining the business capital structure:

The capital structure of a business is considered as the composition of total external or internal debt to the shareholder’s capital.

Financial planning includes the decision on debt to equity ratio and kind of investment required both in the short term and long term which doesn’t affect the capital structure of the company.

Avoid excess generation of funds:

Unnecessary excess and shortage of funds are always an expensive deal for businesses.

One of the most important objectives of financial planning is to prevent the business from rising of unnecessary funds. Excess funds are just an idle asset of a business that cannot generate any revenue for the business but have their own cost.

Counter strategies for Risks:

Financial planning identifies the risks and issues associated with the business plan.

Once the issues are identified at the planning stage, the counter strategies are prepared to counter the identified issues. This ensures the smooth completion of the project and saves a lot of money and time.

Importance of Financial Planning:

Financial planning helps businesses to prepare a balanced plan for their short term and long goals. The most common importance is as follows: 

  1. Arrange funds according to the project need at the right time.
  2. Financial planning helps to plan and execute long term development which plays a vital role in the growth of the business.
  3. Financial planning helps to prepare for any shortcomings and risks. This rise the chances of success for the project.
  4. Proper financial planning gives a competitive edge by arranging sufficient funds for every stage of the project.

Financial planning: What is it?

A financial plan is a projection of the expected incomes and expenses of a firm. It can be on an annual basis, semiannual, or quarterly depending on the firms’ goals and objectives.

A financial plan can be in the form of budgets. A financial plan can include estimations of cash needs and how to spend and raise the cash.

The main components of a financial plan are; tax reduction strategy, risk management strategy, retirement strategy, long term investment plan, and estate plan.

Financial planning is the process of projecting the future requirements of a firm so as to be prepared and to meet the goals and objectives

The steps followed in financial planning are

  1. Establishment of client-advisor relationship and the goals of financial planning.  In this step, the client is asked questions by the advisor to identify his goals. The advisor may inform the client of the services he is offering, his experience and maybe the education background so as to establish a relationship of trust.
  2. Gathering data that is to be used to make the financial plans. Under this step, the advisor may enquire about the time frame the plan will cover and the resources available at that time.
  3. Analysis of data. The advisor analyzes data obtained in step to and comes up with reports to show your current financial profile. He may develop ratios such as liquidity and debt service ratios.
  4. Coming up with a plan. The advisor using information from steps two and three comes up with a financial plan. He also addresses the goals and objectives set in step one. The advisor explains the plan to the client.
  5. Implementing the plan. This is simply putting the plan to work. The client should work towards the goals and plans made.
  6. Monitoring the plan. Due to the changing needs in the business environment, the plan may have to be altered from time to time to fit in the changing environment.

Importance of financial planning

  1. Management of income. Through a financial plan, one is able to estimate the amount of money required to fulfill certain obligations.
  2. Financial understanding. This is attained when specific, measurable, attainable, realistic and time-bound goals are set and understood.
  3. Balance of inflow and outflow of funds. This leads to business stability
  4. Financial planning help in coming up with growth and expansion strategies.
  5. Attracting investors to invest in the business. Investors will invest in a business that does not waste funds but exercises control over the funds and utilizes the funds efficiently.
  6. Raising funds. A financial plan can help a business maintain an optimal level of funds to cater for day to day expenses. Having fewer funds can negatively affect the operations of the business. Financial planning solves this.
  7. Investment. Considering the income and expenditure of the business financial planning can help come up with better investment policies.

Financial statements and elements of financial statements

There are two main financial statements available to users; the statement of financial position and the income statement.

The balance sheet shows the financial position of the entity at a given point in time. The accounting equation is reflected in the balance sheet. The equation, normally called the bookkeeping equation is:

Assets – liabilities = capital

The equation shows that for a firm to operate, it needs resources (assets) that have to be supplied by external parties including creditors (liabilities) and from the owner (capital).

Business transactions will always affect two items of the accounting system. Assets and liabilities are valued according to accounting conventions.

Assets could be defined as being resources controlled by an enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise.

Current assets are those assets whose benefits are expected to flow within a period of fewer than six months.

They form part of the enterprise’s operating cycle or are held for trading purposes e.g. inventory, accounts receivable (debtors), cash in hand and cash at bank.

Non-current assets have their benefits expected to flow for a period of more than 12 months.

They are tangible and intangible assets acquired for retention by an entity for the purpose of providing a service to the business.

Examples of tangible non-current assets include buildings, equipment, and machinery. Intangible non-current assets include goodwill, copyrights, patents, royalties.

A liability is defined as a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow of resources embodying economic benefits from the enterprise.

They represent claims on the business by the outsiders. Current liabilities are expected to be settled in the normal course of the entity’s operating cycle and within 12 months.

Equity is the residual interest in the assets of the enterprise after deducting all the liabilities.

The accounting equation and the statement of financial position,

The accounting equation is the basis of financial accounting. Transactions are recorded using the double-entry system of bookkeeping showing the two-fold effect that is done to maintain equality of the equation.

The double entry system requires the use of an account.

An Account is the most basic accounting record. It summarizes the increases and decreases in a particular asset, liability, revenue, expense or a capital item.

An account is divided into two sides; the left is the debit and the other the credit side. To debit therefore will mean to enter an amount on the left-hand side of an account and vice-versa.

The double entry concept states that “for every debit entry, there is a corresponding credit entry”.

The basic double-entry rules for accounts are:

Accounts To record Entry in the account
Assets Increase Debit
  Decrease Credit
Liabilities Increase  Credit
  Decrease Debit
Capital Increase Credit
  Decrease Debit
Revenue Increase Credit
Expenses Increase Debit

Principles and concepts of accounting.

Concepts are the underlying assumptions used in the preparation of financial statements (balance sheet or statement of financial position, income statements and cash flow statements).

The concepts include:

  1. Going concern. This assumes that the business will continue its operations into the foreseeable future. The management should not only focus on the current but also the future.
  2. Time concept. It is also called accounting period convection. It states that the lifetime of the business is subdivided into small periods called financial years so as to ease the burden of reporting.
  3. Business entity concept. This concept considers the owners of the business and the business as separate entities. The affairs of the business are recorded separately from those of its owners.
  4. Monetary principle. Assumes that business entity financial impact is broken down into transactions that are measurable and quantified in monetary terms.

The principles include:

  1. Historical cost; it  Suggests that assets should be recorded at cost, at the purchase price or at the acquisition price
  2. Monetary principle This principle holds that accounting will only endeavor to deal with those items to which a monetary value can be attached. As such, financial statements reflect only the items that can be measured in monetary terms. Goodwill, for example, is never shown in the statements because it has no monetary measurement
  3. Accrual concept: The accruals concept is also known as the matching concept. In the principle, revenues and costs are recognized when earned or incurred and not as the monetary attachment is received or paid. What this means is that the time when the revenue is received or the expense is incurred is completely disregarded. This leads into two scenarios; prepayments and accruals Prepayments occur when money is received for a period that it has yet to be earned, or an expense is paid for but has not yet been incurred. Accruals occur when the expense for the money is being paid for has already been incurred i.e. the expense belongs to a past period, or when an income is received way after the period of earning has expired.
  4. Revenue realization concept: It states that a sale should be recognized when the event from which it arises has taken place and the receipt of cash from the transaction is reasonably certain. Revenue can be recognized at different levels of selling such as when the inquiry is made, during delivery, at issue of invoice or when payment is made. Revenue realization demands that only when the money receivable is reasonably certain of reception should accountants recognize it as income. For instance, it may not be prudent to recognize a sale when a customer makes an inquiry because the requisition may be revoked well before the goods are even ordered or delivered.
  5. Prudence: Prudence states that where alternatives exist, the one selected should be one that gives the most cautious presentation of the financial position of the business. Assets and profits should not be overstated, but a balance must be achieved to prevent the material overstatement of liabilities and losses. Where losses were foreseen, it should be anticipated and taken immediately into account. In other words, accountants should never anticipate gains but must always provide for losses.
  6. Consistency: The items in the financial statement should be presented and classified in the same manner from one period to the next unless there is a significant change in the nature of the operations of the business, or a review of its financial statement presentation demonstrates that relevance is better achieved by presenting items in a different way, or a change is required by a new international standard. For instance, an entity is not allowed to change form LIFO to FIFO or otherwise unless: – there is a significant change in the business – there is a new accounting order – It helps present the information better.
  7. Materiality: Information is material if its non-disclosure could influence the decisions of users. Materiality depends on the size and nature of the item being judged. Strict adherence to accounting rules is not necessary for accounting for trivial items such as loose tools, e.g. a stapler should not be capitalized, and a bribe cannot be itemized under expenses.
  8. Duality: Duality principle emphasizes the double-entry book-keeping entry that every transaction has two effects, for every debit, there is a corresponding, equal and opposite credit entry. As such it forms the basis of the double-entry system of bookkeeping.
  9. Substance over form: Some transactions have a real nature that differs from their legal form. This principle states that whenever it is legally possible, the real substance prevails over the legal form

Limitations of accounting

 Historical.  Accounting information is prepared based on past period monetary transactions.

It is hardly feasible that what happened in the past will hold on in the future and so the accounting information may be considered irrelevant on that basis alone.

Too quantitative rather than qualitative Accounting information consists of too many figures and less of explanations. For any system to be useful, it must strike a balance between quantitative and qualitative measures.

 Only comparable to similar businesses.  Accounting information makes it only comparable to businesses of similar nature.

It is difficult to compare a service-oriented organization to a manufacturing-based firm.