Financial Planning: What Is It? and How Does It Work?

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

A financial plan can be in the form of a budget. 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 projecting the future requirements of a firm to be prepared and 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 his educational background 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 inquire about the time frame the plan will cover and the available resources.
  3. Analysis of data. The advisor analyzes data obtained in steps to and 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 the changing environment.

Importance of financial planning

  1. Management of income. Through a financial plan, one can 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 to 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.
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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 due to 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 the 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 to provide 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 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 capital item.

An account is divided into two sides; the left is the debit and the other the credit side. Therefore, debuting will mean entering an amount on the left-hand side of an account and vice-versa.

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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 preparing financial statements (balance sheet or statement of financial position, income statements, and cash flow statements).

The concepts include:

  1. Going concerned. 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 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 measurable and quantified transactions in monetary terms.

The principles include:

  1. Historical cost; Suggests that assets should be recorded at cost, purchase price, or 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. This means that when the revenue is received or the expense is incurred completely disregarded. This leads to two scenarios; prepayments and accruals. Prepayments occur when money is received for a period that 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 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. 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 the 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 inquires because the requisition may be revoked well before the goods are ordered or delivered.
  5. Prudence: Prudence states that where alternatives exist, the one selected should give the most cautious presentation of the business’s financial position. 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, they 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 like the operations of the business, or a review of its financial statement presentation demonstrates that relevance is better achieved by presenting items differently, or a new international standard requires a change. For instance, an entity is not allowed to change from 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 unnecessary 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.
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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 fewer 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 isn’t easy to compare a service-oriented organization to a manufacturing-based firm.