Finance Study Notes – Business Studies HSC

Role of Financial Management – Chap 9Financial management – planning and monitoring of a business’s financial resources to enable the business to achieve its financial objectivesStrategic Role of financial management –

Strategy refers to long term, broad aims affecting all key business areas (each key business function managers must co-operate to the strategic plan of the business)

By managing the businesses finanes Strategic plans encompass the strategies that a business will use to achieve its long-term goals.

Includes: setting financial objectives, sourcing finance, preparing budgets and forecasting, preparing financial statements, maintaining cash flow, fund distribution

33% of small businesses fail due to poor management of financial resources Financial plan necessary for seeking financing from financial institutions and enables financial

predictionsObjectives of financial management –

Profitability (excess revenue) – ability to maximise profits to satisfy owners and shareholders and long-term stability

Growth – ability to increase in size in the long term depending on businesses ability to develop and use asset structure to increase sales, profits, and market share (In order to achieve their global target of generating €50 billion in sales by 2020, IKEA set an objective of increasing growth by 8 per cent each year. To achieve this, the furniture store will be expanding into India and China, where they plan on opening 25 stores by 2025.)

Efficiency – minimise costs and manage assets so that maximum profit is achieved with lowest possible level of assets. Generally, relates to the operations or revenue-producing activities of a business – requires monitoring of assets, inventories, cash, receivables

Liquidity – the extent to which a business can meet its financial commitments in the short term. A business must have sufficient cash flow to meet its financial obligations or be able to convert current assets quickly

Solvency – extent to which a business can meet financial commitments in longer term – important for owners/shareholders/creditors as it’s an investment risk indication. Indicates ability to repay debt measured through gearing (proportion of debt (external source) and the proportion of equity (internal source) that is used to finance activities – ratio determines solvency)

Short-term and Long-term financial objectiveso Short-term: tactical (1-2 years) and operational (day to day) plans, regularly reviewed to

ensure targets are being met and resources used to best advantageo Long-term: strategic plans determined for set period of more than 5 years. Broad goals

that require short term goals to achieve Conflicts between short-term and long-term objectives

o Goal of growth – expansion short term increases costs and gearing, long term increases value

o To achieve long-term profitability, businesses need to invest in human and physical resources costing money limiting ability to meet short term obligations

Interdependence with other key business functions – Mutual dependence occurs when functions overlap and employees work towards common goals Marketing, operations, HR rely on financial managers to allocate them adequate funds, in return

finance relies on other functions to produce products, on marketing to promote products, HR to manage staff

Influences on financial management – chap 10 Internal sources of finance Global market influences Influences of government External sources of finance Financial institutions

Sources of finance – internal/external Establishment phase owners/shareholders contribute funds, but as the business grows a range of

options are open for financing Financial decision making requires relevant information to be identified, collected, and analysed

to determine an appropriate course of action Internal sources:

o Funds generated inside the businesso Retained profits – most common – retained earnings or profits in which all profits are

not distributed but kept in the business as a cheap and accessible source of finance. Advantages - Doesn’t increase debt levels, no new shareholders to share profits with, no interest payments. Disadvantages – limited, may get wasted

o In Aus businesses approx. 50% of profits on average are retained to be reinvested External sources:

o Funds provided by sources outside the business, including banks, other financial institutions, government, suppliers, or financial intermediaries

o Debt finance – short-term and long-term borrowing from external sources by a business – increased funds = increased earnings = increased profits – regular repayments – increased risk due to interest plus original investment needing to be repaid

o Debt: short-term borrowing Provided through financial institutions through overdrafts, commercial bills, and

bank loans – used to finance temporary shortages in cash flow for working capital – generally repaid within 12 months + current liability

Overdraft – bank allows business/individual to overdraw account up to an agreed limit to help overcome a temporary cash shortfall. Low interest, paid on the daily outstanding balance of the account. Repayable on demand although rare – overall very flexible

Commercial bills – short-term loans issued by financial institutions for large amounts (over $100 000) for a period of generally between 30-180 days. Flexible in relation to interest that needs to be paid and repayment period – usually secured against business assets and generally roll over until borrower has funds to repay in full (bank bills)

Factoring – selling accounts receivable for a discounted price to a finance or factoring company. Receive up to 90% of number of receivables within 48 hours of submitting invoices to the factoring company. Improves cash flow and reduces worry about collecting accounts – ‘without recourse’ means business transfers responsibility for non-collection to the factoring company – ‘with

recourse’ means business responsible for bad debts – greater risk due to unpaid debts

Trade credit: cheapest for borrowing. Facility allows regular customers with a good credit rating to obtain funds, for a specific period of time, from their bank without any interest charges (will not be question on this)

o Debt: long-term borrowing Funds borrowed for periods longer than 12 months, used to purchase major

assets serving as security – non-current liabilities Mortgage – loan secured by the property of the borrower – property cannot be

sold or used as further security Debentures – issued by a company for a fixed rate of interest and a fixed period

of time. Repaid on maturity by buying back debenture. Security via company assets. Company profit does not impact interest rate due to fixed nature. Must have prospectus

Unsecured notes – loan from investors for a set period of time. Not secured against assets presenting most risk for lender, generating higher rate of interest

Leasing – payment of money for the use of equipment that is owned by another party. Enables an enterprise to borrow funds and use equipment without the large capital outlay required.

Operating leases – assets leased for short periods, usually shorter than the life of the asset. Can be cancelled without penalty

Financial leases – lessor purchases asset on behalf of lessee. Used for life of asset, repayments are fixed for economic life of asset between 3-5 years

Advantages of leasing: assists business with cash flow as payments related to leasing are spread over time, costs of establishing leases is lower than other financing methods, if some assets are leased a business may be in a better position to borrow funds, providing long term financing without reducing ownership, cash flow easily monitored due to fixed repayments, tax deduction

Disadvantage – interest charges may be higher than other forms of borrowing

Corporations are required by law to reveal leases in published financial statements

o Equity External source of funds refers to the finance raised by a company through

inviting new owners Ordinary Shares – common – purchase makes individual part-owner of a

company giving voting rights according to number of shares that they have as well as dividends (distribution of company profit to shareholders calculated number of cents per share) – share of ownership, share of profits (dividends). Voting rights according to number of shares. Advantages – no interest payments, dividends are not mandatory/is a choice. Disadvantages – process of issuing shares is expensive and takes time, not enough people might buy them ‘undersubscription’, dilution of ownership

New issue (Primary shares and new offerings): security issued and sold for the first time on a public market (ASX). Initial Public Offering (IPO). Advantages – successful = large amount of funds, underwritten business can buy unsold shares. Disadvantages – expensive and takes longer, not enough buyers

Rights issue: after IPO existing shareholders get to buy more shares at a special price. Advantages – cheaper and faster than IPO. Disadvantages – lower price, less possible buyers

Placements: privately selling shares (not through IPO). Allotment of shares made directly from the company to investors, additional shares offered at a discount to their current trading price. Discount intends to persuade investors. Advantages – cheaper, faster, easier than IPO. Disadvantages – not raise enough money

Share purchase plans: shareholders choose to get shares instead of dividends Purchase shares without brokerage fees, issue new shares without issuing a prospectus, max $15 000 shares to each shareholder. Advantages – quick, cheap. Disadvantages – lower price than offering new shares

Private equity – money invested into a private company to raise capital for expansion. businesses that buy other businesses. Advantages – access to large amounts of money, easier than IPO, investors have good/new ideas. Disadvantages – original owners lose control; private equity firms are not interested in growing the business (cut costs, sell assets, takeover)

Financial institutions Collect funds and invest them in financial assets Banks - Commonwealth

o Receive savings as deposits from individuals, businesses, governments, and make investments and loans to borrowers

o Largest form of financial institution in Australia – has declined due to deregulation of financial markets – 54 banks operating in Australia, main 4: ANZ, Commonwealth, NAB, Westpac

o Supervised by Reserve Bank of Australia Investment Banks – Newport Capital Group (Fujitsu is a customer), Goldman Sacs

o Borrowing and lending services – provide a variety of loans, sometimes customisable – primarily to business sector

o Impose conditions when lending, may require equity in the business borrowing fundso Investment banks:

Trade in money, securities, and financial futures Arrange long-term finance for expansion Provide working capital Advise clients on foreign exchange cover Advise on mergers and takeovers Underwrite corporate and semi-government issues of securities Operate unit trusts including cash management trusts, property trusts and

equity trusts Arrange overseas finance

o Advantage – lots of different types of loano Disadvantage – conditions may not be appropriate for business – may force change of

business model Finance companies – Aussie Personal Loans

o Non-bank financial intermediaries that specialise in smaller commercial financeo Provide short-term and medium-term loans to businesses through consumer hire-

purchase loans, personal loans and secured loans – major providers of lease finance and some specialise in factoring or cash flow financing

o 105 registered finance companies in Australiao Raise money through share issue (debenture) – lenders have security of priority over

firms’ assets in event of liquidation – finance companies can sell assets to recover initial loan in business failure

o Can provide business with quick funding with high interest rateo Regulated by Australian Prudential Regulation Authority (APRA)o Advantages – facts access to finance

o Disadvantages – interest rate will be higher Life insurance companies – TAL Life insurance (highest market share)

o Non-bank financial intermediaries who provide cover and a lump sum payment in the event of death. Policy holders pay premiums and insurer guarantees to [ay designated beneficiary a sum of money upon death of the insured person

o Provide both equity and loans to corporate sector through receipts of insurance premiums, which provide funds for investment – funds received in premiums called reserves, invested in financial assets – pool together money and invest in businesses

Superannuation funds – MLC Superannuation Fundo Grown over 25 years due to tax incentives and compulsory superannuation (1992)o Superannuation – scheme set up by federal government, which requires all employers to

make a financial contribution to a fund which will provide benefits to an employee when they retire

o Employers required to make contributions for 18-69 yrs who earn $450 a montho Employers must pay amount equal to 9.5% of employee’s salary into fund on top of

general wage over the course of working lifeo Super funds invest money received from contributions into company shares, property,

and managed funds – dine so members will earn investment returns on moneyo pool together money and invest in businesses

Unit trusts – David Garry and Associateso (mutual funds) take funds from large number of small investors and invest in specific

type of financial assets. Unit trusts invest in any mixture of cash, shares, fixed interest securities (gov bonds) or property, usually connected to management firm that manages diversified investment portfolio

o pool together money and invest in businesses Australian Securities Exchange

o ASX – primary stock exchange group in Aus. – created by 2006 merger of Australian Stock Exchange and Sydney Futures Exchange – market where shares are bought and sold

o Functions as market operator, clearing house, and payment system facilitator. It oversees compliance with operating rules and promotes standards of corporate governance among listed companies

o Products/services: Shares, futures, warrants, exchange traded options, contracts for difference,

exchange traded funds, real estate investment trusts, listed investment companies, interest rate securities

o Biggest stocks – BHP, CBA, Rio Tinto, Suncorp, and Telstrao Acts as primary market – new issue of debt instruments by the borrower of funds –

enables company to raise new capital through the issue of shares and receipt of proceeds from the sale of securities

o Also operates as secondary market – existing securities – pre-owned or second-hand securities, such as shares, are traded between investors – transactions do not increase amount of financial assets, increases liquidity of assets influencing the primary market

o Advantages – access to lots of money, doesn’t add to debt levelso Disadvantages – costs money to be listed, risk of undersubscription

Influences of government Influenced through economic policy – monetary and fiscal, legislation, roles of government

bodies The Australian Securities and Investments Commission (ASIC)

o Independent statutory commission accountable to Commonwealth parliamento Corporations Act 2001- enforces and administers and protects consumers in areas of

investment, insurance, superannuation, and banking (not lending)

o Aim to reduce fraud and unfair practices in financial markets and financial products – ensures companies adhere to law, collects info and makes it public including financial info that companies must disclose in annual reports

o If business breaches law ASIC investigate and determine remedy – imprisonment or monetary penalty

o Failure to comply = negative publicity Company Taxation

o All incorporated businesses are required to pay company tax on profits – levied at a flat rate of 30% of net profit and use a progressive scale

o Government changes – 2016/17 tax year company tax rate was reduced to 27.5% for small businesses with a turnover of less than $10 million

o Paid before profits are distributed to shareholders as dividendso Gov process of reform of federal tax system in order to improve Australia’s international

competitiveness and make Australia a more attractive place to invest, driving economic growth

o Leasing assets are cheaper tax-wise than buying assetsGlobal Market influences

Large uncontrollable financial influences include the availability of funds, interest rates, and global outlook. ‘uncontrollable’ means influences are part of external business environment and may not be significantly controlled by the business – significant influence is Globalisation

Global economic outlooko Refers specifically to the projected changes to the level of economic growth throughout

the world – if positive this will have an impact on the financial decisions such as Increase demand for products and services – business will need to increase

production to meet demand and therefore require funds to purchase equipment, employ staff, or expand size

Decrease in interest rates on funds borrowed internationally from the financial money market. Results mainly from a decrease in the level of risk associated with repayments – business sales decrease as do profits

o Poor economic outlook will have an impact on financial decisions of a business in the opposite way to those mentioned previously

o World Bank forecast that the global economy would grow 3.1% in 2018 – factors that impact on global economy include:

Increase in manufacturing and trade Increasing consumer confidence Increased investment spending Uncertainty surrounding Brexit Expected slowing in the growth in Chinese economy Increase in commodity and oil prices Financial risks from high and rising credit growth and house price increases

Availability of fundso Refers to the ease with which a business can access funds on the international financial

markets – Large businesses may need to access funds internationally to expand globally - various conditions and rates apply and these will be based primarily on:

Risk Demand and supply Domestic economic conditions

o GFC had a major impact on the availability of funds for all companies and institutions, caused a sharp increase in interest rates that reflected the high level of risk in lending

Interest rateso Cost of borrowing money – higher level of risk involved in lending to a business, the

higher the interest rates – business that plans to either relocate offshore or expand domestic production facilities to increase direct exporting will need to raise finance

o Australian rates are usually above countries such as the US and Japan, thus Australian businesses could be tempted to borrow the necessary finance from an overseas source to gain the advantage of lower interest rates – real risk is exchange rate movements, adverse currency fluctuation could see the advantage of cheaper overseas interest rates quickly eliminated

Analyse the influence of government and the global a market on financial managemento Implication –

Legislation influences finance decisions, impacts choice of legal structure due to obligations

Legal obligation compliance Failure to comply with regulations, ASIC remedies Negative publicity could result for businesses who do not comply with

government regulations Taxation regulations will affect business’s financial decisions as some decisions

might be better for taxation purposes Taxation regulations require sound financial management so the business will

have adequate financial resources available for when their taxation obligations are due

o Implications for businesses in relation to the influences of the global market Global economic outlook will affect demand for exports, a positive outlook will

increase demand for Australian products whereas negative will decrease Availability of funds will impact on whether Australian businesses can access the

money they need to expand Overseas interest rates will also affect Australian businesses who borrow funds

from overseas, if interest rates and/or exchange rates change, then this could lead to an increase in repayments and therefore a reduction in profits

Planning and financial management – chap 11Planning and implementing

Financial needs – inflows>outflows, more money coming in than out

o Financial information includes balance sheets, income statements, cash flow statements, sales/price forecasts, budgets, bank statements, weekly reports, break-even analysis

o Determined by – size of business, current phase of the business cycle, future plans for growth and development, capacity to source finance (debt and/or equity), management skills for assessing financial needs and planning

o Business plan may be used when seeking finance or support for a project from a bank or investors, these institutions must ensure that financial commitment will result in success – types of info in business plan depends on audience (employees, owners, lenders, investors) – needed to show that a business can generate acceptable return on investment sought

Budgetso Provide information in quantitative terms about requirements to achieve a particular

purposeo Budgets show – cash required for planned outlays for a particular period, cost of capital

expenditure and associated expenses against earning capacity, estimated use and cost of raw materials or inventory, number and cost of labour hours required for production

o Reflect strategic planning about resource use and provide info about goals and are used in strategic, tactical, and operational planning

Determining financial

needs

Developing budgets

Maintaining record

systems

Identifying financial risks

Establishing financial controls

o Enable constant monitoring of objectives and provide a basis for administrative control, sales effort, planning, price setting, stock control, expenses, and production cost

o Used in both planning and control – control measure, planned performance can be measured against actual performance and corrective action taken as needed

o Budgeting must consider – review of past figures and trends, gathered estimates, potential market/market share, trend, seasonal fluctuation, proposed expansion or discontinuation of projects, proposals to alter price/quality, current orders, plant capacity, considerations from external environment (financial trends, availability of materials and labour)

o Types of budgets Operating budgets – main activities of a business including sales, production,

raw materials, direct labour, expenses, and cost of goods sold – this info used in preparing budgeted financial statements

Project budgets – capital expenditure and research and development – includes info about purpose of asset purchase, life span of asset, revenue generated from purchase – info included in budgeted financial statements

Financial budgets – relate to financial data of a business and include the budgeted income statement, balance sheet, and cash flows – income statements and balance sheet reflect results of operating activities and cash flow statement shows liquidity of a business

Record systemso Mechanism employed by business to ensure that data is recorded and info provided by

record systems is accurate, reliable, efficient, and accessibleo ASIC – poor record keeping is major cause of business failureo Minimising errors in recording process and maintaining accurate financial statements

important – double entry system of accounting is an important control aspect (record all items twice, entries seen to balance, and checks to find errors can be carried out quickly)

o ATO legal requirement to keep certain records for minimum of 5 yearso Financial statements – revenue statement, balance sheet, cash-flow statement

Financial riskso Risk to a business of being unable to cover its financial obligations (debts incurred

through borrowing) – if this occurs bankruptcy will resulto In assessing financial risk, consider – amount of business’s borrowings, borrowings are

due to be repaid, interest rates, required level of current assets needed to finance operations

o If business financed from borrowings – higher risk – greater expectation of profits/dividends

o To minimise risk, business consider amount of profit to be generated – must cover debt and justify risk – also consider liquidity of assets, short-term debt it must have liquid assets so debt including interest and repayment of principal on loans are covered

Financial controlso Most common cause of financial loss/problems – theft, fraud, damage or loss of assets,

errors in record systemo Theft/fraud – unnecessary over purchase of stock for personal use, conflict of interest,

misuse of expense accounts, false invoices theft of inventory/assets, or credit card fraudo Financial controls – policies and procedures that ensure that the plans of a business will

be achieved in the most efficient wayo Policy/procedure must be followed by both management and employees – control

important in assets such as accounts receivable, inventory, and casho Common policies that promote control – clear authorisation and responsibility for tasks

in the business, separation of duties, rotation of duties, control of cash, protection of assets, control of credit procedures (follow up overdue accounts and customer credit checks)

Debt and Equity Financing Use short-term finance for short term needs, use long-term finance for long term activities Debt finance – short-term and long-term borrowing from external sources by a business –

liability to a business as it is money owedo Attractive to businesses because funds are usually readily available and interest

payments are tax deductible, reducing cost of debt financeo Advantages – funds readily available, increased funds leads to increased profits, tax

deductable interest payments, flexible payments available, not dilute ownershipo Disadvantages – increased risk if debt comes from financial institutions, security

required, repayments must be regular, lenders have claim on finances in bankruptcy, interest can be expensive

Equity finance – internal sources of finance in the businesso Remains in business for an indefinite time, because funds do not have to be repaid at a

set date as with debt financingo Advantages – do not have to be repaid, cheaper than other sources due to lack of

interest payments, owners retain control over use of finance, low gearing, less risk for business

o Disadvantages – lower profits and lower returns, expectation that owner will have return on investment, long expensive process to obtain funds, ownership diluted

Matching the terms and sources of finance to business purpose Terms of finance must be suitable for the purpose for which the funds are required Use of short-term finance to fund long-term assets – financial problems as amount borrowed

must be repaid before the long-term assets have had time to generate cash flow Use of long-term finance to fund short-term situations results in profits being reduced for a

greater than necessary period of time Structure also impacts finance – public/shares Short-term finance should be used for short-term asset purchase and vice versa

Monitoring and controlling Cash flow statement

o Financial statement that indicates the movement of cash receipts and cash payments resulting from transactions over a period of time – info regarding businesses ability to repay debt and identify trend

o Users of the statement – creditors, lenders, owners, shareholders, potential shareholders

o Better predictor of status that profitability, shows whether a firm can – Generate favourable cash flow ratio Pay financial commitments when they fall due Have sufficient funds for growth/change Obtain external finance Pay drawings to owners or dividends

o Activities of businesses are divided into 3 categories Operating activities = cash in/outflows relating to main business activity

(provision of g/s). Income from sales plus dividends and interest received. Outflows consist of payments to suppliers, employees, and general operating expenses

Investing activities = cash in/outflows relating to purchase and sale of non-current assets and investments, used to generate income for business

Financing activities = cash in/outflows relating to borrowing activities of the business. Inflows relate to equity or debt, outflows relate to repayment, dividends, or cash drawings (of owner)

o Usually prepared from income statement and balance sheet. ONLY CASH TRANSACTIONS Income statement (statement of financial performance)

o Income statement is a summary of the income earned and the expenses incurred over a period of trading – helps users of info to see revenue, expenditure and profit derivation

o Statement shows: Operating income earned from the main function of the business, such as sales

of inventories, services, and non-operating revenue earned from other operations such as interest, etc.

Operating expenses such as purchase of inventories, payment for services and other expenses incurred in the main operation of the business

First record income earned by business, second step record cost of goods sold (purchases of materials/goods) , minus COGS for gross profit, net profit is gross profit minus expenses

o Types of expenses Selling expenses – expenses related to process of selling g/s; can be directly

traced to need for sales Administration expenses – costs directly related to the general running of the

business Finance expenses – Costs associated with borrowing money from outside

people or organisations and to minimising business risk Balance sheet (statement of financial position)

o Represents business’s assets and liabilities at a particular point in time and represents the net worth (equity) of the business – shows financial stability

o Shows level of C/NC Liabilities/assets Asset – items of value. Current can be turned to cash within 12 months, non-

current greater than 12 months Liabilities – claims against assets, representing what is owed by the business Owners’ equity – funds contributed by the owner, represents net worth of

businesso Analysis indicates – assets to repay debts, assets being utilised to maximise profits,

owners making good return on investmentso Accounting equation – relationship between assets, liabilities, and owners’ equity

Assets = Liabilities + Owners’ Equity

Calculating financial ratios and strategies to improve performance Analysis involves working the financial information into significant and acceptable forms that

make it more meaningful, and highlighting relationships between different aspects of a business Vertical analysis compares figures within one financial year – e.g. expressing gross profit as a % of

sales and comparing debt to equity Horizontal analysis – figures from different financial years compared Trend analysis – compares figures for periods of 3-5 years Interpretation is making judgements and decisions using the data gathered from analysis Liquidity

o Extent to which a business can meet short-term financial commitments, ability to pay debts when they fall due – holding of outstanding debts means the business has less cash to earn revenue

o Current ratio (working capital) – Current ratio = current assets/current liabilities Ability of a business to repay current liabilities using current assets 2:1 indicates sound financial position for a firm, large businesses in food

industry may have lower ratio (Woolworths 0.6:1) Strategies to improve liquidity – factoring, selling non-essential non-current

assets, injecting equity Gearing (solvency) – ability to meet long-term financial commitments, gearing measures

relationship between debt and equity – proportion of debt to equity used to finance business – higher risk industry’s that gain greater profits have higher debt to equity ratios. Factors such as risk, return and degree of control over the enterprise influence the level of leverage that is appropriate for a business – level of owner control must be considered as well as return on

investment, cost of debt, size and stability of business, liquidity of assets, purposes of short-term debt

o Calculated from balance sheeto Debt to equity ratio = total liabilities/total equity

Shows extent to which the firm is relying on debt or outside sources to finance the business

Ratio greater than 1 means that the business has less equity than debt Ratio of between 0 and 1 means that the business has more equity than debt Higher the ratio = less solvent the firm – higher ratio of debt to equity the higher

the risk Firm must consider interest rates, consumer confidence, and economic

indicators to determine if balance is appropriateo Improving gearing – reduce debt or increase equity: sell non-essential assets, re-

negotiate loans, lease assets, sell more shares Profitability

o Earning performance of a business and indicates its capacity to use its resources to maximise profits, depends on revenue earned by a business and the ability of the business to increase selling prices to cover purchases and expenses

o Parties interested in business profitability Owners and shareholders wanting to know whether the firm is earning

acceptable return on their investment Creditors want to know whether they will be paid, and if they should loan in

future Lenders want to know whether the principal on the loan and interest will be

repaid and whether to lend to the firm Management sees whether policies need to be adjusted

o income ratio used to measure profitability or earning capacity of the firm – ratios are the gross profit ratio, net profit ratio, return on equity ratio

o Gross profit ratio Difference between sales revenue and COGS, amount of sales available to meet

expenses – fall in rate of gross profit may mean a fall in amount of net profit Gross profit ratio gives % of sale revenue that results in gross profit – only

calculated for goods businesses not service businesses – only used by businesses reselling stock at a higher price

Gross Profit ratio = Gross profit/sales Indicates effectiveness of planning policies concerning pricing, sales, discounts,

and valuation of stock Low ratio = alternative suppliers need to be sourced, and competitors

investigatedo Net profit ratio

Represents profit or return to the owners, which is revenue less expenses – represents sole trader/partnerships return on business contribution – usual to return part of profit as dividends

Net profit ratio = net profit/sales Shows amount of sales revenue that results in net profit, expenses after gross

profit High ratio is good – too high may mean lack of re-investment

o Return on equity ratio Return on equity ratio = Net profit/total equity How effective the funds contributed by the owners have been in generating

profit, hence return on investment Return for owners should be better than that of other investments Most investors would want at least 10% return because of investing risk

Owners compare previous return, industry average, and return with alternative investment considerations

Higher ratio = better return for owner, if return unfavourable – owners consider alternative options (selling business)

Efficiencyo Efficiency is the ability of a business to minimise its costs and manage its assets so that

maximum profit is achieved with the lowest possible level of assets, effective planning and managing goals is necessary – more efficient = greater profits and financial stability

o Expense ratio Expense ratio = Total expenses/sales Indicates number of sales that are allocated to individual expenses, indicating

day to day efficiency Ratio used to determine where highest expenses are from and why the ratio has

increased/decreased Compare with past performance and industry average – lower % the better

o Accounts receivable turnover ratio Accounts receivable turnover ratio = 365 / (sales/accounts receivable) Measures effectiveness of firm’s credit policy and efficiency of debt collection If too above 30 days firms must examine cash flow, credit policies, collection

policies, and doubtful debt policy Average time taken by Australian businesses to pay their invoices is 44.4 days

Assessing performance using comparative ratio analysiso Judgements are made by comparing a firm’s analysis against other ratios and

benchmarks – can compare ratios with similar businesses, different time periods, industry standards, and benchmarks

o Ratios provide snapshot of particular point in time meaning info will varyo Can also be compared with previously determined budget figure

Identifying the limitations of financial reporting Financial reports/ratio analysis provide information on the state of the business and indicate

trends in its operations Financial reports must be used with caution because they might not give an accurate idea of a

firm’s financial position Normalised earnings

o Earnings that have been adjusted to consider charges in the economic cycle or remove one off or unusual items that effect profitability – more accurate depiction of true company earnings

o Easier to compare profitability figures for a business from 1 1 year to the next against another business e.g. Removal of land sale as it would show large capital gain not showing investors true business performance

Capitalising expenseso Accounting method where a business records expense as an asset on the balance sheet

rather than as an expense on the income statement – not accurately represent true financial condition of the business as it understates the expenses and overstates the profits as well as the assets of the business

o Accountants ut expense as asset making yearly profit look larger than actualo Long term asset can spread costs over years - depreciationo Eg. R&D, development expenditure

Valuing assetso Estimating value of assets when recording them on a balance sheet, can be difficult to

estimateo Sometimes recorded as historical cost – accounting method where assets are listed on a

balance sheet with the value at which they were purchased, advantageous as cost can

be verified but may distort balance sheet with an inaccurate representation due to change in market value

o Non-current assets such as land, typically increase in value over time, other experience depreciation

o Depreciation – managers have to estimate value lost yearly, using accounting standards they account for depreciation to present a more accurate business report – different type of depreciation calculation systems may mislead investors, thus there is a limitation on interpretation as depreciation rate is an estimate and may give a false impression of business value

o Some assets difficult to value, intangible assets are often not included on a balance sheet due to inability to calculate value, there may be temptation to overvalue to make business appear more stable

Timing issueso Matching principle – accounting concept where expenses incurred by a business must be

recorded on the income statement for the accounting period in which the revenue, to which expenses related are earned – accountant should record revenue at the same time as expenses related to that revenue

o Revenue earned will match costs that were incurred to earn revenue. Matching principle results in presentation of a more accurate representation of the financial position of a business

Debt repaymentso Gearing ratio used to determine whether businesses are at risk of meeting long-term

financial commitments, highly geared may be alarming for some stakeholders due to high risk but also profit potential is greater

o Can be limited due to inability to disclose specific information concerning debt such as Long the business has had or been recovering debt Capacity of business or debtor to repay amount owed (close to bankruptcy?) Adequacy of provisions and methods the business has for debt recovery, use of

factoring may not be appropriate for smaller businesses Provision business has in place doubtful debts and how evident in the financial

reports Whether debt repayments have been held over until another accounting period When debts are due

o Recording of repayments may distort the reality of a business’s status to be of greater favourability

Notes to financial statemento Report details and additional information that are left out the main reporting

documents, such as balance sheet, income statement, and cash flow statemento Contain info that may be useful to stakeholders to help them understand financial

statementso Contain info such as accounting methodologies used for recording and reporting

transactions that cam affect the bottom-line return expected from an investment in a company – may contain further details about how figures in financial statements were calculated and procedures used to develop them

Ethical issues related to financial reports Financial managers have ethical and legal responsibility – must reflect owner and shareholder

interest Debt funds may be used to increase profits with added risk for shareholders Laws relating to corporations include responsibilities of directors and disclosure – duty to act in

goo faith, exercise power with purpose of corporation, exercise reasonable and proper discretion, avoid conflicts of interest

ASX corporate governance council officiates requirements of corporations listed and responsibilities in regard to compliance, disclosure, and transparency

Examine ethical financial reporting practiceso Audited accounts –Audit is an independent check of the accuracy of financial records

and accounting procedures – 3 types Internal audits – conducted internally by employees to check accounting

procedures and the accuracy of financial records Management audits – conducted to review the firm’s strategic plan and

determine if changes should be made. Factors impacting this are human resources, production processes, and finance

External audits – requirement of the Corporations Act 2001 (Cth) – firms reports are investigated by independent and specialised audit accountants to guarantee their authenticity – auditor issues a conformation of accuracy. International financial reporting standards aimed for greater transparency and accountability for all businesses globally – in small businesses only used if business is for sale or as a check against theft and fraud – conducted by an accounting business and certified public accountants (CPA’s)

Audits assist in guarding against unnecessary waste, inefficient use if resources, misuse of funds, fraud and theft, used to ensure accepted accounting standards providing accurate financial information

o Record keeping Source documents must be created for every transaction, even for cash

transactions If cash is exchanged and not recorded, it will not appear on business revenue,

reducing business profit, lowering tax burden – ATO regularly monitors business operators and their taxation responsibilities

Proper financial records must be kept for a minimum of five yearso Reporting practices

Other stakeholders are entitled to access a business’s financial information, in a private company they are legally entitled to receive financial reports

To pretend profit is lower than it really is an attempt to defraud the ATO – illegal, also makes raising additional more difficult due to poor profits

Understating profit or overstating the value of assets may prove counter-productive when potential buyers scrutinise reports

Financial management strategies – chap 12Cash flow management

Cash flow is the movement of cash in/out of a business over a period of time. Maintaining cash flow and liquidity is essential

Cash flow statements – indicated movement of cash receipts and cash payments resulting from transactions over a period of time. Also identifies trend

Management strategieso Temporary shortfalls in cash are often covered through overdrawing on accounts – long-

term shortfalls are concerning and may result in business failureo most common SMEs experience cash flow problems – slow paying debtors, tightened

lending restrictions, unsustainable growth, failure to perform credit checks o Distribution of payments

Distributing payments throughout the time period so that large expenses do not occur at the same time - Equal cashflow over the months

Cash flow projection can assist in identifying periods of potential shortfalls and surpluses

o Discounts for earlier payments Offer debtors discount for early payments – effective for those who owe large

amountso Factoring

Selling accounts receivable for a discounted price to a finance or specialist factoring company

Working capital (liquidity) management Business must have sufficient liquidity so that cash is available or current assets can be converted

to cash to pay debts – failure to pay debts can alienate a business’s creditors and suppliers who incur extra debt collection costs and lose confidence in the business

Working capital is the term used in businesses to describe the funds available for short-term financial commitments of a business. Net working capital is the difference between current assets and current liabilities, represents funds needed for day-to-day operations of a business to produce profit and provide cash for the short-term

Through business cycle current assets are constantly changing as inventories are sold. Business failure can result from poor management of working capital

Working capital management involves determining the best mix or current assets and liabilities to achieve the objectives of the business

Current (working capital) ratioo Current ratio shows if current assets can cover current liabilities, indicates amount of

risk taken by a business in relation to profitability and liquidity, and can help determine whether the business’s financial structure is acceptable

o High current ratio may indicate the business has invested too much in current assets that bring in a small return, profitability may be reduced as businesses have chosen to reduce its risk of not being able to pay its debts by having a higher ratio

o Low current ratio – business is more profitable if its long-term assets are invested into, but there is a risk of not being able to pay current liabilities

Control of current assetso Management of current assets is necessary as excess inventories will lead to unused

assets, causing liquidity problems. o Cash – ensures the business can repay debts, and invest in short-term money markets.

Planning for cash shortages can prevent liquidity problems. Businesses try to keep their cash balances at a minimum and hold marketable securities as reserves of liquidity. Reserves of cash and marketable securities guard against sudden shortages or disruptions to cash flow. An overdraft might also be arranged to allow a business to overdraw its account to an agreed overdraft amount

o Receivables (accounts receivable): Receivables – sums of money due to a business from customers to whom it has supplied goods or services. Receivables are recorded as accounts receivable. Producers for managing accounts receivable includes checking the credit rating of prospective customers, sending customers’ statements monthly, following up on accounts, stipulating a reasonable payback period, putting policies in place for collecting bad debts. Disadvantages of operating a tight credit control policy is the possibility that customers might choose to buy from other firms

o Inventories: significant amount of current assets is made up by inventories – insufficient inventory of quick-selling items will lead to loss of customers. Inventories are a cost to the business if not sold

Control of current liabilitieso Payables (accounts payable) – Payables are sums of money owed by the business to

other businesses from whom it has purchased goods and services. Holding back of accounts payable until their final due date can improve a firm’s liquidity position. May also be possible to take advantage of discounts offered by creditors. Accounts payable involves periodic review of suppliers and the credit facilities that provide e.g. discounts, interest-free credit periods, extended terms for payments, sometimes offered by established suppliers without interest or other penalty. Alternative financing plans should be investigated with suppliers, motor vehicles dealers have slow stock turnover and often use floor stock finance. Means suppliers agree to provide motor vehicles for a period before the payment is due. Costs and benefits in using credit must be determined in the control of accounts payable

o Loans – business may need to borrow funds in the short term for a number of purposes. Management of loans is important, as costs for establishment and interest rates must be monitored to minimise costs. Control of loans involves investigating alternative sources of funds from different banks and financial institutions. Positive ongoing relationships with financial institutions ensure appropriate short-term loans are used to meet the businesses financial commitments

o Overdrafts – convenient and relatively cheap short-term borrowing form. Enable business to get past cash shortages. Banks require regular payments be made on overdrafts and may charge account keeping fees. Businesses must have a policy for using and managing overdrafts and monitor budgets in a daily or weekly basis so that cash supplies can be controlled

Strategies for managing working capitalo Leasing

Leasing involves the payment of money for the use of equipment that is owned by another party. Lease is a contract between lessor and lessee that lets the lessee rent an asset for a period of time in exchange for periodical payments

Advantages of leasing: cash outflows related to leasing are spread over several years as opposed to the one-off large initial cash outflow, allows business to make use of good quality assets which might have been unaffordable if they had to purchase outright, lease payments are considered operating expenses and therefore tax deductable, allows businesses the flexibility to upgrade to new and better assets, reduce the risk of technological obsolescence since the leased asset can be upgraded, depending on terms of agreement it reduces the risk of unpredictable costs associated with the repairs and maintenance of equipment, lease payment helps with cashflow forecasting and budgeting as the payments are fixed for a specified time

o Sale and lease-back Sale and lease-back refers to the process of selling an owned asset to a lessor

and then leasing the asset back through fixed payments for a specified period of time

Improves businesses liquidity since it enables the business to receive a large cash injection from the sale of the asset which can be used as working capital if the business is experiencing a cash shortfall

Profitability management Involves control of both business costs and revenue Cost controls

o Fixed and variable costs Fixed costs – are not dependent on level of operating activity in a business. Do

not change when business activity changes, and must be paid regardless of business events. i.e. salaries, depreciation, insurance, lease, etc.

Variable costs – vary in direct relationship to levels of operating activity or production in a business, includes labour costs and energy costs. i.e. materials and labour used in item production

Monitoring these levels is important to ensure profit maximisationo Cost centres

A number of costs can be directly attributable to a particular section of a business (cost centre)

Department within a business that is responsible for a particular set of activities that benefits the organisation

By treating cost centre as separate unit – business can measure how much is spent on each function yearly, gives better understanding of how resources are used

Main function of cost centre is to track expenseso Expense minimisation

Is business expenses are too high profits will be weakened as they consume business resources

Policies should encourage staff to minimise expenses where possible Revenue controls

o Revenue – income earned from the main activity of a business, from sales or fees for services – tools to control revenue are budgets and cost-volume-profit analysis

o Marketing objectives Lead to increase in sales, thus increasing revenue – objectives must be pitched

at a level of sales that will cover costs and result in profit – cost-volume-profit analysis determines revenue needed to break even and impacts on profit due to changes in activity, prices, or costs

Changes in sales mix affects revenue – businesses should control this by maintaining a clear focus on the important customer base on which most of the revenue depends before diversifying or ceasing production

Pricing policy should be closely monitored and controlled – overpricing fails to attract customers, while under-pricing results in cash shortfalls and low profit

Factors influencing pricing Costs of g/s Prices charges by competition Short and long-term goals Image and quality associated with brand or product Government policy

Global Financial management Comparing risks in domestic and global transactions

o Globalisation brings currency fluctuations, interest rate concerns, new methods of international payment, hedging, and derivatives – greater financial risk

Exchange rateso All global transactions are necessary to convert one currency into another – performed

through foreign exchange market (forex, fx) which determines the price of one currency relative to another

o Foreign exchange dealers constantly buying and selling each other’s currency establishing exchange rate – speculating value

o Foreign exchange rate is the ratio of one currency to anothero Effect of currency fluctuation –

Due to fluctuation in demand and supply Currency appreciation raises the value of the Australian dollar in terms of

foreign currencies, each unit of foreign currency buys fewer AUD – one AUD buys more foreign currency. Makes exports more expensive on international markets but prices for imports will fall – reduces international competitiveness of Australian exporting businesses

Currency depreciation lowers price of AUD in terms of other currencies, resulting in cheaper exports and rising price of imports, improving Australian international competitiveness

Interest rateso Business offshore relocation or expanding domestic production facilities to increase

exports will result in a need to raise financeo Global businesses have option of borrowing domestically or from financial markets

overseaso Australian rates are usually higher, therefore Australian businesses may borrow money

from overseas to gain the advantage of lower interest rates – risk in exchange rate movements with adverse currency fluctuations seeing advantages of cheaper overseas interest rates eliminated = impacting profitability

Methods of international payments

o Major worry for exporters is that if the products are shipped before payment received there is no guarantee of importer payment – vice versa

o Third party who both parties trust is used – normally bank acting as intermediaryo 4 basic methods of payment – payment in advanced (least risk), letter of credit

(moderate risk), clean payment (highest risk), bill of exchange (moderate risk) – depends of business assessment of importer’s ability to pay (creditworthiness)

Payment in advance – allows exporter to receive payment then arrange for goods to be sent, no risk for exporter, often used if other party is a subsidiary or credit worthiness is uncertain – most risk for importers

Letter of credit – ensure payment received, exporters require importers to have a letter of credit confirmed by a secure bank. - document a buyer can request from their bank that guarantees the payments of goods will be transferred to the seller, issued by importers bank promising payment once conditions are met – agreement can’t be withdrawn, if buyer doesn’t pay bank has to

Clean payment – open account payable method, exporter ships goods directly to importer before payment is received – time exporter gives the buyer to pay or the goods is called the credit term, only if exporter is confident importer will pay – riskiest for exporters, best for importers

Bills of exchange – document drawn up by exporter demanding payment from the importer at a specific, widely used and allows exporter to maintain control over goods until payment is made/guaranteed

Document (bill) against payment – importer collects goods only after paying for them, exporter draws up bill of exchange with Australian bank and sends it to the importers bank with a set of documents allowing importer to collect goods after payment is made

Document (bill) against acceptance – method importer collects goods before payment, same document process, except importer only signs for acceptance of goods and terms of the bill to receive documents that allow them to pay for the goods at a later date

Risk of payment issues greater than for a letter of credit, documents against acceptance expose exporter to greater risk than against payment

Hedgingo 2 parties agree to exchange currency and finalise a deal immediately a spot exchange

occurs. Spot exchange rate is the value of one currency in another currency on a particular day – not the most favourable rate as exchange rate fluctuations can result in reduction in profits, minimising this risk can be done through hedging

o Hedging – refers to process of minimising the risk of currency fluctuations to help reduce the level of uncertainty involved

o Natural hedging – minimise risk of foreign exchange exposure: establishing offshore subsidiaries, arranging for import payments and export receipts in same foreign currency, implementing market strategies that attempt to reduce price sensitivity of exported products, insisting on both import and export contracts denominated in AUD transfers risk to buyer/importer

o Financial instrument hedging – derivatives can be used to minimise or spread the ric or exchange rate fluctuations

Derivativeso Simple financial instruments that may be used to lessen the exporting risks associated

with currency fluctuations o Derivatives is used unwisely, can be dangerous as the risks against which they are

supposed to protect – 3 main derivatives: forward exchange contracts, option contracts, swap contracts

o Forward exchange contract

Contract to exchange one currency for another at an agreed exchange rate on a future date, usually after a period of 30, 90, or 180 days

Bank guarantees the exporter, within set time, a fixed rate of exchange for the money generated from the sale of exported goods

o Options contract Option gives the option holder the right, but not the obligation, to buy or sell

foreign currency at some time in the future Option holders are protected from unfavourable exchange rate fluctuations, yet

maintain the opportunity for gain should exchange rate movements be favoured

o Swap contract Currency swap – agreement to exchange currency in the spot market with an

agreement to reverse the transaction in the future, involves spot sale of one currency together with a forward repurchase of the currency at a specified date in the future

Businesses use these when they need to raise finance in a currency issued by a country in which they are not well known and are forced to pay a higher interest rate than would be available to a better-known borrower or a local business

Main advantage of swap contract is that it allows the business to alter its exposure to exchange fluctuations without discarding the original transaction