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Grace De Leon Business Studies HSC

HSC 10:3 – Finance

Chapter 9: Role of financeFinance• Financial management deals with the analysis, interpretation and evaluation of all financial

records of the business• The planning and monitoring of a business financial resource in order to allow the business

to achieve its financial objectives.• Financial management is responsible for financial planning of the business. Helps determine

viability of venture, make decisions about its future and make projections for liquidity and performance

Strategic role of finance• Strategies adopted by the business go toward a short and long term goal, operating and

growing• Accounting knowledge and skill is essential to analyse and interpret financial data• Accounting is the ‘language’ of the financial aspect of businesses, it measures, processes and

communicates financial information• Strategic planning ensures the business survives in the competitive environment

Objectives of financial management• To achieve longer term goals, they must have short-term objectives (profitability, growth,

efficiency, liquidity and solvency)• Financial management must find the best way to achieve these goals, this involves

identifying, evaluating alternative courses of actions and making recommendationsProfitability• The earnings of a business after expenses are paid, to maximise its profits• Measured by the net profit in the income statement• Gross profit, revenue remaining after paying costs of goods sold• Satisfies owners/stakeholders in the short-term good for sustainability in the long-term• Monitor revenue + pricing policies costs + expenses+ inventory levels/assets = profitability• Earnings before interest and tax (EBIT) is a more precise measurement of profitability,

measures profit made from operations• Revenue – COGS = gross profit – expenses = net profitGrowth• Size of business compared to competitors• Ability of business to increase size in the longer term• Depends on ability to develop and use its asset structure to increase sales, profits and

market share• Ensures a sustainable future for business• Profit will increase by


- Increasing physical size of business by expanding or moving to bigger facility- Increasing value of assets- Increasing sales and profits

Efficiency• Ability to minimise costs, manage its assets so maximum profit is achieved with the lowest

possible level of assets• Related to profitability as a business can increase profit and decrease costs• Calculated using an expense ratio. Total expenses/total sales• Another measure is the collection of accounts receivable e.g. invoices (bill sent to customer

requiring payment by a date)Liquidity• Ability to pay its debts as they fall due and short-term liabilities using current assets• Must have sufficient cash flow to meet its financial obligations or can convert current assets

into cash quickly• Controls of cash flow ensure supply of cash is needed• Debtors, are expected to pay their accounts within a short time so its relatively liquid asset• Current assets, cash and other assets that are sold or converted into cash in 12 months• Current liabilities, debts that are due within 12 months• Current assets need to be greater than current liabilities

• Liquidity = current assetscurrent liabilities

Solvency• The ability to pay both short-term and long-term liabilities as they fall due, shows its

financially stable• Gearing, tells how much debt (leverage) its operations compared to its use of equity finance• Must not be too much cash or too little cash to pay liabilitiesShort term and long termShort term• Short term financial objectives are tactical (1 or 2 years) and operational (day-to-day) plans

of a business• Viewed regularly to see if goals are met and if resources are being best used to meet

objectivesLong term• The strategic plans of a business, determined for a set period of time. 5+ years• Broad goals such as increased market share, will require short-term goals to assist in its

achievement• Regularly view progress annually to see if changes are to be implementedInterdependence with other key functions• Finance funds extra resources and business in general• Middle management develops short-term plans (tactical)• Finance manager must allocate adequate funds to each department to be able to operate

successfully. Manager would also develop budgets and cost control for each department


Chapter 10: Influences on financial management • Businesses need finance to conduct their operations. The source of finance can come within

(internal) or from outside (external)

Internal sources of finance• The initial funds put into the business by the owners (equity) or generated from

business activity (retained profits), not repaid. Recorded as equity in a balance sheet.• Owner’s equity, funds contributed by owners/partners to establish + build business• Retained profits, the left over funds after its been distributed, cheap and accessible

source of finance for future activities• Grants, financial gifts provided by government to assist the business to establish or

expand, needs to meet strict criteriaExternal sources of finance• Come from external organisations, it can be a debt or an equity• Debt, money that’s been borrowed. Equity, attached to ownership of shares in an

incorporated business, owner’s financial claim on the assets of businessDEBT, SHORT TERM (12 MONTHS)Overdraft• Loan secured by the property of the borrower (business).• Mortgaged property cannot be sold or used as security for further following until mortgage

is repaid.• Paid through repayments, 15 yearsCommercial bill,• Written order for a loan amount that is guaranteed by the business’ bank.• Borrowed with surplus funds, paid within 30-180 daysFactoring,• Selling accounts receivable at a discount to firm that specialises in collecting accounts

receivable and creating cash inflow.• Factoring takes over mgmt., collection of unpaid accounts under terms, pays seller value of

accounts minus commission or fee.DEBT, LONG TERM (+2 YEARS)Mortgage,• Loan secured by the property of the borrower (business).• Mortgaged property cannot be sold or used as security for further following until mortgage

is repaid.• Paid through repayments, 15 yearsDebentures,• Issued by a company for a fixed rate of interest and time.• Not secured to specific property.• Acquired by offering prospectus to the general public on securities exchange.• Investment opportunity offered to those who want good return from a risky investmentUnsecured notes,• Loan for a set period of time but is not backed by any collateral or assets, quite the risk for

investors in the note (lender).• Done to generate money for initiatives such as share repurchases and acquisitions


Leasing• Business lease non-current assets, e.g. cars, equipment for payments to the owner• Reduces cost of acquiring these assets as full value of the asset in one transaction does not

have to made instantly• Provides tax advantages as lease payments are tax deductableEQUITY• Venture capital, acquired from specialist venture financial institution that seeks to become

part-owner in business• Public equity, anyone who can invest in the business.Ordinary shares, shares to the public through securities exchange. Includes,New issue• Security that has been issued and sold for the first time on a public market, referred to as

primary shares or new offerings.• A prospectus (document that describing financial security) is issued through a stockbroker

and shares are made on the securities exchangeRight issues• The privilege granted to shareholders to buy new shares in the same companyPlacements• Offering additional shares to specific institutions and specific investors• Company does this without official prospectus• Funds used to expand activities or to acquire businessesShare purchase plans• An offer to existing shareholders in listed company the opportunity to purchase more

shares without brokerage fees• Shares can be offered at a discount to current market price required from ASCPrivate equity• Business invites people/organisations to invest in business. Shareholders don’t need to be

paid instantly and owners don’t have so much control• Money isn’t listed on Australian Securities Exchange (ASIX)• Aim of private company is to raise capital to fund expansion/investment of future businessFinancial institutions• Businesses also acquire funds from (investment) banks, finance and life insurance

companies, superannuation funds, unit trusts, companies and the ASIX, intrnl. financial markets and overseas stock exchanges

• Financial institutions often seek debt security, a type of loan that a business obtains that is issued by a promise of repayment on a certain date at a specific rate of interest

Banks• Accepts deposits from general public and provide funds for loans, in turn makes

investments• Provides legal services such as legal and taxation advice and risk mgmt.• Banks have subsidiaries in superannuation and mutual and other funds.• Banks are supervised by the Reserve Bank of Australia• GFC, banks weary in lending policies, loan defaults (non-repayment loans) are expensive.• Corporate products, online banking, detailed statements, biz. credit cards, overdraft mgmt.,

EFTPOS key/credit card and BPAY online bills, insurance + superannuation, international trade advice, economic outlook reports

Investment banks• Deals with businesses and governments in raising large amounts of capital by underwriting

share issues. Arrange any type of finance needed• These banks want some equity in the borrowing of funds so they can influence the direction

of the businesses activities• Assist in mergers and takeovers. Provide advice, arrange finance a business may need• Loans will be customised


Finance and life insurances companies• Non-bank financial intermediaries that specialise in smaller commercial finance.• Provide loans to businesses and individuals through secured and unsecured loans• Secured loans, requires an asset (property) that is a security for the loan. If failed to pay, the

asset will be forfeited to the lending institution• Unsecured loans, does not need an asset as security. Loans are repayed in instalments• Often arrange commercial bills, leasing finances, and debentures (which they raise capital

in)• Funds received in premiums are called reserves. Provides compensation if in a situation• Life insurance provides insurance against death and disabilitySuperannuation funds• Provide funds to the corporate sector through investment of funds received from

contribution and fees• Returns earned by selling debt securities to businesses, which repay loans with interest• Set at 9% funded by employer• Source on income when someone stops workingUnit trusts• Or (mutual funds) are taken from large no. of small investors and invest them in specific

types of financial assets. Formed under a trust deed• Investments include short-term money market (cash mgmt. trusts), shares, mortgages and

property, public securities• There is property trust, equity trust, mortgage trust and fixed-interest trustsAustralian Securities Exchange• ASX, a market that brings together buyers and sellers to exchange shares• Once approved, businesses can issue shares to the general public on the primary market.

Buyers and sellers can exchange shares on the secondary market• Functions as a market operator, clearing house and payments system facilitatorInfluence of government• Gov. influences a biz. financial mgmt. decision making with economic policies such as those

relating to the monetary and fiscal policy.• Monetary policy, steps taken by Reserve Bank of Australia to affect the finance market and

assist the federal government to achieve its goal of low inflation and economic growth. Securities and loans are sold and brought to put pressure on interest rates to alter economic cycle

Australian Securities and Investment Commission• Formed to regulate corporations, markets and the provision of financial services covered

under the Corporations Act 2001- Act covers provisions for consumer protection, the supervision of financial market

operations, insurance, superannuation, life insurance, retirement savings and medical indemnity

• Aim of ASIC is to assist adhere to the law, collects information, about companies and make it available to the public

• ASIC’s responsibilities include ensuring company directors carry out their duties honestly, diligently and in the best interests of their company. Reduce fraud and unfair practices in financial markets and products

Company taxation• Companies and corporations in Australia pay company tax on profits


• Tax is levied at a rate of 30%, company tax is paid before profits are distributed to shareholders as dividends

• Government sees this as an incentive for businesses to retain profits and use funds to grow their business- This gives people the thought of gaining benefits by taking risks, makes Australia look a

lot more attractive for foreign investment, and create new jobs and a higher economic growth

Global market influences• Financial risk associated with global markets are greater than those encountered

domestically, but such risk is necessary for a business strategy to be implemented• Important to note on globalisations influence on financial markets. It has created an

interdependence between economies and their business (and finance) sector, relies on trade for expansion and increased profits

• Large external influences include economic outlook, availability of funds and interest rates.

Economic outlook• Refers to specific projected changes to the level of economic growth throughout the world• Positive outlooks will impact on the financial decisions of a business

- Increased demand for goods and services. An increase in production to meet demand, which would lead to need of funds to purchase equipment, employ/train staff, or expand size of business

- Decrease interest rates on funds borrowed internationally from the financial money market. Which results in a decrease of level of risk associated with repayments. Business sales will increase, as do profits

Availability of funds• Refers to the ease a business accessing funds (for borrowing) on the international finance

markets, many of these institutions are willing to issue money in order to raise capital• Conditions and rates that need to be applied are based on

- Risk- Supply and demand- Domestic economic conditions

Interest rates• The cost of borrowing money• Higher level of risk in business means the higher interest rate• If a business wants to undertake change (e.g. expansion) would need to financial aid to

undertake the change• Australian businesses often take risks, which is why interest rates are generally higher.

Many businesses are tempted to borrow from international institutions for lower interest rates- The risk behind that is the exchange rate movements,

• Any adverse currency fluctuation sees the advantages of overseas interest rates. But in the long-term it is generally much more expensive


Chapter 11: Processes of financial management Planning and implementing• This is the setting of goals and objectives, determining the strategies to achieve goals,

identifying and evaluating alternative courses of action and choosing the best alternative for the business

Addressing current financial position• See where the business is standing and where its heading. Looks over current finance

reports, budgets, record systems etc.Determine financial needs• Essential to determine where a business is headed and how it’ll get there, important to

know where needs are. Where funds are needed• As operations begin, financial information (balance sheets etc.) need to analysed to

determine if profits can be given to shareholdersDevelop budgets• Predicts short and big term activities, and a plan to achieve set outcomes based on forecast

figures. Info in quantitative terms• Shows cash required, cost capital expenditure and associated expenses, estimated use and

cost of raw materials or inventory, number and cost of labour hours for production• Classified as operating, project or financial budgets

Maintain record systems• The mechanisms employed to ensure data is recorded and the information provided by the

recording system is accurate, reliable efficient and accessibleIdentify financial risks• Being unable to cover its financial obligations such as debts that incur from borrowingsEstablish financial costs• Ensure plans are determined will lead to achievement of goals the most efficient wayDebt and equity financingDebt finance• Relates to the short-term and long borrowing from external sources by a business liability

owed to external sources• Funds are usually readily available• Interest payments are tax deductible• Risk and return must be carefully considered when determining whether debt or equity

finance is usedAdvantages of debt Disadvantages of debtFunds are usually readily available Increased risk if debt comes from financial

institutions because the interest, bank chargesIncreased funds should lead to increased earnings and profits

Security is required by the business

Tax deduction for interest payments Regular repayments have to be made


Equity financing• Relates to the internal sources of finance in the business• Remains in business for an indefinite time, does not have to be repaid at a set date• Requires sufficient profits for business to continue to operate• Provides confidence to creditors and lenders• Safety net for unexpected downturns or changes in biz. activities

Advantages of equity Disadvantages of equityDoes not have to be repaid unless owner leaves business

Lower profits and lower returns for the owner

Cheaper than other sources of finance as there is no interest

The expectation that owner will have about the return on the investment (ROI)

Less risk for the business and ownerMatching the terms + sources of finance to business purpose• Terms, long + short. Sources, debt + equity. Purpose, what are finances used for?• Influences to consider

- Terms of finance, suitable for the structure if business and purpose of which funds are required

- Cost of each source of funding whether from equity capital or debt capital- Structure of business

• Factors to consider- Costs, measured for each available sources of funds as costs fluctuate depending on

market and economic conditions- Flexibility of the source of funding to consider- Availability of finance- Level of control

Monitoring and controlling• Inconsistent methods of review and systems of control will have an immediate impact on

the viability of the business• Requires managements to monitor the internal and external factors that will impact

financially on business operationsCash flow statement• Is one of the key financial reports that are part of effective financial planning• Indicates the movement of cash receipts and payments resulting from transactions over a

period of time• Provides a link between income statement and balance sheets, gives important information

regarding a firm’s ability to pay its debts on time• Shows firm can generate favourable cash flow and pay its financial commitmentsIncome statements• Shows the operating results for a period shows revenue earned expenses incurred over the

accounting period with the resultant profit loss• Summary of the income and expenses of a business over a set period of time, such as

financial year• Earnings from the main objective of the business• Indicates profitability and efficiencyBalance sheet• Represents assets and liabilities at a particular point in time and the net worth (equity) of

the business, also the financial stability• Gives a snapshot or summary of what the business owes and owes on a certain day• If the business has enough assets to cover its debts, the interest and money borrowed can be

paid• A = L + E

- Assets, what is owned. Liabilities, claims by people rather than owners against assets and what is owned by the business. (Owner’s) Equity, the owners financial interest in the business or net worth of the business


Financial ratios• Financial managers are a combination of tools to make informed decisions regarding the

financial resources of the business• Financial ratios are calculated to enable managers to make comparisons between different

time periods and against industry averages/bench makers• Accounting is a tool managers use to help manage business finances and make informed

decisions• Comparative ratio analysis of these financial statements allows managers to identify in their

businessesLiquidity ratio (current ratios)• Used to measure the ability of the business to pay debts as they fall due• Assets should be higher than debts

Cur rent ratios : current assetscurrent liabilities

• Recommended ratio is 2:1 (unless otherwise stated). This means the business has $2 current assets for every $1 current liabilities => leaves business solvent

inventory+cash+ACs receivable(debtors)overdraft+ACs payable (creditors )

• Short-term stuff• The extent to which the business can meet its financial commitments in the short term• Also related to liquidity, is what is called working capital, money used in the day to day

running of the businessCurrent assets – current liabilities

Gearing ratio (solvency)• This is a measure of the business long term financial stability or ability to pay debts• Relationship between debt and equity• Measures the solvency of the business

total debttotalequity

• Recommended level is generally taken as 6:1 or 60%. This means for every $1 the owners contribute the business borrows 60c

• Proportion of debt (external finance) and the proportion of equity

debt ¿equity= total liabilitiesownersequity

Profitability• The earning performance of the business and indicates its capacity to use its resources to

maximise profits• Gross profit ratio, the amount of sales that is available to meet expenses. The higher the ratio

the bettergross profitrevenue

• Net profit ratio, the profit or return to the owners. The higher the ratio the betternet profitrevenue

• Return on equity ratio, how effective the funds have been in generating profitEfficiency• The ability of the firm to use its resources effectively in ensuring financial stability and

profitability of the business• Expense ratio, the amount of sales that are allocated to individual expenses, the lower the

better, the more efficientexpensesrevenue


• Accounts receivable turnover ratio, the effectiveness of a firm’s credit policy and how effectively it collects its debts. High turnover ratios indicate the business has effective debt collection

expensessales

=x×per year

365x×¿=no .of days(30‼)¿

Comparative ratio analysis• By comparing the current year’s result and the last year’s, the manager will see any trends

in profit, costs and financial stability• Determine if the business is reaching its financial goals in profitability, growth, efficiency,

liquidity and solvency• Also compare to other businesses in industry – benchmarking• See if it’s above average, see if it’s a ‘best result’Limitations of financial reports• Complicated and detailed accounts will confuse individuals• May not give a clear picture of a business’ profitability

Ethical issues related to financial reports• Accountants must display integrity, objectivity, confidentiality and a high level of

professional and technical ability• Financial managers may not fake it when recording transactions and preparing financial

reports to gain more profits• Businesses must be aware of the triple bottom line, which is a measure of their financial,


social, cultural and environmental performance• Audits, are crucial that is a part of the control function and generally used to examine the

financial affairs of the business- Internal audits, conducted by the employees to check accounting procedures and the

accuracy of financial records- Management audits, conducted to review the firm’s strategic plan and to determine if

changes should be made- External audits, conducted by independent and specialised audit accountants.

Requirement under the Corporations Act 2001• Internal and external audits assist in guarding against unnecessary waste, inefficient use of

records, misuse of funds, fraud and theft• External auditors are used to provide an annual audit of accounting practice and procedures


Chapter 12: Financial management strategiesCash flow management• Cash flow is the movement of cash in and out a business over a period of time• Management is required to make sure payments are made and received without creating a

cash flow problem• Management bust have a bank account to pay expenses such as

- Rent due each month- Leasing costs for the company car- Monthly phone bill and internet service- Wages of staff paid fortnightly

• The financial manager can draw up a budget to anticipate how much cash the business needs to pay expenses- A budget is a tool to evaluate the performance of a business by comparing actual and

planned results- They are drawn as spreadsheets to illustrate changes in data overtime

• Businesses must be liquid to avoid going bankrupt• Keeping records of cash flow will allow you to know how much cash you have, but doesn’t

tell you the debts you owe or debts others have for you

Cash flow statements• Provides the business about its cash flows and outflows over a period of time to identify

periods when the business may experience liquidity problems• Information is used to pay its debts on time• By using budgets to identify these periods, cash can be managed to ensure that there will be

enough on hand when required in the future• Summarises how the business will pay for short-term liabilities from sales of inventory• Managers can avoid cash shortage by planning ahead• Can predict where cash will be needed and retain cash from periods when inflow is higher,

this avoids the need for more debt• The management strategies include distribution of payments, discounts for early payments

and factoringDistribution of payments• This is distributing payments throughout the month, year or other periods so cash shortfalls

do not occur, instead of doing so at the same time• Insurance companies often offer the choice of paying insurance premiums monthly instead

of yearly• The business can also stretch its accounts payable by paying liabilities and expenses on the

last possible due date, to keep the money in the business bank account for as long it can• Prepay expenses such as rent or interest, when it has the cash to avoid problems arising

from non-payment at a later time


• Leasing new equipment and expensive technology will distribute cost evenly over the term of the lease asset

Discounts for early payment• This is offering creditors a discount for early payments• This strategy is effective when targeted at creditors who owe the largest amounts over the

financial year period• May also affect the cash flow statusFactoring• This is the selling of accounts receivable for a discounted price to a finance or specialist

factoring company• Business saves cost involved in following up on unpaid accounts and debt collectionWorking capital management• This is the current asset used in the day-to-day running of a business• It determines the best mix of current assets and liabilities to achieve the business’ objectives• The working capital ratio shows if current assets can cover liabilities – that is, a business can

determine whether it can pay its immediate debts• The business needs to ensure that payments are received on goods it has sold on credit to

customers• Formula: net working capital = current assets – current liabilities• Working capital ratio = current assets ÷ current liabilities

Control of current assets• This refers to the management process that determines the optimal amount of each current

asset held, as well as funding finance for the asset• Cash

- Money in the hands of the company and ensures business can repay its debts, loans and accounts in the short term

- The most liquid current asset- Makes sure business survives in long term- Enables business to take advantage of investment opportunities- Can increase amount by sale and leaseback (selling non-current assets)

• Receivables- Sums of money due to a business from customers to whom it has supplied goods and

services- Business must monitor its accounts receivables and ensure their timing allows the

business to maintain adequate cash resources- The quicker the debtors pay the better the firm’s cash position- Procedures for managing accounts receivables:

o Checking the credit rating of prospective customerso Sending customers’ statements monthly and at the same time each month so

that debtors know when to expect accountso Following up on accounts that are not paid by the due dateo Stipulating a reasonable period, usually 30 days, for the payment of accounts


o Putting policies in place for collecting bad debts- The disadvantage for operating a tight credit policy is customers switching firms

• Inventories- This is the total amount of goods/materials in the business e.g. raw, work in progress

and finished- Goods must be monitored and protected otherwise the business will lose money and to

remain solvent- Methods include

o Physical inspections and countso Securityo Limiting staff access

- Too much/slow movement, cash shortage. Insufficient/too quick, loss of customers/sales

Control of current liabilities• Current liabilities refer to the financial commitments that must be paid by a business in the

short term- Payables

o Money the business owes to its suppliers (creditors)o The number of days given to repay loans will depend on the credit rating

(assessment of business’ ability to repay loans)o Business should pay its invoices on the last day they are due, thus keeping the

money as long as possibleo Control of accounts payable involves periodic reviews of suppliers, and the

credit facilities they provide such as discounts, interest free periods, extended terms of payments

- Loanso Sums of money that are borrowed from financial institutions for the purpose of

funding things such as purchases of property and equipmento These loans can either be short term or long termo Business should compare others loans to find the most appropriate and efficient

source- Overdrafts

o A relatively cheap and convenient form of short-term borrowingo The main objective is to allow a business cover temporary cash shortageso Can control it by ensuring all cash is promptly deposited in business’ account to

reduce the amount owingStrategies• Leasing

- It is the hiring of an asset from another person/company who has purchased the asset and retains ownership of it

- Leasing ‘frees up’ cash and can use it in other aspects of the business, level of working capital is improved

- Regular and fixed payments are needed• Sales and leasebacks

- Selling of an owned asset to a lessor and leasing the asset back through fixed payments for a specified number of years

- Increases liquidity because the cash that is obtained from sales is used as working capital

Profitability management• Involves control of both the business’ costs and revenues• Accurate and up-to-date financial data and reports are essential tools for effective

profitability management


• A good accounting and financial system has effective controls to ensure the business- Does not overspend- Does not lose assets- Records financial records and transactions correctly

Cost controlFixed and variable costs• Business can reduce costs in labour and inputs• Outsourcing of non-core functions e.g. call centres to handle inquiries, hiring specialist to

handle payrolls• Fixed costs, do not change when a business produces more goods e.g. salaries, rents, lease

payments• Variable costs do vary as output and sales change e.g. employee wages and overtime

payments and advertising• Strategies to cut variable costs

- Negotiating discounts with all suppliers- Reducing the number of suppliers- Switching to a cheaper supplier

Cost centres• The expenses associated with each key business function• Set up for each division to account for the expenses/costs involved in the function they

perform• May provide them with a budget and monitor their expenses to minimise waste and achieve

maximum use of resources• Manager can take the total cost of making and supplying a good and calculate the percentage

contribution of each cost centreExpense minimisation• Profits can be weakened if the expenses of a business are high as they consume valuable

resources of a business• Guidelines and policies should be established to encourage staff to minimise expenses

where possibleRevenue controlsMarketing objectives• Sales objectives must be pitched at a level of sales that will cover costs, both fixed and

variable, and result in profit• A cost-volume-profit analysis can determine the level of revenue sufficient for a business to

cover its fixed and variable costs to breakeven• A sales budget (predicted future sales for the year) is used to predict future sales of the

business based on patterns of sales in previous years, economic conditions• Sales mix is the strategy used to sell the range of products a business supplies. It is a report

can be used to identify which method of promotion works bestGlobal financial management• The financial management of a global business shares many of the same issues as a domestic

business• However, when a commercial transaction involves businesses from two different countries,

a number of issues become important- Currency exchange/exchange rates- Interest rates- Methods of payment- Hedging- Derivatives

Exchange rates• An exchange rate is the value of country’s currency in terms of another• Currency rate fluctuations are a significant influence on the profitability and financial


stability of global businesses. Change when businesses exchange money or buy finished products overseas

• When costs and revenues are transferred between nations the exchange rate can further increase or decrease the value of the net profit

Floating exchange rates• This means that the exchange rate changes depending on market forces• When the value of a currency increases the currency is said to have appreciated (worth

more)• When the value of a currency decreases the currency is said to have depreciated (worth

less)Effects of changes• If the Australia dollar appreciates the effect is that the goods we sell overseas (exports)

become more expensive, and goods coming into Australia (imports) become cheaper• This movement has a significant effect on business costs, and revenues and therefore,

profitability• If the Australian dollar falls in value, or depreciates, our exports become cheaper and

imports become more expensive – again affecting profitability• Exports – the people outside of the country purchase these. Imports – the stuff we buy

overseas• For tourism based businesses, a low Australian dollar means more international tourists

visiting Australia. A high dollar – Australians travel overseas• Although this in effect will make Australia’s global competition decrease making a deficit in

the economyWhat to do?• A business needs to come up with strategies to ensure that the amount of money it receives

or pays is not affected by currency fluctuations. These include the use of hedging and derivatives

Interest rates price of money- what we earn• A global business can borrow from financial markets in other countries and will aim to

borrow at the cheapest price• However, there is an exchange rate risk that needs to be considered• If the value of the AUD depreciates then interest repayments increase because it costs more

AUD to obtain the same amount of foreign currency to repay loan and interestMethods of international payment• Business, global businesses rely on appropriate and efficient payment for the goods and

services sold• Customer, the importer needs to know how to pay for goods quickly and easily, but also

requires confidence/guarantee that will actually receive the productMethods of payment• Payment system is crucial to the success of a global business• For a global business/customer the payment is complicated y

- Invisibility of customer- Language barriers- Difference in monetary system

• Thus, neither party completely trusts the other, due to apprehension created by the above factors. This creates the need for a third party (e.g. Banks, Financial Intermediaries)

Payment in Advance• Allows the exporter to receive the payment and then arrange for the goods to be sent• This method exposes the exporter to virtually no risk• Unfortunately, very few importers accept these terms, therefore to be competitive firms

must offer a range of methodsLetter of Credit• Is commitment by the importers bank• The bank promises to pay the exporter a specified amount when the documents proving


shipment of goods are received• Once the bank has made a commitment, it cannot be withdrawnClean payment• Easiest and quickest method• Occurs the payment is sent to, but not received by, the exporter before the goods are

transported. Requires total trust!• Risk to the exporter is minimal, and preferred by themBill of exchange• A document drawn up by the exporter demanding payment from the importer at a specified

time• Most widely used by exporters to maintain control over the goods until payment is made or

guaranteed• Two types:

- Document (Bill) against paymento The exporter draws up a bill of exchange with an Australian bank and send it

through to the importers bank, along with documents to collect the goodso The importers bank then transfers the funds to the exporters banko Risk is that the importer may delay or not pick up the documents/pay for the

goods- Document (bill) against acceptance

o The importer may collect the goods before paying for themo The same process as previously explained, except the importer must sign only

acceptance of the goods and the terms of the bill to receive the documents that allow them to pay for the goods at a later date

o The risk is that importers may delay paymentOpen credit• Allows the importer access to the goods with the promise to repay at a later date• This exposes the exporter to the greatest amount of risk as the exporter is totally reliant on

the importers willingness to payWhich is best??• The option selected will depend on the business’s assessment of the importers ability to pay

– i.e. the importers creditworthinessHedging• Two parties agree to exchange currency and finalise a deal immediately, the transaction is

referred to as spot exchange (immediate)• The spot exchange rate is the value of one currency in another currency on a particular day• Spot rates are not always desirable for firms• Firms can reduce the risk of currency fluctuations/risks using hedging• Any strategy or financial tool used to reduce the risk of loss resulting from financial

transactions such as converting one currency to another• This is where the business provides itself with a set of circumstances which helps to avoid

currency fluctuations- Establishes offshore subsidiaries (any profit, or any appreciation/depreciation made

overseas won’t impact the business as it is to themselves )- Arranging for import and export payments denominated in the same currency. Any

losses are offset by gains- Insisting on both import and export contracts denominated in Australian dollars.

Transfers risk to the buyer (importer)Derivatives• Financial products called derivatives, that can be used to minimise risk of exchange rate

fluctuations• A derivative is an agreement between two people or parties (biz) that has a value

determined by the price of something else (called the underlying)


• It is a financial contract with a value linked to the expected future price movements of the asset it is linked to – such as a share or a currency

acehsc · web viewassist in mergers and takeovers. provide advice, arrange finance a business may...

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