Finance Notes (1).docx

Finance Finance refers to how a business funds its activities — where it gets the money to trade, why it chooses to use certain lenders — as well as the costs, risks, terms and benefits of different types of borrowing. Financial Management refers to the planning, organising and controlling of the financial resources of a business to achieve the goals of the business.

1. Role of financial management 1.1 Strategic Role of financial management The strategic role of financial management is to provide the financial resources to allow the implementation of the businesses strategic plan. This may include:  Setting financial objectives + ensuring the business achieves goals  Sourcing finance  Preparing budgets + financial statements  Maintaining sufficient cash flow  Distributing funds to other business areas Financial management: The analysis, interpretation and evaluation of a business’s financial records 1.2 Objectives of financial management Objectives refer to what the business wants to achieve (goals). 1.2.1 Main Goals

Profitability  

Profitability is the ability of a business to maximise its profits To ensure that profit is maximised, a business must carefully monitor its revenue and pricing policies, costs and expenses, inventory levels and levels of assets.

Growth  

Growth is the ability of the business to increase its size in the longer term. Growth of a business depends on its ability to develop and use its asset structure to increase sales, profits and market share.

Efficiency  

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. Achieving efficiency requires a firm to have control measures in place to monitor assets.

Liquidity  

Liquidity is the ability of a business to pay its debts as they fall due. A business must have sufficient cash flow to meet its financial obligations or can convert current assets into cash quickly; for example, by selling inventory. The quicker an asset can be turned into an asset the more liquid it is

Solvency  

Solvency is the extent to which the business can meet its financial commitments in the longer term. Indicates whether a business will be able to repay finance borrowed for investments in capital (noncurrent assets). Important to shareholders, owners and creditors of a business as it indicates risk to investments.

1.2.2 Short term and Long term

Short Term 

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Short-term financial objectives are the tactical (one to two years) and 
 operational (day-today) plans of a business. Need to be reviewed regularly to see if targets are being met and resources are being used to the best advantage. For example, if management has a goal to achieve a 15 per cent increase in profit for the next 10 years, the tactical plans might involve purchasing additional machinery, updating old equipment with new technologies, expanding into new markets and providing new services. 


Long Term 

Long-term financial objectives are the strategic plans of a business. They are determined for a set period of time, generally more than five years. They tend to be broad goals such as increasing profit or market share, and each will require a series of short-term goals to assist in its achievement. The business would review their progress annually to determine if changes need to be implemented. 


Conflicts can occur between short-term and long-term objectives eg. Long-term maybe be growth which is costly, while a short-term goal may be to increase profits and these contradict each other.

1.3 Interdependence with other key business functions Interdependence refers to all key functions working together to achieve the businesses goals. - Operations: provides funds for transformation process. Operations need to design and develop future models based on funds allocated for R&D and production - Human Resources: provides funds for wages and retraining. Consider costs of replacing dissatisfied staff eg recruitment and training - Marketing: provides funds for promotion, therefore increasing sales and thus returning to available finance. Provide various secondary market research data such as sales analysis, to determine future marketing strategies Qantas ● Operations: ○ Finance funds the purchasing of new planes - $1.9B spent in 2013-2014 ○ Budgets raised through fleet renewals ● Marketing: ○ Finance funds new check-in facilities, new carriers flying to China, budget plans (Jetstar) + marketing → market share + profitability ● HR: ○ Finance funds staff (monetary + non-monetary), T&D ○ $275M spent on training per year Financial decisions impact staff levels, outsourcing, new airline launches + cutting of flights

2. Influences on financial management 2.1 Internal sources of finance – retained profits  

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Internal finance comes either from the business’s owners (equity or capital) or from the outcomes of business activities (retained profits) Owners’ equity is the funds contributed by owners or partners to establish and build the business. Equity capital can be raised in other ways; for example, by taking on another partner or seeking funds from an investor who then becomes an owner or shareholder, selling off any unproductive assets or through the issuing of private shares. The most common source of internal finance is retained earnings or profits in which all profits are not distributed, but are kept in the business as a cheap and accessible source of finance for future activities. Most businesses keep some of their profit in the form of retained earnings.

2.2 External sources of finance External finance refers to the funds provided by sources outside the business, including banks, other financial institutions, government, suppliers or financial intermediaries. Finance provided from external sources through creditors or lenders is known as debt finance.

Debt Short Term Borrowing Short-term borrowing is provided by financial institutions through bank overdrafts, commercial bills and bank loans. This type of borrowing is used to finance temporary shortages in cash flow or finance for working capital. Short-term borrowing generally refers to those funds that will be repaid within one or two years.

Bank Overdraft With a bank overdraft, the bank allows a business or individual to overdraw their account up to an agreed limit and for a specified time, to help overcome a temporary cash shortfall. Bank overdrafts assist businesses with short-term liquidity problems, for example a seasonal decrease in sales. Costs for bank overdrafts are minimal, and interest rates are lower than on other forms of borrowing.

Commercial Bills Commercial bills are a type of bill of exchange (loan) issued by institutions other than banks and are given for larger amounts, usually over $100 000 for a period of between 90 and 180 days. The borrower receives the money immediately and promises to pay the sum of money and interest at a future time. They are called ‘commercial’ to indicate they are issued by non-bank financial institutions. Commercial bills play a significant role in Australia’s financial markets, with bills of exchange forming an important segment of the short-term money market.

Factoring Factoring is the selling of accounts receivable for a discounted price to a finance or factoring company. It enables a business to raise funds immediately by selling accounts receivable at a discount to a firm that specialises in collecting accounts receivable (a finance or factoring business). Factoring is an important source of short-term finance because the business will receive up to 90 per cent of the amount of receivables within 48 hours of submitting its invoices to the factoring company. Factoring involves greater risk than other sources of short-term borrowing such as bank overdrafts and commercial bills because of the likelihood of unpaid debts.

Long Term Borrowing Long-term borrowing relates to funds borrowed for periods longer than two years. It can be secured or unsecured, and interest rates are usually variable. It is used to finance real estate, plant (factory/office) and equipment. Long-term borrowing includes mortgages and debentures.

Mortgage A mortgage is a loan secured by the property of the borrower (business). The property that is mortgaged cannot be sold or used as security for further borrowing until the mortgage is repaid. Mortgage loans are used to finance property purchases, such as new premises, a factory or office. They are repaid, usually through regular repayments, over an agreed period such as 15 years.

Debentures Debentures are issued by a company for a fixed rate of interest and for a fixed period of time. Debentures are usually not secured to specific property. Companies that borrow offer security to the lender usually over the company’s assets. On maturity, the company repays the amount of the debenture by buying back the debenture. The amount of profit made by a company has no effect on the rate of interest because debentures carry a fixed rate of interest. Finance companies raise much of their funds through debenture issues to the public.

Unsecured Notes An unsecured note is a loan from an investor for a set period of time but is not backed by any collateral or assets, and therefore presents the most risk to the investors in the note (the lender). For this reason, it attracts a higher rate of interest than a secured note. Companies sell unsecured notes to generate money for their initiatives such as share repurchases and acquisitions.

Leasing Leasing is usually a long-term source of borrowing for businesses. It involves the payment of money for the use of equipment that is owned by another party. The lessee uses the equipment and the lessor owns and leases the equipment for an agreed period of time.

Equity Equity refers to the finance (cash) raised by a company by issuing shares to the public for purchase through the Australian Securities Exchange (ASX). This is used as an alternative to debt funding. 


Ordinary Shares Ordinary shares are the most commonly traded shares in Australia. The purchase of ordinary shares by individuals means they have become part- owners of a publicly listed company and may receive payments called dividends. The value of the share is determined by a company’s current or future performance. 
 The following terms refer to variations in the type or issue of ordinary shares: New issue – A security that has been issued and sold for the first time on a public market; sometimes referred to as primary shares or new offerings 
 Rights issue – The privilege granted to shareholders to buy new shares in the 
 same company Placements – Allotment of shares, debentures, and so on made directly from the company to investors 
 Share purchase plan – An offer to existing shareholders in a listed company the opportunity to purchase more shares in that company without brokerage fees. The shares can also be offered at a discount to the current market price. 


Private Equity Private equity is the money invested in a (private) company not listed on the Australian Securities Exchange (ASX). The aim of the private company (like the publicly listed companies who sell ordinary shares) is to raise capital to finance future expansion/investment of the business.

2.3 Financial Institutions Banks Take deposits from the public then loan out those funds to individuals and businesses at higher interest rates. Offer variety of financial services eg. Online banking, credit cards, overdrafts and loans.

Investment Banks Provide services in borrowing and lending primarily to business sector. Have variety of different loans thus most customizable to suit business’s needs. Can also arrange overseas finance.

Finance Companies & Life Insurance companies Finance and life insurance companies are non-bank financial intermediaries that specialise in smaller commercial finance. These companies are regulated by the Australian Prudential Regulation Authority (APRA). Life insurance raise funds through selling insurance and then lending received money to businesses at high interest rates.

Superannuation Funds Percentage of employee’s wage that helps build investment for retirement. Superannuation companies can use contributions to provide finance to businesses.

Unit Trusts A unit trust is a form of collective investment in which a large number of investors contribute funds. Money is then put together and invested into financial assets by trustee.

The Australian Securities Exchange The Australian Securities Exchange (ASX) is the primary stock exchange group in Australia. Enables companies to raise sales through issues of shares and operates as a secondary market where preowned shares are traded between investors.

2.4 Influence of government Economic policies such as those relating to monetary (interest rates) and fiscal (taxation) policy, legislation and the various roles of government bodies or department who are responsible for monitoring and administration.

Australian Securities and Investments Commission -

They are accountable to the Commonwealth parliament and are an independent statutory commission. They enforce the Corporations Act (2011) and protects consumer in the areas of investments, life and general insurance, superannuation and banking (not lending) in Australia. Aim to reduce fraud and unfair practices in financial markets & products Collects information on companies and makes it available to the public (includes the information that companies must disclose in their annual report) Failure to comply with the Corporations Act generates negative publicity for business

Company Taxation -

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Companies pay tax on profits at a rate of 30% (small to medium business has been reduced to 27.5%) Company tax is paid before dividends are distributed to shareholders Australian government has undertaken a process of reform of the federal tax system that will improve competitiveness of Australian internationally making it attractive to invest and improving the economic growth  more jobs and higher wages Tax in 2000-2001 was reduced from 36% to 34% and then again to 30% in 2002

2.5 Global Market Influences

Economic Outlook This refers to the projected changes in the level of economic growth (globally). If the outlook is positive there will be: - An increase of demand for products/services, requiring an increase of production and therefore funds (equipment, staff or expansion of premise) - A decrease of interest rates on funds borrowed internationally because of the decrease of risk associated with repayments (as sales increase profits increase) - However, increase of demand can cause interest rates to rise sometimes Poor economic outlook has the opposite effect.

Availability of funds The availability of funds refers to the ease with which a business can access funds (for borrowing) on the international financial markets. Conditions and rates that apply to borrowed funds depends on the amount of risk, level of supply and demand, and domestic economic conditions.

Interest Rates Interest rates are the cost of borrowing money. The higher the level of risk involved in lending to a business, the higher the interest rates. 
 Australian rates tend to be above international rates, causing some businesses to borrow overseas. However, the fluctuations of the exchange rate can see the advantage of international interest rates be eliminated.

3. Processes of financial management 3.1 Planning and Implementing Financial planning determines how a business’s goals will be achieved. Begins with long-term (2-10 years) or strategic financial plans, includes a business planned capital expenditure (what is spent on a business’s noncurrent assets or fixed assets and is used to generate revenue) and/or planned investments, planned sources of finance, spending on R&D, marketing and product development activities. Short-term (up to 2 years) plans are more specific.

Financial Needs ● ● ● ●

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Must know needs to determine business direction Financial information must be collected Financial position determined by balance sheets, income + cash flow statements Financial needs of a business are determined by: ○ Business size ○ Current phase of BLC ○ Future plans of growth + development To plan effectively, businesses must know their needs + the financial position ○ Must consider all costs faced by the business over period of time ○ Must review how much the business will make during that time Determining financial needs ensures businesses can meet short term liabilities + the strategic goals Business plans outline required finance, proposed sources of finance + range of financial statements

Budgets ● Budgets: provide information in quantitative terms regarding the requirements to achieve a particular purpose ● A forecast of expected future results ● Plan expected costs + revenues of business activities over time ● Vital for planning + implementing financial goals Budgets allow managers to: ● Plan effectively for the future - identify potential threats + problems ● Monitor + control implementation of financial plans ● Impose discipline in implementing financial plans Types of budgets: Operating budgets: relate to the main activities of a business. Can include budgets relating to sales, production, expenses + COGS Project budgets: Relate to capital expenditure, + research + development. Include information about the purpose of asset purpose, lifespan of an asset + revenue the asset would generate Financial budgets: financial data of a business. Predictions of the operating + project budgets are included. Include income statements, balance sheets + cash flow statements.

Cash flow shows liquidity, Income statement + balance sheet shows results of operating activities.

Record Systems ● Mechanisms/systems used by a business to ensure data is recorded + the provided information is accurate, reliable + accessible ● Management bases decisions on this information when needed ● Double entry system ensures errors are found quickly ○ Recording all items twice to see if the entries balance ● Systems should be consistent with up to date + well organised information available ● Financial data includes invoices, payments + wages

Financial Risks Financial risk is the risk to a business of being unable to cover its financial obligations, such as the debts that a business incurs through borrowings, both short term and longer term. If the business is unable to meet its financial obligations, bankruptcy will result. Consideration must be given to amount of funds that need to be repaid, the terms (interest rates) and level of current assets that are essential for Operations.

Financial Controls Financial controls are the policies and procedures that ensure that the plans of a business will be achieved in the most efficient way. Includes budgeting (Assists with estimating resource needs) and variance reporting (shows differences between budgeted and actual performance) Common causes of financial problems: theft, fraud, loss of assets + errors in record systems ● Controls are designed to ensure they can be followed by management + employees ● Common policies promoting control: ○ Clear authorisation + responsibility for tasks ○ Separation of duties ○ Rotation of duties ○ Control of cash ● Budgets are a form of financial control

3.1.1 Debt and equity financing – advantages and disadvantages

Debt Finance Advantages

Disadvantages

● Funds are usually readily available ● Tax deduction for interest payments ● Increased funds should lead to increased earnings and profits ● Funds are readily available at short notice ● Interest payments are tax deductible ● Flexible payment periods + types of available debt ● Does not dilute current ownership

● Increased risk if debt comes from financial institutions because the interest, bank charges, government charges and the principal must be repaid ● Security is required by the business ● Lenders have first claim on any money if the business ends in bankruptcy ● Regular repayments must be made ● Can be expensive

Equity Finance Advantages

Disadvantages

● Doesn’t need to be repaid until owners leave business ● Cheaper as no interest ● Owners who contributed equity retain control over how it’s used ● Low gearing (more equity than debt finance)

● Lower profits and lower returns for the owner ● The expectation that the owner will have about the return on investment (ROI) ● Expectation the owner will have a return on investment ● Ownership is diluted ● Long, expensive process to obtain funds

3.1.2 Matching the terms and source of finance to business purpose Finance should be appropriate to its use and is influenced by: ● Terms of finance: must be suitable structure e.g. short term finance for short term needs ● Cost of each source funding: Required rate of return that can be expected needs to be considered and balanced against cost of each source ● Structure of business: Small businesses have fewer opportunities for equity capital than larger businesses. Public businesses can sell shares to raise equity ● Costs: Set up costs and interest rates. Costs can fluctuate depending on market and economic conditions

● Flexibility of source of funding: Funds to be variable so that if firm have excess funds, borrowings can be paid of faster. Overdrafts provide greater flexibility ● Availability of finance: Heavy dependence on a few investors can increase risk ● Level of control: If lender requires security over an asset and other conditions of lending are needed, it limits financing possibilities for the future. ● Using short-term finance to fund long-term finance → financial problems ● Using long-term finance to fund short-term finance → businesses continuing to pay the mortgage after the situation has resolved → reduced profits

3.2 Monitoring and Controlling Inconsistent methods and review systems of control will impact the viability of the business and requires management to monitor the internal (internal production methods) and external (changes to economic outlook or workplace laws) factors that will impact the businesses operations. Main financial controls used for monitoring include:

Cash flow Statement A cash flow statement is a financial statement that indicates the movement of cash receipts and cash payments resulting from transactions over a period of time. A cash flow statement is one of the key financial reports that are part of effective financial planning. It provides the link between the income statement and balance sheet, as it gives important information regarding a firm’s ability to pay its debts on time.

Income Statement – revenue statement / profit and loss statement The income statement shows the operating results for a period. It shows the revenue earned and expenses incurred over the accounting period with the resultant profit or loss. The income statement shows the operating efficiency — that is, income earned and expenses incurred over the accounting period with the resultant profit or loss. Income is the earnings from the main objectives of the business. Expenses are recurring amounts that are paid out while the business earns its revenue.

COGS = Opening stock + purchases - closing stock Gross profit = sales revenue - COGS Net profit = gross profit - expenses

Balance Sheet A balance sheet represents a business’s assets and liabilities at a particular point in time and represents the net worth (equity) of the business. It shows the financial stability of the business. The balance sheet is prepared at the end of the accounting period. The balance sheet shows the level of current and non-current assets, current and non-current liabilities, including investments and owners’ equity.  

Assets represent what is owned by a business. 
 Liabilities are claims by people other than owners against assets, and represent what

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is owed by the business. 
 Owners’ equity represents the owners’ financial interest in the business or net worth of the business.

3.3 Financial Ratios Financial Ratios are tools used to analyse and interpret the financial statements. Ratio analysis can be used in two ways:  

To compare the performance of a business with other businesses in the industry (its competitors) at the same time To compare the performance of the business over time

Analysis of financial statements is usually aimed at the areas of:   

Financial Stability (i.e. liquidity and gearing) Profitability Efficiency

3.3.1 Liquidity – current ratio (current assets ÷ current liabilities) 

Liquidity refers to the ability of a business to pay its short-term debts as they fall due (this usually refers to a period less than 12 months)

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One of the most common liquidity ratios is the current ration (or working capital ratio). The current ratio measures the level of current assets available to meet a business’s current liabilities – the ability of a business to pay its short term debts.

A ratio of 2:1 means that for every $1 of short term debt the business has $2 of short term assets to meet the debt. It is generally accept that a ratio of 2:1 indicates a sound financial position for a firm. That is, the firm should have double the amount of assets to cover its liabilities. Current Ratio = Current assets ÷ Current liabilities

3.3.2 Gearing – debt to equity ratio (current liabilities ÷ total equity) 

Gearing is a measure of the long term financial stability of a business. Gearing ratios determine the firm’s solvency – that is, its ability to meet its financial commitments in the longer term. Potential investors and creditors are interested in gearing ratios, as they show whether the creditors will be paid or whether investors can expect a good return on their money.

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Gearing measures the relationship between debt and equity. Gearing is the proportion of debt (external finance) and the proportion of equity (internal finance) that is used to finance the activities of a business. Debt-to-equity ratio = (total liabilities ÷ total equity)

Generally, anything less than 60% is regarded as ‘satisfactorily geared’. Higher levels of gearing are regarded as ‘highly geared’. A ratio of 1:1 indicates a sound financial position

3.3.3 Profitability 

Profitability is the earning performance of the business

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Profitability depends on the revenue earned by a business and the ability of the business to increase selling prices to cover purchase costs and other expenses incurred in earning income

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The income statement is used to measure the profitability or earning capacity of the firm. Figures from the income statement are used to calculate gross profit and net profit ratios.

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Gross profit ratio (gross profit ÷ sales)

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Gross profit is the difference between the value of sales revenue and the cost of goods sold

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The gross profit ratio (GPR) calculates for every $1 of sales how much gross profit the business makes after paying for the cost of goods sold

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The ratio represents the profit margin between the wholescale cost of the firm’s inventory and the price the business sells it for

Gross profit ratio = gross profit ÷ sales

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Net profit ratio (net profit ÷ sales)

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Net profit is the difference between gross profit and expenses

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Net profit represents the profit or return to the owners

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For sole traders and partnerships, this represents a return for both their contribution to the firm in terms of labour and on the funds, they have contributed to the business.

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The net profit ratio shows the amount of sales revenue that results in net profit. The cost or expenses after gross profit must be low enough to generate a profit.

Net profit ratio = net profit ÷ sales

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Return on equity ratio (net profit ÷ total equity)

Return on owners’ equity measures how much the owners will ear per dollar of investment. The return on equity ratio shoes how effective the funds contributed by the owners have been in generating profit, and hence a return on their investment. The return for owners must be better than any return that could be gained from alternative investments, such as bank investments.

Return on equity ratio = net profit ÷ total equity

3.3.4 Efficiency 

Efficiency is how well something is done. It is the ability of the firm to use its resources effectively in ensuring financial stability and profitability of the business

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A business improves it efficiency when it gets more output from a given amount of inputs

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Improved efficiency can improve a business’s competitive advantage

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Expense ratio (total expenses ÷ sales)

The expense ratio relates sales to the expenses incurred in making the sales Expense ratio = total expenses ÷ sales

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Accounts receivable turnover ratio (sales ÷ accounts receivable)

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The accounts receivable turnover ratio tells the business how many days, on average it takes to collect accounts receivable.

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Accounts receivable turnover ratio measure the effectiveness of a firm’s credit policy and how efficiently it collects its debts

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It measures how many times the accounts receivable balance is converted into cash or how quickly debtors pay their accounts

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By dividing the ratio into 365, businesses can determine the average length it takes to convert the balance into cash. Accounts receivable turnover ratio = sales ÷ accounts receivable Divide the result of this equation by the number of days in a year, i.e. 365

Liquidity Current Ratio Measures the level of current assets available to meet a business’s current liabilities – the ability of a business to meet its short-term debt

Current Assets -------------------------Current Liabilities

Gearing (Solvency) Debt-to-equity ratio The relationship between long-term funds provided by creditors and those provided by the business’s owners

Total Liabilities ---------------------Owners’ Equity

Profitability Gross Profit ratio The difference between the value of sales revenue and the cost of goods sold

Net Profit ratio Represent the profit and return to the owners. The difference between gross profit and expenses Return on Equity Shows how effective the funds contributed by the owners have been in generating profit. Measures how much they will earn per dollar of investment

Gross Profit -----------------Sales

Net Profit ----------------Sales

Net Profit --------------Total Equity

Efficiency Expense ratio Relates sales to the expenses incurred in making the sales

Accounts Receivable Turnover ratio Tells the business how many days, on average it takes to collect accounts receivable

Total expenses ---------------------Sales

Sales 360 ÷ ------------------------------Accounts Receivable

3.3.5 Comparative ratio analysis - Over different time periods, against standards, with similar businesses Judgements are made by comparing a business’s analysis against other figures, percentages and ratios from a different time period, against a standard or a similar business - Over different time period: Identify tends in profit, costs and financial stability. Determine if it reaching main financial goals. - Against Standards: A standard/benchmark is the result that the business is aiming for in its objectives, may be global standards and thus shows how the business compares against the best in the world. - With similar businesses: Compare results with businesses in the same industry (industry average) and see whether business is above or below average.

3.4 Limitations of financial reports – normalised earnings, capitalising expenses, valuing assets, timing issues, debt repayments, notes to the financial statements Issue Normalised Earnings

Description ●

● ● Capitalising expenses

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● ● Valuing assets

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Normalised earnings: Earnings that have been adjusted to take into account economic boom and bust periods or unusual influences that will impact profitability Gives a more accurate depiction of the company’s true earnings Therefore easier to compare profitability figures against other businesses Capitalising expenses: Accounting method where expenses are recorded as an asset on the balance sheet instead of an expense on the income statement Doesn’t accurately represent the business’s financial position understates expenses + overstates profits and assets E.g. R&D Valuing asses: The process of estimating the value of assets when recording them on a balance sheet Difficult to estimate Can be written as a historical cost ○ Historical cost: Accounting method where assets are listed on a balance sheet at its purchase value ○ Advantage: Costs can be verified ○ Disadvantage: Value may distort the business’s balance sheet → inaccurate representation of assets ○ Original cost may differ from its current market value Some non-current assets increase in value over time (i.e. land) or may depreciate over time (i.e. cars) Businesses have to estimate how much value depreciating items lose each year ○ Businesses can choose to calculate depreciation from several methods - may mislead investors ○ Depreciation rate is an estimate which may give a false

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Timing Issue

Debt repayments

Financial reports cover activities over a period of time, usually one year. Therefore, the business’s financial position may not be a true representation if the business has experienced seasonal fluctuations. As financial reporting is done in periods (quarterly, half yearly and yearly) it is possible to distort the current financial position of a business by holding off on a large expense or revenue as it doesn’t show up in the current account period and may reduce taxable profits ● ●

● ● Notes to the financial statement

impression regarding business worth Difficult to value some assets ○ Intangible items are assets sometimes not included on balance sheets - difficult to value ○ Businesses may overvalue them if placed on a balance sheet to make a business appear more financially stable

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Debt repayments: The money owed to the business or owed by the business Financial reports can be limited - don’t have the capacity to disclose specific information about debt repayment such as: ○ How long the business has had or has been recovering debt ○ Methods used in the recovery of debt ○ Have debt repayments been held over until another account period → false impression of situation? ○ When debts are due Firms can either set aside funds to provide for liabilities or roll over debt finance → delayed repayments Recording of debt repayments can distort the ‘reality’ of the business’s status Reports the details + additional information left out of the main reporting documents Contain information that may be useful to stakeholders to help them determine + explain financial situations May include details about how financial statement figures were calculated

3.5 Ethical issues related to financial reports Managers and accountants have an ethical and legal obligation to ensure financial records are accurate. Generally, financial management decisions must reflect the objectives of a business and the interests of owners and shareholders. Ethical considerations are closely related to legal aspects of financial management. Legislation is in place to guard against unethical business activity. In relation to financial management, directors have a duty to: - Act in good faith - Exercise power for proper purpose - Exercise discretion reasonably and responsibly - Avoid conflicts of interest

Ethical Financial Report Practices -

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Audited Accounts: The audit is an independent check of the accuracy of financial records and accounting procedures. Users of this information include financial institutions, owners, shareholders and potential investors. Types of audits include o Internal audit - carried out by employees to check procedures and records o Management audit - conducted to review businesses strategic plan and determine if changes are needed o External audit - requirement of the Cooperation’s Act 2001, investigated by independent specialist to guarantee authenticity. They produce a statement stating that the records and procedures are accurate, give a fair and true state of affairs and they comply with Australian standards Record Keeping: All accounting processes depend on how accurately and honestly data is recorded in financial reports. Eg. Some businesses may accept cash payments and not record them, which lowers profits but lowers amount that is paid in tax (tax evasion) Goods and Services Tax (GST) Obligations: A stated purpose for the GST was to make it more difficult for businesses and individuals operating in the ‘Cash Economy’ to avoid tax. Businesses have ethical and legal obligation to comply with GST Reporting Practices: Shareholders in a private company ae legally entitled to receive financial reports annually, even if shareholders are family members in a small business. To pretend that profit is lower that it should be is attempting to defraud the Australian Taxation Office (ATO). Understating profit may make it more difficult to persuade those sources of finance to lend to the business. Understating profit or overstating the value of assets may prove counter-productive when a potential buyer subjects the reports to close inspection.

4. Financial management strategies 4.1 Cash flow management – cash flow statement Cash flow is the movement of cash in and out of a business over a period of time. Matching cash in to cash out is important. Cash flow records don’t show what debts you have or what is owed to you by others. Budgets is an important tool for managing cash flows. It can also identify trends and can be a useful predictor of change.

4.2 Management Strategies - Distribution of payments, discounts for early payments, factoring Management must implement strategies to ensure that cash is available to make payments when they are due — for example, to the Australian Taxation Office, suppliers for accounts payable, employees for wages, owners and shareholders for profits and dividends, banks and financial institutions for interest on loans or overdrafts, and leasing payments.

Distribution of payments An important strategy involves distributing payments throughout the month, year or other period so that cash shortfalls do not occur. A cash flow projection can assist in identifying periods of potential shortfalls and surpluses.

Discounts for early payment Another cash flow management strategy is offering creditors a discount for early payments. This strategy is most effective when targeted at those creditors who owe the largest amounts over the financial year period. This is not only beneficial for the creditors who can save money and therefore improve their cash flow, but it also positively affects the business’s cash flow status.

Factoring Factoring is the selling of accounts receivable for a discounted price to a finance or specialist factoring company. The business saves on the costs involved in following up on unpaid accounts and debt collection. Factoring is growing in popularity as a strategy to improve working capital.

4.2 Working capital management – Balance sheet Working capital is the funds available for the short-term financial commitments of a business. Net working capital is the difference between current assets and current liabilities. It represents those funds that are needed for the day-to-day operations of a business to produce profits and provide cash for short-term liquidity. Current assets are assets that
 a business can expect to convert into cash within 12 months. They usually include cash and accounts receivable. Current liabilities are liabilities that a business must repay within the short term. They usually include overdraft and accounts payable. Working Capital = Current Assets – Current Liabilities Working capital management involves determining the best mix of current assets and current liabilities needed to achieve the objectives of the business. Management must achieve a balance between using funds to create profits and holding sufficient funds to cover payments. The more efficient a business is in organising and using its working capital, the more effective and profitable it will be.

4.2.1 Control of current assets – cash, receivables and inventories Management of current assets is important for monitoring working capital. Control of current assets requires management to select the optimal amount of each current asset held, as well as raising the finance required to fund those assets. The costs and benefits of holding too much or too little of each asset must be assessed. Working capital must be sufficient to maintain liquidity and access to credit (overdraft) to meet unexpected and unforeseen circumstances.

Cash Cash ensures that debts repay loans and pay accounts can be paid in short term and that opportunities such as investments can be taken. Planning for the timing of cash receipts, cash payments and asset purchases avoids the situation of cash shortages or excess cash.

Receivables A business must monitor its accounts receivable and ensure that their timing allows the business to maintain adequate cash resources. Known as debtors, businesses should have a strong policy to ensure there are no lost sales. This can be done by sending reminders, removing option of credit to customers, offer incentives for early payment, factoring, setting a payment period and checking credit history. The disadvantage of operating a tight credit control policy is the possibility that customers might choose to buy from other firms. The costs and benefits must be weighed up carefully by management.

Inventories Businesses may have too much cash invested in their stock, the rate of inventory or stock turnover differs depending on the type of business e.g. a supermarket and car dealership. Stock can cost a lot in storage, reduce working capital. Methods for internal controlling includes physical inspections, security, correct storage, employing JIT. Computer inventory management can reduce stock misplaced or stolen as records are accurate.

4.2.2 Control of current liabilities – payables, loans and overdraft Current liabilities are financial commitments that must be paid by a business in the short term. Minimising the costs related to a firm’s current liabilities is an important part of the management of working capital. This involves being able to convert current assets into cash to ensure that the business’s creditors (accounts payable, bank loans or overdrafts) are paid.

Payables Payables are sums of money owed by the business to other businesses from whom it has purchased goods and services. Payables are recorded as accounts payable. Businesses can hold back on paying payables (stretching) to improve liquidity as some creditors allow a period of interest free trade credit. Businesses could also use discounts given for early payments. Accounts must be paid by final due date to avoid extra charges. Problems include too many bills to pay at once, more cash out than in and paying too early or too late on bills

Loans Short-term loans are important sources of short-term funding for businesses. Costs for establishment, interest rates and ongoing charges must be investigated and monitored to minimise cost. Short-term loans are generally an expensive form of borrowing for a business and their use should be minimised. Control of loans involves investigating alternative sources of funds from different banks and financial institutions. Positive, ongoing relationships with financial institutions ensure that the most appropriate short-term loan is used to meet the short-term financial commitments of the business.

Overdrafts Overdrafts allow businesses to overcome temporary cash shortages. Banks require regular repayments and may charge account keeping fees, establishment fees and interest. Bank charges need to be monitored as charges depend on type of overdraft used. Businesses must ensure that all cash received is promptly put into the businesses overdraft account to reduce amount owing.

4.2.3 Strategies – leasing, sale and lease back Businesses use a number of strategies to manage working capital, which is required to fund the day-to-day operations of a business.

Leasing Leasing is the hiring of an asset from another person or company who has purchased the asset and retains ownership of it. The start-up cost for leasing is significantly lower than purchasing, payments are usually tax deductible, business doesn’t pay for maintenance and it is easier to budget for lease payments as they are regular and stable.

Sale and lease back Sale and lease-back is the selling of an owned asset to a lessor and leasing the asset back through fixed payments for a specified number of years. Sale and lease-back increases a business’s liquidity because the cash that is obtained from the sale is then used as working capital.

4.3 Profitability Management – income statement (Revenue / P&L) Profitability management involves the control of both the business’s costs and its revenue. Accurate and up-to-date financial data and reports are essential tools for effective profitability management.

4.3.1 Cost Controls – fixed and variable, cost centres, expense minimisation Most business decisions — for example, to open a new store or buy a new piece of machinery — are influenced by costs. The costs associated with a decision need to be carefully examined before it is implemented.

Fixed and variable Fixed costs don’t change with an increase of production or sales e.g. Rent, salaries interest and loans. Variable costs do change with an increase of production of sales e.g. Wages, electricity and inputs costs, thus making them easier to control as there is more flexibility. A reduction in variable cost allows managers to increase profits or decrease prices and increases competitiveness of the business.

Cost centres Cost centres are areas, departments or sections of a business to which costs can be directly attributed. A work area/department/factory which has separate costs from the rest of the business and is monitored carefully (by a specific manager) thus any issues are picked up and fixed, reducing costs. Direct costs are those that can be allocated to a product. Direct costs are also called variable costs for example, depreciation of equipment used solely in the production of one good. Indirect costs are those that are shared by more than one product, activity, department or region. For example, the depreciation of equipment used to make several products would have indirect costs allocated on some equitable basis.

Expense minimisation Profits can be weakened if the expenses of a business are high, as they consume valuable resources within a business. Guidelines and policies should be established to encourage staff to minimise expenses where possible. Savings can be substantial if people eliminate waste and reduce expenses such as wages, rent and leasing payments to their absolute minimum. Cost centres are used to identify expenses contributing most to products

4.3.2 Revenue controls – marketing objectives Revenue is the income earned from the main activity of a business. For most businesses, revenue comes from sales or, in the case of a service business, from fees for professional services or commission. In determining an acceptable level of revenue with a view to maximising profits, a business must have clear ideas and policies, particularly about its marketing objectives including the sales objectives, sales mix or pricing policy.

Marketing objectives 

Sales objectives: The most important marketing objective is to continuously improve the processes that result in sales. If the business meets customers need better than its competitors, sales will improve.  Sales Mix: Refers to the breakdown of sales revenue by products (expressed in percentages). The sales mix can be the key to revenue and profit improvement.  Pricing Mix: Refers to the breakdown of products on the basis of their contribution to profitability Pricing Policy: A guide to staff on the overall pricing strategy that the business will use. Several factors can influence the pricing policy e.g. Demand and supply of products and competitors pricing. The policy will balance goals of revenue maximisation against profit maximisation.

4.4 Global financial management Global business brings extra concerns for financial managers — in particular, currency fluctuations/exchange rates, interest rates, methods of international payment, hedging and derivatives. Financial risks associated with global expansion are greater than those encountered domestically, but such risk taking is necessary for the business strategy to be implemented. Global business: Businesses open to increased influence from the external environment

4.4.1 Exchange Rates / Currency fluctuations In all global transactions, one currency must be converted to another through the foreign exchange rate (a ratio of one currency to another, tells you how much one currency is worth of another). Currency levels can either: - Appreciate: raises the value of the AUD, so foreign currency buys fewer AUD. Makes exports more expensive and imports cheaper. Reduces international competitiveness of Australian exporting business. - Depreciation: lowers price of the AUD, foreign currency buys more AUD. Exports become cheaper and imports more expensive. Improves international competitiveness

4.4.2 Interest Rates Australian interest rates tend to be higher than other countries which may tempt people to borrowing from overseas to gain advantage of lower interest rates. However, the exchange rate may mean the advantage of lower rates may be eliminated.

4.4.3 Methods of international payments The reasons for complicated payments may include dealing with someone they’ve never seen, speaks another language, uses a different currency or is difficult to deal with due to trust. Importers and exporters will use third parties (usually banks) to minimise tensions. Methods of payment include (In order of least to most risk for exporter) : 1. Payment in Advance: Money is transferred to exporter’s bank account before goods are shipped. The payment in advance method allows the exporter to receive payment and then arrange for the goods to be sent. 2. Letter of Credit: Importers bank guarantees that the arranged amount will be paid when the good arrive in importers warehouse. Bank is not taking any risk for nonpayment. Can cost a lot in bank fees. A letter of credit is a commitment by the importer’s bank, which promises to pay the exporter a specified amount when the documents proving shipment of the goods are presented. 3. Clean Payment: Goods are shipped before payment is received. Clean payment (remittance) occurs when the payment is sent to, but not received by, the exporter before the goods are transported. Such an arrangement requires complete trust between both parties.

4. Bills of Exchange: A document that instructs buyer to pay for goods on a specific date. Exporter gives a bill of landing when goods are sent, which is an agreement between exporter and transporter which sets out where the goods are to be delivered but also the legal ownership of the goods.  Document (bill) against payment  Document (bill) against acceptance

4.4.4 Hedging The spot exchange rate is the value of one currency in another currency on a particular day. Hedging is the process of minimising the risk of currency fluctuations. To minimise the effects of currency fluctuation, hedging can be used. Hedging helps reduce the level of uncertainty involved with international financial transactions. Hedging includes natural hedging and financial instrument hedging (derivatives). Natural hedging includes:    

Setting up offshore subsidiaries to handle the same currency as importer Arranging for import payments and export receipts to be in the same foreign currency. Implementing marketing strategies to reduce price sensitivity of exported products Insisting that contracts be in AUD to transfer risk to importer of goods

4.4.5 Derivatives Derivatives are simple financial instruments that may be used to lessen the exporting risks associated with currency fluctuations. The three main derivatives available for exporters include: 

Forward exchange rate: a contract to exchange one currency for another currency at an agreed exchange rate on a future date, usually after a period of 30, 90 or 180 days. This means that the bank guarantees the exporter, within the set time, a fixed rate of exchange for the money generated from the sale of the exported goods. 


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Options contract: An option contracts gives the buyer the right, but not the obligation, to buy or sell foreign currency at some time in the future, usually when the currency is to their advantage

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Swap Contract: A currency swap is an agreement to exchange currency in the spot market with an agreement to reverse the transaction in the future. The main advantage of a swap contract is that it allows the business to alter its exposure to exchange fluctuations without discarding the original transaction. E.g. swapping $50 million AUD for USD today and agreeing to reverse the swap within 3 months.