HSC BUSINESS STUDIES

FINANCE

Role of financial management

• Strategic role of financial management

• Objectives of financial management

– Profitability, growth, efficiency, liquidity, solvency

– Short-term and long-term

• Interdependence with other key business functions

STRATEGIC ROLE OF FINANCIAL MANAGEMENT

Financial management refers to how businesses raise, use and monitor financial resources (resources in a business that have a monetary value) to best maximise their goals. It involves the ongoing planning, monitoring and controlling of the financial position and performance of a business in order to enable it to achieve its financial goals.

The role of financial management in strategic planning (encompassing the strategies that a business will use to achieve its financial goals, outlining both goals, objectives and future direction) is to identify:

- The financial requirements of achieving the strategic (or medium-long term) goals of the firm

- The ways in which these requirements can be met i.e. the sources of finance which could be used

- The preferable sources of finance i.e. the mixture of debt and equity finance desired and the possible financial instruments which will be used to raise the required funds

- The timing of these financial requirements

In other words, the role is to provide the financial resources to allow the implementation of the business’ strategic plan. Strategic planning of financial resources is essential to a business’s success and growth

OBJECTIVES OF FINANCIAL MANAGEMENT

– Profitability, growth, efficiency, liquidity, solvency

– Short-term and long-term

The main objectives of financial managers are the maximising of investment returns and the achievement of goals for profits, growth, efficiency, liquidity and solvency.

PEGLS- leading to sustainability, stability, viability

Profitability is another important financial objective of management. Profitability is the ability of a business to maximise its profits. Profits satisfy owners or shareholders in the short term but are also important for the longer term sustainability of a firm.

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 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.

Growth is an important financial objective of management as it ensures that the business is sustainable into the future.

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.

Efficiency generally relates to the operations or revenue-producing activities of the business. Achieving efficiency requires a firm to have control measures in place to monitor assets. A business that aims for efficiency must monitor the levels of inventories and cash and the collection of receivables.

Liquidity is an important financial objective of management. 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 be able to convert current assets into cash quickly.

Controls over the flow of cash into and out of the business ensure that it has supplies of cash when needed. Cash shortfalls and excess or idle cash must be avoided as both involve loss of profitability for a business.

Solvency is the extent to which the business can meet its financial commitments in the longer term. The longer term refers to a time period greater than 12 months. Solvency is particularly important to the owners, shareholders and creditors of a business because it is an indication of the risks to their investment.

Solvency indicates whether a business will be able to repay amounts that have been borrowed for investments in capital.

Short-term financial objectives are the tactical (one to two years) and operational (day-to-day) plans of a business. These would be reviewed regularly to see if targets are being met and if resources are being used to the best advantage to achieve the objectives.

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.

INTERDEPENDENCE WITH OTHER KEY FUNCTIONS

Finance and operations-a major goal of any business is to create value while the goal of people and institutions that have invested in the business is to receive a return on their investment. Both of these goals are financial and both have implications for operations.

Finance and marketing-marketing is the way most businesses generate sales. By generating sales the business is increasing in value and this helps with its short-term financial goal of managing cash flow. Three important indicators highlight the link between marketing and finance: sales volume and value, market share, and operating income.

Finance and HR-finance is in a key position to help HR achieve its objectives. This is because in many businesses, finance is becoming the main source of performance measurement data. The information finance gathers on earnings, productivity and customer satisfaction provides insight

into the staffing and development needs of a business and without this HR cannot do its job effectively.

Influences on financial management

Internal sources of finance- retained profits External sources of finance

- Debt- short term borrowing (overdraft, commercial bills, factoring), long term borrowing (mortgage, debentures, unsecured notes, leasing)

- Equity- ordinary shares (new issues, rights issues, placements, share purchase plans), private equity

Financial institutions- banks, investment banks, finance companies, superannuation funds, life insurance companies, unit trusts and the ASX

Influence of government- ASIC, company taxation Global market influences- economic outlook, availability of funds, interest rates

INTERNAL SOURCES OF FINANCE- RETAINED PROFITS

Internal finance refers to the funds that are provided by the owners of the business (finance) or from the outcomes of business activities (retained earnings) as well as capital contributed by owners. These are often referred to as equity.

Owner’s equity refers to the funds contributed by owners or partners to establish and build the business. This can be raised by acquiring further investors.

Retained profits refers to the profits which are not distributed, but are kept in the business as a cheap and accessible source of finance for future activities. In other words, it is the net profit that has been reinvested in the business, and increases the owner’s claim.

EXTERNAL SOURCES OF FINANCE

- Debt- short term borrowing (overdraft, commercial bills, factoring), long term borrowing (mortgage, debentures, unsecured notes, leasing)

- Equity- ordinary shares (new issues, rights issues, placements, share purchase plans), private equity

External sources of 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 is known as debt finance (borrowed money) and equity in public and private businesses.

Debt- short term borrowing (overdraft, commercial bills, factoring)

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 1-2 years.

A bank overdraft refers to a bank allowing a business or individual to overdraw an account to an agreed limit for a specified time. This assists short term cash flow (liquidity) by overcoming any temporary cash shortfalls.

Overdrafts are flexible, costs are minimal and interest rates are lower than other forms of borrowing.

A commercial bill refers to a type of bill of exchange (document ordering the payment of money at some fixed future date) issued by institutions other than banks. They are highly liquid and can be converted into cash easily by selling them at a discount.

Given for large amounts, over $100 000 for a period of between 90 and 180 days. Factoring refers to the selling of accounts receivable for a discounted price to a finance

business and it improves cash flow and gearing immediately. Risky due to chance of unpaid debts and more expensive due to discounted selling.

Long term borrowing (mortgage, debentures, unsecured notes, leasing)

Long term borrowing refers to funds borrowed for periods longer than 2 years, used to finance property, inventory and equipment.

A mortgage refers to a loan secured by the property of the borrower, repaid through regular repayments over a specified period of time. A mortgage loan is a secured loan, where there is less risk for the lender, hence interest rates are lower.

Debentures are issued by a company for a fixed rate of interest and for a fixed period of time.

A debenture is a contract setting out the conditions of a loan to a company from the general public. The debenture is a secured loan. The security offered by the company might be specific in the sense that specific property and buildings are listed as the security, or it could be a ‘floating charge’. A floating charge means that all the company’s assets (which are not mortgaged to someone else) become the security for the loan. A debenture issue is expensive, so debentures are usually for large amounts of borrowings.

Unsecured notes refers to a loan for a set period of time but is not backed by any collateral or assets, therefore presenting a risk to investors, attracting a higher interest rate. These are sold by businesses to generate cash flow for business activities such as acquisition.

Leasing refers to a long term source of borrowing which involves the payment of money for the use of equipment that is owned by another party for an agreed period of time. A business can borrow funds and use equipment without large capital outlay required and costs and benefits are transferred from the lessor to the lessee.

- Operating leases- assets leased for short periods, shorter than the life of the asset, with the owner carrying maintenance of the asset. Can be cancelled.

- Financial leases- lessor purchases asset on behalf of lessee, for the life of the asset, with repayments fixed for the economic life of the asset (3-5 years). Cannot be cancelled.

Equity- ordinary shares (new issues, rights issues, placements, share purchase plans), private equity

Equity refers to the finance raised by a business by issuing shares. Purchase of ordinary shares means that individuals have become part owners of a public

company and may receive dividends (distribution of a business’ profits to shareholders) New issue-a security that has been issued and sold for the first time on a public market Rights issue- the privilege granted to shareholders to buy new shares in the same business Placements- allotment of shares, debentures etc made directly from the business to

investors Share purchase plan- an offer to existing shareholders the opportunity to purchase further

shares in that business without brokerage fees. (discounted) Private equity refers to money invested in a private business (not listed on ASX) with the aim

of raise capital to finance future expansion/investment of a business.

Financial institutions- banks, investment banks, finance companies, superannuation funds, life insurance companies, unit trusts and the ASX

Banks are the largest source of funds for businesses and consumers. They also provide a range of financial services.

Finance companies raise funds mainly through debenture issues and use these funds to make medium- and short-term loans to businesses. Insurance companies cover risks that people face through insurance policies. The company invests customers' premiums in other businesses and investment opportunities as a method of spreading their exposure to risk.

Investment banks are banks that specialise in investment banking, for medium to large corporations. Their functions involve private equity activities, international finance, funds management and advisory services.

Superannuation funds pool large amounts of funds for long-term lending and investing in shares and property.

Life insurance companies provide compensation in the event of death or injury. To purchase insurance, customers pay a premium to an insurance company. These companies invest in businesses as a method of spreading their exposure to risk.

A unit trust is a fund that is managed by a trustee which is usually a company. It raises funds from investors which it holds in trust for them and invests those funds in various investments. The advantage for investors is that they can pool their funds and earn a much larger return on those funds than if each investor had acted independently.

The ASX provides a market where investors and companies come together to buy and sell equities and other financial assets so that businesses can raise capital and investors can acquire shares of ownership in listed companies.

ASX-primary markets deal with the new issue of debt instruments by the borrower of funds. Secondary markets deal with the purchase and sale of existing securities.

Influence of government- ASIC, company taxation

The Australian Securities and Investments Commission (ASIC). ASIC is an independent statutory commission accountable to the Commonwealth parliament. It enforces and administers the Corporations Act and protects consumers in the areas of investments, life and general insurance, superannuation and banking (except lending) in Australia. The aim of ASIC is to assist in reducing fraud and unfair practices in financial markets and financial products. ASIC ensures that companies adhere to the law, collects information about companies and makes it available to the public.

The Australian government has undertaken a process of reform of the federal tax system that will improve Australia’s international competitiveness and make Australia an even more attractive place to invest, thereby driving long-term economic growth. This will mean more jobs and higher wages for working Australians.

Global market influences- economic outlook, availability of funds, interest rates

The global economic outlook refers specifically to the projected changes to the level of economic growth throughout the world. The outlook influences a business’ decisions.

The availability of funds refers to the ease with which a business can access funds (for borrowing) on the international financial markets. There are various conditions and rates that apply and these will be based primarily on:

- Risk- demand and supply- Domestic economic conditions.

Interest rates are the cost of borrowing money. This is directly proportional to the level of risk involved in lending to a business. A business looking at forms of global expansion will need to raise or acquire additional finance.

Processes of financial management

planning and implementing – financial needs, budgets, record systems, financial risks, financial controls

– debt and equity financing – advantages and disadvantages of each

– matching the terms and source of finance to business purpose

monitoring and controlling – cash flow statement, income statement, balance sheet financial ratios

– liquidity – current ratio (current assets ÷ current liabilities)

– gearing – debt to equity ratio (total liabilities ÷ total equity)

– profitability – gross profit ratio (gross profit ÷ sales); net profit ratio (net profit ÷

sales); return on equity ratio (net profit ÷ total equity)

– efficiency – expense ratio (total expenses ÷ sales), accounts receivable turnover ratio

(sales ÷ accounts receivable)

– comparative ratio analysis – over different time periods, against standards, with

similar businesses

limitations of financial reports – normalised earnings, capitalising expenses, valuing assets, timing issues, debt repayments, notes to the financial statements

ethical issues related to financial reports

Planning and implementing – financial needs, budgets, record systems, financial risks, financial controls

Financial management is responsible for the financial planning of the business. This will help determine the viability of the venture, make decisions about its future and make projections for liquidity and performance.

Planning processes- the setting of goals and objectives, determining the strategies to achieve those goals and objectives, identifying and evaluating alternative courses of action and choosing the best alternative for the business.

The financial planning process begins with long-term or strategic financial plans. Long-term plans include a business’s planned capital expenditure and/or planned investments.

Capital expenditure is what is spent on a business’s non-current or fixed assets. It is used to generate revenue and ultimately returns to owners and shareholders.

The planning cycle involves:- Addressing present financial position- Determining financial needs- Developing budgets- Maintaining record systems- Identifying financial risks- Establishing financial controls

Financial needs will be indicated through important financial information collected in order to make future plans. This financial information includes balance sheets, income statements, cash flow statements etc.

The financial needs of a business will be determined by:- the size of the business- the current phase of the business cycle- future plans for growth and development- capacity to source finance — debt and/or equity- management skills for assessing financial needs and planning.

Budgets provide information in quantitative terms (that is, as facts and figures) about requirements to achieve a particular purpose.

Budgets reflect the strategic planning decisions about how resources are to be used. They provide financial information for a business’s specific goals and are used in strategic, tactical and operational planning.

Types of budgets include:

- Operating budgets relate to the main activities of a business and may include budgets relating to sales, production, raw materials, direct labour, expenses and cost of goods sold. Information from operating budgets is used in preparing budgeted financial statements.

- Project budgets relate to capital expenditure, and research and development. Capital expenditure budgets in a business’s strategic plan include information about the purpose of the asset purchase, life span of the asset and the revenue that would be generated from the purchase. Information from project budgets is included in the budgeted financial statements.

- Financial budgets relate to the financial data of a business. The predictions of the operating and project budgets are included in the budgeted financial statements. Financial budgets include the budgeted income statement, balance sheet and cash flows. The income statement and balance sheet reflect the results of operating activities and the cash flow statement shows the liquidity of a business.

Budgets can generally be used to indicate the following:

- cash required for planned outlays for a particular period- the cost of capital expenditure and associated expenses against earning capacity- estimated use and cost of raw materials or inventory- number and cost of labour hours required for production.

Record systems are the mechanisms employed by a business to ensure that data are recorded and the information provided by record systems is accurate, reliable, efficient and accessible. Management bases its decisions on the information when needed and must have guarantees that the information is accurate and reliable.

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.

Financial controls refer to the policies and procedures that ensure that the plans of a business will be achieved in the most efficient way.

The policies and procedures of a business are designed to ensure they are followed by management and employees. Control is particularly important in assets such as accounts receivable, inventory and cash.

Debt and equity financing – advantages and disadvantages of each

Debt finance refers to the short and long term borrowing from external sources by a business.

Equity finance refers to the internal sources of finance for a business. Advantages and disadvantages of debt finance

Funds are usually readily available Increased risk if debt comes from financial institutions because the interest, bank charges, government charges and the principal have to be repaid

- Increased 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

- - Lenders have first claim on any money if the business ends in bankruptcy

Advantages and disadvantages of equity finance

- Does not have to be repaid unless the owner leaves the business

- Lower profits and lower returns for the owner

- Cheaper than other sources of finance as there are no interest payments

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

- The owners who have contributed the equity retain control over how that finance is used

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- Low gearing (use resources of the owner and not external sources of finance)

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- Less risk for the business and the owner

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Matching the terms and source of finance to business purpose

Businesses must find the source of finance that is most appropriate to fund the activities arising from these decisions as when a business identifies and plans to meet its financial objectives, it is necessary to match the terms of finance with purpose. This will be influenced by:

- The terms of finance- The cost of each source of funding- The structure of the business

- Costs- Flexibility- Availability of finance

Monitoring and controlling – cash flow statement, income statement, balance sheet

Monitoring and controlling is essential in financial management as inconsistent methods of review and systems of control will have an immediate impact on the viability of the business, thus requiring management to monitor internal and external factors that impact business operations financially.

A cash flow statement 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.

The cash flow statement indicates the movement of cash receipts and cash payments resulting from transactions over a period of time. It can also identify trends and can be a useful predictor of change.

A statement of cash flows can show whether a firm can:

generate a favourable cash flow (inflows exceed outflows) pay its financial commitments as they fall due — for example, interest on borrowings,

repayment of borrowings, accounts payable have sufficient funds for future expansion or change obtain finance from external sources when needed pay drawings to owners or dividends to shareholders.

Operating activities are the cash inflows and outflows relating to the main activity of the business — that is, the provision of goods and services. Income from sales (cash and credit) make up the main operating inflow plus dividends and interest received.

Investing activities are the cash inflows and outflows relating to purchase and sale of non-current assets and investments. These assets and investments are used to generate income for the business.

Financing activities are the cash inflows and outflows relating to the borrowing activities of the business. Borrowing inflows can relate to equity (issue of shares or capital contribution from owner) or debt (loans from financial institutions). The income statement indicates the operating results (operating efficiency).

The income statement shows the operating efficiency (results) — 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.

The income statement shows:

operating income earned from the main function of the business, such as sales of inventories, services and non-operating revenue earned from other operations, such as interest, rent and commission

operating expenses such as purchase of inventories, payment for services and other expenses incurred in the main operation of the business, such as advertising, rent, telephone and insurance.

By examining figures from previous income statements, managers can make comparisons and analyse trends before making important financial decisions. They can see whether expenses are increasing, decreasing or remaining the same, why profits have increased or decreased and in which areas there has been significant change.

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.

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

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

business.

The balance sheet shows the financial stability of the business. Analysis of the balance sheet can indicate whether:

the business has enough assets to cover its debts the interest and money borrowed can be paid the assets of the business are being used to maximise profits the owners of the business are making a good return on their investment.

The accounting equation, which forms the basis of the accounting process, shows the relationship between assets, liabilities and owners’ equity.

Assets are what is owned by a business; liabilities and owners’ equity are what is owed by a business.

The accounting equation shows that the assets of the business may be financed by either the owners or by parties external to the business.

Assets = Liabilities + Owners’ equity

Owners’ equity = Assets − Liabilities

Liabilities = Assets − Owners’ equity

Profit is the difference between revenue and expenses. The accounting equation could more accurately be expressed as:

Assets = Liabilities + Capital + Revenue − Expenses

Assets = Liabilities + Capital + Profit (Revenue − Expenses)

Financial ratios

– liquidity – current ratio (current assets ÷ current liabilities)

– gearing – debt to equity ratio (total liabilities ÷ total equity)

– profitability – gross profit ratio (gross profit ÷ sales); net profit ratio (net profit ÷

sales); return on equity ratio (net profit ÷ total equity)

– efficiency – expense ratio (total expenses ÷ sales), accounts receivable turnover ratio

(sales ÷ accounts receivable)

Comparative ratio analysis – over different time periods, against standards, with

similar businesses

Analysis involves working the financial information into significant and acceptable forms, making it more meaningful and highlighting relationships between different aspects of a business.

The main types of analysis are vertical, horizontal and trend analysis.

Vertical analysis compares figures within one financial year; for example, expressing gross profit as a percentage of sales and comparing debt to equity.

Horizontal analysis compares figures from different financial years; for example, comparing 2011 and 2012.

Trend analysis compares figures for periods of three to five years. Interpretation is making judgements and decisions using the data gathered from analysis.

Ratio Formula Example on page

Analysis of which aspect of the financial statement

What does analysis of this ratio show about a business?

Interpretations of ratio results

Current ratio

Current assets/current liabilities

310 Liquidity Shows the short-term financial stability of a business (i.e. its ability to meet its short-term financial commitments)

It is generally accepted that a ratio of 2:1 indicates a sound financial position (i.e. a firm should have double the amount of assets to cover its liabilities).

Debt to equity ratio

Total liabilities/owner’s equity

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

The higher the ratio, the less solvent the firm (i.e. the higher the ratio of debt to equity, the higher the business risk).

Gross profit ratio

Gross profit/sales 314 profitability Shows the changes from one accounting period to another and indicates the effectiveness of planning policies concerning pricing, sales, discounts, the valuation of stock etc.

The higher the ratio the better.

If the ratio is low, alternative suppliers may need to be sourced and competitors investigated.

Net profit ratio

Net profit/sales 314 profitability Net profit ratio represents the profit or return to the owners.

A firm will be aiming for a high net profit ratio.

A low net profit ratio indicates that expenses should be examined to look for possibility of reductions.

Return on equity ratio

Net profit/total equity

315 profitability Shows how effective the funds contributed by the owners have been in generating profit and so the return on investment (ROI)

The higher the ratio or percentage, the better the return for the owner.

Expense ratio

Total expenses/sales

316 Efficiency Each of the categories of expenses is

Expense ratios indicate day-to-day

compared with sales. The ratio indicates the amount of sales that are allocated to individual expenses such as selling, administration, COGS and financial expenses.

efficiency of the business. Expense ratios need to be kept at a reasonable level, and management must monitor each type of expense in relation to sales.

Higher expense ratios may be the result of poor management.

Accounts receivable turnover ratio

365/(sales/accounts receivable)

316 Efficiency Measures the effectiveness of a firm’s credit policy and how efficiently it collects its debt.

High turnover ratios indicate the business has efficient debt collection.

Ratio analysis taken for a firm over a number of years can be compared with similar businesses and against common industry standards or benchmarks as well as against different time periods in order to identify trends and improve on previous results.

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

Ratio analysis provides information on the state of the business and indicates trends in its operations.

Misleading information impacts on business decision making and puts the business at risk.

Normalised earnings This is the process of removing one time or unusual influences from the balance sheet to show the true earnings of a company. An example of this would be the removal of a land sale, which would achieve a large capital gain.

Capitalising earnings This is the process of adding a capital expense to the balance sheet that is regarded as an asset (in that it will add to the value of the company and is therefore recorded on the balance sheet) rather that an expense (in this situation, it would be recorded on the income statement).

Examples of capitalising expenses include:

research and development development expenditure

Valuing assets This is the process of estimating the market value of assets or liabilities. The valuations can be used in a variety of contexts for a business, including investment analysis, mergers and acquisitions and financial reporting.

Two main methods used for valuing assets include:

1. Discounted cash flow method. This method estimates the value of an asset based on its expected future cash flows, which are discounted to the present (i.e. the present value).

2. Guideline company method. This method determines the value of a firm by observing the prices of similar companies (guideline companies) that sold in the market.

Timing issues 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.

Debt repayments Financial reports can be limited because they do not have the capacity to disclose specific information about debt repayments such as:

How long the business has had or has been recovering the debt

The capacity of the business or its debtor to repay the amount/s owed (What if a debtor is close to bankruptcy and will not be able to repay a debt?)

The adequacy of provisions and methods the business has for the recovery of debt. (Larger businesses have the ability to outsource debt recovery by hiring an agent to undertake this process but smaller

business may not have the resources to do the same as it is costly and time consuming.)

What provision does the business have in place for doubtful debts and how is this evident in the financial reports?

Have debt repayments been held over until another accounting period therefore giving a false impression of the situation?

The recording of debt repayments on financial reports can be used to distort the ‘reality’ of the business’s status and this may be undertaken to provide a more favourable overview of the business at that point in time.

Notes to the financial statement Notes to the financial statements report the details and additional information that are left out of the main reporting documents, such as the balance sheet and income statement. These notes contain important information such as the accounting methodologies used for recording and reporting transactions that can affect the bottom-line return expected from an investment in a company.

Ethical issues related to financial reports

In all activities of a business the goals of the business remain paramount. Planning, monitoring, control and corrective action are all part of the process.

The audit is an independent check of the accuracy of financial records and accounting procedures, and it has an important role in this process.

Internal audits. These are conducted internally by employees to check accounting procedures and the accuracy of financial records.

Management audits. These are conducted to review the firm’s strategic plan and to determine if changes should be made. The factors affecting the strategic plan may include human resources, production processes and finance.

External audits. These are a requirement of the Corporations Act 2001 (Cwlth). Record keeping- ATO. GST obligations. Reporting practices- The business activity statement (BAS) records a business’ claim for input

tax credits and accounts payable for GST.

financial management strategies

• cash flow management

– cash flow statements

– distribution of payments, discounts for early payment, factoring

• working capital management

– control of current assets – cash, receivables, inventories

– control of current liabilities – payables, loans, overdrafts

– strategies – leasing, sale and lease back

• profitability management

– cost controls – fixed and variable, cost centres, expense minimisation

– revenue controls – marketing objectives

• global financial management

– exchange rates

– interest rates

– methods of international payment – payment in advance, letter of credit, clean

payment, bill of exchange

– hedging

– derivatives

cash flow management

– cash flow statements

– distribution of payments, discounts for early payment, factoring

Cash flow is the movement of cash in and out of a business over a period of time. 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 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 are able to 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.

working capital management

– control of current assets – cash, receivables, inventories

– control of current liabilities – payables, loans, overdrafts

– strategies – leasing, sale and lease back

control of current assets – cash, receivables, inventories

Current assets refer to assets that a business can expect to convert into cash within 12 months such as cash and AR.

Current liabilities refer to liabilities that a business must repay within 12 months such as overdraft and AP.

Working capital refers to the funds available for short term financial commitments of a business.

Net working capital refers to the difference between CA and CL, representing those funds that are needed for the operational activities of a business to produce profits and provide cash for short term liquidity.

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.

A high current ratio may indicate the business has invested too much in current assets that bring in a small return. Profitability may be reduced as the business has chosen to reduce its risk of not being able to pay its debts by having a higher current ratio.

A low current ratio may mean that the business is more profitable if it is investing its resources in longer term assets and generating more profits. However, there is a risk that the business may not be able to pay its current liabilities.

Cash- Cash is critical for business success, and careful consideration must be given to the levels of cash receivables and inventories that are held by a business. Cash ensures that the business can pay its debts, repay loans and pay accounts in the short term, and that the business survives in the long term.

Planning for the timing of cash receipts, cash payments and asset purchases avoids the situation of cash shortages or excess cash.

Receivables refers to sums of money due to a business from customers whom it has supplied goods or services.

A business must monitor its accounts receivable and ensure that their timing allows the business to maintain adequate cash resources.

Procedures for managing accounts receivable include:- checking the credit rating of prospective customers- sending customers’ statements monthly and at the same time each month so that

debtors know when to expect accounts- following up on accounts that are not paid by the due date- stipulating a reasonable period, usually 30 days, for the payment of accounts- putting policies in place for collecting bad debts, such as using a debt collection

agency. Inventories make up a significant amount of current assets, and their levels must be carefully

monitored so that excess or insufficient levels of stock do not occur.

Too much inventory or slow-moving inventory will lead to cash shortages. Insufficient inventory of quick-selling items may also lead to loss of customers, and hence lost sales.

‘Just-in-time’ is one method used by some businesses to ensure that inventory is not lying idle. An arrangement is made with a supplier that orders will be supplied immediately. The firm carries little or no inventory and relies on the supplier to fulfil orders as soon as required.

control of current liabilities – payables, loans, overdrafts

Payables refer to the sums of money owed by the business to other businesses from whom it has purchased goods and services.

A business must monitor its payables and ensure that their timing allows the business to maintain adequate cash resources.

Control of accounts payable involves periodic reviews of suppliers and the credit facilities they provide, for example:

discounts interest-free credit periods extended terms for payments, sometimes offered by established suppliers without interest

or other penalty.

Management of loans is important, as costs for establishment, interest rates and ongoing charges must be investigated and monitored to minimise costs.

Short-term loans are important sources of short-term funding for businesses although 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.

Bank overdrafts involve an arrangement with the bank that the business’s account can be overdrawn to a certain amount for a specified time, which enable a business to overcome temporary cash shortages.

Banks require that regular payments be made on overdrafts and may charge account-keeping fees, establishment fees and interest.

Businesses should have a policy for using and managing bank overdrafts and monitor budgets on a daily or weekly basis so that cash supplies can be controlled.

Strategies – leasing, sale and lease back

Strategies are utilised to manage working capital, which is required to fund the day-to-day operations of a business.

Leasing is the hiring of an asset from another person or company who has purchased the asset and retains ownership of it, through fixed payments for a specified time.

Leasing ‘frees up’ cash that can be used elsewhere in a business, so the level of working capital is improved, and is tax deductible

Firms can also increase their number of assets through leasing and this means that revenue, and therefore profits, can be increased.

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.

Profitability management

– Cost controls – fixed and variable, cost centres, expense minimisation

– Revenue controls – marketing objectives

Profitability management involves the control of both the business’s costs and its revenue. Fixed costs are not dependent on the level of operating activity in a business. Fixed costs do

not change when the level of activity changes — they must be paid regardless of what happens in the business.

Examples of fixed costs are salaries, depreciation, insurance and lease. Variable costs are those that change proportionately with the level of operating activity in a

business. For example, materials and labour used in the production of a particular item are variable

costs, because they are often readily identifiable in a business and can be directly attributable to a particular product.

Changes in the volume of activity need to be managed in terms of the associated changes in costs.

Comparisons of costs with budgets, standards and previous periods ensure that costs are minimised and profits maximised.

Cost centres refer to particular areas, departments or sections of a business to which costs can be directly attributed to.

Direct costs are those that can be allocated to a particular product, activity, department or region;

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.

Profits can be weakened if the expenses of a business are high, as they consume valuable resources within a business, thus acquiring the need for expense minimisation.

Guidelines and policies should be established to encourage staff to minimise expenses where possible.

Savings can be substantial if people take a critical look at costs and eliminate waste and unnecessary spending.

Sales objectives -must be pitched at a level of sales that will cover costs, both fixed and variable, and result in a profit.

A cost-volume-profit analysis can determine the level of revenue sufficient for a business to cover its fixed and variable costs to break even, and predict the effect on profit of changes in the level of activity, prices or costs.

Sales mix- businesses should control this by maintaining a clear focus on the important customer base on which most of the revenue depends before diversifying or extending product ranges or ceasing production on particular lines.

Research should be carried out to identify the potential effects of sales-mix changes before decisions are made.

Pricing policy- overpricing could fail to attract buyers, while underpricing may bring higher

sales but may still result in cash shortfalls and low profits. Overpricing could fail to attract buyers, while underpricing may bring higher sales but may

still result in cash shortfalls and low profits.

Factors that influence pricing include:

the costs associated with producing the goods or services (materials, labour, overheads) prices charged by the competition short- and long-term goals — for example, if the business aims to improve market share

over a five-year period, prices may be reduced the image or level of quality that people associate with the goods or services government policies.

global financial management

– exchange rates

– interest rates

– methods of international payment – payment in advance, letter of credit, clean payment, bill of exchange

– hedging

– derivatives

In all global transactions it is necessary to convert one currency into another. This transaction is performed through the foreign exchange market, which determines the

price of one currency relative to another.

The foreign exchange rate is the ratio of one currency to another; it tells how much a unit of one currency is worth in terms of another.

Exchange rates fluctuate over time due to variations in demand and supply. The impact of this currency fluctuation is twofold:

1. A currency appreciation -This means that each unit of foreign currency buys fewer Australian dollars. However, one Australian dollar buys more foreign currency. Therefore, an appreciation makes our exports more expensive on international markets but prices for imports will fall.

The result of the appreciation, therefore, reduces the international competitiveness of Australian exporting businesses.

2. A currency depreciation has the opposite impact. Therefore, each unit of foreign currency buys more Australian dollars. The result is that our exports become cheaper and the price of imports will rise.

A depreciation, therefore, improves the international competitiveness of Australian exporting businesses.

Currency fluctuations, therefore, will impact on the revenue profitability and production costs.

A business that plans to either relocate offshore or expand domestic production facilities to increase direct exporting will normally need to raise finance to undertake these activities.

Businesses could be tempted to borrow the necessary finance from an overseas source to gain the advantage of lower interest rates.

Any adverse currency fluctuation could see the advantage of cheaper overseas interest rates quickly eliminated. In the long term, the ‘cheap’ interest rates may end up costing more.

Hedging The spot exchange rate is the value of one currency in another currency on a particular day. Hedging refers to the process of minimising the risk or currency fluctuations. Natural hedging refers to a number of strategies a business may adopt to eliminate or

minimise the risk of foreign exchange exposure.

Derivatives Derivates refer to simple financial instruments that may be used to lessen the exporting risks

associated with currency fluctuations. A forward exchange contract is 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.

An option gives the buyer (option holder) the right, but not the obligation, to buy or sell foreign currency at some time in the future.

Option holders are protected from unfavourable exchange rate fluctuations, yet maintain the opportunity for gain should exchange rate movements be favourable.

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.

Methods of international payment Levels of risk for exporter (least to most):

- Payment in advance- Letter of credit- Clean payment- Bill of exchange- document against payment- Bill of exchange- document against acceptance

The payment in advance method allows the exporter to receive payment and then arrange for the goods to be sent.

This method exposes the exporter to virtually no risk and is often used if the other party is a subsidiary or when the credit worthiness of the buyer is uncertain.

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.

A letter of credit is very popular with exporters. This is because it relies on the overseas bank rather than the importer.

Clean payment (remittance) occurs when the payment is sent to, but not received by, the exporter before the goods are transported.

Clearly in this method the risk to the exporter is minimal, but unfortunately it is not a method of payment favoured by importers.

A bill of exchange is a document drawn up by the exporter demanding payment from the importer at a specified time.

- Document (bill) against payment. Using this method, the importer can collect the goods only after paying for them.

- Document (bill) against acceptance. Using this method, the importer may collect the goods before paying for them.

The risk of non-payment or payment delays when using a bill of exchange is always greater than for a letter of credit.

The risk with documents against payment is that the importer may not collect the documents nor pay for the goods.

With documents against acceptance there is the risk the importer may delay payment or not pay at all.