HSC Business Studies. Published Jul 2, BAND 6 HSC BUSINESS STD NOTES. By Tanya (97 ATAR)

Transcription

1 HSC Business Studies Year 2016 Mark Pages 200 Published Jul 2, BAND 6 HSC BUSINESS STD NOTES By Tanya (97 ATAR)

2 Your notes author, Tanya. Tanya achieved an ATAR of 97 in 2016 while attending Penrith High School Tanya says: Powered by TCPDF (

3 Business Studies HSC Topic: Finance Students learn about Summary Notes Business have specific goals they wish to achieve. 1. Role of financial management Strategic role of financial management The strategies that a business adopts work towards achieving both its short and long term goals. Financial management is the planning, monitoring, controlling of a firms financial resources enabling the business to achieve its financial goals. The Strategic role of financial management is achieving the objectives of the business. Specifically: Financial Management s role is to: i) Make funds available for business activities and ii) Ensure that day-to- day transactions and operations run smoothly from a financial perspective The mismanagement of financial resources can lead to problems such as: Insufficient cash to pay creditors Inadequate capital for expansion Too many assets that are non- productive Delays in accounts being paid Possible business failure Overstocking of materials Strategies for monitoring the financial resources of a business must be incorporated into its strategic plan. This involves: Monitoring a business s cash flow

4 Paying its debts Developing financial control techniques Objectives of Financial Management For a business to achieve its longer-term goals it must have a number of short term, specific objectives. Each of the following objectives need to be maximized. Profitability Liquidity Efficiency Growth Solvency The major challenge of financial management is to find a happy medium between conflicting objective. Objectives of financial management Profitability vs Liquidity Profitability vs Solvency Profitability vs Efficiency Liquidity = current liabilities. Solvency= not current liabilities Objective 1- Profitability o Profitability The profit or earning are reported in the company s income statement AKA revenue statement Profit= Revenue Expenses Profitability is the ability of a business to maximise its profits o Growth Boosting profitability includes both increasing the amount of money coming into the business and minimising how much it is spending

5 Whilst profit satisfies the owners or shareholders in the short term, its also crucial for the long-term sustainability of the business. o Efficiency Objective 2- Liquidity Liquidity refers to cash flow and how easily assets can be turned into cash to finance current liabilities. Short term objective. o Liquidity A business needs to have sufficient cash to be able to meet its short- term obligations, like paying suppliers and interest on loans. A business might be highly profitable, but not liquid if its value is tied up in assets that cannot quickly be converted into cash. Excessive liquidity may mean that the firm is missing opportunities to use the money more profitably, such as expanding the business. o Solvency Profitability is NOT liquidity. E.g. Car dealer worth a lot more but it is hard to sell ca car quickly. Objective 3 Efficiency Efficiency refers to the level of outputs obtained from inputs in the production process. Financial Management aims to reduce costs by maximising the output from each input. Making the business more efficient generally mean making it better at making more money such as: Boosting sales revenue compared to expenses Short/ Long Term goal Objectives 4- Growth Growth refers to the aim of increasing the size of a business. Methods for achieving this objective include: 1.Acquiring more resources

6 2. Merging with another business 3. Taking over another business. Finance is the key component of any decision relating to growth as expansion requires significant outlays of money. Objective 5 Solvency Solvency refer to the firm s ability to cover it long-term liabilities. Long term refers to a period greater than 12 months. Debt is useful and often necessary for businesses, allowing them to expand and function smoothly. BUT Finance must ensure that debt levels do not exceed the business ability to repay the borrowings in the future. Need debt to grow/expand. Bad if they don t have enough current assets to pay it off. Non-current assets - Machinery - Cars Short term and long term financial objectives 1. Short term financial objectives These are tactical (one to two years) and operations (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. 2. Long- term financial objectives These are the strategic plans of a business and are determined for a set period of more than 5 years They tend to be broad goals such as increasing market share, and will require a series of short-term goals to assist in its

7 achievement. The business would review these annually to determine if changes need to be implemented Interdependence with key business functions Must interact with all other functions in order to achieve the goals of a business Operations : Funding from finance, while actions and outcomes by operations, such as the efficiency of production and inventory decisions, affect financial decisions Marketing: Marketing activities especially promotion require funding from finance, while marketing generates funds that the financial department manages. Human Resource management: requires finance to pay staff and financial management decisions may affect staff levels, while the size and attributes of the workforce affect financial objectives as labour is a major cost of production and affects efficiency. Sources of Finance

8 o Short term and long term Internal Sources Internal finance comes either from the business s owners (equity or capital) or from the outcomes of business activities (retained profit). Owner s equity 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. Retained profits All profits are not distributed but are kept as cheap and accessible finance for future activities.

9 External sources Interdependence with other key business functions 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. 2. Influences on financial management Internal sources of finance Debt- Short term o Retained profits External sources of finance Provided financial institutions through bank overdrafts, commercial bills and bank loans. 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. Name Bank Overdraft Definition Banks allows a business or Specific Info Assist short- term liquidity

10 individuals to overdraw their account up to an agreed limit and for a specific time help overcome a temporary cash shortfall Commercial bills They are a type of bill of exchange issued by institutions other than banks, and are given for larger amounts. A bill of exchange is a document ordering the payment of a certain amount of money at some fixed future date Factoring Factoring is the selling of accounts receivable for a discounted price to a finance or factoring company problems Costs minimal Interest rates lower than other forms of borrowing Banks require agreed limits to be overdraft Interest is paid on daily outstanding balance of the account Flexible Usually over $ period of days Borrower receives money immediately and promises to pay the money and interest at a future date. Issues by non- bank financial institution Business raises funds immediately by selling account receivable Business will receive 90% of the amount receivable with 48 hrs of submitting its invoice to a factoring company. Business can improve its cash flow Business does not worry about chasing the receivables however the full amount will not be received by the

11 business. Factoring company service With recourse= bad debts still the responsibility of the business Without recourse means business will transfer responsibility to the factoring company. Greater risk due to chance of unpaid debt. Expensive source of finance and business usually responsible for the debts that remain unpaid and they pay commission on the debt to the factoring company. Debt- Long Term Borrowing Debt: short-term borrowing relates to funds borrowed for periods longer than two years. It can be secured or unsecured, and interest rates are usually variable. Secured means with an assets and unsecured is without. E.g. mortgage is secured and unsecured is credit card. It is used to finance real estate, plant (factory/office) and equipment. Long-term borrowing includes mortgages and debentures. Name Def Specific Info A mortgage is a loan secured by Mortgage Property cannot be sold or the property of the borrower used as security unless the full (business). amount borrowed has been payed. Finance property purchases, such as new premises, factory or an office. Repaid through

12 o Overdraft Debentures Debentures are issued by a company for a fixed rate of interest and for a fixed Time o Commercial bills o Factoring Debt: long-term borrowing o Mortgage Unsecured Notes An unsecured note is a loan for a set period of time but is not backed by any collateral or assets, Leasing Leasing is usually a long-term o Debentures o Unsecured Notes o Leasing Two Types Operational Financial source of borrowing for businesses. regular repayments over an agreed period. E.g. 15 years Not secured to a specific property. Companies that borrow offer security to the lender over the company s assets. On maturity the company repays the amount of the debenture by buying back the debenture. Amount of profit made by the company has no effect on the rate of interest due to debentures carrying a fixed rate of interest. Finance companies raise much of their funds by issuing debentures to the public. Most risk to investors the (lender) High rate of interest. Companies sell unsecured notes generate money for incentives. Involves payment of money for the use of equipment that is owed by another party. Enables enterprise to borrow funds and use the equipment without large capital outlay required. Lessee uses the equipment and the lessor owns and leases the equipment for an agreed

13 Equity external source o Ordinary Shares period of time. People who used it have been finance companies. Businesses choose the equipment, arrange for the finance company to purchase it, then lease it from the finance company, which retains ownership for the period of the lease. Operational Assets leased for short periods, usually shorter than the life of the assets. Owner maintains the asset. Operational leases can be cancelled, often without a penalty. o Private equity Financial lessor purchases the asset on behalf of the lessee. Financial leases are usually for the life of the asset. Lease repayments are fixed for the economic life of the asset, usually between three and five years. Plant, vehicles, equipment, furniture and fixtures are leased as financial leases. There are usually penalties for cancellation of financial leases. Leasing assets for long periods as financial leases is cheaper

14 than leasing them as operating leases. Some of the advantages of leasing as a source of finance include: Cheaper than other methods of finance Some assets leased the business might be in a better position to borrow funds Long-term financing without reducing control over ownership 100 Repayment of leases are for a period so cash flow can be monitored easily Lease payments are a tax deduction Disadvantage: Interest rates may be higher By law corporations required to reveal significant leases in published financial statements or in notes to the financial statements. External Equity

15 Equity refers to the finance (cash) raised by a company by issuing shares to the public for purchase through the Australian Securities Exchange (ASX). Used as an alternative to debt funding. Equity as a source of external finance includes: Ordinary shares (new issue, rights issue, placements, share purchase plans) Private equity Ordinary shares They become part owners of a public listed company and may receive payments such as dividends. Variations in the type or issue of ordinary shares. New issue- security that has issued or sold for the first time on a public market. AKA primary shares or new offerings. Rights issue- 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 The money invested in a private company not listed on ASX. Aim of is to raise capital to finance further expansion of the business. Summary The main sources of internal finance are owner s equity and retained profits, which are the business profits that are not distributed to shareholders but are commonly used as a source of finance for current or future expenses such as capital equipment. External finance is the funds provided by sources outside the business, such as financial institutions, governments and suppliers. External sources of finance are broadly categorised as either debt or equity each will influence the financial management decision of a business. Debt finance can be short-term borrowings such as overdrafts, commercial bills and factoring; or long-term borrowings such as mortgages, debentures, unsecured notes and leasing.

16 Equity refers to the cash raised by a company by: Issuing ordinary shares to the public for purchase through the ASX Private shares (equity) in companies not listed on the ASX. The major participants in financial markets are banks, investment banks, finance and life insurance companies, superannuation funds, unit trusts (mutual funds), companies, and the Australian Securities Exchange.. Banks Banks are the major operators in financial markets and are the most important source of funds for businesses. Banks receive savings as deposits from individuals, businesses and governments, and, in turn, make investments and loans to borrowers. Banks are the largest form of financial institution in Australia, although their share has declined as the financial markets have become deregulated. T Banks are supervised by the Reserve Bank of Australia.

17 Financial Institutions o Banks (Banks do everything but other ones specialise) Investment banks o Investment Banks Investment banks do big things. o Finance Companies o Superannuation Funds o Life Insurance Companies o Units Trusts o Australian Securities Exchange Investment banks make up one of the fastest growing sectors in the Australian fi nancial system, providing services in both borrowing and lending, primarily to the business sector. Investment banks: trade in money, securities and financial futures arrange long-term finance for company expansion provide working capital arrange project finance advise clients on foreign exchange cover advise on mergers and takeovers provide portfolio investment management services underwrite corporate and semi-government issues of securities operate unit trusts including cash management trusts, property trusts and equity trusts arrange overseas finance. Finance and life insurance companies (Finance companies do both individuals and businesses. It is up to the finance company to choose their consumers. ) Finance and life insurance companies are non-bank financial intermediaries that specialise in smaller commercial finance Finance companies act primarily as intermediaries in financial markets. They provide loans to businesses and individuals through consumer hire-purchase loans, personal loans and secured loans to businesses. They are also the major providers of lease finance to businesses. Some finance companies specialise in factoring or cash flow financing. Finance companies raise capital through share issues (debentures). Debentures

18 are for a fixed term and carry a fixed rate of interest. Lenders have the security of priority over the firm s assets in the event of liquidation. In other words, the finance company is entitled to sell the assets of the business to recover the initial loan if the business fails. Insurance companies provide loans to the corporate sector through receipts of insurance premiums, which provide funds for investment. They provide large amounts of both equity and loan capital to businesses. Insurance can be general insurance (covering property or accident) or life insurance. The funds received in premiums, called reserves, are invested in financial assets. The premiums paid by investors provide for compensation should something adverse happen, such as injury or death, or for savings for future needs. Superannuation funds Superannuation funds have grown rapidly in Australia over the past 20 years due to tax incentives and compulsory superannuation introduced by the government. These organisations provide funds to the corporate sector through investment of funds received from superannuation contributions. Superannuation funds are able to invest in long-term securities as company shares, government and company debt because of the long-term nature of their funds. Unit trusts Unit trusts (also known as mutual funds) take funds from a large number of small investors and invest them in specific types of financial assets. Unit trusts investments include the short-term money market (cash management trusts), shares, mortgages and property, and public securities. In recent years some unit trusts have also invested in gold, silver, oil and gas. Unit trusts are usually connected to a management firm that manages a diversified investment portfolio for its investors. Australian Securities Exchange The Australian Securities Exchange (ASX) was created by the merger of the Australian Stock Exchange and the Sydney Futures Exchange in July 2006 and is the primary stock exchange group in Australia. The ASX functions as a market operator, clearing house and payments system facilitator. The ASX

19 Influence of Government o Australian Securities and Investments Commission o Company Taxation offers products and services including: shares futures exchange traded options warrants contracts for difference exchange traded funds real estate investment trusts listed investment companies interest rate securities. Importantly for businesses, the ASX acts as a primary market. This primary market enables a company to raise new capital through the issue of shares and through the receipt of proceeds from the sale of securities. The ASX also operates as a secondary market. The secondary market is where pre-owned or second-hand securities, such as shares, are traded between investors who may be individuals, businesses, governments or financial institutions. Transactions in this market do not increase the total amount of financial assets the secondary market increases the liquidity of financial assets and, therefore, influences the primary market for securities Influence of government The government influences a business s financial management decision making with economic policies such as those relating to the monetary and fiscal policy, legislation and the various roles of government bodies or departments who are responsible for monitoring and administration 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. This includes the financial information that companies must disclose in their

20 Global Market Influences o Economic Outlook o Availability of Funds o Interest Rates annual reports. In 1998, the responsibilities of ASIC were broadened to cover supervision of the retail investments industry as well as overseeing the Corporations Act. ASIC assumed responsibility for the supervision of trading on Australia s domestic licensed equity, derivatives and futures markets. Company taxation. Companies and corporations in Australia pay company tax on profits. This tax is levied at a fl at rate of 30 per cent; unlike personal income taxes, which use a progressive scale. Company tax is paid before profits are distributed to shareholders as dividends. 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 long term economic growth The Australian company tax rate was reduced from 36 to 34 per cent for and to 30 per cent until Global market influences t such risk taking is necessary for a business strategy to be implemented.

21 Global economic outlook The global economic outlook refers specifically to the projected changes to the level of economic growth throughout the world. If the outlook is positive (that is, world economic growth is to increase) then this will impact on the financial decisions of a business. This may include: increasing demand for products and services. decrease the interest rates on funds borrowed internationally from the financial money market. 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. There are various conditions and rates that apply and these will be based primarily on: risk demand and supply 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. increase direct exporting will normally need to raise finance to undertake these activities. Therefore, Australian businesses could be tempted to borrow the necessary finance from an overseas source to gain the advantage of lower interest rates. However, the real risk here is exchange rate movements. 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.

22 3. Processes of financial management Planning and implementing o Financial needs o Budgets 11.1 Planning and implementing Financial planning is essential if a business is to achieve its goals Long-term plans include a business s planned capital expenditure and/or planned investments. Capital expenditure is what is spent on a business s noncurrent or fixed assets Long-term plans cover a period of between two and 10 years, and guide the development of short-term tactical and operating plans. Short-term plans are more specific and cover plans and budgets for periods of one to two years or one year or less. Planning processes involve 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. Financial needs To determine where a business is headed and how it will get there, it is

23 o Record systems o Financial risks o Financial controls important to know what its needs are. Important financial information needs to be collected before future plans can be made. This financial information includes balance sheets, income statements, cash flow statements, sales and price forecasts, budgets, bank statements, weekly reports from departments, break-even analysis, reports from financial ratio analysis and interpretation. 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. These institutions need a guarantee that their financial commitment to the business will be successful. A business plan sets out finance required, the proposed sources of finance and a range of financial statements. The types of information included in a business plan s financial statements depend on the audience for the business plan employees, owners, lenders or potential investors. Financial information is needed to show that the business can generate an acceptable return for the investment being sought and should, therefore, include an analysis of financial performance, income statement, cash flow statement, balance sheet and financial ratio analysis reports. Developing budgets Budgets provide information in quantitative terms (that is, as facts and figures) about requirements to achieve a particular purpose. Budgets can be drawn up to show: 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. 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. Budgets enable constant monitoring of objectives and provide a basis for

24 administrative control, direction of sales effort, production planning, control of stocks, price setting, financial requirements, control of expenses and of production cost. Budgets are used in both the planning and the control aspects of a business. As a control measure, planned performance can be measured against actual performance and corrective action taken as needed. A budget is an important part of the planning process and various factors need to be considered in preparing it, such as: review of past figures and trends, and estimates gathered from relevant departments in the business potential market or market share, and trends and seasonal fluctuations in the market proposed expansion or discontinuation of projects proposals to alter price or quality of products current orders and plant capacity considerations from the external environment for example, financial trends from the external environment, availability of materials and labour. Budgets are often prepared to predict a range of activities relating to short-term and longer term plans and activities. Budgets can be classified as operating, project or financial budgets.

25 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. 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. Record systems 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. The double entry system of accounting is an important control aspect. By recording all items twice, the entries can be seen to balance, and checks to find errors can be carried out quickly. 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. There are many questions that a business must answer in relation to financial risk: Should the business borrow to expand its operations? Will shareholders/owners be prepared to contribute to the business or will expansion be financed through borrowings? Should the business use its excess funds to purchase assets or invest on the short-term money market?

26 If the business is financed from borrowings there is higher risk. The higher the risk, the greater the expectation of profit or dividends. To minimise financial risk, businesses must consider the amount of profit t that will be generated. The profit t must be sufficient to cover the cost of debt as well as increasing profit to justify the amount of risk taken by owners and shareholders. Financial controls Financial problems and losses prevent a business from achieving its goals. The most common causes of financial problems and losses are: theft fraud damage or loss of assets errors in record systems. Theft and fraud include unnecessary or over-purchase of stock for personal use, conflict of interest, misuse of expense accounts, false invoices, theft of inventory or assets and credit card fraud. Financial controls ensure that the plans that have been determined will lead to the achievement of the business s goals 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. Some common policies and procedures that promote control within a business are: clear authorisation and responsibility for tasks in the business control of credit procedures, such as following up overdue accounts and customer credit checks. Budgets and variance reporting are financial controls used in businesses. As previously outlined, budgets are an important planning tool as they assist a business to estimate resource requirements for a specific future period to predict what will be achieved by a business. For example, preparing a cash budget enables a business to predict cash shortages.

27 Debt and equity financing External or debt finance is a liability to a business as it is money owed to external sources. Equity finance relates to the internal sources of finance in the business

28 Debt finance Debt can be attractive to businesses because funds are usually readily available and interest payments are tax deductible therefore reducing the cost of debt fi nuancing Debt and equity financing: advantages and disadvantages of each Equity finance In the case of equity finance, shareholders funds represent the highest proportion of total funds to finance business operations and assets. Equity finance is the most important source of funds for companies because it remains in the business for an indefinite time, because funds do not have to be repaid at a set date as with debt financing. Equity funds provide confidence to creditors and lenders, who are more willing to lend to a business if there are equity funds

29 Matching the terms and sources

30 of finance to business purpose Businesses must find the source of finance that is most appropriate to fund the activities arising from these decisions. This will be influenced by: The terms of finance must also be suitable for the structure of the business and the purpose for which the funds are required. The cost of each source of funding, whether from equity capital (share issues and retained earnings) or debt capital such as borrowings, must be determined. The required rate of return that can be expected is also taken into consideration and balanced against the costs of each source. The structure of the business can also influence decisions about finance. Small businesses have fewer opportunities for equity capital than larger businesses. Equity for unincorporated businesses has to be raised from private sources or by taking on another partner. Corporate businesses can raise equity by issuing shares to the public. Matching the term and source of finance to business purpose Costs, including set-up costs and interest rates, must be measured for each of the available sources of funds, as costs fluctuate depending on market and economic conditions. Flexibility of the source of funding is another important consideration. Business often require sources of funds to be variable so that, if firms have excess funds, borrowings can be paid off more quickly, increased or renewed as conditions change. Bank overdrafts provide greater flexibility for business than debentures and factoring. The availability of finance cannot be taken for granted and is an important financial consideration. Too heavy a dependence on a small number of investors can increase risk if an investor pulls out and commitments cannot be met. The level of control maintained by a business is also an important

31 consideration. If the lender requires security over an asset and other conditions of lending are imposed, a business s ability to consider future financing possibilities is reduced. Summary Finance for a business can come from either external or internal sources. External (or debt finance) is a liability as it is owed to sources external to the business. Equity finance relates to internal sources of finance. Most businesses have a combination of both internal and external finance. Although repayments of interest to an external provider of funds are costs to the business, debt finance can be attractive as it is readily available and interest payments can be tax deductable. Equity finance is the most important source of funds for a business as it remains in the business for an indefinite time and does not need to be repaid on a set date. When a business identifies and plans to meet its financial objectives, it is necessary to match the terms of finance with its purpose. This requires a business to consider: the terms, flexibility and availability of finance the cost of each source of funding the structure of the business. Monitoring and controlling The main financial controls used for monitoring include: 1. cash flow statements 2. income statements 3. balance sheets Cash flow statements 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

32 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. Monitoring and controlling o Cash flow statement 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 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. Outflows consist of payments to: suppliers employees other operating expenses (insurance, rent, advertising, etc.). Investing activities are the cash inflows and outflows relating to purchase and sale of non-current assets and investments.

33 o Income statement Income statements (statements of financial performance) The income statement shows the operating efficiency that is, income earned and expenses incurred over the accounting period with the resultant profit or

34 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. o Balance sheet Balance sheets (statements of financial position)

35 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. A balance sheet represents a business s assets and liabilities at a particular point in time, expressed in money terms, and represents the net worth of the business. Assets are items of value owned by the business. Current assets can be turned into cash within 12 months, whereas non-current assets are not expected to be turned into cash within 12 months. Liabilities are claims by people other than owners against the assets (items of debt), and represent what is owed by the business. Current liabilities must be repaid within 12 months, whereas non-current liabilities must be met some time after the next 12 months. Owners equity represents the owners financial interest in the business or net worth of the business. Also referred to as capital. 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 is owed by the business. Owners equity represents the owners financial interest in the business or net worth of the business. Balance sheet the accounting equation and relationships The accounting equation, which forms the basis of the accounting process, shows the relationship between assets, liabilities and owners equity. Summary

36 Monitoring and controlling is essential for maintaining business viability, and affects all aspects of business operations especially financial management. The main financial controls used for monitoring include cash flow statements, income statements and balance sheets. A cash fl ow statement provides the link between the income statement and the balance sheet. It provides information about a fi rm s ability to pay its debts on time. The cash flow statement specifically records the movement of cash receipts and cash payments that result from transactions over a given time, for example a month. Creditors, lenders, owners and shareholders all use a cash flow statement to assess the ability of the business to manage its cash and identify trends in cash flow over time. The income statement shows: operating income such as sales of inventory and services plus other earnings from interest and dividends operating expenses such as the purchase of inventory, payment of services and other expenses such as rent, advertising and insurance. Profit is the difference between revenue and expenses. The balance sheet shows the outcome of the accounting process. The accounting equation, which forms the basis of the accounting process, shows the relationship between assets, liabilities and owners equity. Comparative ratio analysis Judgements are then made by comparing a firm s analysis against other figures, percentages and ratios. This is known as comparative ratio analysis It is important to look at trends in the financial information over several years. Analysis can also include budget figures so that predicted figures can be compared against actual figures, usually over short time periods such as per month. Comparison with other businesses and benchmarking comparing results against standards that have been developed for a particular industry are

37 common. Also, each firm has differences, and finding comparable firms may be difficult. Benchmarks are useful but are merely a guide. For example, financial gearing is often used to compare firms, so that if the industry average of debt to equity was 80 per cent and a particular firm had 40 per cent, then it would need to examine the risks and analyse the reasons for the differences. In the past, Australian businesses have mainly used Australian standards but, with the globalisation of business, world standards are more commonly used for benchmarking.

38 Financial Ratios

39 o Liquidity current ratio o Gearing debt to equity ratio Financial strategies o Profitability Financial statements summarise the activities of a business over a period of time and must be analysed to increase understanding of the implications of those activities. Gross profit ratio Analysis involves working with the financial information and make it more meaningful. Net profit ratio Vertical analysis compares figures within one financial year Horizontal compares figures from different financial years Trend analysis compares figures for periods of three to five years. Return on equity ratio Financial Ratios Ratios are one of the main tools to analyse financial information. Need to interpreted the data Profitability Efficiency Financial stability liquidity and gearing o Efficiency

40 Ratio Expense ratio Accounts receivable turnover ratio Formula Analysis of which aspect of the financial statement? Acceptable ratio Interpretation of ratio results

41 Name: Liquidity, Current Ratio or Working Capital Ratio Liquidity is the extent to which a business can meets financial commitments in the short term. The business must have sufficient resources to pay its debts and enough funds for unexpected expenses. Assess the business can pay its debts when they are due. The business must be careful to ensure that it has enough current assets that could be used to generate cash quickly, but not so much that resources are not being used for producing revenue. Current ratio = Current Assets Current Liabilities Current assets and current liabilities determine the liquidity or short term financial stability of a business. = (2 DP) The firm has $1.54 of CURRENT ASSETS to cover $1 of CURRENT LIABILITIES. INFO BALANCE SHEET HIGH= GOOD E.g. 2 A ratio of less than 1:1 indicates there are insufficient assets to pay current commitments or liabilities. If successful before it may find ration of 1.54:1 acceptable. If not the firm may have to sell non current assets (because CURRENT ASSETS not selling) to cover liabilities, which will reduce its capacity to earn profits or it may have to borrow in the short term. It depends on what type of asset is it.

42 Solvency Gearing Or Leverage or debt to equity ratio Determine solvency ability meet financial commitments in the long term. BALANCE SHEET They might refer to it as net profit but it is retained profit HIGH= BAD LOW = GOOD = 0.3:1 or 33.3% The firm has $0.33 in external debt for every $1 of internal debt (owner s equity) Ratio of 1:1indicates a sound financial position E.g. 2 Ratio of 1.8: 1 = large amount of interest to repay and vulnerable if lenders demand payment Industry carries higher risk = higher debt to equity ratio Debt affects stakeholders and potential investors due to high risk = discourage investment No optimal level of gearing Must consider - Return on investment - Cost of debt - Size and stability of the business s earning capacity - Liquidity of business s assets - Purpose of long term debt The higher the ratio

43 the less solvent the firm. HIGHER = HIGHER RISK The firm must look at: Interest rates Business confidence Economic indicators to determine if the balance of debt t equity is appropriate for its particular business Profitability (GPR) Gross Profit Ratio (NPR) Net profit ratio (ROE) Return on owner s equity Profitability is the earning performance of the business and indicates its capacity to use its resources to maximise profits Profitability depends on the revenue INCOME STATEMENT used to measure profitability. Figures for GPR and NPR from Income statement For ROE figures from income statement/balance sheet GPR amount of sales available to bee expenses resulting in net profit Fall = may mean fall in net profit The amount of decrease depends on: Price reductions as a result Involves evaluating results by comparing benchmarks, industry averages or by trend analysis. E.g. 1 GPR = / * 100 = For every $1 in sales, $0.50 is returned as gross profit. NPR shows the Highly geared = more risk with regard to long term financial stability Profit amount determined by Volume of sales Mark up on purchases Level of expenses GPR of 50% is quite high. An NPR in excess of 18% would generally be considered high. NPR range of 10-

44 earned by a business and the ability of the business to increase selling price to cover purchase costs and other expenses incurred Parties interested in business s profitability 1. Owners and shareholders 2. Creditors whether paid and should offer credit in the future 3. Lenders whether the principal on the loan and interest wil be repaid 4. Management uses profitability to decide on the need for adjustment to policies of specials or sales Mark downs on out of date stock Theft of stock Errors determining prices Net profit represent the profit or return to the owners. For sole traders and partnerships return based on financial contribution to the business = contribution of labour For a company, part of the net profit is given to shareholders as dividends with the rest beign retained for future expansion. The expenses after the gross profit must be low enough to generate a net profit. The amount of sales must be sufficiently high to cover the costs and expenses of the firm. (fixed costs and variable costs ) A low net profit ratio indicates that expenses should be examined to see whether reductions can be made. (Do NOT look at COGS look at expenses and make a recommendation) Using NPR in conjunction with GPR analyse the proportion returns from every $1 of sales revenue E.g / * 100 =25% For every $1 in sales, $0.25 is returned as net profit. ROE: NET PROFIT/ O.E *100 =% For every $1 contributed by the owners, the business returns $0.4 in net profit. 18% acceptable. NPR less than 10% considered low.

45 impact of the operating expense separately to COGS ROE ratio shows how effective the funds contributed by the owners have been in generating profits and hence a return on their investment. The return for the owners has to be better than any return that could be gained from alternative investments Owners are interested not only in the return for the current year but also in comparing the current year s return with the previous years and against industry averages. If return compare well= owners might consider expansion or diversification Return is unfavourable, the owners could consider alternative options, including selling of the business.

46 Efficiency Expenses ratio Accounts receivable turnover ratio Efficiency is the ability of a firm to use it resources effectively in ensuring financial stability and profitability of the business. Expenses ratio The expenses ratio compares total expenses within sales Knowing the proportion of expenses to sales and developing strategies to lower these expenses will add to the efficiency of the business o Comparative ratio analysis Accounts receivable turnover ratio -measures the effectiveness of a firm s credit policy and how efficiently it collects its debts It measures how many times the accounts receivable balance is converted into cash or how quickly debtors pay their accounts By dividing the ratio into 365 business can determine the average number of days it takes to convert the balance into cash. If a firm s accounts receivable turnover is 54 days but it creditors allow 30 days before payment, the firm would need to examine cash flow, its credit policies, it credit collection procedures and costs Data from INCOME STATEMENT High= BAD for expenses Expenses ratio = Total expenses/sales * Accounts receivable ration = Sales / Accounts receivable = X /X = no of days to convert to cash E.g. For every $1 returned in sales, $0.42 is allocated to expenses. E.g / 16.7 times/year = 21.8 days A good aim is for business to seek to turn over every 30 days or less.

47 Over different time periods and it policies relating to doubtful debts Against standards With similar businesses Comparative ratio analysis Limitations of financial reports o Normalised earnings Judgements are then made by comparing a firm s analysis against other figures, percentages and ratios. This is known as comparative ratio analysis It is important to look at trends in the financial information over several years. Analysis can also include budget figures so that predicted figures can be compared against actual figures, usually over short time periods such as per month. Comparison with other businesses and benchmarking comparing results against standards that have been developed for a particular industry are common. Also, each firm has differences, and finding comparable firms may be difficult. Benchmarks are useful but are merely a guide. For example, financial gearing is often used to compare firms, so that if the industry average of debt to equity was 80 per cent and a particular firm had 40 per cent, then it would need to examine the risks and analyse the reasons for the differences.

48 o Capitalising expenses o Valuing assets o Timing issues o Debt repayments o Notes to the financial statements In the past, Australian businesses have mainly used Australian standards but, with the globalisation of business, world standards are more commonly used for benchmarking.

49 Ethical issues related to financial reports 11.7 Ethical issues related to financial reports Businesses have ethical and legal responsibilities in relation to financial management. There are growing calls for codes of behaviour to regulate the activities of businesses in relation to financial management Ethical considerations are closely related to legal aspects of financial management. Audited accounts 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. Audits are an important part of the control function and are generally used to examine the financial affairs of a business. There are three types of audits: 1. Internal audits. These are conducted internally by employees to check accounting procedures and the accuracy of financial records. 2. 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. 3. External audits. These are a requirement of the Corporations Act 2001