finance

• What is the strategic role of financial management?

  • Setting financial objectives + sourcing finance
  • Preparing budgets and forecasting + preparing financial statements
  • Maintaining sufficient cash flow
  • Distributing funds to other parts of the business (interdependence)
• What are the five financial objectives of a business?

  1. Profitability: maximising the earnings of the business after expenses have been paid
  2. Efficiency: ability to use resources effectively by generating maximum return for minimum cost
  3. Growth: size of business compared to competitors in terms of sales and market share
  4. Liquidity: ability to pay short term liabilities using its current assets
  5. Solvency: ability to pay both short term and long term liabilities as they fall due
• Short term vs Long term objectives

  Short term - Liquidity and Efficiency

  Long term - Profitability and Growth
• Interdependence with other KBFs


  • Must allocate adequate funds to each department to be able to operate successfully 
  • Develops budgets and cost controls for each department
• Internal Finance

  1. Owners’ equity: the funds contributed by owners or partners to establish and build the business.
  2. Retained profits: profits that are not distributed to the owners but are kept in the business as an accessible source of finance for future activities
• External Finance - Debt - Short Term

  1. Overdraft: bank allows a business or individual to overdraw their account up to an agreed limit and for a specified time, to help overcome a temporary cash shortfall
  2. Commercial bills: Short-term loans issued by financial institutions for larger amounts (>$100,000) for a fixed period of generally 30 to 180 months. 
  3. Factoring: Enables a business to raise funds immediately by selling accounts receivable at a discount to a finance or factoring business
• External Finance - Debt - Long Term

  1. Mortgage: A loan secured by the property of the borrower used to finance property purchases such as a factory or office. Timeframe of 20-25 years.
  2. Debentures: Issued by a company for a fixed rate of interest and for a fixed period of time. Raises funds from investors as opposed to financial institutions.
  3. Unsecured Notes: A loan from investors for a set period of time - not secured against business’s assets, therefore presents high risk for lenders (3-10 years)
  4. Leasing: Involves the payment of money for the use of equipment that is owned by another party.
• External Finance - Equity

  Ordinary shares: purchase of ordinary shares means individuals have become part-owners of a publicly listed company and receive payments called dividends. Value of share is determined by the company’s current or future performance
• Types of Ordinary Shares

  1. New Issues: Stockbroker issues shares on ASX (primary market), shareholder receives dividend, business receives money from share, individual may trade shares to other buyers (secondary market) and receive money
  2. Rights issues: The privilege granted to shareholders to buy new shares in the same company. They are not obliged to buy rights issues; can sell to another.
• Types of Ordinary Shares

  3. Placements: Allotment of shares made directly from the company to investors. Offer to existing shareholders at a discount to buy their loyalty. 

  4. Share purchase plans: An offer to existing shareholders in a listed company to purchase more shares in the company with brokerage fees. Permission required from ASIC. Process is inexpensive and benefits both company and investor. 
• External Finance - Equity - Private Equity


  Private Equity: the money invested in a (private) company not listed on ASX. Aims to raise capital to finance future expansion/investment of the business.
• Financial Institutions


  1. banks
  2. investment banks
  3. finance and life insurance companies
  4. superannuations funds
  5. unit trusts
  6. the ASX
• Influence of Government - ASIC


  an independent statutory commission accountable to the Commonwealth parliament

  • Enforces and administers the Corporations Act 2001 and protects consumers in the areas of investments, consumer protection, life and general insurance, superannuation and banking (except lending) in Australia
  • Aims to assist in reducing fraud and unfair practices in financial markets and financial products
• Influence of Government - Company Taxation

  Companies and corporations in Australia pay company tax on profits - before distributed to shareholders. This tax is levied at a flat rate of 30%, and 25% for a SME
• Global Market Influences - Economic Outlook

  Refers specifically to the projected changes to the level of economic growth throughout the world.

  • positive outlook (world economic growth is to increase)
  • Increasing demand for products and services
  • Decrease in the interest rates on funds borrowed internationally from the financial money market - decreased risk
  • Influenced by
  • Increase in manufacturing and trade
  • Increasing consumer confidence
  • Increased investment spending
• Global Market Influences - Availability of Funds

  Refers to the ease with which a business can access funds (for borrowing) on the international financial markets.

  • Various condition and rates apply, based primarily on: risk, demand and supply, and domestic economic conditions
  • e.g. Global Financial Crisis 2008-09
• Global Market Influences - Interest Rates


  • The higher the level of risk involved in lending to a business, the higher the interest rates
  • Australia’s interest rates are generally higher than overseas - may source from overseas institutions for lower interest rates
  • Exchange rate movements - any adverse currency fluctuation could see the advantage of cheaper overseas interest rates quickly eliminated → cheap interest rates could end up costing more in the long term
• Financial Planning and Implementing includes:


  1. Financial Needs: Determined by size, stage of business cycle, future plans for growth and development, and their capacity to source finance
  2. Budgets: Provides information about current and future direction of the finances of a business. Budgets show the cost of planned expenditure, capital, raw materials, and labour - can be operating, project, financial
  3. Record Systems: Keeping up to date record systems ensure data is accurate and reliable - important for tax purposes.
• Financial Planning and Implementing includes:

  3. Financial Risks: Businesses must understand the risk of being unable to cover its financial obligations. Sufficient profit is required to cover debt - especially short term. Risk is minimised through taking out insurance.

  4. Financial problems and losses e.g. theft, fraud, loss of assets; prevent a business from achieving its goals. Policies to promote control:

  • Control of cash e.g. cash registers, cash banked daily
  • Protection of assets e.g. lock building, security
  • Control of credit procedures e.g. follow up overdue accounts
• Comparison of Debt and Equity


  Debt:

  • Repaid by periodic repayments 
  • Interest payments are fixed
  • Interest payments are tax deductible
  • Lenders usually require a lower rate of return
• Comparison of Debt and Equity


  Equity:

  • No maturity date
  • Dividends are proportional to success
  • Dividends are not tax deductible
  • Shareholders require higher return due to higher risk
• Advantages and Disadvantages of Debt


  Advantages:

  • Funds are readily available 
  • Flexible payment periods and types of debt available
  • Will not dilute current ownership

  Disadvantages:

  • Security is required
  • Can be expensive - interest
  • Regular repayments
• Advantages and Disadvantages of Equity


  Advantages:

  • Not repaid unless owner leaves the business
  • Cheaper - no interest
  • Low gearing and less risk

  Disadvantages:

  • Ownership is diluted
  • Lower profits and lower returns for the owner
  • Long and expensive process
• Cash Flow Statement


  Indicates the movement of cash receipts (inflow) and cash payments (outflow) resulting from transactions over a period of time

  • Purpose: identify trends to help better manage flow, anticipate cash flow shortages and also cash overflow and can be a useful predictor of change, forecasting
  • Useful for: creditors and lenders of finance, owners and shareholders who can assess the ability of the business to manage its cash
• Cash Flow Formula


  $Opening Balance +$$Cash Flow - Cash Outflow =$$Closing Balance$
• Cash Flow Statement - Types of Activities


  1. Operating activities: Relate to the main activity of the business (provide goods & services) → e.g. inflows - sales (cash/credit), outflows - payments to suppliers
  2. Investing activities: Relate to the purchase and sale of non-current assets and investments that are used to generate income for a business → e.g. purchasing property
  3. Financing activities: Relate to the borrowing activities of a business. equity (shares or own contribution) or debt (loans)
• Income Statement


  reports the earnings of the business over a specific period of time

  • Shows how much the business sold, how much it cost to sell, what profit was made
  • Evaluating changes in profit levels, assessing increases in expenses and making comparisons with previous years to determine profitability and efficiency
• Items in an income statement

  Net Sales: Amount of revenue a business has earned from sales when the effects of sales returns are deducted

  COGS: An expense - cost to produce the goods that have been sold. Indicates the markup on the goods sold (usually 50-100%) to determine level of income. 

  COGS = opening stock + purchases – closing stock
• Items in an income statement

  Gross Profit: Profit made from sales less COGS, before expenses are deducted. 

  Gross Profit = Sales – COGS

  Expenses: Costs incurred in the process of acquiring or manufacturing a good or service. Selling, Administrative, Financial

  Net profit: Difference between gross profit and expenses.

  Net Profit = Gross Profit – Expenses
• Balance Sheet


  represents a business’s assets and liabilities at a particular point in time and represents the net worth (equity) of the business

  Purpose:

  • The return on the owners’ investment - important for potential investors
  • The sources and extent of borrowing - important for financial institutions
• Balance Sheet


  Assets: items of value owned by the business (current/non-current)

  Liabilities: items of debt owed to outside parties (current/non-current)

  Owners’ equity: the funds contributed by the owner(s) and represents the net worth of the business. Consists of capital (funds contributed by owners) and retained profits.

  Assets = Liabilities + Owners’ equity
• Current Ratio - Liquidity


  gives an indication of how well liabilities are covered by current assets

  Current Ratio = Current Assets ÷ Current Liabilities

  Analysis

  • below 1:1 - not liquid, more debt than assets to cover them
  • At 1:1 - liquid but not ideal, just enough to cover but doesn't account for unexpected debts
  • 2:1 - liquid and IDEAL
  • Above 2:1 - liquid but not ideal - too many current assets which should be invested
• Debt to Equity Ratio - Gearing


  Gearing (solvency): the proportion of debt (external finance) and the proportion of equity (internal finance) that is used to finance the activities of a business (LONG TERM)

  • Gearing ratios determine the firm's solvency: the ability to meet its financial commitments in the longer term - the extent to which the business relies on debt to fund its operation
  • The more highly geared the business (debt > equity), the greater risk for the business but the greater potential for profit
• Debt to Equity Ratio


  Debt to Equity Ratio = Total Liabilities ÷ Total Equity x 100

  Analysis:

  • Below 50% - not ideal, more equity than debt, insolvent, lowly geared - not taking advantage of their borrowing capacity to grow the business
  • 50 to 100% - IDEAL - equal equity to debt or borrowing are less than the owner’s contribution so the risk is relatively low
  • Above 100% - not ideal, more debt to equity, insolvent, highly geared, relying more heavily on debt could mean insolvency if facing extreme economic fluctuations

  The higher the ratio, the less solvent the business is.
• Gross Profit Ratio

  • Highlights the gross profit in relation to sales
  • Considers the profitability of the business after COGS have been subtracted
  • Guide to whether the business is paying too much for the goods that it sells

  Gross Profit Ratio = Gross Profit ÷ Sales x 100

  THE HIGHER THE RATIO, THE BETTER

  • Low ratio → COGS is too high, must lower costs or raise prices to increase sales
  • Industry average (40%) → e.g. Apple has large markups
  • High ratio → prices may be uncompetitive
• Net Profit Ratio


  • Shows the amount of sales revenue that results in net profit
  • The expenses after gross profit must be low enough to generate a net profit AND sales must be sufficiently high to cover the expenses of the firm and still result in profit

  Net Profit Ratio = Net Profit ÷ Sales x 100

  THE HIGHER THE RATIO, THE BETTER

  • Low ratio → expenses are too high, must examine to make reductions
  • Industry average → retail industry is 13-20%
  • High ratio → ideal, means that expenses are paid for and still making high return
• Return on Equity Ratio

  • Shows how effective the funds contributed by the owners have been in generating profit, and hence a return on their investment
  • Measures the percentage return on the owner’s contributions to the business

  Return on Equity Ratio = Net Profit ÷ Total Equity x 100

  THE HIGHER THE RATIO, THE BETTER THE RETURN

  • Needs to be greater that what could be earned by investing money into a bank
  • Used as a comparison tool for investors who own shares (or potentially could) in a number of businesses
• Expense Ratio

  • Compares total expenses with sales to indicate the day-to-day efficiency of the firm
  • Some expenses will be fixed and some will fluctuate according to the level of sales
  • Decline may also be due to lower interest rates or less debt being used

  Expense Ratio = Expenses ÷ Sales x 100

  THE LOWER THE RATIO, THE BETTER

  • Too high → business should cut expenses (selling, admin, finance)
  • Too low → be careful of random (indiscriminate) cost cutting - cutting the wrong thing
• Accounts Receivable Turnover


  • Measures the effectiveness of a firm’s credit policy and how efficiently it collects its debt
  • Measures how many times the accounts receivable balance is converted into cash or how quickly debtors pay their accounts
  • Can be improved by improving cash flow
• Accounts Receivable Turnover

  Accounts Receivable Turnover = Sales ÷ Accounts Receivable x 100

  365 ÷ Answer =  average length of time (in days) it takes to convert the balance into cash

  Analysis:

  • High (above 30 days) → business is inefficient, not ideal, trouble collecting money
  • 30 to 40 days → business should look at ways to collect money e.g. early discounts
  • Low (30 days or below) → IDEAL and efficient, debtors are paying on time (Because credit policy usually allows 30 days before payment)