- Financial management à the planning and monitoring of a business’s financial resources to enable the business to achieve its financial objectives.
- Mismanagement of financial resources can lead to problems
- Strategic plans of a business involve setting long-term objectives and taking a long-term view of where management wants the business to go.
Profitability, Growth, Efficiency, Liquidity, Solvency
- Achievable and manageable outcomes that can be measured and elevated
Goals > Longer term outcomes of a business e.g. maximise profits
- Relies on finance for adequate funding of manufacturing of products
- Finance relies on operations to produce the products, so that funding may be sourced
- Relies on finance for adequate funding of promotion and advertising
- Finance relies on marketing so that products are promoted in ways that bring income
- Relies on finance for adequate funding for staff management and training
- Finance relies on human resources so that staff are trained/qualified appropriately to help heighten sales
- Funds contributed by business owners/partners to establish and build business
- Equity capital can be also be sourced by additional partners, funds from investors/shareholders, selling off assets, issuing of private shares
- Most common source of internal finance
- Saved earnings for future activities
- 50% of profits in Australian businesses are retained
- Selling Assets à businesses sell their dormant (unused) assets
- Advantage; If relocating, sale of land and buildings can also sell some other fixed assets to raise funds and survive a liquidity problem
- Family and Friends à borrowing from family and friends
- Advantage; Straightforward, and inexpensive, does not require authorisation from banks and may not have interest costs
- Disadvantage; limited amounts, provokes arguments and fallouts
- Investing Extra Cash à Cash that does not need to be spent imminently can be placed in an interest bearing saving account
- Advantage; Earns interest for business, acts as another source of finance
- Disadvantage; returns is not high
- Working Capital à refers to the money that is available day-to-day running of a business comes from sales of goods/services, need to pay for everyday costs
Banks > major operations in financial markets and most important source of funds for business
Investment Banks > Provides specialised advice and services for a businesses financial needs
Finance Companies > Non-bank financial institutions, acting as financial intermediaries. Provides loans to businesses/individuals through consumer hire-purchase loans, personal loans and secured loans to businesses.
Superannuation Funds > invest contributions of members into a range of short/long term investments with aim of maximising a return
Life Insurance Companies > Non-bank financial intermediary who provides cover and lump sum payment in the event of death. Policyholders pay regular premiums and insurer guarantees to pay the designated beneficiary a sum of money upon death of the insured person or under other circumstances specified in the contract.
Unit Trusts > take funds from a large number of small investors and investors and invest them in specific types of financial assets. These investments include the short-term money market (cash management trusts), shares, mortgages and property, and public securities
ASX > Acts as a primary/secondary market for sales of shares to public. Offers products and services; Shares, futures, exchange-traded options, warrants, contracts for difference, exchange traded funds, real estate investment funds, listed investment companies, interest rate securities
Australian Securities and Investments Commission (ASIC)
- ASIC is an independent statutory commission accountable to the Commonwealth parliament.
- Enforces and administers the Corporations Act 2001 to protect consumers with investments, life and general insurance, superannuation and banking in Australia
- Aim is to assist in reducing fraud and unfair practices in financial markets and products
- Ensures that companies follow the law, collecting information about companies and making it available to public including financial information that companies must disclose in annual reports
- ASIC will investigate and determine a remedy for a business whom has breached the Corporations Act 2001
- The remedy will depend on the seriousness of the misconduct and may include imprisonment and monetary penalties
- Private and public Australian businesses must pay company tax on profits
- This tax is at a flat rate of 30% of net profit
- Company tax is paid before profits are distributed to shareholders as dividends
- Australian Government has undertaken a process of reform of the federal tax system to improve Australia’s international competitiveness and make Australia an even more attractive place to invest, and thus drive long-term economic growth
- This means increase in jobs and higher wages for working Australians
- Company taxation has decreased from 36% in 2000, down to a current 30%
Financial risks associated with global markets are greater than those encountered domestically, but such risk taking is necessary for a business strategy to be implemented
- Global Economic Outlook à refers to the projected changes to the level of economic growth throughout the world
- Positive outlooks will impact the financial decisions of a business whilst negative outlooks will impact on financial decisions of a business in the opposite way
- Positive impacts may include à
- Increasing demand for products and services
- Decreasing interest rates on funds borrowed internationally from the financial money market
Availability of Funds
- Availability of Funds à refers to the ease with which a business can access funds for borrowing on the international financial markets
- International financial markets are made up of institutions, companies and governments prepared to lend money to individuals, companies or governments needing to raise capital
- Various conditions and rates apply and are based on:
- Demand and Supply
- Domestic Economic Conditions
- The Global Financial Crisis 2008-2009 impacted the availability of funds for companies and institutions and caused an spike in interest rates
- Interest Rates à the cost of borrowing money
- The higher the level of risk involved = the higher the interest rates
- Australian interest rates tend to be above overseas countries. Therefore, Australian businesses may borrow finances from overseas sources to gain the advantage of lower interest rates.
- To determine where a business is headed, how it will get there and its future plans, it is important to know what its needs are
- Information for this 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.
- Financial needs of a business will be determined by:
- Size of the business
- 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.
- Business Plan à used when seeking from a bank or other financial institution. A business plan sets out finance required, the proposed sources of finance and a range of financial statements.
- Provides information in quantitative terms about requirements to achieve a particular purpose
- Used in planning and control aspects of a business. As a control measure, planned performance can be measured against actual performance and corrective action taken as needed.
- Provides financial information for a business’s specific goals
- Budgets can show:
- Cash required for planned outlays for a particular period
- 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
- Operating Budgets à Sales production, expenses, raw materials and labour hours
- Project Budgets à Capital expenditure and Research and Development
- Financial Budgets à Income statement, balance sheet, cash flow statement
- Managers need to set up a record system that allows them to record all needed information
- Record Systems à mechanisms employed by a business to ensure that data is recorded and the information provided by record systems is accurate, reliable, efficient and accessible
- Record keeping is a legal requirement. Businesses are required by the Australian Taxation Office to keep certain records for a minimum of five years
- Accounting software programs have been developed to assist businesses with their records. Many accounting programs allow users to email and send financial information to clients, suppliers or to the ATO
- Risk of being unable to cover 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
- Minimise financial risk à consider amount of profit that will be generated. Profit must be sufficient to cover cost of debt as well as increasing profits to justify the amount of risk taken by owners and shareholders
- Should be consideration of the liquidity of a business’s assets. If a business has short-term debt, it must have liquid assets so that debts can be covered
- Financial problems and losses prevent a business from achieving goals
- Common causes of financial problems and losses are Theft, Fraud, Damage/loss of assets and Errors in record systems
- Common policies and procedures that promote control:
- Clear authorisation and responsibility for tasks in the business
- Separation of duties — e.g. one person responsible for ordering and another for receiving inventories; one person writes cheques and another signs the cheques
- Rotation of duties — e.g. staff are skilled in a number of areas and rotate duties
- Control of cash – e.g. use of cash registers, cash banked daily, no money kept on premises overnight, payments made by cheque not cash
- Protection of assets — e.g. buildings are kept locked, a registry of assets is maintained, regular checks of inventory are carried out and security surveillance systems are installed
- Control of credit procedures – following up overdue accounts and customer credit checks.
Debt and Equity Financing (Advantages and Disadvantages)
- Debt finance is made up of borrowed funds
- Involves a contractual agreement based on specific conditions over a period of time.
- Business repays the initial amount + interest
- Usually incurs admin fees and government charges such as stamp duty
- Attractive to businesses because funds are readily available and interest payments are tax deductible
- Money lent to the business in exchange for ownership in the business
- Includes start-up capital and additional capital raised through share issues
- Shareholders’ funds represent the highest proportion of total funds to finance business operations and assets
- Most important source of funds for companies as it remains in the business for an indefinite time
- Safer than debt, but requires sufficient profits so that the business can continue to operate
- Provides confidence to creditors/lenders
Matching the Terms and Source of Finance to Business Purpose
- When a business identifies and plans to meet its financial objectives, it is needed to match the terms of finance with its purpose
- Short-term finance should be used to purchase short-term assets
- Long-term finance should be used for long-term assets
Cash Flow Statement
- Key financial report that are apart of effective financial planning
- Provides link between the income statement and balance sheet, giving information regarding a firm’s ability to pay debts on time
- Shows movement of cash receipts and cash payments resulting from transactions over time and helps to identify trends and can be a useful predictor of change
- Users: creditors, lenders of finance, owners and shareholders
- Potential shareholders check a businesses cash flow over a number of years
- Fluctuating pattern of cash flows might point to difficulties in the business
Cash flow statements can show whether a business can:
- Generate a favourable cash flow (inflows exceed outflows)
- Pay its financial commitments as they fall due
- Have sufficient funds for future expansion or change
- Obtain finance from external sources when needed
- Pay drawings to owners or dividends to shareholders.
- Prepared from the income statement and balance sheet, as they summarise transactions
- Only cash transactions are included in the cash flow statement
- Cash inflows and outflows relating to the main activity of the business.
- Main inflows are the sales (cash and credit) plus dividends and interest received.
- Main outflows consist of payments to: suppliers, employees and other-operating expenses
- 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.
- g. selling an old motor vehicle, purchasing new equipment or property
- Cash inflows and outflows relating to the borrowing activities of the business.
- Borrowing inflows can relate to equity or debt
Income Statements Cash outflows relate to the repayments of debt and cash drawings of the owner or payments of dividends to shareholders
- A summary of the income earned and the expenses incurred over a trading period
- Helps to see exactly how much money has come into the business as revenue, how much has gone out as expenditure and how much has been derived as profit
- Income Statements Show:
- Operating incomeg. sales of inventories, services and non-operating revenue earned from other operations, such as interest, rent and commission
- Operating expensesg. purchase of inventories, payment for services and other expenses incurred in the main operation of the business, such as advertising, rent, telephone and insurance
- Shows difference between the income and expenses to be either profit or loss
- First Step à record the income earned by business.
- Second Step à record the cost of goods sold, and to use this figure to calculate gross profit
- Third Step à deduct operating expenses from gross profit to calculate net profit
- 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
- Relates to the process of selling the good/service and traced to the need for sales
- Includes: commission, salary, wages, advertising, electricity, depreciation on shop fittings
- Costs directive related to the general running of the business
- Includes à Stationary, office salaries, rent, audit fee’s, accountant fee’s, rates, telephone, depreciation on buildings, insurance
- Costs associated with borrowing money from outsiders to minimise business risk
- Includes à interest payments, lease payments, dividends and insurance payments
- Represents a business’s assets and liabilities at a particular point in time and represent the net worth (equity) of the business.
- Shows the financial stability of the business.
- The balance sheet is prepared at the end of the accounting period.
- Shows the level of current and non-current assets, and current and non-current liabilities, including investments and owners’ equity
Assets à items of value owned by the business. Current assets can be turned into cash within 12 months; non-current assets can be turned into cash after 12 months
Liabilities à claims by outsider against assets, and represents what the business owes
Owners’ Equity à funds contributed by the owner and represents the business net worth
- 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 balance sheet shows the return on the owners’ investment, the sources and extent of borrowings, the level of inventories
- The figures show whether the business has sufficient assets to continue to make profits in the longer term, how much of the assets are financed from outside borrowings, whether the business can expect to meet its financial obligations in the short and long term, and how the year’s figures compare with the other years
- Figures from previous years’ balance sheets can also be analysed and presented to show the decision makers the trends and changes in the business that need to be investigated
- The balance sheet shows the outcome of the accounting process. The accounting equation can be represented in different ways but, because it is an equation, it must always be equal.
- The accounting equation shows the effect of the business’s operations on owners’ equity. Owners’ equity comprises two elements — capital, or funds contributed by the owner or owners to the business, and retained profits
Liquidity (Current Assets)
- Extent to which the business can meet its financial commitments in the short term
- The business should have sufficient resources to pay debts and enough funds for unexpected expenses
- To assess a business’s liquidity, the business ability to pay its debts when they are due must be assessed. Is there sufficient cash and a level of assets and inventories that can be converted to cash quickly to repay the firm’s debts — that is, the firm’s accounts payable, interest and loans?
- The holding of outstanding debts means the business has less cash to earn revenue. The quicker the firm receives cash from its accounts receivable, the quicker those funds can be used to earn revenue.
- Current assets and current liabilities determine the liquidity or short-term financial stability of a business
Current Ratio (Working Capital)
- The current ratio measures the businesses ability to pay back their current liabilities with their current assets
- The higher the current ratio, the more capable the business is of meeting their short-term obligations
- An acceptable ratio will depend on factors, such as the type of firm, how other firms in the industry are operating and factors in the external environment
- Answer is written as a ratio
- A ratio of 2:1 indicates a sound financial position for a business, meaning the business should have double the amount of assets to cover liabilities
- A ratio of 0.5:1 means the business is not liquid and is unable to pay short-term debts
- A ratio of 5:1 means business resources are not being used efficiently, meaning the excess cash should be reinvested into the business E.g. upgrading systems
- Ways to improve liquidity:
- Improve the ‘recievables’ policy à be more strict in collecting money owing to the business from customers
- Reduce the amount of stock/inventory the business holds
- Sell non-current assets
- Reduce current liabilities à move towards equity funding
- Pay “accounts payable” (bills) at the last possible date
- Gearing measures the relationship between debt and equity. Gearing is the proportion of debt and the proportion of equity that is used to finance the activities of a business
- Gearing ratios determine the firm’s solvency, which is its ability to meet financial commitments in the longer term
- Potential investors and creditors are interested in gearing ratios, as they show if creditors will be paid or if investors can expect a good return on their money
- Gearing is an important consideration for businesses as the higher geared the business the greater the risk for the business but the greater potential for profit
- Factors such as risk, return and degree of control over the enterprise influence the level of leverage that is appropriate for a business
- A business must consider:
- Return on investment
- Cost of debt
- Size and stability of the business’s earning capacity
- Liquidity of the business’s assets (the greater the cash flow and the more liquid the assets, the more likely the interest charges will be paid)
- Purposes of short-term debt
Debt to Equity Ratio
- The debt to equity ratio shows the extent to which the firm is relying on debt or outside sources to finance the business
- There must be a careful balance between debt and equity
- 100% à highly geared. They have a lot of liabilities and little equity. They should reduce debts, or increase equity. Large businesses are safe in this range
- 50% à small businesses should be in this range, as with a very low level like this, the business can feel safe to get a loan to expand the business
- If ratio is extremely low, the business might not be taking advantage of its ability to borrow money and expand
- A highly geared firm (a firm that uses more debt than equity) carries more risk with regard to longer-term financial stability. Investors would be less attracted to a firm with a higher debt to equity ratio because this indicates a greater financial risk
- How to improve gearing:
- Reduce debts
- Increase input of equity (e.g. sell more shares)
- Profitability is the earning performance of the business and indicates its capacity to use its resources to maximise profits
- Profitability depends on the revenue earned by a business and the ability of the business to increase selling prices to cover purchase costs and other expenses incurred in earning income
- A number of parties are interested in a business’s profitability:
- Owners and shareholders want to know whether the firm is earning an acceptable return on their investment.
- Creditors want to know whether they will be paid and should offer credit in the future.
- Lenders want to know whether the principal on the loan and interest will be repaid and whether to lend to the firm in the future.
- Management uses profitability to decide the need for policy adjustments
- The amount of profit is determined by factors such as the volume of sales, the mark-up on purchases and the level of expenses
- Financial information must be examined to see where changes have occurred and where changes need to be made in the future
- Income statements used to measure profitability or earning capacity of the firm
Gross Profit Ratio:
- Gross profit represents the amount of sales that is available to meet expenses resulting in net profit
- Amount of decrease depends on factors such as; price reductions as a result of specials or sales, mark-downs on out-of-date stock, theft of stock, errors in determining prices, changes in the mark-up policies or changes in the mix of sales
- Gross profit is the difference between sales revenue and the direct COGS
- Other expenses such as employee salaries and advertising costs, are later deducted from gross profit to determine the net profit
- Written as a percentage
- It is the percentage of each dollar that is gross profit (the selling price minus the cost of making or buying the good originally)
- High figures are better, but should be compared to previous years & competitors
- Very high figures may mean that the business is overcharging their products
- How to Improve Cost Controls:
- Reduce fixed and variable costs (e.g. obtain materials at lower prices)
- Make individual areas of the business responsible for keeping a low COGS
- How to Improve Revenue Control:
- Set and achieve marketing objectives (sell more)
Net Profit Ratio:
- Net profit represents the profit or returns to the owners
- For sole traders and partnerships, net profit represents a return on their contribution to the business.
- Company’s sometimes return part of net profit to shareholders as dividends and retain a part for future expansion
- Net profit ratio shows the amount of sales revenue that results in net profit
- Costs or expenses after gross profit must be low enough to generate a net profit
- The amount of sales must be sufficiently high to cover the costs or expenses of the firm and still result in a profit
- Written as a percentage
- It is different from the Gross Profit Ratio because accounts for expenses
- A business should be aiming at a higher gross and net profit ratio, but comparisons should be made with past performances, competitors and industry averages to understand where they stand
- The average for the retail industry is about 13-20%
- A low ratio means that the business is struggling with costs and expenses
- What Expenses to Minimize:
- Administrative expenses (rent, printing, etc)
- Selling expenses (esp. advertising)
- Financial expenses (e.g. change high interest loans into lower interest loan)
Return on Equity Ratio:
- The return on equity ratio shows how effective funds contributed by owners have been in generating profit, and hence the return on their investment
- Return for owners should be better than any return that could be gained from alternative investments
- If return on equity rises due to increased leverage (debt) the improved result should be seen as carrying increased risk
- Owners are also in comparing with other years and against industry averages to check for improvement
- The higher the ratio or percentage, the better the return for the owner
- If returns compare favourably, owners may consider expansion of the business
- How to Improve:
- Reduce COGS and expenses
- Effective marketing
- Improve efficiency
- Efficiency is the ability of the business to use its resources effectively in ensuring financial stability and profitability of the business.
- Efficiency relates to the effectiveness of management in directing and maintaining the goals and objectives of the firm
- The more efficient the firm, the greater its profits and financial stability.
- The expense ratio compares the total expenses with sales
- The ratio indicates the amount of sales that are allocated to individual expenses, such as selling, administration, cost of goods sold and financial expenses
- It also indicates the day- to-day efficiency of the business
- Management uses this ratio to determine where the highest expenses are from and why the ratio has either increased or decreased
- Decline in financial expense ratio may be a result of lower interest rates or less debt
- The lower the percentage, the better
- With a high expense ratio, the business would need monitor and control their expenses and avoid unnecessary expenses
- Ways to Improve:
- Know the source of the expenses then try to lower them where possible
Accounts Receivable Turnover Ratio:
- 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, businesses can determine the average length of time it takes to convert the balance into cash
- 40+ days à Business is having trouble collecting money from people
- Less than 30 days à Customers are paying on time
- How to Improve:
- Charge extra for late payments
- Offer discount for early payments
- Monitor the business’s accounts more effectively
- Be careful granting credit
Comparative Ratio Analysis
- For analysis to be meaningful, comparisons and benchmarks are needed. Comparing a firm’s analysis against other figures, percentages and ratios then makes judgments. This is a comparative ratio analysis and is important to business
- Comparisons can be done by comparing ratios with results from previous years, similar businesses and against common industry standards or benchmarks
- It is important to look at trends in the financial information over several years. Figures from at least the previous two years can indicate directions or trends and make ratio analysis more meaningful
- Normalised earnings are earnings that are adjusted to take into account changes in the economic cycle or to remove one-off influences that affect profitability
- Done to give accurate depictions of the companies true earnings to make it easier to compare profitability figures for a business from various years and against other businesses
- g. the removal of a land sale, which would achieve a large capital gain
- Accounting method where a business records an expense as an asset on the balance sheet rather than as an expense on the income statement
- Doesn’t accurately show a businesses true financial condition as it understates the expenses and overstates the profits as well as the assets of the business
- g. research and development, and development expenditure
- Process of estimating the value of assets when recording them on a balance sheet
- Assets are difficult to estimate so its value may be written as its historical cost, which is the value at which they were purchased
- Advantage of historical cost is that it can be verified but the disadvantage is that this value may distort the business’s balance sheet, meaning that it will not accurately represent the true worth of the business’s assets, as the original cost of an asset may be different from its current market value
- Non-current assets typically increase over time e.g. land, but some such as vehicles depreciate in value over time
- For depreciating assets, businesses estimate how much they lose each year
- There are rules governing how depreciation is calculated, but financial managers are free to choose from several methods, which may mislead some investors
- Limitation when interpreting financial reports as the depreciation rate is an estimate and may give false impressions about the business worth
- Intangible assets such as goodwill, trademarks and brand names are of value to a business. Sometimes they’re not included on a balance sheet as their value is difficult to calculate
- Accountants may adjust the timing of revenue inflows and debt repayments to make the business appear more profitable, as it may delay banking revenue until the start of a new financial year in order to decrease the business’s current taxation commitment. Additional methods of prepaying expenses may provide businesses with additional tax deductions for the current financial period.
- Accountants may also use shorter accounting periods (less than a year) to avoid including transactions that affect the business’s profitability or financial stability
- The Matching Principle à
- Each transaction is to be recorded at the time it occurs.
- When followed, it means the accountant has matched the revenue earned to the costs that were incurred to earn this revenue. E.g. a business sells $12 000 worth of goods in June 2010. During June 2010 it also paid a salesperson $1200 in wages. Therefore, the business must record $12 000 in sales revenue less $1200 in wages expenses in June 2010.
- Businesses can’t record expenses from a different financial year
- Recording them in a period other than the one in which they occurred can hide unfavourable transactions. By recording these transactions outside the current financial year, for instance, they will not appear on the current financial reports. They will be hidden in the accounts for a different financial year
- Businesses may claim that mistakes are made due to the volume of transactions that occur each day and claim that it makes it difficult to get accurate reports for the last day of the financial year
- The gearing ratio in financial reports is used to determine whether businesses are likely to meet long-term financial commitments. A highly geared business may be alarming for some stakeholders as it has increased risk, but their potential for profit is greater.
- g. higher levels of debt to fund growth can lead to increased profits in the future.
- Finance reports are limited as they don’t have capacity to disclose specific info about debt repayments such as à
- How long the business has been recovering from debt
- The capacity of the business
- The methods the business has for the recovery of debt
- What provisions 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
- When debts are due
Notes to the Financial Statements
- 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, income statement and cash flow statement.
- They contain information that may be useful to stakeholders to explain financial statements. They contain 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. They may also contain details about how the figures in the financial statements were calculated and the procedures that were used to develop them.
- Social attitudes have forced businesses to consider the ethics of their decisions
- They must ensure that financial decisions are judged morally correct, socially and environmentally responsible and ‘the right thing to do’
- Accountants are expected to display integrity, objectivity, confidentiality and a high level of professional and technical ability
- The Institute of Chartered Accountants in Australia oversees and sets accounting standards that must be followed in the preparation of financial reports, yet some financial managers will try to stretch boundaries set by these rules. Accountants cannot ‘be creative’ when recording transactions and preparing financial reports in order to make the business appear more profitable and secure.
- From 1 July 2004, changes to the Corporations Act 2001 forced companies to reveal details of the salary packages of directors and executives, forcing them to be more honest in behaviour. There is also greater pressure from shareholders for directors and executives to perform according to what they earn
- Businesses have responsibility to look after employees, the work environment and the local community in which the business owners and employees live. Managers may misuse the business funds with credit cards for personal expenses. This is an unethical use of company funds.
- Triple Bottom Line à
- Business owners need to accept the concept of the triple bottom line, which is as well as financial returns; there is a cost or return to society and the environment. Businesses should act in a socially responsible and ecologically sustainable manner by formally recognising the wider costs or impacts of the business.
- As well as reporting on profitability of a business, TBL-based reporting provides a balanced and enhanced non-financial disclosure. TBL-based reporting is more accepted as a method of reporting the success of a business and allows an organisation to prepare for future challenges and opportunities, including those considered intangible, e.g. reputation
- Business accounts can be monitored through auditing, an independent check of the financial records of a business by an accountant to ensure that financial reports represent a true and fair financial picture of the business.
- Audited accounts are a legal requirement of all public companies, clubs and associations each year. Alternatively, managers can perform it internally.
- Audits are necessary because:
- Shareholders need to be able to trust the annual report if they wish to invest in the business, sell their shares or determine whether the dividend is fair
- Owners want to know the accuracy of profit results
- The government wants to determine how much tax the business should pay
- Managers want to establish whether resources or money can be saved, there has been fraud or any misuse of funds by employees, and correct rules and accounting standards have been followed when creating reports.
- Financial reports have many assets valued at historical cost (original purchase price), and have an undervalued share price or low profitability. These undervalued businesses are targets for unethical corporate raiders. These raiders take over the undervalued businesses; and strip them of their assets for profit.
Cash Flow à movement of cash in and out of a business over a period of time.
Cash Flow Statements
- Cash flow statements indicate the movement of cash receipts and cash payments resulting from transactions over a period of time
- It can identify trends and can be a useful predictor of change
- Businesses that have shortfalls of cash over long periods are of concern for a business as insolvency or bankruptcy may result
- Management must implement strategies to ensure that cash is available to make payments when they are due
Distribution of Payments
- Involves distributing payments throughout the month, year or other period so that large expenses do not occur at the same time and cash shortfalls do not occur
- This means there is a more equal cash outflow each month rather than large outflows in particular months.
- Cash flow projections can identify periods of potential shortfalls and surpluses.
Discounts for Early Payment
- Offering creditors a discount for early payments
- Most effective when targeted at creditors who owe the largest amounts over the financial year period
- Beneficial for creditors who can save money and therefore improve their cash flow
- Positively affects the business’s cash flow status.
- Selling of accounts receivable for a discounted price to a finance or specialist factoring company.
- Business saves on costs involved in following up unpaid accounts and debt collection
- Factoring is used as a strategy to improve working capital
- Short-term liquidity is important as it means a business can take advantage of profit opportunities when they arise, as well as meet short-term financial obligations, pay creditors on time to claim discounts, pay tax and meet payments on loans and overdrafts
- Working capital à term used by businesses to describe the funds available for the short-term financial commitments of a business
- Net working capital à represents funds needed for day-to-day operations of a business to produce profits and provide cash for short-term liquidity
- Current assets constantly change as inventories are sold, cash is paid out and payments are received.
- Working capital is often the major asset of a business
- Working capital management à determining the best mix of current assets and current liabilities needed to achieve the objectives of the business. The more efficient a business is in organising and using working capital, the more effective and profitable it will be
The Current (Working Capital Ratio)
- Shows if current assets can cover current liabilities, meaning it helps to determine whether a business is managing cash flows so that it can pay immediate debts.
- Ratio indicates the amount of risk taken by a business in relation to profitability and liquidity, and can determine if the business’s financial structure is acceptable
Control of Current Assets
- Managing cash, accounts recievable and inventory correctly
- Excess inventories and lack of control over accounts receivable lead to an increased level of unused assets, leading in turn to increased costs and liquidity problems
- Insufficient inventories and tight credit control policies may lead to problems
- 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.
- Businesses need to monitor inflows and outflows
- Inflows à Payments from customers, Interest on savings/investments
- Outflows à Wages, rent and taxes, Purchasing stock and Loan repayments
- Cash budget à used to predict cash receipts (inflows) and cash payments (outflows)
- Sums of money due to a business from customers to whom it has supplied goods and 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 à The stock a business holds
- Makes up a significant amount of current assets
- Too much inventory or slow-moving inventory will lead to cash shortages
- Insufficient inventory of quick-selling items may lead to loss of customers and lost sales
Control of Current Liabilities
- The effective monitoring and management of a businesses payments and short-term debts such as accounts payable, loans and overdrafts
- Sums of money owed by the business to suppliers
- Recorded as accounts payables
- Too many bills/invoices may put strain on the business as well as affecting their credit ratings
- Managing accounts payable;
- Arranging payment to be paid on the actual due date
- Paying earlier than due date if discount is offered
- Implementing internal controls to prevent embezzlement (employee theft of business) by accounts payable by personnel.
- Researching suppliers which provide interest free periods, discounts and extended terms for payment
- Businesses often use short-term loans as a source of finance
- Loans can be packaged to suit particular requirements of the business
- Finance companies and banks will have varying interest rates and loan fees
- Variable interest rate à interest rate fluctuates throughout the life of the loan
- Fixed interest rate à interest rate remains the same through the whole loan
- Enables a business to overcome temporary cash shortages
- Involves an arrangement with the bank that the business’s account can be overdrawn to a certain amount
- Banks require regular payments to be made on overdrafts and may charge account/keeping fees, establishment fees and interest.
- Businesses should have a policy for using and managing overdrafts and monitor budgets on a daily or weekly basis so that cash supplies can be controlled
- Hiring of an asset from another person or company who has purchased the asset and retains ownership of it.
- Leasing ‘frees up’ cash that can be used elsewhere in a business, so the level of working capital is improved.
- Attractive strategy for some business’s as it is an expense 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
- 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 cash obtained from the sale is then used as working capital
- Profitability Management à involves the control of both the business’s costs and its revenue
Fixed and Variable
- Fixed Costs à Not dependent on the level of operating activity in a business
- Do not change when the level of activity changes — paid regardless of what happens in the business
- g. salaries, depreciation, insurance and lease
- Variable Costs à Change proportionately with the level of operating activity in a business
- g. 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 changes in costs.
- Comparisons of costs with budgets, standards and previous periods ensure that costs are minimised and profits maximised
- An area or division of a business where costs occur
- Businesses may divide themselves to better monitor the costs in different areas e.g. marketing, employment relations, finance, operations
- Direct Costs à Costs that can be allocated to a particular product. Also called variable costs.
- Indirect Costs à Costs that are shared by more than one product
- Profits can weaken if the business expenses are high
- Guidelines/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
- Revenue à income generated by a business’s main operations
- Revenue comes from sales or from fees for professional services or commission
- In determining an acceptable level of revenue with a view to maximising profits, a business must have clear ideas and policies, particularly about its marketing objectives including the sales objectives, sales mix or pricing policy
- Should lead to an increase in sales and hence an increase in revenue
- Sales objectives must be pitched at a level of sales that will cover costs, and result in a profit
- A cost-volume-profit analysis can determine the level of revenue sufficient for a business to cover costs to break even
- Changes to the sales mix can affect revenue. 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.
- Pricing policy affects revenue and working capital. Pricing decisions should be closely monitored and controlled. 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:
- Costs associated with producing the goods or services (materials, labour, overheads)
- Prices charged by the competition
- Short and long-term goals
- Market share over a five-year period, prices may be reduced
- Image/level of quality associated with the goods or services government policies
- When transactions are conducted on a global scale, one currency must be converted to another.
- Transactions are 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
- Currency fluctuations are changes in the value of a country’s money
- A global business has the option of borrowing money from financial institutions in Australia, or they to borrow money from other overseas finance markets
- Australian businesses could be tempted to borrow finances from overseas sources to gain the advantage of lower interest rates
- Any adverse currency fluctuation could see the advantage of cheaper overseas interest rates quickly eliminated
Methods of International Payment
- International payments can be complicated as the business may be dealing with someone they have never seen, who speaks another language, uses a different monetary system, who abides by a different legal system and/or who may prove difficult to deal with if problems occur later on
- A major worry for exporters is that if products are shipped before payment’s received, there may be no guarantee that the importer will pay
- Importers worry that if payment is sent before the products are received, there is no guarantee that the exporter will send the products
- A method of payment using a third party, who both parties trust, is used to ensure both parties are benefited. This is normally a bank, which acts in an intermediary role
- Businesses can select 4 different types of payment including;
- Payment in advance
- Letter of credit
- Clean payment
- Bill of exchange
Payment in Advance
- Allows the exporter to receive payment and then arrange for the goods to be sent
- Exposes the exporter to no risk and is often used if the other party is a subsidiary or when the credit worthiness of the buyer is uncertain
- Few importers will agree to these terms because it exposes them to the most risk as they have no guarantee that they will receive their order
Letter of Credit
- Document buyers can request from their bank to guarantee the payment of goods will be transferred to the seller
- Issued by the importer’s bank to the exporter promising to pay them a specified amount once certain conditions have been met
- The bank will only issue a letter of credit if they know the buyer will pay.
- Popular with exporters
- When the exporter ships the goods directly to importer before payment is received
- Goods are usually shipped with an invoice requesting payment at a certain time after delivery
- Time the exporter gives the buyer to pay for the goods is called the credit term.
- Method is only used when exporter is confident that importer will pay by the agreed time
- One of the riskiest options for exporters
- One of the most advantageous options for importers
Bill of Exchange
- Document drawn up by the exporter demanding payment from the importer at a specified time.
- One of the most used and allows exporter to maintain control over goods until payment is made or guaranteed
- Two Types of Bill of Exchange:
- Document (bill) Against Payment à importer collects goods only after paying for them. Exporter draws up a bill of exchange with their bank and sends it to the importer’s bank along with a set of documents that will allow the importer to collect the goods. The importer’s bank hands over the documents after payment is made. Importer’s bank then transfers funds to the exporter’s bank.
- Document (bill) Against Acceptance à Importer may collect goods before Same process applies as with documents against payment, except importer must sign only acceptance of the goods and the terms of the bill of exchange to receive the documents that allow him or her to pay for the goods at a later date.
- Risk of non-payment or payment delays when using a bill of exchange is greater than for a letter of credit
- Documents against payment there is a risk that the importer may not collect the documents or pay for the goods.
- Documents against acceptance there is risk that the importer may delay payment or not pay
- Process of minimising the risk of currency fluctuations
- Two parties agree to exchange currency and finalise deal immediately, the transaction is referred to as a spot exchange
- Spot exchange rate à value of one currency in another currency on a particular day
- Hedging helps reduce the level of uncertainty involved with international financial transactions
- Simple financial instruments used to lessen exporting risks associated with currency fluctuations
- Forward Exchange Contracts à Contract to exchange one currency for another currency at an agreed exchange rate on a future date
- Options Contract à gives the buyer the right 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
- Swap Contract à agreement to exchange currency in the spot market with an agreement to reverse the transaction in the future
- Swap contracts allows the business to alter its exposure to exchange fluctuations without discarding the original transaction