HSC BUSINESS STUDIES FINANCE

ROLE OF FINANCIAL MANAGEMENT

STRATEGIC ROLE OF FINANCIAL MANAGEMENT

Financial management is defined as the planning and monitoring of a businesss

financial resources in order to enable the business to achieve its financial
objectives. (Crucial if a business is to achieve its financial goals; predominantly
maximising profits)
Financial resources - Those resources in a business that have money value ie.
Cash, liquid securities, assets
The strategic role of financial management refers specifically to the strategies
that are adopted by the business with regards to managing financial resources to
achieve its short and long-term goals.
The strategies that a business uses to achieve its goals are incorporated into a
strategic plan (encompasses a long term view of the business). This entails the
strategies for monitoring the financial resources of a business, such as:
monitoring an businesss cash flows
paying its debts
If managed incorrectly a number of problems may exist including:
- Insufficient cash to pay suppliers
- Insufficient capital to expand
- Too many non-productive assets
- Delays in payment
- Possible business failure

OBJECTIVES OF FINANCIAL MANAGEMENT

- Maximise the businesss Profitability, growth, efficiency, liquidity,
solvency
- Short term and long term

The objectives of financial management are to maximise: Profitability, growth,

efficiency, liquidity, solvency
The responsibility of financial management is to make decisions about the best way
to achieve those objectives
PROFITABILITY
-

Refers to the ability of a business to maximise its profits, which is

significant in satisfying owners and/or investors in the short term in
accordance with the longer term sustainability of a firm

To ensure profit is maximised, a business must carefully monitor its

revenue and pricing policies, costs/expenses, inventory and asset levels

GROWTH
-

Refers to a sustained increase in the size of a business

Ensures the sustainability of the business into the future (Important
financial objective of management)

Growth can be achieved by:

-

Increasing sales and profits

Increasing the value of the assets [Any item of economic value owned by
an entity] in a business
Increasing the physical size of the business by expanding or moving to a
larger office or factory

EFFICIENCY
-

The ability of a business to minimise its costs and manage its assets so
that maximum profit is achieved with the lowest possible level of assets
(inputs)
A business that aims for efficiency must monitor the levels of inventories
and cash (control measures)

LIQUIDITY
-

Refers to a business ability to transfer the value of their assets quickly

into cash (Eg. Selling inventory in), in order to meet its financial
obligations (liabilities) generally in the short term
Yearly management of cash flow is essential to even out fluctuations in the
levels of cash inflows and outflows. (Ensures that has supplies of cash
when needed to satisfy the demands of firms which they owe)

SOLVENCY
-

Refers to the extent to which a business can meet both its short and long
term financial commitments as they fall due.

Solvency indicates:
-

Financial stability
Risks to a businesss investment (Will be able to pay or not for money
borrowed used to invest in capital i.e. Machinery, capital)

SHORT TERM AND LONG TERM

The financial objectives can be translated into both short term and long term
SHORT-TERM FINANCIAL OBJECTIVES
Are the tactical (1 to 2 years) and operational (day to day) objectives of a business.
They are mainly concerned with managing cash flow and ensuring that the balance

between current assets and current liabilities is positive for the business, so that the
business is able to pay off its debt obligations when they fall due, hence remaining
solvent.
LONG-TERM FINANCIAL OBJECTIVES
Long term financial objectives exist over a predetermined period of time (Usually 5
years or more). These generally are more broad (e.g. to increase profit margins &
maximise growth). They are generally monitored annually to determine if changes
need to be implemented.

INTERDEPENDENCE WITH OTHER KEY BUSINESS FUNCTIONS

Interdependence refers to the mutual dependence that each of the functions

have on each other in terms of relying on each other to perform effectively and
at full capacity.
FINANCE & OPERATIONS
-

Financial managers need to allocate adequate funds to the operations

function in order for the creation of value to the inputs, thereby
generating sales
In terms of operations, a business may seek changes to the supply
chain in order to reduce the level of expenses incurred by the business

FINANCE & MARKETING

-

Allocation of adequate funds to the marketing function in order to

advertise, thereby generating sales which is used as a means of
enhancing shareholder value (Increase the price of shares)

FINANCE & HUMAN RESOURCES

-

HR requires funds to remunerate staff as well as funding effective

human resource strategies like training and development
HR is essential in hiring employees fit for roles within the finance
department

OVERALL
-

The financial manager must allocate funds to each department to

operate successfully. The manager will also need to develop budgets
and cost controls for each department.

INFLUENCES ON FINANCIAL MANAGEMENT

INTERNAL SOURCES OF FINANCE RETAINED PROFITS

INTRO: INTERNAL AND EXTERNAL

A business cannot establish itself without funds to enable it to pursue its
activities. In the establishment of a business, owners and/or shareholders usually
contribute funds. When a business is considering growth and development in
later years, it may seek to source funds internally or externally, which is
assessed through financial decision making (Relevant information analysed to
determine appropriate course of action).
INTERNAL SOURCES OF FINANCE
-

Obtained from within the business; either from the businesss owners
(equity) or from the activity of the business (retained profits).
Owners Equity refers to the funds contributed by the owners to
establish and build the business. They tend to be the owners personal
savings
Retained Profits (Most common source of internal finance) in which
all profits are not distributed, but are kept in the business as an
accessible source of finance for future activities. This net profit
therefore acts as a source of reinvestment back into the business.

EXTERNAL SOURCES OF FINANCE

o DEBT short-term borrowing (overdraft, commercial bills,
factoring), long-term borrowing (mortgage, debentures, unsecured
notes, leasing)
o EQUITY ordinary shares (new issues, rights issues, placements,
share purchase plans), private equity

External finance refers to the funds provided by sources outside the business
including banks, other financial institutions, government, suppliers or financial
intermediaries. External sources of finance are broadly categorised as either debt
or equity each will influence the financial management decision of a business.
Debt refers to any money that has been borrowed. Regular repayments on the
borrowing must be made so firms have to generate sufficient earnings to make
the payments.
Types of external debt include short-term (Would be repayable within 12 months)
and long-term (Over 12 months).
Debt: Short term borrowing
This type of borrowing is used to finance temporary shortages in cash flow or
finance for working capital.
Examples of short term debt financing:

OVERDRAFT Arrangement between a business and a bank that allows

the business to overdraw their account up to an agreed limit and for a
specified time, to assist in overcoming a temporary cash shortfall/ shortterm liquidity problems. Costs for overdrafts are minimal and interest rate
levels are lower than on other forms of borrowing.
COMMERCIAL BILLS Refers to a document that orders the payment of
a certain amount of money loaned at some fixed future date (bill of
exchange). The document is issued by institutions other than banks (i.e.
businesses with surplus funds), and are given for larger amounts, usually
$100,000 for a period of between 90 and 180 days. A business uses this
method to finance temporary periods of lower cash inflows or higher cash
outflows. These funds are repaid within a year.
FACTORING Important source of short-term finance that enables a
business to raise funds immediately (Improving cash flow and gearing) by
selling accounts receivable at a discount to a finance company. The
company will pay the seller the value of the accounts minus a discount.
(Imposes a greater risk of bad debts being the responsibility of the
business)
The factory company takes over management and collection of unpaid
accounts under terms. A factoring company may offer its services with or
without recourse:
1.

With recourse factoring: The business will pay the factor the amount
owing (remaining responsible), should the factor fail to recoup all the
debts. (Business will still be responsible for the value of all bad debts)
(More common)

2.

Without recourse factoring: Business transfers responsibility for

recouping the debt to the factoring company. If there are debts that
cannot be collected, then the factor incurs the loss.

Examples of Long term debt financing: (funds borrowed for periods longer than
two years & can be secured or unsecured)
o

MORTGAGE A loan which is repaid over a set number of years with

interest. They are used to finance property purchases & are secured by the
borrower. The property used to secure the loan cant be used as a security
for further investment or sold until the mortgage is repaid.
DEBENTURES - Debentures are issued by a company for a fixed rate of
interest and for a fixed time. Debentures are usually not secured to
specific property. Companies that borrow offer security to the lender
usually over the companys assets. On maturity, the company repays the
amount of the debenture by buying back the debenture.
UNSECURED NOTES Loan that is not secured by a businesss assets.
This poses the greatest risk & hence offers higher interest rates. (Higher
return on loan)

LEASING - Leasing is a long-term form of borrowing equipment & noncurrent assets owned by another party (Requires payment of money for
use in the form of rent). This reduces the cost of acquiring these assets as
full value of the asset in one transaction does not have to be made
instantly.
Two types of leases exist:
A financial lease is for a set time and payments cover interest and cover
the life span of the product. An operational lease refers to assets leased
for short periods, usually shorter than the life of the asset. Operating
leases can be cancelled, often without penalty.

Equity Refers to the value of (cash) raised by a company by issuing shares to

the public on the Australian Securities Exchange. (Alternative to debt funding)
Equity as a source of external finance includes: (Examples of equity finance)
-

Ordinary shares (new issue, rights issue, placements, share purchase

plan)
Private equity

ORDINARY SHARES
-

Most common traded shares to the public (through the securities

exchange) & when sold transfer part ownership of the business to the
shareholder. (Receives payments in the form of dividends)
The following are variations of ordinary shares:
o

o
o

New Issue - A security that has been issued and sold for the
first time on a public market (Also referred to as Primary Shares).
A prospectus (document that describes the financial security) is
issued through a stockbroker.
Rights Issue The privilege granted to shareholders to buy
new shares in the same company
Placements - Offering additional shares to specific institutions
and specific investors. The company does this without a formal
prospectus. These funds may be used to expand activities or to
acquire businesses.
Share purchase plans - an offer to sell shares to existing
shareholders for a discounted price.

PRIVATE EQUITY
-

Refers to the money invested in a (private) company not listed on the

Australian securities exchange (ASX). The aim of the private company
(like the publicly listed companies who sell ordinary shares) is to raise
capital to finance future expansion/investment of the business.

FINANCIAL INSTITUTIONS BANKS, INVESTMENT BANKS, FINANCE

COMPANIES, SUPERANNUATION FUNDS, LIFE INSURANCE
COMPANIES, UNIT TRUSTS AND THE AUSTRALIAN SECURITIES
EXCHANGE

Financial institutions Institution that provides financial services for its clients or
members (Channel between savers and borrowers of funds)
BANKS
-

Major operators in financial markets & are the main providers of

finance/funds for businesses
Supervised by the Reserve Bank of Australia
Banks receive savings as deposits from individuals, businesses and
governments, and, in turn, make investments and loans to borrowers.
Interest is charged on the cost of borrowing
They provide a no. of corporate services including:
Online banking
Insurance & superannuation
Legal and tax advice
Risk management
Economic outlooks

EXAMPLES: NAB, Commonwealth Bank, Westpac, ANZ

INVESTMENT BANKS
Investment banks differ from Authorised Deposit taking institutions (Big
four Banks) in that they are primarily focused on providing borrowing and
lending services to the business sector.
-

They specialise in arranging financial transactions for companies &

projects

Investment banks are further involved in:

-

Trading money, securities & futures

Providing advice on mergers and acquisitions
Arranging overseas finance
Operating trusts

EXAMPLES: Macquarie Bank

FINANCE AND LIFE INSURANCE COMPANIES
Finance and life insurance companies are non-bank financial
intermediaries that provide secured and non-secured loans but do not take
deposits from the general public.
-

These companies are regulated by (APRA).

Finance Companies

They provide loans to businesses and individuals through consumer

hire-purchase loans, personal loans and secured loans to businesses.
(Higher interest rates)
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)
EXAMPLES: Australian Guarantee Corporation, Custom Credit
Corporation

Life insurance companies provide insurance (Guarantee of compensation for

specified loss, illness or death in return for payment) against death & disability
through selling policies & receiving regular premiums (Financial cost of obtaining
an insurance cover) that guarantee a minimum payout upon death.
EXAMPLES: MLC, AMP, Allianz
SUPERANNUATION FUNDS
These organisations provide funds to the corporate sector through investment of
funds received from superannuation contributions of members. 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, and thereby
lend retirement savings.
UNIT TRUSTS (aka 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.

AUSTRALIAN SECURITIES EXCHANGE

(ASX)
-

Formed in 2006 with the merger of the Australian Stock Exchange &
the Sydney futures Exchange
Is a market that brings together buyers and sellers to exchange shares.
The ASX acts as both a primary & secondary market
A primary market deals with the issue of new shares & securities,
whilst a secondary market deals with the sale and purchase of existing
securities and shares.
The ASX assists companies to raise initial capital finance through issue
of shares, and provides a market for existing (company shares, futures,
contracts for difference, trusts, other forms of securities) to be traded.

INFLUENCE OF GOVERNMENT AUSTRALIAN SECURITIES AND

INVESTMENT COMMISSION (ASIC), COMPANY TAXATION

The government influences a businesss financial management decision making

through economic policies and current and changing legislation.
Two important government influences on financial management are:
o

THE AUSTRALIAN SECURITIES AND INVESTMENTS COMMISSION

ASIC is an independent statutory commission accountable to the Commonwealth

parliament. It enforces and administers the Corporations Act 2001 (Cth) &
protects consumers in the areas of investments, insurance, superannuation, &
banking (except lending) in AU . The aim of ASIC is to assist in reducing fraud
and unfair practices in financial markets and products. ASIC ensures that
companies adhere to the law, collects information about companies and makes it
available to the public.
o

COMPANY TAXATION

Companies and corporations in Australia pay company tax on profits (Imposed by

the Australian Government), which is presently 30% of net profit. Company tax is
paid before profits are distributed to shareholders as dividends. The government
plans to lower taxes to foreign investment, and create new jobs.

GLOBAL MARKET INFLUENCES ECONOMIC OUTLOOK,

AVAILABILITY OF FUNDS, INTEREST RATES

Global market influences increasingly affect business financial decisions, and this
is specifically evident in the availability of funds for loans and the interest rates
charged for these loans, in accordance with the global economic outlook.

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 (high
economic growth) then this will impact on the financial decisions of a business.
This may include:
-

Increasing demand for products and services. Hence, businesses will

need to increase production to meet demand and will require funds to
purchase equipment, employ or train staff, or expand the size of the
business
Decrease the interest rates on funds borrowed internationally from the
financial money market. This results mainly from a decrease in the

level of risk associated with repayments. As business sales increase, so

too does profits.
However a poor economic outlook will impact on financial decisions of a business
in the opposite to those mentioned above.

AVAILABILITY OF FUNDS

Refers to the ease with which a business can access funds (for borrowing) on the
international financial markets (Made up of institutions, companies and
governments that are prepared to lend money to those who require capital). The
availability of funds depends on the risk, demand and supply and the domestic
economic conditions.

INTEREST RATES (AFFECTS both Savings/deposits & loans)

Are the cost of borrowing money. The higher the level of risk involved in lending
to a business, the higher the interest rates.

PROCESSES OF FINANCIAL MANAGEMENT

o
o

PLANNING AND IMPLEMENTING FINANCIAL NEEDS, BUDGETS ,

RECORD SYSTEMS, FINANCIAL RISKS, FINANCIAL CONTROLS
DEBT AND EQUITY FINANCING ADVANTAGES AND DISADVANTAGES OF
EACH
MATCHING THE TERMS AND SOURCE OF FINANCE TO BUSINESS PURPOSE

Financial management is responsible for the financial planning of the business.

Financial planning determines how a businesss goals will be achieved.
The elements in the planning cycle are:
-

DETERMINING FINANCIAL NEEDS

Financial needs are essential to determine where a business is headed and how it
will get there; it is important to know what its needs are.
The financial needs of a business are determined by a situational analysis of the
current financial position of the business with regards to the size of the business,
the current phase of the business cycle, capacity to source finance (debt and/or
equity) as well as any future plans for growth and development.

These plans are developed into balance sheets, income statements, cash flow
statements, budgets & a range of other documents that provide financial
information on a business capacity to generate an acceptable return for the
investment being sought.
-

DEVELOPING BUDGETS (to identify sources of revenue and

expenses)

A budget is a plan predicting the revenue and expenses of a business for a future
time period. It provides quantitative information (i.e. cash required for planned
outlays) about requirements to achieve a particular purpose. They allow for
constant monitoring & progress checks of production.
Budgets can be classified as operating, project or financial budgets.
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. It may be used to produce an income statement & plan
inventory levels, labour requirements or raw materials.
Project budgets relate to capital expenditure (purpose of asset purchase, life
span, & revenue that would be generated from the purchase) and research and
development
Financial budgets relate to the financial data of a business & 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. They provide a forecast of
flows of inflows of cash which is significant in organising finance for slower than
expected growth.
-

(MAINTAINING) RECORD SYSTEMS

Refers to the mechanisms employed by a business to ensure that data are

recorded (i.e. Sales, expenses, assets & liabilities) and the information provided
by records systems is accurate, reliable, efficient and accessible. Minimising
errors in the recording process and producing accurate and reliable financial
statements are important aspects of maintaining (effective) record systems,
whereby a business improves efficiency and is able to identify issues of concern
and opportunity.
-

IDENTIFYING 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.
The main financial risk arises from not having enough cash flow to meet its
commitments such as the debts that a business incurs through borrowings, both
short term and longer term.

If the business is financed from borrowings there is higher risk. The higher the
risk, the greater the expectation of profits or dividends.
In minimising financial risks a business can take advantage of business
opportunities. Strategies to reduce risk include credit controls, hedging,
derivatives, insurance & diversification.
-

ESTABLISHING FINANCIAL CONTROLS

The most common causes of financial problems and losses are: theft, fraud,
damage or loss of assets and errors in record systems.
Financial controls are the policies and procedures that ensure that the plans of a
business will be achieved in the most efficient way.
Financial controls include budgets, cash flow statements, income (revenue)
statements & balance sheets.
Policies to promote control are rotation of duties, control of cash where cash is
banked daily, protection of assets and control of credit procedures.
o

DEBT AND EQUITY FINANCING ADVANTAGES AND DISADVANTAGES OF

EACH

The finance for a business comes from both internal and external sources, and
most businesses use a combination of both. 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 a business & takes the form of money obtained
from investors in exchange for an ownership share of the business.
ADVANTAGES AND DISADVANTAGES OF DEBT FINANCE
Advantages of Debt
Interest payments are tax deductible
therefore reducing the cost of debt
financing
Funds are usually readily available
Increased funds should lead to increased
earnings and profits

Disadvantages of Debt
Increased risk if debt comes from financial
institutions because interest, bank
charges, government charges and the
principal have to be repaid
Repayments begin immediately and must
be met regardless of business cash flow
Collateral (assets that can be taken if loan
cannot be repaid) is often needed to
secure a loan
Lenders have first claim on any money if
the business ends in bankruptcy

ADVANTAGES AND DISADVANTAGES OF FINANCE EQUITY

Advantages of Equity
Does not have to be repaid unless the

Disadvantages of Equity
Investors become part-owners of the

owner leaves the business; Investors hope

to reclaim their investment out of future
profits
Low gearing (Ratio between debt and
equity finance/ Lower the ratio, lower
percentage of borrowed funds)
Does not incur interest charges, so
cheaper than other sources of finance
Less risk

business gaining a say in business

decisions, hence managers face a loss of
control
Lower profits and return from the owner
since a proportion of the profits go to the
additional new owners
The expectation that the owner will have
about the return on investment (ROI)

MATCHING THE TERMS AND SOURCE OF FINANCE TO BUSINESS PURPOSE

***

The matching principal is vital as it allows businesses to determine the most

appropriate source of finance to fund activities while ensuring financial
objectives are met.
Some influencing factors (in selecting the most appropriate source of finance)
include:
o
-

Must be suitable for the structure of the business and the purpose for
which the funds are required. E.g. Short-term finance options should be
suitable to match the short-term purposes of the business, such as
managing a temporary cash flow shortfall.
o

The terms of finance

The structure of the business

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.
Public companies can raise equity by issuing shares to the public.
Therefore, there are greater opportunities in raising equity capital.
o

Costs

Must be measured for each of the available sources of funds, as costs

fluctuate depending on market and economic conditions
o
-

Flexibility

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
o

Too heavy a dependence on a small number of investors can increase

risk if investors start to pull out or their commitments cannot be met.
A business credit rating may influence the various sources of finance it
has access to.
o

The availability of finance

The level of control

In that case of equity finance, introducing more partners or a change in

business structure can lead to a change in the level of control over the
business.

MONITORING AND CONTROLLING CASH FLOW STATEMENT,

INCOME STATEMENT, BALANCE SHEET

The process of monitoring and controlling is essential in all aspects of business

functions, especially in the processes of financial management, in order to
maintain business viability.
The main financial controls used for monitoring include cash flow statements,
income statements and balance sheets.
CASH FLOW STATEMENTS
-

Is a financial statement that indicates the movement of cash receipts

(cash inflow) and cash payments (cash outflow) resulting from
transactions over a period of time.
It gives important information regarding a firms ability to pay its debts
(financial obligations) on time,
Further to this it shows whether a business has sufficient funds for
future expansion or change

In preparing a cash flow statement, the activities of a business are generally

divided into three categories
-

Operating activities: Cash outflow and inflow relating to the provision of

goods and services (E.g. Cash inflows: Sales plus dividends and interest
received) (E.g. Cash outflows: Payments to suppliers, employees &
insurance, rent)
Investing activities: Cash inflows and outflows relating to purchase and
sale of non-current assets and investments (E.g. Selling old motor
vehicle, & Purchasing new plant and equipment)
Financing activities: Cash inflows and outflows relating to the borrowing
activities of the business. Borrowing inflows can relate to equity (issue
of shares or capital contribution from owner) or debt (loans from

financial institutions). Cash outflows relate to the repayments of debt

and cash drawings of the owner or payments of dividends to
shareholders.

INCOME STATEMENTS (aka Profit and Loss Statements)

-

The income statement shows the operating efficiency that is income

generated & expenses incurred
It indicates the businesss profitability and efficiency & shows the
operating income earned (ie. Sales of inventories, service etc.) from
the main function of the business as well as operating expenses such
as purchase of inventories, payment for services etc.

The difference between the income and expenses is the profit or if expenses
exceed income the loss.
Gross Profit = Sales- COGS
Cost of Goods Sold = Opening Stock + Purchases Closing stock
Net Profit = Gross Profit Expenses
By examining figures from previous income statements managers can compare
and analyse trends prior to making important financial decisions (to maintain
strategic direction), (Regarding increases/decreases in expenses/profits)

BALANCE SHEETS
A balance sheet represents a businesss assets and liabilities at a particular point
in time, expressed in money terms, and shows the:
-

financial stability of the business (Has enough assets to cover its

liabilities)
Assets are being used efficiently
The owners are making a good return

The accounting equation, which forms the basis of the accounting process, shows
the relationship between assets, liabilities and owners equity.
Assets = Liabilities + Owners Equity
Assets = Current assets + Non-Current assets
Assets represent what is owned by the business and are items of value
Liabilities represent what is owed by the business and are items of debt
Current Assets/Liabilities are those that can be used or need to be paid in the
short term E.g. Cash, bills, short term loans
Non-current assets/liabilities refer to those that cant be used or dont have to be
paid in the short term. Eg. Properties, Mortgages
Owners equity is the funds contributed by the owner(s) for it to acquire
resources and begin operating

FINANCIAL RATIOS
o LIQUIDITY CURRENT RATIO (CURRENT ASSETS CURRENT
LIABILITIES)
o GEARING DEBT TO EQUITY RATIO (TOTAL LIABILITIES TOTAL
EQUITY)
o PROFITABILITY GROSS PROFIT RATIO (GROSS PROFIT Sales); NET
PROFIT RATIO (NET PROFIT SALES); RETURN ON EQUITY RATIO
(NET PROFIT TOTAL EQUITY)
o EFFICIENCY - EXPENSE RATIO (TOTAL EXPENSES SALES),
ACCOUNTS RECEIVABLE TURNOVER
o RATIO (SALES ACCOUNTS RECEIVABLES)
o COMPARATIVE RATIO ANALYSIS OVER DIFFERENT TIME PERIODS,
AGAINST STANDARDS, WITH SIMILAR BUSINESSES

The financial statements of a business must be analysed to gain a thorough

understanding of the activities of a business. The analysis involves comparing
similar figures contained in the financial statements and balance sheets. The
main types of analysis include: vertical (within one year), horizontal (between
different years) and trend (over a period of 35 years). The analysis of financial

statements is usually aimed at the areas of financial stability (liquidity and

gearing), profitability and efficiency.
FINANCIAL RATIOS measure relationships between different elements of financial
statements and may be expressed in different ways e.g. as a percentage, a
fraction, a times figure or a rate
Liquidity
Liquidity is the extent to which the business can meet its financial commitments
in the short term. This means, a business must have enough resources to pay its
debt and cover unexpected expense.
Current assets (assets that a business can expect to convert into cash within 12
months i.e. cash and accounts receivable) and current liabilities (are liabilities
that a business must repay within the short term i.e. overdraft and accounts
payable) determine the liquidity or short-term financial stability of a business;
hence a current ratio can be used to show liquidity.
Current Ratio=
Current Assets

Current Liabilities

Expressed: Percentage or ratio (usually ratio)

Current assets and liabilities are turned into cash within 12 months. For example,
assets such as inventories and accounts receivable would be paid in a month or
two, as would liabilities, such as the firms own accounts payable. It is generally
accepted that a ratio of 2:1 indicates a sound financial position for a firm. That is,
the firm should have double the amount of assets to cover its liabilities.
(Ratio of less than 1:1 indicates there are insufficient assets to pay current
commitments or liabilities)
However an acceptable ratio will also depend on a number of factors, such as
the type of firm, how other firms in the industry are operating and factors in the
external environment.
Gearing
-

Refers to the ratio between debt (external finance) and equity (internal
finance) that is used to finance the activities of a business.

Debt to equity (gearing) =

Total Liabilities

Total equity (owners equity)

Expressed: Percentage or ratio (usually ratio)

The debt to equity ratio shows the extent to which the firm is relying on debt or
outside sources to finance the business.
-

Important control aspect for management because the relationship

between debt and equity must be carefully balanced
The degree of gearing will depend on the type of business. For
instance: Mining companies are generally heavily geared as the cost to
finance operations is high but the return on investment is high
The higher the debt to equity ratio (Highly geared firm that uses more
debt than equity), the less solvent the firm and the more risk with
regard to longer term financial stability in terms of being unable to
meet its longer term obligations
Investors, thus, would be less attracted to the firm
An acceptable gearing ratio is 1.5:1 or 66% equity but this will depend
on factors such as the type of industry & earning capacity

Strategies to improve:
-

Reducing Debt
Increasing use of equity financing where possible.

Profitability
Profitability is the earning performance of the business and indicates its capacity
to use resources to maximise profit. The income statement is used to measure
the profitability of the business. Figures from this statement are used to calculate
the gross profit and net profit ratios.
GROSS PROFIT RATIO
Gross profit represents the amount of sales that is available to meet expenses
resulting in net profit. A fall in the rate of gross profit may mean a fall in the rate
of net profit. The amount of that decrease depends on factors such as price
reductions, theft, and errors in determining prices.
Gross Profit Ratio= Gross Profit
expressed as a percentage

Revenue (from sales)

Higher the percentage the better

(%) This ratio is always

Strategies to improve:
-

Reducing COGS factors

JIT Management

Advertising/Promotion/Marketing/Sales

NET PROFIT RATIO

Represents the profit or return to the owners
Net Profit Ratio =
percentage

Net Profit

(%) Ratio is always expressed as a

Revenue (from sales)

The net profit ratio shows the amount of sales revenue that result in net profit. A
firm would be aiming at a high net profit ratio. A low net profit ratio indicates that
expenses should be examined to see whether reductions can be made.
RETURN ON EQUITY RATIO
The 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.
Return on Equity ratio =
a decimal/percentage

Net Profit

Ratio can be expressed as either

Total equity (Owners equity)

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

Generally acceptable minimum return should be in the order of 12-16%

Less than this would be considered unacceptable because the owners

could invest their money elsewhere.

A return greater than 16% is considered good and a return of 20%+ is

excellent.

Efficiency
Efficiency is the ability of the business to use its resources effectively to ensure
financial stability and profitability. It relates specifically to managements ability
to achieve its goals and objectives.

The two main ways to calculate efficiency include the expense ratio and the
accounts receivable turnover ratio.
EXPENSE RATIO
This ratio indicates the day to day efficiency of the business. The ratio indicates
the amount of sales that are allocated to individual expenses such as selling,
administration, COGS and financial expenses.
Expense ratios need to be kept at a reasonable level, and management must
monitor each type of expense in relation to sales. Higher expense ratios may be
the result of poor management. The lower the ratio the better.

Expense ratio =
percentage

Total expenses

(%) Always expressed as a

Sales
Strategies to improve:
-

Reduce expenses, for example reduce overtime thus cutting wages

ACCOUNTS RECEIVABLE TURNOVER RATIO

-

Measures the effectiveness of a firms credit policy and how efficiently it

collects its debt

Accounts receivable turnover ratio =

Sales

Accounts Receivable

Note: Always expressed as times or days

Note: The sales may appear as credit sales
Note: To express in days: (How often debts are being repaid)
365 accounts receivable turnover ratio
Debt collection figures indicate relative efficiency in the collection of debts (The
activity of making individuals and businesses pay debts). High turnover ratios
indicate the business has efficient debt collection.

Strategies to improve:
- Offering discounts for early payment of debt
- Chasing up slow paying debtors
- Changing payment term/credit term
- Withdrawing credit facilities
- Encouraging cash sales, possibly through discounts for cash sales.
If a business account turnover is (E.g. 84 days) but creditors only allow 30 days
to be paid, cash-flow problems may occur
Comparative Ratio Analysis can be used for comparisons, such as:
-

Over different time periods Comparing ratios for a business over various
periods to identify trends and assist with interpretation of ratio results.
Against common standards Ratios are compared with industry averages
to assist managers interpretation and decision making on the businesss
performance.
With similar businesses Comparing ratios from businesses in the same
industry and of same size to give an insight into business performance.

LIMITATIONS OF FINANCIAL REPORTS NORMALISED EARNINGS,

CAPITALISING EXPENSES, VALUING ASSETS, TIMING ISSUES, DEBT
REPAYMENTS, NOTES TO THE FINANCIAL STATEMENTS

There are limitations to financial reports. They can be misinterpreted and can be
misleading, both of which will impact on the decision making of management
and potentially put the business at risk.
Limitations of financial reports include the following:
-

Normalised earnings: This is the process of removing one time or

unusual influences from the balance sheet to show the true earnings of a
company. An example of this would be the removal of a land sale, which
would achieve a large capital gain (profit from the sale of property or of an
investment).

Capitalised expenses are where one-off operating expenses are

regarded as an asset (capitalized), which can then be depreciated over
time and recorded in the balance sheet of the business. This causes the
operating expenses to decrease thus increasing operating profit for the
business, and the assets of the business will increase and this will cause a
change to the liabilities of the business.

Valuing assets is the process of estimating the market value of assets or

liabilities. Some assets change value over time due to inflation and the

market. Therefore it would have been worth less in the past and would not
reflect the true value. This means assets have to be revalued to account
for the appreciation or depreciation. Some assets like patents or goodwill
also cannot be recorded as it is hard to place a value on these intangible
items.
-

Timing issues: Finance reports cover activities over a period of time,

usually one year. Therefore, the businesss financial position may not be a
true representation if the business has experienced seasonal fluctuations.

Debt repayments can present a point of concern. Reports do not have

the capacity to disclose specific information about debt repayments such
as:
* How long the business has had or has been recovering the debt

* The capacity of the business or its debtor to repay the amount/s owed
(What if a debtor is close to bankruptcy and will not be able to repay a
debt?)
Therefore, financial statements in isolation are limited in their usefulness
when analysing performance.

Notes to financial statements are the details and additional

information that are left out of the main reporting documents and put
separately at the end, such as the balance sheet and income statement.
Information can include the explanation of individual items in the reports,
the valuing system used for assets and how the value for an intangible
asset was arrived at.

ETHICAL ISSUES RELATED TO FINANCIAL REPORTS

Businesses have an ethical and legal responsibility to provide accurate financial

records.
The main ethical issues related to financial reports are as follows:
Inappropriate cut-off periods and misuse of funds. An audit is an
independent examination of financial information and can be internal or
external. All public companies have their accounts externally audited to
make sure information is a true record of finances. Large businesses will
also frequently use internal auditors.
Fictitious revenues Revenues that do not exist and have been included
to make the business look better than it really is.
Hidden liabilities and expenses Expenses not included in balance
sheets or income statements to hide the true outgoing from owners,
shareholders or other stakeholders.

 Improper disclosures or omissions Can obscure the real position of a

business or imply something exists when it does not.
Fraudulent asset valuations Variation of historical value or reckless
valuing of intangible assets such as goodwill.
To pretend profits are lower than reality would defraud the ATO. Deemed
Illegal, Unethical & in trying to raise capital, investment would be harder
to find.

Accurate financial reports depend on the quality of record keeping & are
necessary for taxation purposes as well as for other stakeholders.
Auditing involves an independent check of the accuracy of financial records.
Three types of audits exist:
-

INTERNAL AUDITS: Conducted internally by employees to check the

accuracy of financial records
MANAGEMENT AUDITS: Conducted to review the firms strategic plan.
Audits may cover HR, finance & the production process
EXTERNAL AUDITS: These are required under the Corporations Act 2001
(Cth). The firms financial reports are audited by professional, independent
audit specialists to guarantee authenticity

FINANCIAL MANAGEMENT STRATEGIES

CASH FLOW MANAGEMENT

o CASH FLOW STATEMENTS
o DISTRIBUTION OF PAYMENTS,DISCOUNTS FOR EARLY PAYMENT,
FACTORING

Cash flow refers to the movement of cash in and out of a business over a period
of time. Management is required to make sure payments are made and received
without creating a cash flow problem.
Cash inflows come from sales, accounts receivable and commissions. Cash
outflows include wages, payments to suppliers, insurance and loan repayments.
A cash flow statement provides important information regarding a firms ability
to pay its debts on time. A cash flow statement can assist in identifying periods
of potential shortfalls and surpluses (Distribution of payments)
MANAGEMENT STRATEGIES
Management must implement strategies to ensure that cash is available to make
payments when they are due.
Management strategies for cash flow include:

DISTRIBUTION OF PAYMENTS
By Distributing payments throughout the month, year or other period a business
is able to prevent cash shortfalls from occurring. (Desirable for businesses that
receive regular cash inflows)
DISCOUNTS FOR EARLY PAYMENT
Businesses can offer discounts for cash and early payments which encourages
quick payment from debtors, improving cash flow for the business. It can be a
cheaper option than overdraft. Overdrafts and lines of credit can assist
businesses in periods where cash outflow is greater than cash inflow. This is an
expensive short term solution.
FACTORING
Factoring is the selling of a companys accounts receivable to a finance company
for immediate cash. It improves working capital by giving a business immediate
access to cash from its credit sales.

WORKING CAPITAL (liquidity) MANAGEMENT

o Control of current assets - cash, receivables, inventories
o Control of current liabilities payables, loans, overdrafts
o Strategies - leasing, sale and lease back

Working capital refers to the current assets used in the day to day operations of
a business. (Eg. Cash, accounts receivables, inventories)
Net working capital (liquidity) is the difference between current assets and
current liabilities.
Working capital is needed so that a business can buy stock and inventory and
meet its current debts or financial commitments. If working capital is too less,
then there will be liquidity difficulties. If there is an excess of working capital,
that means assets are earning less than the cost to finance them.
(Thus) Working capital management involves determining the best mix of current
assets and current liabilities needed to achieve the objectives of the business.
The working capital ratio is the same as the current ratio
i.e.

WorkingCapital Ratio=

Current Assets
Current liabilities

If the value of this is greater than 1:1 the firm is in a stable position
CONTROL OF CURRENT ASSETS is a part of managing working capital, and
refers to the management process that determines the optimal amount of each
current asset held.

This includes (current assets) Cash, accounts receivables and inventory

CASH
Cash is critical for business success and ensures that the business can pay its
debts, repay loans and pay accounts in the short term, as well as survive in the
long term.
Planning for the timing of cash receipts, cash payments and asset purchases
avoids the situation of cash shortages or excess cash. Businesses try to keep
their cash balances at a minimum and hold marketable securities as reserves of
liquidity. These guard against sudden shortages or disruptions to cash flow. A
bank overdraft might also be arranged to allow a business to overdraw its
account to an agreed overdraft amount.
RECEIVABLES (accounts receivables)
Receivables refer to money owed to a business from customers to whom it has
supplied goods or services.
Consequently, a business must monitor its accounts receivable and ensure that
their timing allows the business to maintain adequate cash resources. The
quicker the debtors pay, the better the firms cash position. Strategies to control
receivables include discounts on cash and early payments, following up on
accounts that are not paid by the due date, sending out reminders more
regularly, having clear credit policy that includes credit rating checks of
prospective consumers.

INVENTORIES
Inventories make up a significant amount of current assets, and their levels must
be carefully monitored and strategies implemented so that excess (Cash
shortages) or insufficient levels of stock (loss of customers, hence loss in sales)
do not occur. Strategies for the management of inventory include regular
stocktaking, control systems like just-in-time and increasing sales to turn
inventory into cash.
CONTROL OF CURRENT LIABILITIES
Current liabilities are financial commitments that must be paid by a business in
the short term.
A business must monitor and manage its current liabilities such as:
PAYABLES (ACCOUNTS PAYABLE)
Accounts payables refer to the money owed by the business to its suppliers.
Strategies include payment on time to avoid late fees, taking advantage of early
payment discounts and maintaining a good credit rating for continuing access to
credit provided by suppliers.

LOANS
Refer to the money borrowed from financial institutions for the purpose of
funding such things as the purchases of property and equipment. These loans
can either be short or long term in duration.
Management of loans is important, as costs for establishment, interest rates and
ongoing charges must be investigated and monitored to minimise costs. Shortterm loans are generally an expensive form of borrowing for a business and their
use should be minimised.
Further to this, the business should compare the cost of the loan to alternative
sources of funds from different banks & financial institutions to find the most
appropriate and cost efficient source.
OVERDRAFTS
a relatively cheap and convenient form of short-term borrowing. They
allow a business to cover temporary cash shortages. Internet banking can
be used to keep track of what is owed in the overdraft
MANAGEMENT STRATEGIES
Strategies for working capital management include:
Leasing
Sale and lease-back
LEASING
Leasing is the hiring of an asset from another person or company who has
purchased the asset and retains ownership of it. By leasing assets, the business
has more working capital (frees up cash) to invest in other assets and
opportunities for expansion of the business. It is an attractive strategy for some
businesses as it is tax deductible.
SALE AND LEASE-BACK
Sale and lease-back is the selling of an owned asset to a lessor and leasing the
asset back through fixed payments for a specified number of years.
Sale and
lease-back increases a businesss liquidity because the cash that is obtained
from the sale is then used as working capital.

PROFITABILITY MANAGEMENT
o COST CONTROLS FIXED AND VARIABLE, COST CENTRES, EXPENSE
MINIMISATION
o REVENUE CONTROLS MARKETING OBJECTIVES

Profitability management involves the control of both the businesss costs and its
revenue. Accurate and up-to-date financial data and reports are essential tools
for effective profitability management.

COST CONTROLS
Cost controls involve:
Understanding and monitoring the levels of both fixed and
variable costs
Fixed costs Costs that do not vary and must be paid regardless of the level of
operating activity in the business (i.e. Salaries & insurance). To minimise fixed
costs, it is essential to negotiate satisfactory arrangements initially.
Variable costs Costs that vary relative to the level of operating activity in a
business (i.e. Materials & labour)
Monitoring the levels of both fixed and variable costs is important in a business.

Accounting for and identifying the source and amount of costs

through the use of cost centres
COST CENTRES - are where businesses allocate a proportion of total costs
(Direct/Indirect) to particular parts of the business in order to control costs.
The cost centres are then responsible for the costs that they incur, and hence
management is therefore able to identify their source and amounts. In order
to minimise the business will need to minimise cost centres.
Expense minimisation
Expense minimisation involves reducing the expenses in order to maximise the
profits and gain a competitive advantage. Strategies include outsourcing, sale
and lease back, replacing labour with technology, reducing inventory overheads
such as using just-in-time and improving budgeting and accountability.
REVENUE CONTROLS
Revenue can be controlled by:
-

Developing marketing objectives & targets

Developing sales forecasts to aid budgets in predicting revenue

A business can also alter their sales mix (Range of products sold by the
business) to change how they market their product.
Control: The business should conduct research to identify the potential effects of
sales-mix changes on revenue before decisions are made (diversifying product
range or ceasing production on particular lines).
A business should also closely monitor and control their pricing policy to
achieve the highest possible revenue. Over pricing could fail to attract buyers
while underpricing may bring higher sales but may still result in cash shortfalls
and low profits.

GLOBAL FINANCIAL MANAGEMENT

o EXCHANGE RATES
o INTEREST RATES
o MATHODS OF INTERNATIONAL PAYMENT PAYMENT IN ADVANCE,
LETTER OF CREDIT, CLEAN PAYMENT, BILL OF EXCHANGE
o HEDGING
o DERIVATIVES

Global financial management refers to the strategies implemented by business

to deal with the export component of business activities. Global financial
management is influenced by a number of financial considerations.
EXCHANGE RATES
The foreign exchange rate is the ratio of one currency to another. If A$1 =
US$0.70, that means one Australian dollar is worth 70 US cents.
Exchange rates/currency fluctuates over time due to variations in demand and
supply, creating risks for global business.
If the Australian dollar appreciates against a foreign currency, the value of the
Australian dollar rises in terms of foreign currencies. The result of the
appreciation, therefore, reduces the international competitiveness of Australian
exporting businesses. Appreciation in the ER make interest repayments cheaper.
If the Australian dollar depreciates compared to foreign currency, there is a
decrease in the value of Australian dollars in terms of foreign currencies.
Depreciation, therefore, improves the international competitiveness of Australian
exporting businesses.
Currency fluctuations, therefore, will impact on the revenue profitability and
production costs.
INTEREST RATES
Refer to the cost of borrowing money. A business that plans to expand domestic
production facilities to increase direct exporting will normally need to raise
finance to undertake these activities. The advantages of overseas borrowing are
that the rate of interest can be cheaper, there are fewer restrictions and finance
may be acquired more quickly and easily. If overseas IR exceed domestic IR
businesses will tend to supply funds overseas rather than domestically to take
advantage of IR differential.
METHODS OF INTERNATIONAL PAYMENT
One of the most crucial aspects of global financial management is to select an
appropriate method of payment. Payment to overseas companies can be
complicated as the result of cultural difference (language, taxation systems)
The main methods of international payment include:
Payment in Advance

Whereby the exporter receives payment for the goods before they are
sent.
- Exposes the exporter to virtually no risk, however exposes the importer to
the most risk (Risk of the goods never being sent & payment already
taken)
Letter of Credit
- A commitment by the importers bank, which promises to pay the exporter
a specified amount when the documents proving shipment of the goods
are presented.
Clean payment
- Occurs when the payment is sent to, but not received by, the exporter
before the goods are transported.
- Requires complete trust between both parties
Bill of Exchange
- A written order from a seller requesting that buyers pay the seller a
specified amount of money at a specified time. The bank ensures the
buyer receives its goods and that the seller is paid.
- Most widely used and allows the exporter to maintain control over the
goods until payment is either made or guaranteed.
Two types of bills exchange exist:
1. Documents against payment: Using this method the importer can only
receive the good after paying for them
2. Document against acceptance: Using this method the importer can receive
the good before paying for them
HEDGING
Refers to any strategy used by the business to minimise the risk of currency
fluctuations, and hence, reduce the level of uncertainty involved with
international financial transactions.
Hedging can occur through:
1) Natural Hedging: This could include establishing offshore subsidiaries,
arranging for import payments & export payments to be denominated in
the same currency so that gains in one will be offset by losses in the other
& implementing marketing strategies that reduce the price sensitivity of
exported product
2) Financial instrument hedging involves products such as derivatives to
spread the risk.
DERIVATIVES
-

Simple financial instruments that may be used to lessen the exporting

risks associated with currency fluctuations.

The three main derivatives available for exporters include:

Forward exchange contracts

Is a contract in which the bank will guarantee the exporter a certain

exchange rate (for the exchange of one currency for another) on a certain
date.
Option contracts
- Gives the buyer the right but not the obligation to buy or sell foreign
currency when the exchange rate movement is to its advantage. It allows
business to use the spot rate (exchange rate on a particular day).
Swap contracts
- A currency swap is an agreement to exchange currency in the spot market
with an agreement to reverse the transaction in the future.
- The main advantage is that it allows the business to alter its exposure to
exchange fluctuations without discarding the original transaction