BUSINESS STUDIES FINANCE

1. Role of Financial Management

1.1 Strategic role of financial management

● Planning and monitoring of a business’ financial resources in order to

allow the business to achieve its financial objectives
● A strategy helps achieve goals- how a business does something
● Strategic plan needed to grow the business- longer term/ vision

Strategy of a business:

1. Decide on goal
2. Set business objectives based on goal
3. Develop strategic plan (10 years)
4. Develop tactical plan (5 years)
5. Develop operational plan (12 months)

Objectives:

● Objectives indicate where the business wants to be/ what it wants to

be doing
● E.g. Increase dividends, market leader within 5 years
● Objectives are achieved through a carefully determined strategy

Strategic plan:

● Most important plan for a business

● Gives a long term view (up to 10 years) of where the business is going,
how it will get there, and a monitoring process

Managing financial resources:

● Financial management is crucial if a business wants to achieve its

financial goals
● Mismanagement leads to problems:
- Insufficient cash to pay suppliers
- Inadequate capital for expansion
- Too many assets that are non-productive
- Delays in accounts being paid
- Possible business failure

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 - Overstocking of materials
● Strategies for monitoring resources are necessary
● Strategic planning of financial resources aid success and growth

1.2 Objectives of financial management

– Profitability, growth, efficiency, liquidity, solvency (PLEGS)

– Short-term and long-term

● Long term goals are achieved through short term, specific objectives
● Objectives are PLEGS- Profitability, Liquidity, Efficiency, Growth and
Solvency

Liquidity: (current ratio)

● The ability of a business to pay its debts as they fall due (short term)
● Related to flow of cash- controls in/ out flow of money
● Need sufficient cash flow to meet short term obligations, cash shortfalls
will result in a loss of profitability

Profitability: (gross, net, return on equity ratio)

● Ability to maximise (largest) profit

● Must monitor revenue, pricing policies, costs, and expenses
● Revenue- expenses= profit

Efficiency: (expense, accounts receivable ratio)

● Ability to minimise costs and manage its assets so that maximum profit
is achieved at the lowest possible level of assets
● Relates to operations or revenue-producing activities
● Inventory, cash and accounts receivable must be monitored

Growth:

● Long term increase in size - compared to competitors

● Is measured by sales, profits, market share, employees, outlets
● Ensures sustainability into the future

Solvency: (debt-to-equity ratio)

● The ability to meet long term financial obligations

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 ● It indicates if a business will be able to repay amounts hat have been
borrowed, i.e. if all assets were sold, could all debt be paid off?

Short-term objectives:

● Can be tactical (1-2 years) or operational (day to day)

● Reviewed regularly to see if targets are being met/ resources are being
used to the best advantage
● Short term objectives need to complement the long-term goals

Long-term objectives:

● They are broad strategic goals (more than 5 years)

● Require short-term objectives to reach them
● Reviewed annually

1.3 Interdependence with other key business functions

● Each function isn’t able to operate successfully in isolation- it relies on

others to perform its role in achieving the broader goals of the business
● Each one must interact with all the other functions to achieve its goals
● Without finance there would be very little business. Finance (funding)
flows to each functional area within a business which enables it to
achieve its goals

Example: 5-year financial goal: 10% increase in profit

● Operations - identify potential changes to suppliers to reduce costs

● Marketing - increase market share using increased promotion and
improvements to product
● Human resources - implementing training to increase efficiency of
employees

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2. Influences on financial management

2.1 Internal sources of finance – retained profits

● Come from the owner or inside the business

● Owners equity come from the finance contributed by the owner or
partner, used as start up capital- to establish and build the business
● Retained profits are revenue from the business that isn’t distributed. It is
the most common form of internal finance and is kept in the business to
finance future activities such as growth

2.2 External sources of finance

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

long-term borrowing (mortgage, debentures, unsecured notes, leasing)

– Equity – ordinary shares (new issues, rights issues, placements, share

purchase plans), private equity

● External finance comes from outside the business

● Can be debt or equity

Debt: Short-term

● Used to finance temporary shortages in cash flow or finance for

working capital
● Repaid within one to two years

1. Bank overdraft

- Allows the bank account to be overdrawn up to a specific limit

- Are flexible and have lower interest rates than other short-term
borrowing (higher than long term), interest paid daily
- Assists short- term liquidity problems

2. Commercial bills

- A type of bill given for large amounts ($100,000 +) for a period between
90-180 days
- Amount and interest are not paid until the end date of the bill

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 3. Factoring

- Selling accounts receivable for a discounted price (usually 90%)

- Accounts receivable are sales that haven’t been paid for yet
- Will improve cash flow and gearing
- “With recourse”: business responsible for bad debts
- “Without recourse”: responsibility of sales not being paid for is with the
factoring company
- Involves greater risk and can be relatively expensive, yet fast

Debt: Long-term

● Used to finance real estate, plant (factory office) and equipment

● Greater than 12months/2 years

1. Mortgage

- Loan secured by property

- Used to finance property
- Repaid through regular principle and interest repayments

2. Debenture

- Issued for a fixed rate of interest and fixed period of time, secured over
a company’s assets
- SECURED
- Repay by buying back the debenture
- Must have a prospectus (document outlining business’ features)

3. Unsecured notes

- A loan for a set period of time, not secured against anything

- Very risky for lender, therefore high interest rates

4. Leasing

- Paying to use the equipment that is owned by another party

- Basically borrowing for money
- Can use equipment without large capital outlay

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 Equity

● External source of funds

● Refers to the finance raised by a company through inviting new owners
● Most important source of funds as it remains in the business, they do not
have to be repaid like debt finance

1. Ordinary shares

- Most commonly traded shares

- Purchasing shares means one becomes a part owner in the business
and will receive dividends (a payment a company can make to
shareholders if it has made a profit)
○ New issue: shares sold for the first time
○ Right issue: offered only to existing shareholders
○ Placements: offered directly from the company to investors- not
through ASX
○ Share purchase plan: offered to existing shareholders to buy
more shares at a discounted price (no need for a prospectus).
Maximum of $30,000 to each shareholder issued

2. Private equity

- Money invested in a private company

- Aims to raise capital to finance future expansion/ investment of the
business
- Company chooses who buys shares

Debt vs. equity

1. Debt

- Liability
- Tax deductible
- Readily available
- Greater risk
- Significant costs
- Can cause solvency problems

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 2. Equity

- Business’ funds
- Attractive to creditors and lenders
- Not tax deductible
- No repayment or interest
- Control
- Increased to reduce gearing (debt to equity ratio)

Points on sources of finance:

● Consider costs, flexibility, availability of finance and level of control

when choosing source
● Finding appropriate source is done through financial decision making
● Businesses need funds to enable it to pursue its activities

2.3 Financial institutions – banks, investment banks, finance companies,

superannuation funds, life insurance companies, unit trusts and the
Australian Securities Exchange

Financial insitutions collect funds, then invest them in financial assets &
provide financial services + deal with financial transactions

Banks:

● Are the most common source of funds and a major operator in

financial markets
● Collect funds from financial surplus (>) units and offer them to financial
deficit units (give to less/needy)
● Profit made through interest rate differential- higher interest rate for
borrowers compared to depositors- and bank fees

Investment (merchant) banks:

● Services provided in borrowing & lending

● Also known as merchant banks as they specialise their lending activities
towards the business sector
● Services include: trading in money, business finance, project financing,
foreign exchange and overseas finance, advice on mergers and
acquisitions, management of portfolios, management of trusts

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Finance companies:

● Non- bank financial institutions specialise in smaller commercial

finance, regulated by the APRA
● Provide short - medium term loans to business
● Act primarily as intermediaries in financial markets
● Provide loans, lease finance, factoring, and overdrafts
● They raise capital through debentures (share issues), can sell assets

Insurance (life) companies: → NON BANK

● Provide loans through insurance premiums

● Lump sum payment in the event of death
● Provide large amounts of equity and loan capital to businesses
● Funds received in premiums, called reserves, are invested in financial
assets
● Premiums provide for compensation during times of adversity

Superannuation funds (for retirement):

● Provide funds to the business sector often for long term investment
● All employees make a financial contribution to a fund that will provide
benefits to an employee when they retire
● Tax incentives and compulsory superannuation introduced by the
government has helped these funds grow
● The source of these funds in the investments from superannuation
contributions (employers)

The ASX (Australian Securities Exchange)

● Is the primary stock exchange group in Australia, created by the

merger of the Australian stock exchange and Sydney Futures
exchange
● Act as a primary and secondary market for the trade of shares
○ Primary: deals with the new issue of debt instruments by the
borrowers of funds
○ Secondary: deals with the purchase & sale of existing securities
● Ensure rules, regulations and laws are followed
● Offer products and services including
○ Shares
○ Futures
○ Exchange traded options
○ Warrants

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 ○ Real estate investment companies

Unit trusts

● Mutual funds
● Take funds from a large number of small investors and invest them in
assets -
○ short-term money market,
○ shares,
○ mortgage,
○ property,
○ public securities,
○ gold, silver, oil, and gas

2.4 Influence of government – Australian Securities and Investments

Commission, company taxation

● Government influence financial management decisions through

economic policies -
○ Monetary and Fiscal policy,
○ legislation,
○ and roles of government bodies or departments.

The Australian securities and investment commission (ASIC):

● An independent statutory commission that enforce business laws

● Enforce and administer the Corporation Act (company act/ law) and
protects consumers (Business police force)
● Assist in reducing fraud and unfair practice in financial markets, and
supervise the retail investment industry and trading
● Collect information about companies and make it available to the
public

Company tax:

● Paid by companies - tax on profits, levied at 27.5% fixed rate

● All Australian businesses that have been incorporated (private & pubic)
are required to pay company tax on profit

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 ● Paid before profits are distributed to shareholders
● Government is undertaking a process of reform of the federal tax
system- reduced from 36% since 2000
● Will lead to long term economic growth- lower tax rate, more attractive
place to invest, more people going into business

2.5 Global market influences – economic outlook, availability of funds,

interest rates

● Globalisation has created interdependence between economies and

their business sector

Global economic outlook: (GLOBAL = WORLD)

● The projected changes to the level of economic growth throughout

the world
● If the outlook is positive, world economic growth is to increase
● Results in increase demand for products and services, and decreased
interest rates on funds borrowed internationally
● A poor economic outlook will impact in the opposite way

Availability of funds:

● Ease with which a business can access funds (for borrowing) on the
international financial markets → easily accessible funds
● International financial markets are made up of institutions,
governments and companies that are prepared to lend funds
● Various conditions and rates apply based on: risk, demand and supply
and domestic economic conditions
● E.g. GFC had a major impact on availability of funds (high risk, high
interest rates)

Interest rates:

● Cost of borrowing money

● The higher the risk, the higher the interest rate
● Australian interest rates tend to be higher than overseas, yet the risk of
borrowing from overseas is the exchange rate movements

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Trends in financial markets:

● Changed in the last 20 years due to deregulation

● Financial transactions are easier due to technology (ecommerce,
facilitated by globalisation and the internet, helps profitability)
● Downside of global financial markets can be seen from the GFC
● Changing technologies continue to impact financial markets

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3. Processes of financial management

3.1 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

● The process involves steps:

a. setting goals/ objectives,
b. determine strategies/ alternatives,
c. evaluate options
● Long term (strategic) plans include capital expenditure (assets used to
make the business run) - generate revenue and returns
● Long term plans also include
○ finance,
○ spending,
○ developing,
○ marketing
they aid short-term goals and plans

The planning cycle:

1. Addressing the present financial position

2. Determining financial needs of the business plan
3. Developing budgets
4. Estimating cash flows
5. Monitoring and controlling
6. Maintaining record systems
7. Planning financial controls
8. Minimising financial risks and losses
● The financial plan is ongoing

Financial needs:

● Financial needs of a business are determined by:

- The size of the business
- Current phase of the business cycle
- Future plans - growth
- Capacity to source funds
- Management skills for assessing financial needs

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 ● What is needed in the future will determine what the business needs
currently

Financial plans:

● They include:
- Capital expenditure
- Planned investments
- Shareholder returns
- R&D expenditure
- Marketing expenses
- Sources of funds
● Financial information is needed to show that the business can generate
an acceptable return for the investment being sought

Developing budgets:

● A financial document used to estimate future revenue and expenses

over a period of time
● Are a forecasting tool used to assist with planning
● Used in strategic, operational and tactical plans
● Types include: cash flow, capital expenditure, raw materials and labour
budgets
● Used as a control measure: planned performance measured against
actual performance
● Used in both planning and control aspects
● Are prepared to predict a range of activities relating to short-term and
long term plans and goals

Operating budgets:

● Main activities of a business

● Show sales production, expenses, raw material, labour hours
● Used in preparing budgeted financial statements

Project budgets:

● Include information about the purpose of the asset purchase, life span
of the asset and revenue it would generate
● capital expenditure
● R&D

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Financial budgets:

● Financial data of a business

● Include budgeted revenue statement, balance sheets and cash flow
budgets

Record systems:

● Mechanisms employed by a business to ensure the data is recored &

the information provided is accurate, reliable, efficient and accessible
● Minimising error and producing accurate/ reliable statements are
important aspects of maintaining record systems
● The double entry system of accounting is one method of checking the
balancing of records (everything is recorded twice)

Financial risks:

● Loosing money/ not being able to meet debts

● Unable to meet financial obligations- bankruptcy
● The higher the risk, the greater the expectation of profits/ dividends
● To minimise risk assess: cash position, liquidity, profit levels, costs of debt
○ Credit risk: danger associated with borrowing money
○ Market risk: competition risk
○ Liquidity risk: cash flow + sufficient funds
○ Operational risk: various dangers

Financial controls:

● The procedures, policies and means by which a business monitors and

controls the allocation & usage of its resources
● Problems prevent from being able to achieve goals- result in business
failure
● Most common failure problems- theft. Fraud, loss of assets, accounting
errors
● Controls include: clear authority and responsibilities for individual tasks,
separations of duties, rotation of financial duties, control of cash,
protection of assets, control of credit procedures
● Budgets and variance reporting are controls used

Financing:

● Can be internal or external

● Need to consider debt and equity and how much is needed

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 Debt finance:

● short-term and long-term borrowing from external sources by a business

● Short-term borrowing is an important source of funding for businesses
● Risk and return must be considered carefully

Advantages Disadvantages

Funds are readily available Increased risk- different types of

repayments (regular or lump)
Increased funds → increased profits
Security is required by the business
Tax deductible
Lenders have first claim on any money if
the business ends in bankruptcy

Equity finance:

● Relates to the internal sources of finance in the business

● Shareholders’ funds represent the highest proportion of total funds to
finance business operations and assets
● Remains in the business
● Creditors and lenders are more willing to lend to a business if there are
equity funds
● Safety net for unexpected downturns

Advantages Disadvantages

Doesn’t have to be repaid (unless owner Lower profits and lower returns
leaves business)
Expectation that the owner will have
Cheaper than other sources - no interest about the return on investment
payments

Owner who contributes equity retain

control over how that finance is used

Low gearing

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Less risk

Matching the terms and sources of finance to business purpose:

● Businesses must find the source of finance that is most appropriate to

fund the activities arising from these decisions
● Source of finance will be influenced by:
○ The terms of finance- suitable for structure and purpose
○ The cost of each source of funding- required rate of return is
taken into consideration/ balanced against the costs of each
source
○ The structure of the business
○ Costs- fluctuate depending on market and economic condition
○ Flexibility- require funds to be variable
○ Availability of finance
○ Level of control

3.2 Monitoring and controlling – cash flow statement, income statement,

balance sheet

● Main financial controls used for monitoring: cash flow statements,

income statements, balance sheets

Cash flow statements:

● Indicates the movement of cash receipts and payments - resulting from

transactions over a period of time
● Reflection of liquidity
● Gives information regarding a firms ability to pay its debts on time
● Users of cash flow statements include creditors, lenders, owners and
shareholders
● Shows whether a firm can:
○ Generate favourable cash flow
○ Pay financial commitments as they fall due
○ Have sufficient funds for future expansion or change
○ Obtain finance from external sources when needed
○ Pay drawing to owners and dividends to shareholders

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 ● Can be divided into operating, investing and financing activities
○ Operating: provision of goods and services cash inflows +
outflows relating to the main activity of the business
○ Financing: cash inflows + outflows relating to the borrowing
activities of the business
○ Investing: cash inflows + outflows relating to the purchase and
sale of non-current assets + investment

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Income statements (statements of financial performance/ revenue
statement)

● Summary of income earned & expenses incurred over a period of

trading
● Determines operating efficiency and if there were a profit or loss
● Shows operating income - main function of the business (COGS) and
operating expenses
● Include income and expenses, selling, administrative and financial
expenses, COGS and net profit

○ Profit = Revenue - expenses

○ COGS = Opening stock + purchases - closing stock
○ Gross profit = Operating income - COGS
○ Net (retained) profit = gross profit - expenses

Expenses: cost incurred in process of acquiring/manufacturing a

good/service to sell + costs associated with managing all aspects of the sales
of that good/service.

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Balance sheet (statements of financial position)

● Is a determination of the financial stability of the business

● Shows the level of current and non-current assets and liabilities,
including investments and owners equity at a particular point in time +
shows financial stability
● Indicates whether:
○ The business has enough assets to cover its debts
○ The interest and money borrowed can be paid (total assets >
liabilities)
○ The assets of the business are being used to maximise profits
○ Represents net worth (equity) of business

CURRENT ASSETS: assets used within 12 months (cash, acc receivables, stock)
NON CURRENT ASSETS: expected life > 12 months (land, fixtures & fittings, cars)
CURRENT LIABILITIES: debts repaid < 12 months (overdraft, account payable)
NON CURRENT LIABILITIES: long term debt items (mortgage, debenture)

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Balance sheet - the accounting equation:
● The accounting equation shows that the assets of the business may be
financed by either the owners or by parties external to the business
● The balance sheet shows the outcome of the accounting process
● Shows the relationship between assets, liabilities, owner’s equity
● Equations:
○ Assets = Liabilities + Owners equity
○ Owners equity = Assets - Liabilities
○ Liabilities = Assets - Owners equity

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3.3 Financial ratios

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

– Gearing – debt to equity ratio (total liabilities ÷ total equity)
– Profitability – gross profit ratio (gross profit ÷ sales); net profit ratio (net profit
÷ sales); return on equity ratio (net profit ÷ total equity)
– Efficiency – expense ratio (total expenses ÷ sales), accounts receivable
turnover ratio (sales ÷ accounts receivable)
– Comparative ratio analysis – over different time periods, against
standards, with similar businesses

● Financial statements summaries the activities of a business over a

period of time and must be analysed to increase understanding of the
implications of those activities
● Main types of analysis:
○ Vertical - compares figures within one financial year
(debt:equity)
○ Horizontal - compares figures from different financial years (2021
vs 2020)
○ Trend - compares figures for period of 3-5 years
● Ratios assist in answering questions relating to profits, solvency,
efficiency, growth and return
● Analysis of financial statements is usually aimed at the areas of
financial stability (liquidity and gearing), profitability and efficiency
● Interpretation: making judgements + decesions using data gathered
from analysis

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Liquidity:

● Current ratio

Current Assets

Current Liabilities

● Ability to meet its short-term financial commitments

● Benchmark ratio of 2:1 = a sound financial position (double the amount
of current assets to cover its current liabilities)
● Higher ratio = the more capable the business is of meeting its short-term
obligations OR business may be using its current assets inefficiently
● Low ratio = business may have difficulty meeting short term obligation

● IMPROVE LIQUIDITY: Factoring, injecting more equity into the business to

pay off liabilities, selling non-essential non-current assets and using
those funds to reduce current liabilities.

Solvency/Gearing:

● Debt to equity ratio

Total Liabilities

Owners Equity

● Extent to which the firm is relying on debt or outside sources to finance

the business
● 1 : 1.5 is the benchmark
● The higher the ratio, the less solvent the firm(the higher the business risk)

● To improve a business’s gearing:

o Reducing debt: sell non-essential assets, or re-negotiate loans to
spread their payments over a longer period. Alternatively, the
business could lease assets as opposed to purchasing them.
o increase equity = retaining more profits, or injecting more equity
funding by selling more shares (public company) or inviting new
owners

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Profitability: - measures business performance

Gross profit ratio

Gross Profit
X 100
Sales

● Gives the percentage of sales revenue that results in gross profit.

● Shows the changes from one accounting period to another & indicates
the effectiveness of planning policies (pricing, sales, discounts, the
valuation of stock ect)
● The higher the ratio = more profitable/COGS is low
● If the ratio is low = sourcing of alternative suppliers, investigate
competitors

Net profit ratio

Net Profit
X 100
Sales

● Represents the profit or return to the owners

● A firm will be aiming for a higher net profit ratio, to still make a profit
● A low net profit ratio = expenses should be examined to look for
possibility of reduction
● 10 % is sound

Return on equity ratio

Net Profit
X 100
Total Equity

● Shows how effective the funds contributed by the owners have been in
generating profit and so the return on investment
● The higher the ratio or percentage, the better the return for the owner
● If returns compare favourably = expansion/diversification of business.
● return is unfavourable = selling off the business
● 10 % is sound

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Efficiency:

Expense ratio
● Formula: total expenses ÷ sales

Total Expenses

Sales

● The ratio indicates the number of sales that are allocated to individual
expenses (day-to-day efficient of the business) - selling, administration,
COGS and financial expenses
● They need to be kept at a reasonable level, and management must
monitor each type of expense in relation to sales.

Accounts receivable turnover ratio

365 ÷ Sales Revenue

Accounts
Receivable

● How efficiently it collects its debts and the effectiveness of a firm’s

credit policy
● Measures how many times the accounts receivable balance is
converted into cash/how quickly debtors pay their accounts.
● High turnover ratios = the business has efficient debt collection
● If a business is not efficient in collecting their accounts receivable they
need to implement strategies to improve this = charging interest on
overdue payments, offering discounts for early payments or being
more selective when granting credit.
● 30 days is efficient

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Comparative ratio analysis:

● Figures, percentages and ratios do not provide a complete picture for

analysis
● For analysis to be meaningful, comparisons and benchmarks are
needed
● Judgements are then made by comparing a firm’s analysis against
other figures, percentages & ratios → aka ‘comparative ratio analysis’
● Analysis taken over a number of years can be compared with similar
businesses, or their results from previous years and against common
industry standards or benchmarks
● Important to look at trends in the financial information over several
years as sales and stock levels may vary significantly throughout a year
so financial information will also vary.
● Analysis can also include budget figures so that predicted figures can
be compared against actual figures

3.4 Limitations of financial reports – normalised earnings, capitalising

expenses, valuing assets, timing issues, debt repayments, notes to the
financial statements

Limitations of financial reports

● Financial reports and ratio analysis provide information on the state of

the business and indicate trends in its operations (not completely
accurate)
● Financial reports are only as good as the detail that comes with them
and have some scope to be creative or misleading
● Users of financial reports must look into all of these possibilities
● Issues are below:

Normalised earnings:

● Process of removing one time, or unusual, influences from the balance

sheet to show the true earnings of a company
● Earnings that have been adjusted to take into account changes in the
economic cycle
● This makes it easier to compare profitability figures for a business from
one year to the next and against other businesses.
Eg. the removal of a land sale, which would achieve a large capital gain

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Capitalising expenses:

● How a cost is treated on a business’s financial statement

● Businesses have two options when adding a cost to their financial
statement:
○ Expense it: included as an expense on the income statement
and will be subtracted from the business’ revenue to determine
the profit.
○ Capitalise it: it is going to count towards capital expenditures.
This means it will be accounted for on the business’s balance
sheet as an asset

Valuing assets:

● This is the process of estimating the value of assets when recording

them on a balance sheet
● Used for investment analysis, mergers/acquisitions and financial
reporting
● Sometimes when an asset is recorded on a balance sheet, its value is
written as its historical cost (an accounting method where assets are
listed on a balance sheet with the value which they were purchased)

Advantages Disadvantages

The cost can be verified. value may distort the business’s

balance sheet - the original cost of
an asset may be different from its
current market value.

● Another limitation of financial reports is that some assets are very

difficult to value (intangible) and may not be included in the balance
sheet as their value is too difficult to work out
● Due to inflation, assets have to be revalued to account for the
appreciation or depreciation
● The method used will influence the assets and owners’ equity on the
balance sheet

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Timing issues:

● Making adjustments to the timing of activities

● When analysing a financial report, limitations can arise due to timing
issues.
● One of the basic accounting concepts is the matching principle (more
accurate representation of the financial position of a business)
○ expenses incurred by a business must be recorded on the
income statement for the accounting period in which the
revenue to which those expenses relate is earned.

Debt repayments:

● Financial reports can be limited because they do not have the

capacity to disclose specific information about debt repayments
● When analysing a financial report, the gearing ratio is often used to
determine whether businesses are at risk of failing to meet their
long-term financial commitments.
● A business that is highly geared may be alarming for some stakeholders
and has increased risk, their potential for profit is greater
● The recording of debt repayments on financial reports can be used to
distort the ‘reality’ of the business’s status and this may be undertaken
to provide a more favourable overview of the business at that point in
time.

Notes to the financial statements:

● Report the details and additional information that are left out of the
main reporting documents
○ balance sheet, income statement and cash flow statement.
● Extra details about accounting methods or specific transactions and
contain info useful to stakeholders to understand them.
● Also may contain further details about how the figures in the financial
statements were calculated and the procedures that were used to
develop them

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3.5 Ethical issues related to financial reports

● Businesses have ethical and legal responsibilities in relation to financial

management
● Legal responsibilities have to be met - law
● Ethical responsibilities should be met - right thing to do
● Ethical considerations are related to legal aspects of financial
management
● Legislation is in place to guard against unethical business activity
● There are growing calls for codes of behaviour to be drawn up to
guide businesses with their financial management
● Supported by ASX

Ethical issues related to financial reports:

Audit accounts:

● Generally used to examine the financial affairs of a business

● Purpose is to obtain an independent opinion on the financial
statements of a business and to ensure that records provide accurate
information for users
● 3 main types of audits:
○ Internal audits: conducted internally by the business’s employees
to check procedures and accuracy to guard against waste,
inefficiency, misuse of funds, fraud and theft - ethical
○ Management audits: conducted to review the business’s
strategic plan - ethical
○ External audits: conducted by independent and specialised
audit accountants to guarantee the authenticity of the
company’s financial accounts (in small businesses only if for sale
or checking against theft and fraud) - legal (these are a
requirement of the Corporations Act 2001 Cwlth). ASIC defines a
company as being ‘large’ if, at the end of the financial year, the
company meets two of the following three criteria:
■ a consolidated revenue of $50million or more
■ consolidated gross assets of $25million or more
■ 100 or more employees
● Auditors check the control procedures of a business by physically
checking assets.

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Record keeping:

● All accounting processes depend on how accurately and honestly

data is recorded in financial reports
● Proper financial records must be kept and held for 7 years (legal
requirement) - may be audited by the government for tax purposes
● Temptation to receive payment in cash form, not card & not record
transaction - if not recorded, will not show up as business revenue, and
will reduce the business’s profit for the year, possibly resulting in a lower
tax burden
● However, If audited by ATO and found to be evading tax = heavily
fined

GST obligations:

● The introduction of GST was to make it more difficult for businesses and
individuals operating in the cash economy to avoid tax
● Businesses have an ethical and legal obligation to comply with GST
reporting requirements
● This includes a quarterly business activity statement (BAS) in which GST
collected, less input tax credits claimed, are reported and the balance
of GST is paid to the ATO

Reporting practices:

● Accurate financial reports are necessary for taxation purposes as well

as for other stakeholders
● Shareholders in a private company are legally entitled to receive
financial reports annually (even if small business or shareholders are
family members)
● Understating profit is not only illegal but can make it difficult to obtain
external sources of funds or even to sell the business
● Overstating the value of assets may prove counter-productive

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4. Financial management strategies

4.1 Cash flow management

– Cash flow statements
– Distribution of payments, discounts for early payment, factoring

● Financial management strategies are highly important in improving

business performance and ensuring financial objectives are met.
● strategies financial managers can implement to address issues of
concern and to help the business achieve its objectives are:
● Matching cash flow in with cash flow out is essential
● Budgets are an important tool for managing cash flows (forecasting
tool)

Cash flow statements:

● Cash flow: movement of cash in and out of a business over a period of

time.
● Statement of cash flow indicates the movement of cash receipts and
cash payment
● A tool to identify trends and predict change
● A cash flow forecast can make managing cash flow easier by helping
owners to predict surpluses or shortages of cash - enabling them to
make more informed decisions

Cash flow management strategies:

● Businesses use overdrafts when they have temporary shortfalls (may
result in insolvency or bankruptcy)
● Must implement strategies to ensure that cash is available to make
payments when they are due. Eg to:
○ The Australian Taxation Office (ATO)
○ Suppliers for accounts payable
○ employees for wages
○ Owners and shareholders for profits and dividends
○ Banks and financial institutions for interest on loans or overdrafts,
and leasing payments

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 Common cash flow management strategies:

Distribution of payments:
● Spreading’ out payments throughout the month/year to avoid lump
sum/large payments at once
● can reduce/avoid shortfalls
● ensures equal cash flow each month
● Cash flow projection helps identify potential short falls/ surpluses
● Key: link outflows to months with surplus cash

Discounts for early payment:

● Incentive offered for customers who pay their bills well before the due
date/deadline
● offering debtors who owe the business money, a discount for early
payment
● Is effective for large amounts of money
● Positively affects cash flow status

Advantages Disadvantages

Reduces risk of late payment and decreases profit margins

associated costs inc. the business (globally
72.5% of invoices are paid late) May impact ability of business to forecast
cash flow
increases customer loyalty & improves
customer relationships, discount = incentive needs to track cash flows carefully, or
over competitors. could mistakenly give discounts to
customers who claim they are paying
sooner, but aren’t.
Improves working capital and will provide
extra liquidity No guarantee that customers will keep
paying quickly
Reduces the risk of non-payment and bad
debt

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 ● Factoring:
○ Selling of accounts receivable for a discounted price to a
finance or specialist factoring company
○ Benefit for business - immediate cash without waiting
○ The business saves on the costs involved in following up on
unpaid accounts and debt collection.
○ Benefit for financer - 3% profit when the account is eventually
paid

Advantages Disadvantages

Immediate cash injection (in your account Factoring reduces a business’s profit margin
within 24 hours) → helps improve working on each invoice they sell
capital
Factoring can be more expensive than
Factoring isn’t a loan, so businesses won’t other forms of short-term finance
be taking on debt or paying interest
It can damage a business’s relationship with
It’s quick and easy to arrange - no lengthy their customers as they no longer deal
application process exclusively with the business, especially if
the factor uses aggressive collection
Businesses can avoid the hassle of methods
collecting debts, freeing up the owner’s
time to concentrate on their business It could indicate to customers that the
business has cash flow problems, potentially
Customers may be more likely to pay on making them wary about dealing with them
time if a factor is collecting the debt

Availability depends more on customers’

credit ratings than the business’s, so even
firms with bad credit may be able to access
factoring

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4.2 Working capital management
– Control of current assets – cash, receivables, inventories

– Control of current liabilities – payables, loans, overdrafts

– Strategies – leasing, sale and lease back

● Short-term liquidity is important for businesses:

o means a business can take advantage of profit opportunities
when they arise
o meet short-term financial obligations,
o pay creditors on time to claim discounts,
o pay tax
o meet payments on loans and overdrafts.
● Current assets are constantly changing as inventories are sold, cash is
paid out and payments are received
● Working capital is the term used in businesses to describe the funds
available for the short-term financial commitments of a business.
o Insufficient working capital = cash shortages or liquidity problems
o Excess of working capital = assets are earning < cost to finance
them
● Net working capital = current assets minus current liabilities
● Represents funds needed for day-to-day operations of a business to
produce profits & provide cash for short-term liquidity.
● Working capital management involves determining the best mix of
current assets & current liabilities needed to achieve the objectives of
the business.

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Control of current assets:
● Current assets may make up approximately 40% of a business’s assets
○ their use and management are important for managing working
capital & require planning and constant monitoring
● Management must select the optimal amount of each current asset
held, as well as raising finance to fund those assets
○ Excess inventories and lack of control over accounts receivable
= an increased level of unused assets → leading in turn to
increased costs and liquidity problems.
○ Excess cash = cost if left idle and unused.
○ insufficient inventories & tight credit control policies = leads to
problems.
● Working capital must be sufficient to maintain liquidity and access to
credit to meet unexpected and unforseen circumstances

Cash:
● Consideration must be given to the levels of cash receivables
and inventory that are held
● Cash is controlled by a cash budget
● Enables managers to time significant outgoing expenses when
there are cash surpluses
● Ensures that the business can pay debt, loans and accounts

Accounts receivable:
● outstanding invoices or payments that a business has
● receivables sums of money due to a business from customers to
whom it has supplied goods or services. Recorded as accounts
receivable.
● Must be managed to ensure that their timing allows the business
to maintain adequate cash resources
● Credit ratings of prospective customers must be checked
● Implementing a credit policy
○ Set of guidelines to staff on how to invoice, monitor and
collect customer debts
● Set credit limits, credit periods, reminders and the debt collection
policy
● A disadvantage of a too strict credit policy - customers might
choose to buy from another firm
● Factoring of accounts receivable is also an option

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 Inventories:
● make up a significant amount of current assets, and their levels
must be carefully monitored so that excess or insufficient levels of
stock do not occur. (Large inventories = more stock = huge cost
to business)
● Stored goods - raw materials, work-in-progress, components parts
or finished goods
● Need to respond to customer demand- too little means lost sales
and too much means excess storage costs
● Inventory policy - sets out where, what and how many units are
stored. Usually computerised
● Just-in-time (JIT) - inventory is supplied just in time to be used. No
storage costs and obsolete or damaged goods

Control of current liabilities:

● Current liabilities are financial commitments that must be paid by a

business in the short term
● Minimising costs related to a firm’s current liabilities = important part of
the management of working capital → involves converting current
assets to cash to ensure that the business’s creditors are paid

Payable (Accounts payable):

● sums of money owed by the business to other businesses from
whom it has purchased goods and services
● Ideal to pay on time - not before or after - paying on the final
date is a cheap means of improving liquidity position
● If paid early - miss out on ‘interest free finance’ from trade credit.
Cash can be used for other expenses and purposes
● If paid late - poor reputation and relationship with suppliers;
could incur costs; unethical behaviours
● Control of accounts payable involves periodic review of suppliers
and their credit facilities, such as:
○ Discounts
○ Interest-free credit periods
○ Extended terms for payments
● Alternative finance such as floor plan and consignment finance
could be used (arrangements)

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 Loans:
● Short-term loans and bridging finance are often used as a
substitute for controlling receivables
● Businesses might not want to risk a poor relationship with a large
client regarding an overdue bill
● Loans incur costs - interest
● Generally an expensive form of borrowing - use should be
minimised

Overdrafts:
● A convenient and cheap form of short term borrowing for a
business
● They enable a business to overcome temporary cash shortages
● Banks require regular payments to be made on overdrafts and
may charge account keeping fees, establishment fees and
interest
● Should have a policy for using and managing bank overdrafts

Strategies for managing working capital:

Leasing:
● the payment of money for the use of equipment that is owned
by another party (hiring)
● Leasing = contract between the lessor (owner of the asset) and
the lessee (user of the asset) that lets the lessee rent an asset for
a period of time in exchange for periodical payments.
● Leasing ‘frees up’ cash that can be used elsewhere in the
business
Advantages:
○ The cash outflows related to leasing are spread over
several years
○ Tax deductible (as considered operating expenses)
○ Allows business to make use of good quality assets
○ Reduces risk of unpredictable costs associated with repairs
and maintenance of equipment.
○ 100% financing
○ Increases the number of assets - revenue and profit can be
increased
○ lease payments help with cashflow forecasting and
budgeting → payments are fixed for a specified time

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 Sale and lease back:

● The selling of an owned asset to a lessor and leasing the asset

back through fixed payments for a specified number of years
● This increases the businesses liquidity as the cash from the sale
can be used as working capital

4.3 Profitability management

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

– Revenue controls – marketing objectives

Cost controls:

● profitability management = control of business’s costs and revenue

● Single most important aspect of running a business
● Many companies have limited opportunities to grow, therefore cost
control is the main way to improve profits
● Key - benchmarking costs, need to be below competitors

Fixed and variable costs:

● Fixed costs are not dependent on the level of operating activity

in a business and do not change when the level of activity
changes (must be paid regardless of what happens in business)
● Variable costs are those that vary in direct relationship to the
levels of operating activity or production in a business → costs
increase with outputs/effected by the activity level
● Changes in the volume of activity need to be managed in terms
of the associated changes in costs

Cost centres:

● A cost centre is a department within a business that is responsible

for a particular set of activities that benefits the organisation
(Areas of a business which a cost can be directly attributed)
● It allows management to measure, budget and control costs for
each specific function
● The use of cost centres helps management utilise resources more
efficiently as it gives them a better understanding of how those
resources are being used.

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 ● main function of a cost centre = to track expenses
● Monitoring expenses through the use of cost centres allows for
greater control of total costs

Expense minimisation:

● businesses need to examine its activities and decide where costs

in the production of its good or provision of its service can be cut
● Profits can be weakened if the expenses of a business are high
● Guidelines and policies should be established to encourage staff
to minimise expenses and eliminate waste and unnecessary
spending

Revenue controls:

● Income earned from the main activity of the business

● Revenue comes from sales, fees for professional services or
commission
● A way to increase profits is to increase revenue
● Business must have clear ideas and policies to maximise profit

Marketing objectives:

● Revenue controls revolve around marketing strategies

● Review of the break-even point (cost-volume-profit analysis) and
the marketing mix
● Changes to the sales mix can affect revenue - ensuring the
business understands needs of the customers + research effects
of sales mix (calculation that determines the proportion of each
product a business sells relative to total sales → the products
profitability)
● Pricing policies and profit margins affect revenue + working
capital - critical for businesses, especially retail
■ Factors influencing pricing:
➢ costs associated with producing the goods or
services (materials, labour, overheads)
➢ Prices charged by the competition
➢ Short and long term goals
➢ Image or level of quality that people associate with
the goods or services
➢ Government policies

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 4.4 Global financial management

– Exchange rates

– Interest rates
– Methods of international payment – payment in advance, letter of credit,
clean payment, bill of exchange

– Hedging

– Derivatives

Exchange rate/ currency fluctuation:

● One country's currency must be converted to another when

transactions are conducted on a global scale through foreign
exchange market (a market that determines the price of one currency
relative to another)
● Currency is valued by dealers buying and selling each others
currencies
● Global transactions are performed through the forex
● The exchange rate is the ratio of one currency to another - telling how
much one unit is worth in another
● Importers in Australia like higher exchange rates - appreciation
● Exporters in Australia like lower exchange rates - depreciation
● Appreciation: raises the value of the Australia dollar in terms of foreign
currencies. Exporters are less competitive, importers are cheaper
● Depreciation has the opposite effect
● Currency fluctuations will impact the business’s profitability and affect
their ability to meet their financial objectives → when revenues and
expenses are transferred between nations, exchange rate can
increase/decrease their value.

Interest rates:

● businesses that plan to relocate offshore/expand domestic production

facilities to increase direct exporting need to raise funds to undertake
international activities
● Tempting to borrow overseas - lower interest rates (Australia tends to
have higher interest rates than other countries)
● Adverse currency fluctuations could see the advantages of cheaper
overseas interest rates quickly eliminated

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Methods of international payment:

● Crucial aspect of global financial management is to select an

appropriate method of payment
● Problem of trust(produt is shipped before payment OR payment sent
before product received, then no guarantee product is shipped) is
solved by a third party - usually a bank

Payment in advance:

● Allows the exporter to receive payment and then arrange for

goods to be sent
● Used if the other party is a subsidiary or when the credit
worthiness of the buyer is uncertain
● Exporter: least amount of risk - none
● Importer: exposes them to risk (no guarantee they will get their
goods)

Letter of credit:

● A document a buyer can request from their bank that

guarantees the payment of goods will be transferred to the seller
● Issued by importer’s bank to the exporter promising to pay them
a specified amount once certain conditions have been met
● Seller has to show proof of shipment of the goods for payment to
occur
● Once the bank has made a commitment it can’t be withdrawn
● Exporter: very popular. Slightly riskier than payment in advance
but still well liked
● Importer: liked

Clean payment (remittance):

● Occurs when the payment is sent to, but not received by, the
exporter before the goods are transported
● Goods are shipped with an invoice requesting payment at a
certain time after delivery (30, 60 or 90 days) → credit term
● Easiest and quickest method
● Exporter: risk is minimal but requires complete trust
● Importer: not favoured

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 Bills of exchange:

● A document drawn up be the exporter demanding payment

from the importer at a specified time
● Goes through the Australian bank and importers bank
● Exporter: allows them to maintain control over the goods until
payment is either made or guaranteed. But this method contains
the most risk for the exporter out of all the methods
● Importer: widely used

○ Document (bill) against payment:

■ Bill of exchange is drawn up in Australian bank and

sent to importer bank with documents allowing
goods to be collected
■ Importer can collect documents and goods only
after paying for them
■ Exporter: risk that the importer wont pay and goods
wont be collected at all
■ Importer: low risk

○ Document (bill)against acceptance:

■ Same process as “against payment” yet importer

must only sign acceptance of goods and terms of
the payment to receive documents/ collect goods
■ Importer may collect goods before paying for them
■ Exporter: high risk as importer may delay payment or
not pay at all
■ Importer: low risk

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Hedging:

● Process of minimising the risk of currency fluctuations

● spot exchange transaction = two parties agree to exchange currents
and finalise a deal immediately
● Exchange rates change constantly so the spot exchange rate many
not be the most favourable rate and changes can leave exporters out
of pocket (value of one currency in another currency on a particular
day)
● Natural hedging examples (don’t require a bank)
○ Establishing offshore subsidiaries
○ Arranging for import payments and export receipts denominated
in the same foreign currency so losses from a movement in
exchange rates will be offset by gains in the other
○ Implement marketing strategies that attempt to reduce the price
sensitivity of the export market
○ Insisting the contract is denominated in Australian dollars

Financial instrument hedging:

● Financial products available, called derivatives, that can be

used to minimise or spread the risk of exchange rate fluctuation

Derivatives:

● Simple financial instruments that may be used to lessen the exporting

risks associated with currency fluctuations (to minimise financial risks
involved with exporting)
● Can be as dangerous as the risks against which they are supposed to
protect

Forward exchange contracts:

● By using a forward exchange contract the bank will guarantee

the exporter a certain exchange rate on a certain date
regardless of what the actual exchange rate is
● Usually after a period of 30, 60, 90 or 180 days

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 Option contracts:

● If a business purchases an option contract it has the option to

buy or sell foreign currency when the exchange rate movement
is to its advantage
● It gives the buyer the right, but not the obligation, to buy or sell
foreign exchange currency at some time in the future

Swap contracts:

● Currency swap: an agreement to exchange currency in the spot

market with an agreement to reverse the transaction in the
future
● Spot sales of one currency together with a forward repurchase of
the currency at a specified date in the future
● It can also be used with borrowings of principle and interest loans
with an agreement to exchange the net present value (principle
and interest) of one currency for the net present value of
another currency at a specified time in the future
● Advantage - allows business to alter its exposure to exchange
fluctuations without discarding the original transaction

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