Year 12 2019 Examination Study Notes

Business Studies
Half-Yearly Paper ​(3 hours)​:

Topic 3:

Finance
Year 12 2019 Examination Study Notes

Role of Financial Management

Strategic Role of Financial Management

Financial management ​refers to the planning, organizing & controlling of financial or monetary resources
The long-term, or strategic, role of financial management is to ​ensure the business continues to operate, grow
and provide substantial profits to the owners.
Financial managers need strong accounting knowledge/skills to interpret & analyze financial data.

Objectives of Financial Management

(i) Profitabilit ● Ability to make a financial return from business activities
y ● To ensure profit is maximized, business must carefully monitor its revenue and
pricing policies, costs and expenses, inventory levels and levels of assets
● Measured using net profit from income statement.
● Long term profit is vital to business survival; growth & investors return on capital.

(ii) Growth ● Increase in size and value of a business over time.

● Could be achieved by increasing value of assets, increasing market
share, taking over a competitor, opening more branches/offices in
Australia or overseas.
● Businesses must monitor levels of growth & manage cash flow
effectively to ensure it is sustainable.
(iii) Efficienc ● Generating maximum returns for minimum costs.
y ● Involves increasing the amount of output with same number of
inputs, or achieving the same amount of profit with a smaller
amount of assets.
● Efficiency may be calculated using an expense ratio & also through
their ability to collect accounts receivable ($ owed to them)
(iv) Liquidity ● The ​ease with which an asset can be converted into cash​. It
refers to the ​extent to which a business can meet its short-term
debt (current liabilities).
● Essential to maintain current assets (e.g. cash in bank, accounts
receivable) greater than current liabilities (less than 12 months e.g.
short term loan, bank overdraft)
● Must have sufficient cash flow to meet its financial obligations or be
able to quickly concert an asset into cash in in order to pay a
liability e.g. selling inventory.
(v) Solvenc ● Ability of business to pay both short-term & long-term
y liabilities as they fall due​.
● Indicates if the business has long term financial stability
● Gearing: shows how much debt finance business has acquired to
fund its operations compared to use of equity finance. Most
businesses use a mixture of both.
● There must not be too much cash or too little cash to pay liabilities.

Short-Term and Long-Term Objectives

- Long term​ objectives (strategic, generally 5yrs+) are broader goals achieved through ​short term​ objectives
(tactical plans, 1-2yrs) which are reviewed more regularly.
- The overall long-term objective of financial management is to increase owner’s wealth; this is dependent on
profitability in the short-term resulting from increased operating efficiency.
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Interdependence with Other Key Business Functions

Operations
- Finance is required for inputs, machinery, land etc. to create value whilst receiving a return on investments
- Operations manages stock & outsourcing whilst finance monitors the cost of it
Marketing
- Generates sales which assists with the short-term financial goal of managing cash flow
- Finance establishes budgets and forecasts marketing must follow
Human Resources
- Finance provides funds for wages/salaries & HR strategies such as training/development

Influences on Financial Management

Sources of Finance

Internal Sources of Finance

Internal funds are obtained from within the business:
(i) Owners equity
Funds contributed by owners/partners to establish and build the business, can be raised in other ways such as taking
on another partner, issuing private shares or selling unproductive assets.

(ii) Retained profits = PART OF OWNERS EQUITY

Earnings that instead of being distributed to shareholders in dividends, are kept in the business as a cheap and
accessible source of finance. On average in Australia 50% of business profits are retained and reinvested.

External Sources of Finance

(i) Short-term borrowing
Short term-debt would be repayable within 12 months. ​O, C, F

Bank overdraft
- Allows business to overdraw their account up to an agreed limit & for a specified time to help overcome temporary
cash shortfall.
- Gives flexibility to borrow money at short notice through cheque account & assists with short term liquidity issues.
- Interest (variable) is paid on the daily outstanding balance of the account.

Commercial bills
- Written instruction to repay a specified amount of money on a specific date in the future.
- Bank does not provide the funds; it is borrowed from non-bank institutions. However, the bank guarantees its
customer will repay the borrowed money.
- Business receives the money immediately & must pay principal + interest back at a future date.
- Typically for amounts exceeding $100 000 and for a period of 3-6 months

Factoring
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- Cash sale of a business's accounts receivable at a discount to a factoring company
- Factoring company will pay business the value of the accounts receivable minus a commission or fee.
- Business receives up to 90% of amount of receivables within 48hrs of submitting its invoices to the factoring
company which will take over management & collection of the unpaid accounts under terms agreed with the
business.
- Method of ​improving liquidity​ at the expense of some of the businesses working capital in the short term.

(ii) Long-term borrowing

Loans with a term of repayment longer than 12 months. Can be secured or unsecured. Used to finance real estate,
plant (factory/office) and equipment. ​M, D, U, L, T

Mortgage
- Used to fund property purchases e.g. land, factory site, offices
- Property asset becomes the security for the repayment of the loan (bank can sell)
- Regular repayments + interest over an agreed period of time

Debentures
- Secured loans made by a company to a business for a fixed rate of interest & period of time
- Lender becomes debenture holder and has the security of the business’s assets
- Used by large established companies to buy buildings, equipment.

Unsecured notes (bonds)

- Issued by finance companies to gain funds
- Loan for a set period of time that is not secured by any assets
- Interest higher than that of a debenture as it presents higher risk to the investor
Leasing
- Businesses lease non-current assets e.g. company car, delivery vehicles, equipment, office or factory space.
- Reduces cost of acquiring the asset as business rents it rather than paying the full value.
- Firm will be obligated to pay the other business rent.
Term Loan
- Loan that has a term of repayment longer than 12 months.

(iii) Equity
Equity refers to the finance raised by a company by issuing shares to the public. Equity as a source of external finance
includes ​private equity​ & ​ordinary shares (new issues, rights issues, placements, share purchase plans).

ADVANTAGE- ​do not need to pay shareholders if the business does not earn a profit, whereas with debt finance you
have to pay interest although it is quicker.

Ordinary Shares
Buying part ownership of a publicly listed company. Shareholder may be entitled to vote on issues raised at general
meetings & receive dividends.

New issues:​ ​security that has been issued and sold for the first time on a public market; sometimes referred
to as primary shares or new offerings. ​A prospectus (a document that describes financial security) is issued
through a stockbroker and shares are made on the securities exchange.
Rights issues:​ ​the privilege granted to shareholders to buy new shares in the same company.
Placements:​ w
​ here the business arranges the sale of large blocks of shares to investment institutions.
Share purchase plan:​ ​allows listed companies to issue up to $5000 in new shares to each existing
shareholder without issuing a prospectus. ​This makes it cheaper for the business & also shareholders as
shares are offered at discounted price without brokerage. Quick & inexpensive way to raise capital however
the share purchase plan must be registered w/ASIC.

Private Equity
Money invested in a private company not listed on the ASX, meaning the general public are not invited to invest.
Advantageous as cost of finance can be postponed since shareholders don’t need their dividends immediately,
however the disadvantage is the original owners have less control as ownership is spread among more people.

Financial Institutions
Year 12 2019 Examination Study Notes
(i) Banks Banks are the main providers of finance to businesses & consumers. They receive
savings and deposits which is then invested in the form of loans to borrowers.
● E.G. Commonwealth, Westpac, NAB

(ii) Investment Banks that specialize in the provision of services to corporations. Their functions
Banks include arranging international finance, providing advice on mergers/takeovers
and managing portfolio investment.
● E.G. Macquarie bank
(iii) Finance and - Both offer a range of secured and unsecured loans to
Insurance businesses.
Companies Insurance companies​ gain large amounts of funds from policy & premium
payments, which they then use to invest and provide loans to other businesses.
● E.G. GIO
Finance companies​ raise capital through debenture (company bond) issue and
are major providers of loans, lease finance & factoring. They typically have higher
interest rates than banks but have a less strict criteria.
● E.G. Esanda, GE money
(iv) Superannuatio These institutions receive long-term funds from superannuation contributions and
n provide them to the corporate sector by investing in shares, government securities
and property.

(v) Unit Trusts Formed under a trust deed and is controlled/managed by a trustee. Units are
offered to the public for investment, the money from the sale of units is then
pooled and invested in financial assets by the trustee.
● Four main types of unit trusts: ​property trust, equity trusts, mortgage
trusts & fixed-interest trusts.

(vi) Australian The primary stock exchange in Australia which acts as a ​primary market​ for
Securities businesses ® enables a company to raise capital through new shares & also acts
as a ​secondary market​ ® purchase and selling of pre-owned securities.
Exchange
(ASX)

Influence of Government
(i) Australian Securities and Investments Commission (ASIC)
- Independent statutory commission that enforces/administers the Corporations Act.
- Protects consumers, investors & creditors by ensuring companies adhere to law and conduct fair transactions.
- Assists in reducing fraud & unfair financial practices.
- Collects information about Australian companies & provides it to the public.

(ii) Company Taxation

- Australian businesses pay 30% (flat rate) of net profit to the government.
- Company tax is paid before profits are distributed to shareholders.
- Government plans to reduce the rate as it would invite foreign investment, create new jobs & higher economic
growth.

Global Market Influences

(i) Economic Outlook
- Refers to the ​expected levels of economic growth​ of individual nations around the world.
- This affects demand for products and interest rates on internationally borrowed funds.
- Influences business decisions as a negative outlook discourages risk taking.
- Positive outlook = increased demand (​↑​production levels) and international investment/borrowing is less risky.

(ii) Availability of Funds

- Refers to the ease with which a business can access funds on the international financial market.
- Australia is seen as a low-risk country for investment, with relatively good rates of return
- Global financial problems significantly decrease availability of funds, making it difficult for businesses to borrow
and raising interest rates e.g. GFC 08/09

(iii) Interest Rates

- The higher the level of risk, the higher the interest rate.
Year 12 2019 Examination Study Notes
- Australian businesses tend to borrow from overseas (e.g. US or Japan) when they want to expand as interest
rates are cheaper, however there is the risk of currency fluctuation.

Processes of Financial Management

Planning and Implementing

(i) Financial Needs

Management must understand where the business is headed and how it will get there.

(ii) Developing Budgets

Includes developing financial budgets and forecasts that allow the business to budget for production, employment of
human resources, raising appropriate funds from appropriate sources as well as developing budgets for all the other
operations conducted by the business.

(iii) Record Systems

Includes developing accounting systems and mechanisms to record the expenses/revenues of the business in a way
that is reliable, accurate and legally compliant.

(iv) Financial Risks

Financial risk is the possibility of the business being unable to cover its financial obligations. Factors such as ​theft of
goods, non-payment of accounts receivable and interest raises ​must also be considered.

(v) Financial Controls

Tools that provide feedback on the financial performance of a business. They can include budgets, cash flow
statements, income statements & balance sheets. These controls are vital for the continual and future planning and
success of the business.

Debt and Equity Financing

Advantages & Disadvantages of Each –

Debt Finance
Advantages Disadvantages

● Funds usually readily available ● Regular repayments must be made

● Tax deduction for interest payments ● Interest may be charged (rates can also
increase)
● Increased funds, increased earnings
● Higher financial risk as debt to equity ratio
● Profits not shared with lender of loan increases
● If loan is secured, defaulting will lead to loss of
asset

Equity Finance
Advantages Disadvantages
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● No interest charges ● Proportion of profits go to additional
● No impact on gearing or financial risk new owners
● Dividend payments are flexible ● Dividends not tax deductible.
● Greater potential for growth and ● More expensive - shareholders
investment require higher return due to higher
risk
● Diluted ownership & less control
(external equity)

Matching the Terms and Source of Finance to Business Purpose

Business’s will be influenced by the following when choosing the appropriate source of finance:
● Matching Principle
The term of the loan should match with the economic lifetime of the asset. It would be inefficient to buy a short-term
asset with a long-term loan. Current assets should be purchased with short-term finance whilst non-current assets
should be purchased with long-term e.g. 25yr mortgage loan.
● Business Structure
Smaller businesses have fewer options for equity capital than large public companies. If they wish to raise equity, they
must take on another partner or access private equity unlike corporate businesses which can be listed on the ASX.

Monitoring and Controlling

(i) Cash Flow Statement
Document summarizing cash transactions that have occurred over a period of time. It shows how much money is
coming into the business (receipts) and out of the business (payments) over the set time period.
● Indicates whether business can generate favorable cash flow and pay its financial commitments.
● Highlights trends (periods of high cash in/out flow) so business can plan ahead & strategize.

(ii) Income Statement (profit and loss)

Outlines income and expenses of a business over a set period of time, indicating the business’s operating efficiency &
profitability.
Income statements show:
● How much the business sold
● How much it cost to sell
● What profit was made
The income statement indicates the level of sales, gross profit and net profit of the business:
● Gross Profit = sales – cost of goods sold
● Net Profit = gross profit - expenses

(iii) Balance Sheet

Represents a business’s assets and liabilities at a particular point in time & presents the net worth of a business. Its
purpose is to indicate the liquidity & solvency of a business.

Balance sheets are comprised of:

● Assets: current (turned into cash in 12 months) or non-current (not expected to be turned into cash in 12
months)
● Liabilities: current or non-current
● Owner’s equity

Financial Ratios
From Calculation Use

Liquidity - Measures how well business can

esses ability to ce sheet Current ratio (working capital): meet its current liabilities from the
meet current assets
short-term
Year 12 2019 Examination Study Notes
financial - Acceptable ratio is 2:1
commitments (assets:liabilities)​® indicates
sound financial position
Gearing - Gearing ratios determine the firm’s
rtion of debt and Debt to equity ratio: solvency (ability to trade long
total liabilities
the proportion ce sheet term) and shows the extent to
owner’s equity
of equity that is which the firm is relying on
used to finance external sources (debt)
business - Acceptable ratio is 0.5:1 or less
activities. than 1:1
- Highly geared = have more debt ®
more risk, less solvency.

Profitabilit Three main ratios used to

y determine profitability:
ability to make a - Indicates the average % of each
financial return Gross profit ratio: dollar of sales that is gross profit.
come ​Gross profit​ ​ x 100
from business
stateme - Acceptable level 50% or above
activities. Sales
nt
Return on equity ratio: - Shows how effective funds
come net profit contributed by the owners have
total equity
stateme been in generating profit (return
nt on investment)
- The higher the ratio or %, the
better the return for the owner.

Net profit ratio: - Measures the net profit for every

ce sheet net profit dollar of sales.
sales
- Acceptable level 18%, if too low
expenses should be examined to
look for possibility of reductions.
Efficiency Income Expense ratio: - Shows relationship between sales
when a business statemen total expenses and expenses incurred in making
is generating max t sales
those sales ® indicates day-to-day
returns from
efficiency of the business.
minimum costs
- The lower the better, otherwise
the business should develop
strategies to lower costs.
IS & BS Accounts receivable turnover - Shows how long it takes for the
ratio: business to collect money from its
1: = result debtors (people owing the
Step 2: 365 ÷ result = days
business $)
- High turnover ratios indicate
business has efficient debt
collection.

Comparative Ratio Analysis

Determines a business's financial position with relation to its previous years, and against similar businesses.
Year 12 2019 Examination Study Notes
● Time comparison- ​involves comparing ratio data of current period with previous. Reveals improving or
declining trends and enables a business to take corrective action (e.g. new suppliers).
● Industry average comparison- ​Australian Tax Office has established a set of industry benchmarks from its
analysis of businesses tax returns. This is used as a guide and can assist managers in interpreting business
performance.
● Benchmark against similar businesses- ​comparing ratios with businesses in same industry of similar size is
useful to ensure business is operating efficiently relative to its peers

Limitations of Financial Reports

(i) Normalized Earnings
- Process of removing one-time influences from the balance sheet such as special circumstances or economic
upswing/downswing.
- E.g. removal of a land sale, which would achieve a large capital gain and distort the businesses true earnings.
- Purpose is to provide a more realistic assessment of the earning performance of a business.

(ii) Capitalizing Expenses

- Turning expenses into assets ​®​ may not represent true financial condition of the business as it understates
expenses
- Instead of including it as an expense on the income statement, it’s included as an asset on the balance sheet.
(e.g. new software system)
- This is to mislead shareholders or potential buyers of the company about the financial position of the business.

(iii) Valuing Assets

- Putting estimated market value of an asset on the balance sheet, businesses often record the original purchase
price.
- Doesn’t truly represent worth of business assets as certain assets could have been purchased at an inflated price
or depreciated (e.g. equipment & vehicles lose value)​®​ distorts accuracy of financial reports.
- Intangible assets cannot always be recorded (e.g. trademarks, goodwill)

(iv) Timing Issues

- Companies listed on the ASX are required to publish half-yearly financial reports.
- Manipulating timing of transactions to mislead about businesses financial position
- E.g.​ adding revenue of current reporting period into that of the previous or recording a current cost as being
outside the financial year so it does not appear on the current reports
- Accrual accounting method​ should be used = recording expenses/sales when they take place rather than when
the cash is actually paid out or received.

(v) Debt Repayments

- Reporting debt finance on the balance sheet as a historic cost (amount initially borrowed) & not presenting the
debt repayments on the revenue statement (as expenses)
- Financial statements do not disclose specific info about nature of debt e.g. when its due, how long its been
outstanding

(vi) Notes to the Financial Statements

- Normally at end of financial reports and includes additional details & info left out of the main reporting documents
(balance sheet and income statement) such as the methodology used to record transactions or pension plan
details.

Ethical Issues Related to Financial Reports

Audits
- Independent examination of the financial records of a business to ensure they represent a true and fair financial
picture of the business.
- Businesses are required by law to have ​external audit
- They are required by law & consist of two types:
● Internal audit: ​employees assess truth and accuracy of records
● External audit: ​conducted by independent accounting firm & ​legally required by Corporations act 2001
(CTH).
- Financial institutions, potential investors and shareholders rely on audited accounts before making decisions.

Accounting Ethically
- Accounting processes depend on how accurate & honest data is recorded in financial reports
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- Source documents ​must be created for every transaction, including those by cash. ​Australian Taxation Office
closely monitors businesses avoiding taxation responsibilities.
- Businesses legally obliged to comply with ​GST​ reporting requirements
- Should not understate profit to fraud ATO or overstate value of assets
- Should not misuse funds or use inappropriate cut off periods

Financial Management Strategies

Cash Flow Management

Cash flow is the movement of cash in and out of the business over a period of time, it must be effectively managed to
ensure payments are made and received without creating a cash flow problem.
(i) Cash Flow Statement
- Predicts monthly inflows & outflows of cash ® directly linked to liquidity
- Enables managers to keep track of cash flow and identify times of potential shortfalls & surpluses so they can plan
ahead and develop budgets for certain periods.

(ii) Management Strategies

Distribution of Payments
- Paying bills at latest possible time (due date) in order to maximize interest earned on banks savings.
- Using credit card to pay bills
- Pay large bills in installments e.g. paying insurance monthly instead of yearly
- Pre pay expenses

Discounts for Early Payment

- Offering creditors, a discount for paying cash on the spot or earlier than statement due date
- Beneficial as businesses get their $ quicker and it encourages quick payment
- Most effective when target at creditors who owe large amount

Factoring
- Selling accounts receivable to a factoring business & receiving a proportion of its value (e.g. 80%, the rest is their
commission) in cash.

Working Capital Management

Working capital​ refers to funds available for the short-term financial commitments of a business.
● WC = CA - CL
Working capital management ​is determining the best mix of current assets and liabilities needed so bills can
be paid as they fall due.
(i) Control of Current Assets
Cash - Business requires cash for predictable purposes (e.g. normal operating costs) & unexpected
events (e.g. equipment breaks).
- Consequently, management needs to prepare cash-flow budget that predicts the timing & size
of cash flows for at least the next 6 months → allows business to anticipate periods of cash
shortage/surplus and make provision for them.
Receivables - Business must monitor its accounts receivables & ensure their timing allows the
business to maintain adequate cash resources.
credit sales =
accounts
receivable
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- Main ways of reducing receivables & encouraging faster payment:
establishing/reviewing ​credit policy​ (​includes (credit limit, credit period, credit
collection policy), ​factoring​, ​discount for early payment​.
Inventories - Inventory control = process of ensuring stock is kept to a minimum so costs are
as low as possible
- Keep less stock of slower selling products and ​larger quantities of faster
moving products​ so business doesn’t lose sales by running out of them.
- Inventory control policy​ to set out storage location of inventory, quantity held
in stock & its condition.
- Just-in-time (JIT)​ inventory control system where minimum inventory is
maintained and arrives just in time for use.

(ii) Control of Current Liabilities

Accounts - Need to be carefully controlled so accounts are paid on time to protect credit rating of business
payables - Stretch accounts payable ​(pay as close to due date as possible) & take advantage of discounts
offered.
- J.I.T​ method of inventory purchase to minimize $ paid
Loans - Interest & loan repayments need to be paid by due date
- Costs for establishment, interest rates & ongoing charges must be monitored to
minimize $.
- Investigating alternative sources of finance from different financial institutions
Overdrafts - Should only be used to fund short term needs.
- Must ensure overdraft size is appropriate & interest paid on time.
- Ensure cash received is promptly deposited in businesses overdraft acc to
reduce amount owing.

(iii) Management Strategies

Leasing
- Owner of asset agrees to another party using their asset in return for payments over a set period.
- Helps business conserve working capital in the short-term to use elsewhere. Payments are also tax deductible.

Sale and Lease Back

- Selling (liquidating) assets and then leasing them back from the purchaser
- Increases liquidity as cash obtained from sale is then used as working capital.

Profitability Management

(i) Cost Controls

Fixed & - Fixed costs = do not change when a business produces more goods (e.g. salaries, lease,
Variable insurance)
Costs - Variable costs = vary according to output (e.g. raw materials, labor/delivery expenses).
- Strategies to cut variable costs include:
● Negotiating discounts w/suppliers (bulk ordering)
Year 12 2019 Examination Study Notes
● Switching to a cheaper supplier
● Reducing amount of staff, J.I.T
Cost Centres - Areas/departments of a business incurring significant costs.
- Controls costs through making employees and managers accountable for the
costs in that department.
- Cost centres will record, measure & monitor their cost usage to ensure minimum
wastage.
Expense Strategies used to reduce costs & expenses include:
Minimization ● Ensuring managers keep to their budgets
● Waste minimization programs
● Replacing full time permanent staff w/casuals
● Replacing labor with technology (where appropriate)
● J.IT (reduces warehousing costs)

(ii) Revenue Controls

Designed to ensure income is flowing into the business on a regular basis. Once this has been achieved, it aims to
increase profit levels. Revenue control can be managed through use of ​marketing objectives​:
Sales - Sales objectives = the link between the marketing plan & financial plan.
Objectives - Sales targets are set to ​maximize sales, increase stock turnover and ultimately maximize
revenue​.
- Planned targets will be monitored against actual performance & corrective action (e.g. further
market research) will be undertaken where appropriate to assist in meeting sales objectives.
Sales Mix - Refers to the breakdown of sales revenue by products ® no. of units sold &
profit per unit
- Allows business to ​identify products with greatest profit margins​ and high
growth potential whilst slow moving/poor profit items can be phased out.
- Better understanding what customers prefer = improved sales mix = improved
profit
Pricing - Pricing strategy to control cash is ​cost based pricing​ = based on COGS + a %
Policy mark up to ensure a set amount of profit is made from each sale
- May use incentives such as cash discounts & sales promotions to attract sales
- Overpricing could fail to attract buyers whilst underpricing may ↑​ ​sales but
↓​profits

Global Financial Management

As a business enters the global economy, greater risk is placed upon its financial performance.
(i) Exchange Rates
- Currency fluctuation affects price paid and received for goods/services sold internationally​ → ​impacts revenue
profitability and production costs
- If Aus$ ​depreciates​ imports become more expensive but our exports become cheaper meaning business will be
more internationally competitive.
- If Aus$ ​appreciates​ imports will be cheaper but exports are more expensive, decreasing international
competitiveness.

(ii) Interest Rates

- Changes in interest rates impact the willingness & ability of businesses
- Australian businesses often tempted to borrow funds from overseas as interest rates are lower, however there is
the risk of adverse currency fluctuations & rising interest rates.

(iii) Methods of International Payment

Like most business-to-business trade, international payment is conducted on credit. Several methods of payment
have been developed to reduce risk:
Payment in - Payment sent by buyer before goods are sent (e.g. via mail, electronic payment)
advance
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Letters of credit - Contract guaranteeing the importer's bank will pay the exporter once bank
receives documentation proving shipment of goods.
Clean payment - Payment is sent to, but not received by exporters until goods are
transported.
- Requires complete trust between the parties.
Bill of exchange - Document instructing the importer to pay for the goods at a specified time.
- International bank acts as intermediary in the transaction, ensuring
exporter is paid & importer receives goods.
- Two types:
● Document against payment ​= importer can collect goods only after paying for them
● Document against acceptance​ = importer may collect goods before paying for
them.
✔ Least risk for exporters: payment in advance, letter of credit, clean payment
✔ Most risk for exporters: bill of exchange (DAP & DAA)

(iv) Hedging
- Any method used to minimize risk or loss in a financial transaction, it is how global businesses overcome the
issue of exchange rate variations.
- Business may enter into a contract (derivatives) or use ​natural hedging​ which is strategies to minimize risk of
foreign exchange exposure e.g. by establishing offshore subsidiaries.

(v) Derivatives
- Financial instruments used to support a business’s hedging activities. It is a contract dealing in the future price
of an asset.
- There are three main types:
● Forward exchange contracts​ = bank locks in certain exchange rate on certain date, regardless of
what actual exchange rate is. Disadvantage is that favorable currency fluctuations cannot taken
advantage of.
● Option contracts = ​right but not obligation to buy or sell at a set exchange rate at a time in the
future. Business can choose not to use this if the currency fluctuation is favorable.
● Swap contracts = ​allows two businesses to use an exchange rate on a particular day & reverse the
transaction at that spot rate despite what currency movement.
Year 12 2019 Examination Study Notes