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Topic 3: finance
Chapter 11: role of financial management
Strategic role of financial management
Financial management deals with the analysis, interpretation and evaluation of all financial records of the business.
The long-term or strategic role of financial management is to ensure that a new business continues to operate, grows and is
able to achieve its goals and objectives.
The decision making process is:
o Owners and managers make decisions and plans

o Owners and managers collect information relating to the decisions and plans


o Owners and managers analyse and evaluate the results of decisions and plans

Objectives of financial management
The first measure owners want to establish is how much profit their business is making.
Financial reports give a detailed financial picture of the businesss profitability and stability.
The financial managers objectives will include the businesss
o Profitability
The earnings of the business after expenses have been paid.
Profitability is measured using net profit from the income statement.
Gross profit is sales revenue minus wholesale cost and freight inwards (or COGS).
Net profit is the final amount of revenue remaining after all expenses have been paid.
Earnings before interest and tax (EBIT) is a more precise measure of profitability, it measures profit made
from operations.


o Growth
This is the size of the business compared to its competitors in the same market. More profits may be
obtained if the size is bigger. It can be achieved by:
increasing the physical size of the business by expanding or moving to a larger office or factory
increasing the value of the assets in a business
increasing sales and profits

o efficiency
This is how much of total revenue is spent on expenses.
Efficiency may be calculated using an expense ratio. Efficiency = total expenses/total sales.
Another measure of is the businesss ability to collect accounts receivable. E.g. invoices (A bill sent to a
customer requiring payment by a date)

o liquidity
This is the ability of the business to pay short-term liabilities using its current assets.
Debtors are expected to pay their accounts within a short time so it is a relatively liquid asset.
Current assets are cash and other assets that are sold or converted into cash within 12 months.
Current liabilities are debts that are due to be paid within 12 months.
Current assets need to be greater than current liabilities.





o solvency
This is the ability of the business to pay both short-term and long-term liabilities as they fall due. It shows
if the business is financially stable.
Gearing: tells you how much debt (or leverage) tells you how much debt its operations compared to its
use of equity finance.
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There must not be too much cash or too little cash to pay liabilities.

Short and long term
Businesses it must often prioritize objectives as they cannot always all be achieved at the same time.
If another one of the businesss objectives is to be environmentally responsible then it must sacrifice efficiency in the
operations.
Consumers can also turn to a businesss competitors if a business is not seen to be environmentally responsible.

Interdependence with other key business functions
The main functions that a business needs to perform are operations, human resources, marketing and finance.
Middle management develops short-term plans (tactical).
The financial manager must allocate
The financial manager must allocate adequate funds to each department to be able to operate successfully. The manager
will also need to develop budgets and cost controls for each department.


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Chapter 12: influences on financial management
A business can source money from inside or outside. Hence, there are 2 types of finance:
o Internal
Internal sources of finance are recorded under equity in the balance sheet. This money can be from the
business owners or from the business activities.
Owners equity-the funds contributed by owners or partners to establish and build the business.
Retained profit - It is net profit that has been reinvested in the business. It is added as equity and
it increases the owners claim.

o External
This is finances from external organizations; it can be a debt or equity.
Debt- any money that has been borrowed. Generally, a short-term debt would be repayable
within 12 months. Long term is over 12 month. Some types are
o Overdraft- when a business is given flexibility to borrow money from a bank at short
notice through its cheque or current account. There is interest that must be paid. It is
often used for working capital and can be claimed as a tax deduction.

o Commercial bill- a written order for a loan amount that is guaranteed by the businesss
bank. It is borrowed from businesses with surplus funds. It is normally from 30-180 days.

o Factoring- when a business sells its accounts receivable asset to a specialist factoring
firm to create cash inflow for the business. The factoring company takes over
management and collection of the unpaid accounts under terms. The factoring company
will pay the seller the value of the accounts minus a commission or fee.

o Mortgage-a loan which is repaid over a set number of years with interest. They are
used to purchase land or properties. The property asset becomes the security for the
repayment.

o Debenture- A type of long-term debt finance that a business can acquire by offering a
prospectus to the general public on the securities exchange. The business is offering an
investment opportunity to people who want a good return from a more risky
investment.

o Unsecured notes- notes usually issued by finance companies to gain funds. They offer
higher interest rates reflecting the greater risk. Unsecured notes are called bonds.

o Leasing- where businesses lease non-current assets, such as cars and equipment for
payments to the owner. This reduces the cost of acquiring these assets as full value of
the asset in one transaction does not have to be made instantly. This agreement can
provide tax advantages as the lease payments are usually tax deductible.



Equity- attached to the ownership of shares in an incorporated business. The owners financial
claim on the assets of the business. Some types are:

o Venture capital- Capital acquired from a specialist venture financial institution that
seeks to become a part-owner in the business.
o Private equity- when a business invites people/organizations to invest in the business.
Shareholders do not need to be paid instantly and the owners do have so much control.

o Public equity- when anyone can invest in the business. They include:

Ordinary shares- shares to the public through securities exchanges. Shares can
Short term
Long term
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be issued with or without the right to vote at the annual general meeting.

New issues- a 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 issue- the privilege granted to shareholders to buy new shares in the
same company

Placements- to offer 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 existing shareholders in a listed company the
opportunity to purchase more shares in that company without brokerage fees.
They are at below normal prices and permission is required from ASIC.
Grants- financial gifts provided by government to assist businesses to establish or expand. They
need to meet strict criteria.

Financial institutions
Businesses can also acquire finance from international financial markets and overseas stock exchanges.
Financial institutions often seek debt security (Any type of loan that a business obtains that is issued by a promise of
repayment on a certain date at a specific rate of interest.)
Some financial institutions include banks, investment banks, finance companies, superannuation funds, life insurance
companies, unit trusts and the Australian Securities Exchange.
o Banks- Banks accept deposits from the general public and provide funds for loans and, in turn, make investments.
They also provide services like: legal and taxation advice and risk management.

o Investment banks- Investment banks deal with businesses and governments in raising large amounts of capital by
underwriting share issues. They arrange any type of finance that is needed.

o Finance and life insurance companies- Finance and life insurance companies are non-bank financial intermediaries
that specialise in smaller commercial finance. They provide loans to businesses and individuals through unsecured
and secured loans. Finance companies raise capital through share issues. Insurance companies provide loans
through ongoing insurance premiums. Generally, interest rates would be higher.
.
o Superannuation funds- These organisations provide funds to the corporate sector through investment of funds
received from superannuation contributions and fees. Superannuation funds earn returns by selling debt
securities to businesses, which repay these loans with interest.

o unit trusts- Unit trusts (also known as mutual funds) take funds from a large number of small investors and invest
them in specific types of financial assets. A trustee controls and manages the trust. Units are offered to the public
for investment.

o Australian Securities Exchange. - a market that brings together buyers and sellers to exchange shares. Once
approved by the ASX businesses can issue shares to the general public on the primary market. Buyers and sellers
can exchange shares on the secondary market.

Influence of government
o The government influences a businesss financial management decision making with economic policies such as those
relating to the monetary and fiscal policy.


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o The monetary policy is steps taken by the Reserve Bank of Australia to affect the finance market and assist the federal
government to achieve its goal of low inflation and economic growth. Securities and loans are sold and bought to put
pressure on interest rates to alter the economic cycle.

o Two important government influences on financial management are:
o The Australian Securities and Investments Commission (ASIC) - This was formed to regulate corporations markets
and the provision of financial services covered under the Corporations Act 2001 (Cth). The aim of ASIC is to assist
in reducing fraud and unfair practices in financial markets and financial 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. Company tax is paid
before profits are distributed to shareholders as dividends. Company tax is presently 30% of net profit. The
government plans to lower taxes to foreign investment, and create new jobs.

Global market influences
o Financial risks associated with global markets are greater than those encountered but such risk taking is necessary for a
business strategy. Largely uncontrollable influences include the availability of funds, interest rates and the global economic
outlook.

o the availability of funds- the ease with which a business can access funds (for borrowing) on the international
financial markets. The availability of funds demand on the risk, demand and supply and the domestic economic
conditions.

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

o Global economic outlook- the projected changes to the level of economic growth throughout the world. It may
increase the demand for products/services and the interest rates on funds borrowed internationally.


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Chapter 13: processes of financial management
Planning and implementing
Financial management is responsible for the financial planning of the business. This will help determine the viability of the
venture, make decisions about its future and make projections for liquidity and performance.
Planning processes- the setting of goals and objectives, determining the strategies to achieve those goals and objectives,
identifying and evaluating alternative courses of action and choosing the best alternative for the business.

Financial needs
A new business will have to determine its start-up costs; this will include such things as the purchase of new equipment,
staff and legal fees.
Once a business has begun operations financial information from balance sheets, income statements, cash flow statements,
sales need to be analyzed to determine if profits can be given to shareholders.

Budgets
A budget - a plan for achieving set outcomes and is based on forecast figures or expectations of future operations. A budget
establishes standards and can be used as a control method, allowing comparisons of actual results with the initial plan and
an evaluation of progress.
Budgets show cash required for planned outlays for a particular period and the cost of capital expenditure and associated
expenses
There are 3 types of budgets:
o Operating budgets - the main activities of a business and may include budgets relating to sales, production, raw
materials.
o Project budgets - capital expenditure, and research and development. E.g. asset purchase, life span of the asset
and the revenue that would be generated from the purchase.
o Financial budgets - financial data of a business. They forecast of funds required to pay for inputs and anticipated
inflow of funds from future sales.

Record systems
Record systems - the mechanisms employed by a business to ensure that data are recorded and the information provided
by record 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 records.
Accounting records of expenses and revenues are kept by law and an annual financial report is presented to shareholders
and the ATO (Australian tax office).
Management information systems (MIS) are often developed by larger businesses to allow managers to access organised
units of information appropriate to their needs.

Financial risks
These are 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 owner needs to take some factors in like theft of goods, non-payment of accounts and interest rate rises.
They can also take out insurance against possible risks or have liquid assets so that debts including interest payments and
the repayment of principal on loans can be covered.

Financial control
Financial controls -controls which ensure that the plans that have been determined will lead to the achievement of the
businesss goals in the most efficient way.
This enables the manager to determine if the objectives set were not achievable or need to be reassessed.

Debt and equity financing
Debt financing relates to the short-term and long-term borrowing from external sources by a business. It is borrowed
funds.
Advantages of debt Disadvantages of debt
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Funds are usually readily available Increased risk if debt comes from financial institutions
because the interest, bank charges
Increased funds should lead to increased earnings and
profits
Security is required by the business
Tax deduction for interest payments Regular repayments have to be made

Equity financing- relates to the internal sources of finance in the business. It is the money lent to the business in exchange
for ownership. This includes start-up capital.










Matching the terms and source of finance to business purpose
Matching principle- Involves using the appropriate finance for purchasing an asset.
o Current assets should be purchased with short-term finance while noncurrent assets should be purchased with
long-term finance, such as a 15-year mortgage loan. The matching principle also relates to matching the recording
of a transaction to the date that it occurred.

There is the accounting rule that revenue earned must be matched to the expenses incurred while earning that revenue.
Comparison of short term and long term debt finance
Type Length of loan
Short term debt
Bank overdraft Unspecified but the business must make minimum monthly payments; rolled
over each month
Credit card Unspecified but the business must make minimum monthly payments; rolled
over each month
Trade credit Minimum of 7 days; maximum of 90 days
Commercial bills 90 days but can be rolled over for additional months

Long term debt
Term loan Fixed number of years
Debentures Number of years set by the issuing company
Mortgage loan Up to 30 years
Advantages of equity Disadvantages of Equity
Does not have to be repaid unless the owner leaves the
business
Lower profits and lower returns for the owner
Cheaper than other sources of finance as there is no
interest
The expectation that the owner will have about the return
on investment (ROI)
Less risk for the business and the owner


Monitoring and controlling
Accounting information is used by managers to monitor and control the businesss functions. Inconsistent methods of
controlling will impact on the viability of the business. The main financial controls used for monitoring include:
Cash flow statement- a document that summarizes cash transactions that have occurred over a period of time. Its
purpose is to provide information about the flow of money in and out the business. Also known as a revenue
statement or profit and loss statement. It shows if a firm can generate a favorable cash flow and pay its financial
commitments.

o Income statements- a summary of the income and expenses of a business over a set period of time, such as a
financial year. It indicates the businesss profitability and efficiency. It is also known as the profit and loss
statement. It shows the operating income earned from the main function of the business.

o Balance sheets- give a snapshot or summary of what the business owns and owes on a certain day. It shows the
financial stability of the business and illustrates that:
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Assets = liabilities + owners equity




Financial ratios
Accounting is a tool managers use to help them manage a businesss finances and make informed decisions.
Comparative ratio analysis of these financial statements allows managers to identify trends in their businesses and to
compare its performance. Also businesss results are compared to industry averages.
Definitions/formulas:
o Liquidity- the extent to which the business can meet its financial commitments in the short term. The amount of
assets should be higher than debts.
Current Ratio = Current Assets / Current Liabilities

o Gearing- also called leverage, it is the relationship between debt and equity. It is the proportion of debt (external
finance) and the proportion of equity. The higher the more they rely on debt.
Debt to Equity = Total Liabilities / Owners Equity

o Profitability - the earning performance of the business and indicates its capacity to use its resources to maximise
profits.
Gross net profit ratio- the amount of sales that is available to meet expenses. The higher the ratio the
better.
Gross Profit Ratio = Gross Profit / Revenue

Net profit ratio- the profit or return to the owners. The higher the ratio the better.
Net Profit Ratio = Net Profit / Revenue

Return on equity ratio- how effective the funds have been in generating profit
Return on Equity = Net Profit (After Tax) / Owners Equity

o Efficiency- the ability of the firm to use its resources effectively in ensuring financial stability and profitability of
the business.
Expense ratio- the amount of sales that are allocated to individual expenses, the lower the better, the
more efficient.
Expense Ratio = Expenses / Revenue

Accounts receivable turnover ratio- the effectiveness of a firms credit policy and how efficiently it
collects its debts High turnover ratios indicate the business has efficient debt collection.
AR Turnover Ratio = 365 / ( Revenue / AR


Limitations of financial reports
Complicated and detailed accounts will confuse individuals.
It may not give a clear picture of a businesss profitability

Limitations
Limit Explanation
Nominalised earnings The earnings that are adjusted to the state of the economy to remove influences. An
example of this would be the removal of a land sale.
Capitalised expenses The costs incurred when financing a non-current asset and added to the cost of the asset.
They are originally added to the balance sheet under the assets, instead they are deducted
from the revenue.
Valuing assets This 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
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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.
Assets sometimes cannot be recorded, e.g. patents (a legal right that gives the owner
exclusive rights to sell, market license or to make a profit).
Timing issues Financial 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. This is to make the business seem more profitable.
Each transaction is supposed to be recorded at the time that it actually occurs. This is the
matching principle.
By recording these transactions outside the current financial year they will not appear on
the current reports.
Debt repayments Reports do not have the capacity to disclose specific information about debt repayments.
Sometimes staff members are free to choose when they take their holidays or may choose
to take a payment for holidays.
Notes to the financial
statement
These are the details and additional information that are left out of the main reporting
documents, such as the balance sheet and income statement.

Ethical issues related to financial reports
Accountants must display integrity objectivity, confidentiality and a high level of professional and technical ability.
Financial managers and accountants cannot be creative when recording transactions and preparing financial reports in
order to make the business appear more profitable.
Managers should not use the businesss credit cards for personal expenses.
Business accounts must be audited or monitored by independent organizations. This is the checking of accounts and
procedures. Audited accounts are a legal requirement of all public companies.
Corporate raiding - process of buying an undervalued company and increasing profit or selling off the businesses assets. The
personal wealth is increased at the cost of employees who lose their jobs.
Australian Accounting Standards regulate how financial reports are to be prepared.


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Chapter 14: financial management strategies
Cash flow management
A business must always have enough cash available to pay bills and expenses. They must also know how to manage the
money coming in and out. Budgets and cash flow statements can allow the business to do this.
Inflows Outflows
Sales Payments to suppliers- raw materials/finished goods
Sales of assets Operating expenses wages/salaries raw
materials/finished goods
Rents Purchase of properties

Budget- a tool used to evaluate the performance of a business by comparing actual results with planned results. It can help
the financial manger anticipate how much cash the business needs to pay expenses.

Cash flow statements
Cash flow statements the movement of cash receipts and cash payments resulting from transactions over a period of
time. They are used to show the trends of short and long term cash inflows and outflows. They also summarize how the
business will pay for short-term liabilities.

Management strategies
Distribution of payments- By spreading expenses over the whole year there is a more equal cash outflow each month
rather than one huge outflow during one month. Another strategy is to prepay expenses, such as rent or interest.

Factoring - accounts can be sold to a factoring business at a discount. The factoring firm pays the business the value of
accounts minus its fee or commission.

Discounts for early payments- A business may offer discounts to speed up cash inflow. Some incentives include small gifts
and discounts on future orders.

Working capital management
Working capital - the current assets used in the day-to-day running of a business. The business needs to ensure that
payments are received on goods it has sold on credit to customers. The formula for working capital is:
o Net working capital = current assets current liabilities

Working capital must be managed effectively and efficiently. The formula for the working capital ratio is:
o Working capital ratio = current assets current liabilities
Control of current assets
Control of current assets involves ensuring there are enough liquid assets to pay current liabilities when due. Some assets
include cash, accounts receivable and inventory.
o Cash- this is the balance in the businesss bank account. It is the most liquid current asset. Businesses can increase
the cash amount by sale and leaseback. This involves selling non-current assets (cars, equipment) to a firm that
specializes in leasing assets. The businesses own assets can be leased out.

o Receivables- sums of money due to a business from customers to whom it has supplied goods or services. The
effectiveness of control over accounts receivable is measured using the turnover ratio/formula:
Turnover ratio = total sales accounts receivable
If this ratio is low then, customers take too long to pay. This slows down the collection of revenue. There
may also be a high number of bad debts (debtors who are unlikely to pay debts). They manager may
impose a credit limit on customers and make credit checks.

o Inventories- this is the total amount of goods or materials in a store or factory, e.g. raw materials, work-in-
progress and finished goods. The inventory must be monitored and protected otherwise business will lose money.
Methods of internal control are:
physical inspections and counts
security
limiting staff access
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Control of current liabilities
o Payables- money the business owes to its suppliers, also known as creditors. The number of days given to repay loans will
depend on the credit rating (An assessment of a businesss ability to repay loans based on its history.) Businesses should
pay its invoices on the last day they are due, thus keeping the money as long as possible.

o Loans- the business should compare the cost of the loan to other sources of finance to find the most appropriate and cost
efficient source.

o Overdrafts- businesses may control overdrafts by ensuring that all cash received is promptly deposited in the businesss
account to reduce the amount owing. Online systems give managers access at all times, whereas banks are limited.

Management strategies
o Leasing- the hiring of an asset from another person or company. Regular and fixed payments are needed.
o Sale and lease back- Selling a non-current asset owned will provide a cash injection to pay expenses as they fall due. They
can enter into a sales agreement.

Profitability management
o A good accounting and financial system has effective controls to ensure the business:
o does not overspend
o does not lose assets
o Records financial records and transactions correctly.

Cost controls
Fixed and variable
o Businesses can reduce costs in two areas: labour and inputs.
o Outsourcing of non-core functions has been the most popular method, e.g. contracting a call centre to handle customer
inquiries or hiring a specialist firm to handle payroll, cleaning. These organisations are aiming to achieve greater efficiency.
o Fixed costs do not change when a business produces more goods, e.g. salaries, rent, lease payments.
o Variable costs do vary as output and sales change. Examples are employee wages and overtime payments, advertising.
o Strategies to cut variable costs include:
o negotiating discounts with all suppliers
o reducing the number of suppliers
o switching to a cheaper supplier,

cost centres
o Cost centres - The expenses associated with each key business function. Management may provide them with a budget and
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monitor their expenses to minimise waste and achieve maximum use of resources. They can be used to identify which type
of expense contributes most to the product.
o Cost centres use budgets as tools to evaluate the performance of by comparing actual to the real amount spent.

Revenue controls
Marketing objectives
Revenue controls include sales forecasts, analyzing the sales mix and the pricing policy of a business.
A sales budget (The predicted future sales a business expects to make during the year) is used to predict future sales of the
business based on:
o patterns of sales in previous years
o economic conditions
Sales mix is the marketing strategy used to sell the range of products a business supplies. It is a report that can be used to
identify which method of promotion works best.

Global financial management
When operating globally, there are factors or additional risks that must be considered, they include exchange rates, interest
rates, methods of international payment, hedging, derivatives.
o Exchange rates- the value of a countrys money calculated using another countrys money. When costs are
transferred it can decrease the value of net profit. If the Australian dollar depreciates, it will cost more to import.
o Interest rates- It is important to find the lowest interest rate, as exchange rate fluctuations can make repayments
more costly. The advantages of overseas borrowing are:
the rate of interest can be cheaper
there are fewer restrictions
finance may be acquired more quickly and easily

o Methods of international payment- there are many methods of payment used but the main ones are payment in
advance, letter of credit, bills of exchange and clean payment.
payment in advance- to receive payment for goods before they are sent. There is the risk of the goods
never being sent.

letter of credit- a document issued by a bank to the seller of goods that has specific instructions from the
buyer of the goods giving the seller the authorisation to draw a specified sum of money from the buyers
bank account under certain conditions.

bills of exchange-a written order from a seller requesting that an importer or buyer pay the seller a
specified amount of money at a specified time. The bank ensures the importer receives its goods and that
the exporter is paid.

clean payment-The goods are shipped before payment is received. This is used when businesses and their
exporters have a good relationship and history.

o Hedging-any strategy used by a business to reduce financial risk. This is done to reduce foreign exchange risks.
Businesses enter into contracts and buy/sell foreign exchange to purchase inputs. It can also be done by using
subsidiaries (a business owned by the global corporation that supplies inputs).
Derivatives- a special contract between global businesses and suppliers. The three main types are:
forward exchange contracts- the bank will guarantee the exporter a certain exchange rate on a
certain date.

currency option contracts- it has the option 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- written allowing the Australian business to pay the US supplier in euros at a spot
rate