Finance Notes Business Studies Hsc 34705z
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Role of Financial Management Strategic role of Financial Management •
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Strategic financial management is the process of setting objectives throughout the business and deciding what resources are needed to achieve these objectives. The ‘finance’ part comes through the specific decisions as to how the resources will be financed. Financial management has a strategic role because it takes place in a changing environment and plans need to be flexible and ready to change. Strategic financial planning sets out the broad series of steps that need to be taken to achieve the business’ strategic objectives. Examples of changing business environments: o Taxation and other laws o Technology o Economy o Financial Innovations Within this changing environment the foals of the business need to be reached. o Liquidity o Solvency o Profitability o Growth o Efficiency
Objectives of Financial Management
Liquidity • A business is liquid when it can pay its debts as they fall due. • The relationship between current assets and current liabilities. • A business must have sufficient cash flow to meet its financial obligations or to be able to convert current assets into cash quickly; for example by selling inventory. • Controls over the flow of cash into and out of the business ensure that it has supplies of cash when needed. • Cash shortfalls and excess cash must be avoided as both involve loss of profitability for a business. • Also known as current ratio, liquidity ratio and working capital ratio Profitability • Profitability is about the size of profit relative to the size of the business’ operations. • Profitability is the ability of a business to maximise its profits. • Profits satisfy owners or shareholders in the short term but are also important for the longer-‐term sustainability of a firm. • High profitability: o Improves confidence in the business by all stakeholders o Makes it easier to attract new capital (growth)
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o Owners are satisfied with the return To improve profitability: o Increase revenues, this means either sell more or sell at a higher price or both. o Decrease expenses, this means improving efficiency.
Efficiency • Efficiency is the ability of a business to minimise its costs and manage its assets so that maximum profit is achieved with the lowest possible level of assets. • A business that is reducing costs is improving efficiency. • Achieving efficiency requires a firm to have control measures in place to monitor assets. • A business that aims for efficiency must monitor the levels of inventories and cash and the collection of receivables. • Improving productivity will: o Reduce costs o Increase outputs from the same amount of inputs o Keep output constant with reduced inputs Growth • Growth is the ability of a business to increase its size in the longer-‐term. • Growth of a business depends on its ability to develop and use its asset structure to increase sales, profits and market share. • Growth is an important financial objective of management as it ensures that the business is sustainable into the future. • It improves potential profits and investor returns and makes a takeover of a business that much harder. Solvency • Solvency is the extent to which the business can meet its financial commitments in the longer term. • Solvency is important to the owners, shareholders and creditors of a business because it is an indication of the risk to their investment. • Solvency indicates whether a business will be able to repay amounts that have been borrowed for investments in capital, such as equipment and machinery. • Also known as gearing, debt to equity ratio. • The higher the gearing (the higher the debt), the riskier the business. Short-‐Term and Long-‐Term • Financial objectives of a business are based on the goals of its strategic plan, which can be translated into both the short and long term. • Short-‐term financial objectives: o The tactical (one to two years) and operational (day to day) plans of a business. o These would be reviewed regularly to see if targets are being met and if resources are being used to the best advantage to achieve the objectives.
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o For example, if management has a goal to achieve a 15 per cent increase in profit for the next 10 years, the tactical plans might involve purchasing additional machinery, updating old equipment with new technologies, expanding into new markets and providing new services. Long-‐ term financial objectives: o The strategic plans of a business. o They are determined for a set period of time, generally more than five years. o They tend to be broad goals such as increasing profit or market share, and each will require a series of short-‐term foals to assist in its achievement. o The business would review their progress annually to determine if changes need to be implemented.
Interdependence with other key business functions To best explain this section we need to use an example, but you can just morph this flow chart to fit a case study in the exam. 1. Strategic goal – to increase profit by 25% in 2 years 2. Each KBF comes up with a plan and budget to help achieve this goal. 3. Marketing – to introduce a new product $4m 4. After getting the marketing plan: a. Operations – plan to extend the factory (to allow the new product to be made) $1.5m b. Human Resources – decides to employ an additional 15 workers to man the new product line $750 000 per annum 5. Finance gets the above 3 plans and determines how to finance the $6.25m. After assessing the current financial position of the firm, the finance manager determines the business cannot finance the $6.25m. The most the business can finance is $3m debt and $1.25 equity. 6. The finance manager will go back to the other 3KBF managers and they will each nee to network their plans within the new budget. 7. Interdependence
Influences on Financial Management
Internal Sources of Finance Retained Profits • When a business makes a profit, it must decide how to use it to benefit the business/owner. • Profits if ‘retained’ within the business can be used to ‘retire’ debt or to purchase new equipment or assets. • Either way the retained profits will increase the owner’s equity and it will improve the debt to equity ratio.
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HSC STUDY BUDDY Sale of Assets • A business may own assets it no longer needs or assts that could be ‘better’ used if turned into cash (liquidated). • One source of equity is to sell non-‐current assts and use the cash for the project (or part there of). • The asset would need to be considered redundant (not needed) for this option to be available. New Capital Injection by the Owner/s • Especially in small businesses the owner’s funds could be considered coming from within the business.
External sources of Finance
Debt – Short Term Borrowing Overdraft • An ‘overdraft’ is when a bank allows a business to withdraw more than it has in its . • Overdrafts are used to overcome cashflow shortages. • An overdraft is a short-‐term loan often repaid within a few days, interest is charged daily. • Overdrafts are relatively expensive. • If an overdraft was needed/used every month it would be a sign there is a problem and something would need to be changed (marketing, sales or expenses) Commercial Bills • A bill is a guarantee by a bank to pay an amount. • It could be for a short period of time. • Interest is cheaper than an overdraft. • Commercial bills are quite flexible. Factoring • Is the ‘selling’ of s receivable or debtors. • If a business uses a ‘factor’ then when it sends an invoice to a credit customer, it sends a copy to the factoring institution – usually a bank. • The factoring institution will immediately deposit an amount (usually 90-‐95% of the invoice) into the business’ . When the credit customer pays the full amount of the invoice – the bank receives its money back (90-‐95%) plus (5-‐10%) extra – which is the bank’s income. Debt – Long Term Borrowing Mortgage • A mortgage is a very long-‐term loan secured by real property, such as land or buildings. • Because the loan is secured the interest rate is relatively low. • If the borrow defaults on the loan, the bank (mortgage holder) will sell the land and building to recoup its money.
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HSC STUDY BUDDY Debentures • Only available to public companies. • A company can ‘borrow’ large sums of money by ‘selling’ debentures to of the public and institutions – like superannuation funds. • A debenture is a loan to a company for a set period of time, for instance 2 3 or 5 years. • They pay an attractive market rate of interest and they are secure by an asset of the company selling them. Unsecured Notes • These are the same as debentures except – o There is no asset backing them, they are ‘unsecured’. o Because they are ‘unsecured’ the interest rate they pay is higher. Leasing • Rather then having one large outlay for a purchase – either debt or equity-‐ business’ can lease equipment, land or buildings. • Leasing involves small regular payments for the use of an asset. • Leasing is often used to assist cash flow management. Equity Ordinary Shares • Ordinary shares are the most commonly traded shares in Australia. • The purchase of ordinary shares by individual’s means they have become part owners of a publicly listed company and may receive payments called dividends. • Value is determined by a company’s current or future performance. New Issues/New Shares • A security that has been issued and sold for the first time on a public market. • New shares are sold on the primary market. • The company sells the new shares and the money from the sale is then available for use. • The purchasers of the new shares are now ‘owners’ of the business and are entitled to a share of the profits (dividends) and to vote at the company’s AGM. • After a share is purchased for the first time – from which the company gets the money – no subsequent sale involves the company receiving money. The owner of the shares gets the money I they sell. The company only records the sale and the details of the new owner. Rights Issue • The privilege granted to shareholders to buy the right to buy new shares in the same company. Placements • Allotment of shares, debentures and so on made directly from the company to investors.
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HSC STUDY BUDDY Share Purchase Plan • An offer to existing shareholders in a listed company the opportunity to purchase mores shares in that company without brokerage fees. Private Equity • Private equity is the money invested in a (private) company not listed on the Australian Securities Exchange. • The aim of the private company (like the publicly listed companies who sell ordinary share) is to raise capital to finance future expansion/investment of the business.
Financial Institutions
Banks • Banks are the largest form of financial institution in Australia. • Most important source of funds for businesses. • Banks receive savings as deposits from individuals, businesses and governments, and, in turn, make investments and loans to borrowers. • Most of the funds provided through financial markets come from banks that operate on their own behalf or on behalf of other corporations. • Banks perform an increasingly wide range of roles rather than specialising in one area, and have subsidiaries in superannuation and mutual, and other funds. • Banks are supervised by the reserve bank of Australia. Investment Banks • Investment banks make up one of the fastest growing sectors in the Australian financial system, providing services in both borrowing and lending, primarily to the business sector. • Investment Banks: o Trade in money, securities and financial futures o Arrange long-‐term finance for company expansion o Provide working Capital o Arrange project finance o Advise clients on foreign exchange cover o Operate untie trusts including cash management trusts, property trusts and equity trusts. o Arrange overseas finance. Finance and Life Insurance Companies • Are non-‐bank financial intermediaries that specialise in smaller commercial finance. • Finance companies act primarily as intermediaries in financial markets. They provide loans to businesses and individuals through consumer high-‐purchase loans, personal loans and secured loans to businesses. • Finance companies are also the major providers of lease finance to businesses and some specialise in factoring or cashflow financing. • Finance companies raise capital through share issues (debentures)
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Insurance companies provide loans to the corporate sector through receipts of insurance s, which provide funds for investments. They provide large amounts of both equity and loan capital to businesses. Insurance can be general insurance (covering property or accident) or life insurance. The funds received in s, called reserves, are invested in financial assets. The s paid by investors provide for compensation or for savings for future needs.
Superannuation Funds • Have grown rapidly in Australia over the past 20 years due to tax incentives and compulsory superannuation introduced by the government. • These organisations provide funds to the corporate sector through investment of funds received from superannuation contribution. • Superannuation funds are able to invest in long-‐term securities as company shares, government and company debt because of the long-‐term nature of their funds. Unit Trusts • Also knows as mutual funds. • Take funds from a large number of small investors and invest them in specific types of financial assets. • Unit trusts investments include the short-‐term money market (cash management trusts), shares, mortgages and property, and public securities. • Usually connected to a management firm that manages a diversified investment portfolio for its investors. Australian Securities Exchange • The Australian securities exchange (ASX) is the primary stock exchange group in Australia. • The ASX functions as a market operator, clearing house and payments system facilitator. • It oversees compliance with its operating rules and promotes standards of corporate governance among Australia’s listed companies. • Products and Services include: o Shares o Real estate investment funds o Listed investment Companies o Interest rate Securities • The ASX acts as a primary market. This primary market enables a company to raise new capital through the issue of new shares and through the receipt of proceeds from the sale of securities. • The ASX also operates as a secondary market. The secondary market is where pre-‐owned or second-‐hand securities, such as shares, are traded between investors who may be individuals, businesses, governments or financial institutions.
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Influence on Government •
The government influences a business’ financial management decision making with economic policies such as those relating to the monetary and fiscal policy, legislation and the various roles of government bodies or departments who are responsible for monitoring and istration.
The Australian Securities and Investments Commission (ASIC) • The ASIC is an independent statutory commission able to the commonwealth parliament. • It enforces and isters the corporations Act and protects consumers in the areas of investments, life and general insurance, superannuation and banking (except lending) in Australia. • The aim of the ASIC is to assist in reducing fraud and unfair practices in financial markets and financial products. • The ASIC ensures that companies adhere to the law, collects information about companies and makes it available to the public. This includes the financial information that companies must disclose in their annual reports. Company Taxation • Companies and corporations in Australia pay company tax on profits. This tax is levied at a flat rate of 30%; unlike personal income taxes, which use a progressive scale. • Company tax is paid for before profits and distributed to shareholders as dividends. • The Australian government has undertaken a process of reform of the federal tax system that will improve Australia’s international competiveness. This will mean more jobs and higher wages for working Australians, as the reform will affect long-‐term economic growth.
Global Market Influences
Global Economic Outlook • The global economic outlook refers specifically to the projected changes to the level of economic growth throughout the world. • If the outlook is positive (economic growth is to increase) then this will impact on the financial decisions of a business. This may include: o Increasing demand for products and services and therefore a business would need to increase production to meet demand. o Decrease the interest rates on funds borrowed internationally from the financial money market. • A poor economic outlook will impact on financial decisions of a business in the opposite way to the above examples. Availability of Funds • The availability of funds refers to the ease with which a business can access funds (for borrowing) on the international financial markets.
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The international financial markets are made up of a range of institutions, companies and governments that are prepared to lend money to individuals, companies or governments who made need to raise capital. There are various conditions and rates that apply and these will be based primarily on: o Risk o Demand and Supply o Domestic economic conditions
Interest Rates • Interest rates are the cost of borrowing money. • The higher the level of risk involved in lending to a business, the higher the interest rates. • Overseas interest rates can be lower than in Australia – it is possible for Australian businesses to borrow from countries with lower interest rates. The problem here is fluctuating exchange rates. • If the exchange rate moves unfavourably for the Australian borrow, they may end up paying back a lot more than they originally calculated. • Australian exporters love: o A weak Australian dollar o A strong global economy • Australian importers love: o A strong Australian dollar o A global economy in which prices are low.
Processes of Financial Management
Planning and Implementing Financial Needs • How much finance is needed for the plan of the business? • Will it be debt or equity and how much of each? • To determine where a business is headed and how it will get there, it is important to know what its needs are. • Important financial information needs to be collected before future plans can be made. • This financial information includes balance sheets, income statements, cash flow statements, sales and price forecasts, budgets, bank statements, weekly reports from departments, break-‐even analysis, reports from financial ratio analysis and interpretation. • The financial needs of a business will be determined by: o The size of the business o The current phase of the business cycle o Future plans for growth and development o Capacity to source finance – debt and/or equity o Management skills for assessing financial needs and planning.
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HSC STUDY BUDDY Budgets • A forecast of anything can be a budget. • Budgets are predictions made based upon past experiences. • Budgets are used in both the planning and the control aspects of a business. • Budgets provide information in quantitative (that is, as facts and figures) about requirements to achieve a particular purpose. • Budgets can be drawn up to show: o Cash required for planned outlays for a particular period o The cost of capital expenditure and associated expenses against earning capacity. o Estimated use and cost of raw materials or inventory. o Number and cost of labour hours required for production. • Budgets reflect the strategic planning decisions about how resources are to be used. • They provide financial information for a business’ specific goals and are used in strategic, tactical and operational planning. • Budgets enable constant monitoring of objectives and provide a basis for istrative control, direction of sales effort, production planning, control of stocks, price setting, financial requirements, control of expenses and of production cost. • Factors that need to be considered in creating a budget are: o Review of past figures and trends, and estimates gathered from relevant departments in the business. o Potential market or market share, and trends and seasonal fluctuations in the market. o Proposed expansion or discontinuation of projects. o Proposals to alter price or quality of products o Current orders and plant capacity o Considerations from the external environment – for example, financial trends from the external environment, availability of materials and labour. • Common budgets include: o Income and Sales o Expenses • Budgets can be made for: o Sick days o Customer complaints o New customers • Operating budgets relate to the main activities of a business and may include budgets relating to sales, production, raw materials, direct labour, expenses and cost of goods sold. • Project budgets relate to capital expenditure, and research and development. • Financial budgets relate to the financial data of a business. Record Systems
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HSC STUDY BUDDY •
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Record systems are the mechanisms employed by a business to ensure that data is recorded and the information provided by the record systems is accurate, reliable, efficient and accessible. In order to more accurately monitor budgets and the progress of the plan, businesses need a record/s/finance system. From the smallest one-‐person business to the largest public company, ing software such as MYOB and QUICKEN are used to store and retrieve information. Balance sheets, revenue statements and cash flow statements are produced always comparing planned vs. actual. Minimising errors in the recording process, and producing accurate and reliable financial statements are important aspects of maintaining record systems.
Financial Risks • Financial risk is the risk to a business of being unable to cover its financial obligations, such as the debts that a business incurs through borrowings, both short and long-‐term. • The financial risk is that businesses won’t be able to pay its bills as they fall due. • Debt incurs interest, the more debt the more interest must be paid. • The more debt the higher the financial risk to a business. • In assessing financial risk for a business, consideration must be given to: o The amount of the businesses borrowings o When borrowings are due to be repaid. o Interest rates o The required level of current assets needed to finance operations. • To minimise financial risk, businesses must consider the amount of profit that will be generated. The profit must be sufficient to cover the cost of debt as well as increasing profits to justify the amount of risk taken by owners and shareholders. • Note: This is why the debt to equity ratio and solvency is so important. Too much debt = too much financial risk = high business failure. Financial Controls • Budgets, regular data and comparing planned vs. actual are how businesses control and monitor their financial (and all) plans. • Financial problems and losses prevent a business from achieving its goals. Some examples include: o Theft and fraud o Damage or loss of assets o Errors in record systems • Financial controls ensure that the plans that have been determined will lead to the achievement of the business’s goals in the most efficient way. • The policies and procedures of a business are designed to ensure that management and employees follow them. Control is particularly important in assets such as s receivable, inventory and cash. • Some common policies and procedures that promote control within a business are:
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Clear authorisation and responsibility for tasks in the business Separation of duties Rotation of duties Control of cash, such as the use of cash s and cash banked daily Protection of assets, such as buildings being locked at night Control of credit customers, such as following up on overdue s
Debt and Equity Financing • The amount of debt that is appropriate for a business depends upon how accurate the cash flow forecast/budget can be. • Businesses that can more accurately predict their income and expenses cash flow can increase debt (to a point) safely. Advantages
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Debt Funds are usually readily available. Increased funds should lead to increased earnings and profits. Debt attracts an interest liability and interest is tax deductible. Debt does not dilute ownership
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Increased risk if debt comes from • financial institutions because the interest, bank charges, government • charges and principal all have to be repaid. Security is required by the •
Equity Does not have to be repaid unless the owner leaves the business. Cheaper than other sources of finance as there are no interest payments. The owners who have contributed the equity retain control over how that finance is used (have a say) Low gearing (use resources of the owner and not external sources of finance) Less risk for the business and the owner. Lower profits and lower returns for the owner. The expectation that the owner will have about the return on investment (ROI) Perpetual claim on the assets Page | 12
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business. Regular repayments have to be paid. Lenders have first claim on any money if the business ends in bankruptcy.
Comparison of Debt and Equity Finance Debt Lenders have prior claim in the event of liquidation Debt must be repaid by periodic repayments Interest payments are tax deductible Lenders usually require a lower rate of return Interest payments are fixed
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and income of the business. Unlike debt, equity has no maturity date. Equity has no tax deductible.
Equity Shareholders have a residual claim on assets Equity has no maturity rate Dividends are not tax deductible Shareholders require higher return due to higher risk Dividend payments are not fixed and may be reduced through lack of funds Equity holders have voting rights
Debt providers have no voting rights Matching the and Source of Finance to Business Purpose • Choices of how to finance will be influenced by: o The of finance must be suitable for the structure of the business and the purpose for which funds are required. o The cost of each source of funding. o The structure of the business. o Costs including set up costs and interest rates. o Flexibility of the source of finance. o The availability of funds. o The level of control maintained by the business. Monitoring and Controlling When a business has a plan in place it needs to be monitored and controlled. In the financial sense, the balance sheet, cash flow and revenue statements need to be monitored carefully when it is evident that actual performance is varying too much
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HSC STUDY BUDDY from planned performance then changes to the plan need to be implemented. Changes could be: • Marketing • Expenses and Budgets • Even the goal could be changed • Personnel (Staff) Cash Flow Statement • A cash flow statement is one of the key financial reports that are part of effective financial planning. • It provides the link between the income statement and balance sheet, as it gives important information regarding a firm’s ability to pays its debts on time. • The cash flow statement indicates the movement of cash receipts and cash payments resulting from transactions over a period of time. • Potential shareholders check that a business has had positive cash flows over a number of years. A fluctuating pattern of cash flows might point to difficulties in the business. • Cash flows can be a better predictor of a business’ status than profitability. A statement of cash flows can show whether a firm can: o Generate a favourable cash glow (inflows exceed outflows) o Pay its financial commitments as they fall due o Have sufficient funds for future expansion or change o Obtain finance from external sources when needed o Pay drawings to owners or dividends to shareholders. • In preparing a cash flow statement, the activities of a business are generally divided into three categories – operating, investing and financing activities. • Operating activities are the cash inflows and outflows relating to the main activity of the business. Income from sales makes up the main operating inflow plus dividends and interest received. Outflows consist of payments to suppliers, employees and other expenses such as rent etc. • Investing activities are the cash inflows and outflows relating to the purchase and sale of non-‐current assets and investments. • Financing activities are the cash inflows and outflows relating to the borrowing activities of the business. • The cash flow statement, income statement and balance sheet are used to show how effectively finance is being used in a business. Income Statement • The income statement shows the operating efficiency – that is, income earned and expenses incurred over the ing period. • Income is the earnings from the main objectives of the business. • Expenses are recurring amounts that are paid out while the business earns its revenue. • The income statement shows: o Operating income earned from the main function of the business, such as sale of stock and non-‐operating revenue earned from other operations, such as interest rent and commission.
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o Operating expenses such as, the purchase of stock and other expenses incurred in the main operation of the business, such as advertising and rent. By examining figures from previous income statements, managers can make comparisons and analyse trends before making important financial decisions. They can see whether expenses are increasing, decreasing or remaining the same and why profits are increasing or decreasing.
Balance Sheet • A balance sheet represents a business’ assets and liabilities at a particular point in time and represents the net worth (equity) of the business. • The balance sheet shows the level of current and non-‐current assets, current and non-‐current liabilities, including investments and owners’ equity. • The balance sheet shows the financial stability of the business and analysis of the balance sheet can indicate whether: o The business has enough assets to cover its debts o The interest and money borrowed can be paid o The assets of the business are being used to maximise profits o The owners of the business are making a good return on their investment. o The year’s figures compare with the previous year. Financial Ratios Comparative Ratio Analysis • Comparing a business’ analysis against other figures, percentages and ratios allows for judgements to be made. This is known as comparative ratio analysis and is important for businesses. • Comparisons can be made in a number of ways. • Ratio analysis taken for a business over a number of years can be compared with similar businesses and again common industry standards or benchmarks. • Figures from at least the previous two years can indicate directions or trends and make ration analysis more meaningful. • Comparisons can be made over different time periods, against standards, or with similar businesses. • Analysis can also include budget figures so that predicted figures can be compared against actual figures. • Comparison with other businesses and benchmarking are common. However, care must be taken to ensure that the same things are compared. Also, each business has differences, and finding comparable firms may be difficult. Limitations of Financial Reports Normalised Earnings
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HSC STUDY BUDDY This is the process of removing one time or unusual influences from the balance sheet to show the true earnings of a company. An example of this would be the removal of a land sale, which would achieve a large capital gain. Capitalising Expenses • This is the process of adding a capital expense to the balance sheet that is regarded as an asset (in that it will add to the value of the company and is therefore recorded on the balance sheet) rather that an expense (in this situation, it would be recorded on the income statement). • Examples of capitalising expenses include: o Research and Development o Development Expenditure Valuing Assets • This is the process of estimating the market value of assets or liabilities. The valuations can be used in a variety of contexts for a business, including investment analysis, mergers and acquisitions and financial reporting. • Two main methods used for valuing assets include: o Discounted cash flow method. This method estimates the value of an asset based on its expected future cash flows, which are discounted to the present (i.e. the present value) o Guideline company method. This method determines the value of a business by observing the prices of similar companies (guideline companies) that are sold in the market. Timing Issues Financial reports cover activities over a period of time, usually one year. Therefore, the business’s financial position may not be a true representation if the business has experienced seasonal fluctuations. Debt Repayments • Financial reports can be limited because they do not have the capacity to disclose specific information about debt repayments such as: o How long the business has had or has been recovering the debt o The capacity of the business or its debtor to repay the amounts owed o The adequacy of provisions and methods the business has for the recovery of debt. o What provision does the business have in place for doubtful debts and how is this evident in the financial reports o Have debt repayments been held over until another ing period therefore giving a false impression of the situation • 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 favorable overview of the business at that point in time. Notes to the Financial Statements • Notes to the financial statements report the details and additional information
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that are left out of the main reporting documents, such as the balance sheet and income statement. These notes contain important information such as the ing methods used for recording and reporting transactions that can affect the bottom-‐line return expected from an investment in a company.
Ethical issues related to Financial Reports • If debt funds are used extensively to finance activities in a business, although debt funds may be used to increase profits, there is added risk for shareholders. The impact of debt funds on risks to shareholders is an ethical issue that must be considered. • In preparing budgets, the expenditures and revenues are estimated. The common practice in business is overestimating expenditures and understanding revenues to allow for unexpected and uncertain events is an ethical issue for a business. • Ethical considerations are closely related to legal aspects of financial management. Legislation is in place to guard against unethical business activity but there is often a time lag between the recognition of a problem and its implementation through law. Audited s • An audit: is an independent check of the accuracy of financial records and ing procedures. • Potential s of information include financial institutions, owners and shareholders and potential investors who rely on this information before making a decision about the business. • Audits are an important part of the control function and are generally used to examine the financial affairs of a business. • There are three types of Audits: o Internal Audits o Management Audits o External Audits • Internal and external audits assist in guarding against unnecessary waste, inefficient use of resources, misuse of funds, fraud and theft. • External auditors are used to provide an annual audit of ing practice and procedures. Record Keeping • All ing processes depend on how accurately and honestly data is recorded. • Source documents must be created for every transaction, even those in which cash has changed hands. Goods and Services Tax (GST) Obligations • Businesses have an ethical and legal obligation to comply with the GST reporting
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Reporting Practices • Not only are accurate financial reports necessary for taxation purposes, but other stakeholders are entitled to access to a business’ financial information • Shareholders in a private company are legally entitled to receive financial reports annually, even if the company is a small business and the shareholders are family .
Financial Management Strategies
Cash Flow Management • • •
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Cash flow is the movement of cash in and out of a business over a period of time. If more money goes out than comes in, or if money must be paid out before cash payments have been received, there is a cash glow problem. Inflows include: o Sales o s Receivable o Commissions o Sale of Assets o Interest on investments o Dividends Outflows include: o Payments to suppliers o Interest on loans o Operating expenses o Purchase of Assets o Loan Repayments
Cash Flow Statements • The statement of cash flow indicates the movement of cash receipts and cash payments resulting from transactions over a period of time. • It can also identify trends and can be a useful predictor of change. Management Strategies • A business may have temporary shortfalls of cash. Many businesses use bank overdrafts to cover these shortages. • Shortfalls of cash over longer periods are of greater concern for a business as insolvency or bankruptcy may result. Distribution of Payments • An important strategy involves distributing payments throughout the month, year or other period so that cash shortfalls do not occur.
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A cash flow projection can assist in identifying periods of potential shortfalls and surpluses.
Discounts for Early Payment • Another cash flow management strategy is offering creditors a discount for early payments. • This strategy is most effective when targeted at those creditors who owe the largest amounts over the financial year period. • This is not only beneficial for the creditors who are able to save money and therefore improve their cash flow, but it also positively affects the business’ cash flow status. Factoring • Factoring is the selling of s receivable for a discounted price to a finance or specialist factoring company. • The business saves on the costs involved in following up on unpaid s and debt collection. • Factoring is growing in popularity as a strategy to improve working capital.
Working Capital Management •
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Short-‐term liquidity is important for businesses. It means a business can take advantage of profit opportunities when they arise, as well as meet short-‐term financial obligations. A business must have sufficient liquidity so that cash is available or current assts can be converted to cash to pay debts. A lack of short-‐term liquidity could result in the sale of non-‐current assets to raise cash. In the long-‐term this can lead to reduced profitability for owners and shareholders. Working capital management involves determining the best mix of current assets and current liabilities needed to achieve the objectives of the business.
Control of Current Assets • Management of current assets is important for monitoring working capital. • Excess inventories and lack of control over s receivable lead to an increased level of unused assets, leading in turn to increased costs and liquidity problems. • Excess cash is a cost if left idle and unused. • Control of current assets requires management to select the optimal amount of each current asset held, as well as raising the finance required to fund those assets. • The costs and benefits of holding too much or too little of each asset must be assessed. • Working capital must be sufficient to maintain liquidity and access to credit (overdraft) to meet unexpected and unforeseen circumstances. Cash
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HSC STUDY BUDDY • • • • •
Cash is critical for business success, and careful consideration must be given to the levels of cash receivables and inventories that are held by a business. Cash ensures that the business can pay its debts, repay loans and pay s in the short term, and that the business survives in the long term. Supplies of cash also enable management to take advantage of investment opportunities, such as the short-‐term money market. Planning for the timing of cash receipts, cash payments and asset purchases avoids the situation of cash shortages or excess cash. Cash shortages can, however, occur due to unforeseen expenses and they are a cost to the business.
s Receivable • The collection of receivables is important in the management of working capital. • Consequently, a business must monitor its s receivable and ensure that their timing allows the business to maintain adequate cash resources. • The quicker the debtors pay, the better the business’ cash position. • Procedures for managing s receivable include: o Checking the credit rating of prospective customers o Seeking customers statements monthly and at the same time each month so that debtors know when to expect s o Following up on s that are not paid by the due date o Stipulating a reasonable period for the payment of s o Putting policies in place for collecting bad debts, such as using a debt collection agency. • The disadvantage of operating a tight credit control policy is the possibility that customers might choose to buy from other firms. Management must weigh up the costs and benefits carefully. Inventories • 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. • Too much inventory or slow-‐moving inventory will lead to cash shortages. Insufficient inventory of quick-‐selling items may also lead to loss of customers, and hence lost sales. • Inventory is a cost to the business if it remains unsold. • Businesses must ensure that inventory turnover is sufficient to generate cash to pay for purchases and to pay suppliers o time so that they will be willing to give credit in the future. Control of Current Liabilities • Minimising the costs related to a firm’s current liabilities is an important part of the management of working capital. • This involves being able to convert current assets into cash to ensure that the business’ creditors (s payable, bank loans or overdrafts) are paid.
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HSC STUDY BUDDY s Payable • A business must monitor its payables and ensure that their timing allows the business to maintain adequate cash resources. • The holding back of s payable until their final due date can be a cheap means to improve a firm’s liquidity position, as some suppliers allow a period of interest-‐free trade credit before requiring payment for goods purchased. • It may also be possible to take advantage of discounts offered by some creditors. This reduces costs and assists with cash flow. • s must, however, be paid by their due dates to avoid any extra charges imposed for late payment and to ensure that trade credit will be extended to the business in the future. • Control of s payable involves periodic reviews of suppliers and the credit facilities they provide, for example: o Discounts o Interest free credit periods o Extended for payments, sometimes offered by established suppliers without interest or other penalties. Loans • Businesses may need to borrow funds in the short term for a number of purposes. • Management of loans is important, as costs for establishment, interest rates and ongoing charges must be investigated and monitored to minimise costs. • Short-‐term loans are generally an expensive form of borrowing for a business and their use should be minimised. • Control of loans involves investigating alternative sources of funds from different banks and financial institutions. • Positive, ongoing relationships with financial institutions ensure that the most appropriate short-‐term loan is used to meet the short-‐term financial commitments of the business. Overdrafts • Bank overdrafts are a convenient and relatively cheap form of short-‐term borrowing for a business. They enable a business to overcome temporary cash shortages. • Features of overdrafts differ between banks, but generally involve an arrangement with the bank that the business’ can be overdrawn to a certain amount. • Banks require that regular payments be made on overdrafts and may charge -‐keeping fees, establishment fees and interest. Interest payable for a bank overdraft is usually less than that for a loan. • Bank charges do, however, need to be carefully monitored, as charges vary depending on the type of overdraft established. • Businesses should have a policy for using and managing bank overdrafts and monitor budgets on a daily or weekly basis so that cash supplies can be
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HSC STUDY BUDDY controlled. Strategies Leasing • Leasing is the hiring of an asset from another person or company who has purchased the asset and retains ownership of it. • Leasing ‘frees up’ cash that can be used elsewhere in a business, so the level of working capital is improved. • It is an attractive strategy for some businesses as it is an expense and is tax deductible. • Firms can also increase their number of assets through leasing and this means that revenue, and therefore profits, can be increased. • Regular and fixed payments made for the lease can be planned to match the business cash flow. • While most loans require a deposit so that a firm can borrow only 90 to 95 per cent of the purchase price of the asset, leasing allows 100 per cent financing. Sale and Lease-‐Back • Sale and lease-‐back is the selling of an owned asset to a lesser and leasing the asset back through fixed payments for a specified number of years. • Sale and lease-‐back increases a business’ liquidity because the cash that is obtained from the sale is then used as working capital.
Profitability Management • •
Profitability management involves the control of both the business’s costs and its revenue. Accurate and up-‐to-‐date financial data and reports are essential tools for effective profitability management.
Cost Controls • Most business decisions are influenced by costs. • The costs associated with a decision need to be carefully examined before it is implemented. Fixed and Variable Costs • Before a business can control its costs, management must have a clear understanding of what those costs are. • Fixed costs are not dependent on the level of operating activity in a business. Fixed costs do not change when the level of activity changes — they must be paid regardless of what happens in the business. • Examples of fixed costs are salaries, depreciation, insurance and lease. • Variable costs are those that change proportionately with the level of operating activity in a business. For example, materials and labour used in the production of a particular item are variable costs, because they are often readily identifiable in a business and can be directly attributable to a particular product. • Monitoring the levels of both fixed and variable costs is important in a business. Changes in the volume of activity need to be managed in of the associated changes in costs.
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Comparisons of costs with budgets, standards and previous periods ensure that costs are minimised and profits maximised.
Cost Centers • A business’ costs and expenses must be ed for, and management needs to be able to identify their source and amounts. • A number of costs can be directly attributable to a particular department or section of a business, and these are termed cost centers. • Cost centers have direct and indirect costs. • Direct costs are those that can be allocated to a particular product, activity, department or region. • Indirect costs are those that are shared by more than one product, activity, department or region. Expense Minimisation • Profits can be weakened if the expenses of a business are high, as they consume valuable resources within a business. • Guidelines and policies should be established to encourage staff to minimise expenses where possible. • Savings can be substantial if people take a critical look at costs and eliminate waste and unnecessary spending. Revenue Controls • Revenue is the income earned from the main activity of a business. • For most businesses, revenue comes from sales or, in the case of a service business, from fees for professional services or commission. • In determining an acceptable level of revenue with a view to maximizing profits, a business must have clear ideas and policies, particularly about its marketing objectives including the sales objectives, sales mix or pricing policy. Marketing Objectives • Sales objectives must be pitched at a level of sales that will cover costs, both fixed and variable, and result in a profit. • A cost-‐volume-‐profit analysis can determine the level of revenue sufficient for a business to cover its fixed and variable costs to break even, and predict the effect on profit of changes in the level of activity, prices or costs. • Pricing policy affects revenue and, therefore, affects working capital. • Pricing decisions should be closely monitored and controlled. Overpricing could fail to attract buyers, while under pricing may bring higher sales but may still result in cash shortfalls and low profits. • Factors that influence pricing include: o The costs associated with producing the goods or service o Prices charged by the competition o Short and long term goals of the business o The image or level of quality that people associate with the goods or services o Government policies.
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Role of Financial Management Strategic role of Financial Management •
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Strategic financial management is the process of setting objectives throughout the business and deciding what resources are needed to achieve these objectives. The ‘finance’ part comes through the specific decisions as to how the resources will be financed. Financial management has a strategic role because it takes place in a changing environment and plans need to be flexible and ready to change. Strategic financial planning sets out the broad series of steps that need to be taken to achieve the business’ strategic objectives. Examples of changing business environments: o Taxation and other laws o Technology o Economy o Financial Innovations Within this changing environment the foals of the business need to be reached. o Liquidity o Solvency o Profitability o Growth o Efficiency
Objectives of Financial Management
Liquidity • A business is liquid when it can pay its debts as they fall due. • The relationship between current assets and current liabilities. • A business must have sufficient cash flow to meet its financial obligations or to be able to convert current assets into cash quickly; for example by selling inventory. • Controls over the flow of cash into and out of the business ensure that it has supplies of cash when needed. • Cash shortfalls and excess cash must be avoided as both involve loss of profitability for a business. • Also known as current ratio, liquidity ratio and working capital ratio Profitability • Profitability is about the size of profit relative to the size of the business’ operations. • Profitability is the ability of a business to maximise its profits. • Profits satisfy owners or shareholders in the short term but are also important for the longer-‐term sustainability of a firm. • High profitability: o Improves confidence in the business by all stakeholders o Makes it easier to attract new capital (growth)
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o Owners are satisfied with the return To improve profitability: o Increase revenues, this means either sell more or sell at a higher price or both. o Decrease expenses, this means improving efficiency.
Efficiency • Efficiency is the ability of a business to minimise its costs and manage its assets so that maximum profit is achieved with the lowest possible level of assets. • A business that is reducing costs is improving efficiency. • Achieving efficiency requires a firm to have control measures in place to monitor assets. • A business that aims for efficiency must monitor the levels of inventories and cash and the collection of receivables. • Improving productivity will: o Reduce costs o Increase outputs from the same amount of inputs o Keep output constant with reduced inputs Growth • Growth is the ability of a business to increase its size in the longer-‐term. • Growth of a business depends on its ability to develop and use its asset structure to increase sales, profits and market share. • Growth is an important financial objective of management as it ensures that the business is sustainable into the future. • It improves potential profits and investor returns and makes a takeover of a business that much harder. Solvency • Solvency is the extent to which the business can meet its financial commitments in the longer term. • Solvency is important to the owners, shareholders and creditors of a business because it is an indication of the risk to their investment. • Solvency indicates whether a business will be able to repay amounts that have been borrowed for investments in capital, such as equipment and machinery. • Also known as gearing, debt to equity ratio. • The higher the gearing (the higher the debt), the riskier the business. Short-‐Term and Long-‐Term • Financial objectives of a business are based on the goals of its strategic plan, which can be translated into both the short and long term. • Short-‐term financial objectives: o The tactical (one to two years) and operational (day to day) plans of a business. o These would be reviewed regularly to see if targets are being met and if resources are being used to the best advantage to achieve the objectives.
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o For example, if management has a goal to achieve a 15 per cent increase in profit for the next 10 years, the tactical plans might involve purchasing additional machinery, updating old equipment with new technologies, expanding into new markets and providing new services. Long-‐ term financial objectives: o The strategic plans of a business. o They are determined for a set period of time, generally more than five years. o They tend to be broad goals such as increasing profit or market share, and each will require a series of short-‐term foals to assist in its achievement. o The business would review their progress annually to determine if changes need to be implemented.
Interdependence with other key business functions To best explain this section we need to use an example, but you can just morph this flow chart to fit a case study in the exam. 1. Strategic goal – to increase profit by 25% in 2 years 2. Each KBF comes up with a plan and budget to help achieve this goal. 3. Marketing – to introduce a new product $4m 4. After getting the marketing plan: a. Operations – plan to extend the factory (to allow the new product to be made) $1.5m b. Human Resources – decides to employ an additional 15 workers to man the new product line $750 000 per annum 5. Finance gets the above 3 plans and determines how to finance the $6.25m. After assessing the current financial position of the firm, the finance manager determines the business cannot finance the $6.25m. The most the business can finance is $3m debt and $1.25 equity. 6. The finance manager will go back to the other 3KBF managers and they will each nee to network their plans within the new budget. 7. Interdependence
Influences on Financial Management
Internal Sources of Finance Retained Profits • When a business makes a profit, it must decide how to use it to benefit the business/owner. • Profits if ‘retained’ within the business can be used to ‘retire’ debt or to purchase new equipment or assets. • Either way the retained profits will increase the owner’s equity and it will improve the debt to equity ratio.
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HSC STUDY BUDDY Sale of Assets • A business may own assets it no longer needs or assts that could be ‘better’ used if turned into cash (liquidated). • One source of equity is to sell non-‐current assts and use the cash for the project (or part there of). • The asset would need to be considered redundant (not needed) for this option to be available. New Capital Injection by the Owner/s • Especially in small businesses the owner’s funds could be considered coming from within the business.
External sources of Finance
Debt – Short Term Borrowing Overdraft • An ‘overdraft’ is when a bank allows a business to withdraw more than it has in its . • Overdrafts are used to overcome cashflow shortages. • An overdraft is a short-‐term loan often repaid within a few days, interest is charged daily. • Overdrafts are relatively expensive. • If an overdraft was needed/used every month it would be a sign there is a problem and something would need to be changed (marketing, sales or expenses) Commercial Bills • A bill is a guarantee by a bank to pay an amount. • It could be for a short period of time. • Interest is cheaper than an overdraft. • Commercial bills are quite flexible. Factoring • Is the ‘selling’ of s receivable or debtors. • If a business uses a ‘factor’ then when it sends an invoice to a credit customer, it sends a copy to the factoring institution – usually a bank. • The factoring institution will immediately deposit an amount (usually 90-‐95% of the invoice) into the business’ . When the credit customer pays the full amount of the invoice – the bank receives its money back (90-‐95%) plus (5-‐10%) extra – which is the bank’s income. Debt – Long Term Borrowing Mortgage • A mortgage is a very long-‐term loan secured by real property, such as land or buildings. • Because the loan is secured the interest rate is relatively low. • If the borrow defaults on the loan, the bank (mortgage holder) will sell the land and building to recoup its money.
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HSC STUDY BUDDY Debentures • Only available to public companies. • A company can ‘borrow’ large sums of money by ‘selling’ debentures to of the public and institutions – like superannuation funds. • A debenture is a loan to a company for a set period of time, for instance 2 3 or 5 years. • They pay an attractive market rate of interest and they are secure by an asset of the company selling them. Unsecured Notes • These are the same as debentures except – o There is no asset backing them, they are ‘unsecured’. o Because they are ‘unsecured’ the interest rate they pay is higher. Leasing • Rather then having one large outlay for a purchase – either debt or equity-‐ business’ can lease equipment, land or buildings. • Leasing involves small regular payments for the use of an asset. • Leasing is often used to assist cash flow management. Equity Ordinary Shares • Ordinary shares are the most commonly traded shares in Australia. • The purchase of ordinary shares by individual’s means they have become part owners of a publicly listed company and may receive payments called dividends. • Value is determined by a company’s current or future performance. New Issues/New Shares • A security that has been issued and sold for the first time on a public market. • New shares are sold on the primary market. • The company sells the new shares and the money from the sale is then available for use. • The purchasers of the new shares are now ‘owners’ of the business and are entitled to a share of the profits (dividends) and to vote at the company’s AGM. • After a share is purchased for the first time – from which the company gets the money – no subsequent sale involves the company receiving money. The owner of the shares gets the money I they sell. The company only records the sale and the details of the new owner. Rights Issue • The privilege granted to shareholders to buy the right to buy new shares in the same company. Placements • Allotment of shares, debentures and so on made directly from the company to investors.
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HSC STUDY BUDDY Share Purchase Plan • An offer to existing shareholders in a listed company the opportunity to purchase mores shares in that company without brokerage fees. Private Equity • Private equity is the money invested in a (private) company not listed on the Australian Securities Exchange. • The aim of the private company (like the publicly listed companies who sell ordinary share) is to raise capital to finance future expansion/investment of the business.
Financial Institutions
Banks • Banks are the largest form of financial institution in Australia. • Most important source of funds for businesses. • Banks receive savings as deposits from individuals, businesses and governments, and, in turn, make investments and loans to borrowers. • Most of the funds provided through financial markets come from banks that operate on their own behalf or on behalf of other corporations. • Banks perform an increasingly wide range of roles rather than specialising in one area, and have subsidiaries in superannuation and mutual, and other funds. • Banks are supervised by the reserve bank of Australia. Investment Banks • Investment banks make up one of the fastest growing sectors in the Australian financial system, providing services in both borrowing and lending, primarily to the business sector. • Investment Banks: o Trade in money, securities and financial futures o Arrange long-‐term finance for company expansion o Provide working Capital o Arrange project finance o Advise clients on foreign exchange cover o Operate untie trusts including cash management trusts, property trusts and equity trusts. o Arrange overseas finance. Finance and Life Insurance Companies • Are non-‐bank financial intermediaries that specialise in smaller commercial finance. • Finance companies act primarily as intermediaries in financial markets. They provide loans to businesses and individuals through consumer high-‐purchase loans, personal loans and secured loans to businesses. • Finance companies are also the major providers of lease finance to businesses and some specialise in factoring or cashflow financing. • Finance companies raise capital through share issues (debentures)
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Insurance companies provide loans to the corporate sector through receipts of insurance s, which provide funds for investments. They provide large amounts of both equity and loan capital to businesses. Insurance can be general insurance (covering property or accident) or life insurance. The funds received in s, called reserves, are invested in financial assets. The s paid by investors provide for compensation or for savings for future needs.
Superannuation Funds • Have grown rapidly in Australia over the past 20 years due to tax incentives and compulsory superannuation introduced by the government. • These organisations provide funds to the corporate sector through investment of funds received from superannuation contribution. • Superannuation funds are able to invest in long-‐term securities as company shares, government and company debt because of the long-‐term nature of their funds. Unit Trusts • Also knows as mutual funds. • Take funds from a large number of small investors and invest them in specific types of financial assets. • Unit trusts investments include the short-‐term money market (cash management trusts), shares, mortgages and property, and public securities. • Usually connected to a management firm that manages a diversified investment portfolio for its investors. Australian Securities Exchange • The Australian securities exchange (ASX) is the primary stock exchange group in Australia. • The ASX functions as a market operator, clearing house and payments system facilitator. • It oversees compliance with its operating rules and promotes standards of corporate governance among Australia’s listed companies. • Products and Services include: o Shares o Real estate investment funds o Listed investment Companies o Interest rate Securities • The ASX acts as a primary market. This primary market enables a company to raise new capital through the issue of new shares and through the receipt of proceeds from the sale of securities. • The ASX also operates as a secondary market. The secondary market is where pre-‐owned or second-‐hand securities, such as shares, are traded between investors who may be individuals, businesses, governments or financial institutions.
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Influence on Government •
The government influences a business’ financial management decision making with economic policies such as those relating to the monetary and fiscal policy, legislation and the various roles of government bodies or departments who are responsible for monitoring and istration.
The Australian Securities and Investments Commission (ASIC) • The ASIC is an independent statutory commission able to the commonwealth parliament. • It enforces and isters the corporations Act and protects consumers in the areas of investments, life and general insurance, superannuation and banking (except lending) in Australia. • The aim of the ASIC is to assist in reducing fraud and unfair practices in financial markets and financial products. • The ASIC ensures that companies adhere to the law, collects information about companies and makes it available to the public. This includes the financial information that companies must disclose in their annual reports. Company Taxation • Companies and corporations in Australia pay company tax on profits. This tax is levied at a flat rate of 30%; unlike personal income taxes, which use a progressive scale. • Company tax is paid for before profits and distributed to shareholders as dividends. • The Australian government has undertaken a process of reform of the federal tax system that will improve Australia’s international competiveness. This will mean more jobs and higher wages for working Australians, as the reform will affect long-‐term economic growth.
Global Market Influences
Global Economic Outlook • The global economic outlook refers specifically to the projected changes to the level of economic growth throughout the world. • If the outlook is positive (economic growth is to increase) then this will impact on the financial decisions of a business. This may include: o Increasing demand for products and services and therefore a business would need to increase production to meet demand. o Decrease the interest rates on funds borrowed internationally from the financial money market. • A poor economic outlook will impact on financial decisions of a business in the opposite way to the above examples. Availability of Funds • The availability of funds refers to the ease with which a business can access funds (for borrowing) on the international financial markets.
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The international financial markets are made up of a range of institutions, companies and governments that are prepared to lend money to individuals, companies or governments who made need to raise capital. There are various conditions and rates that apply and these will be based primarily on: o Risk o Demand and Supply o Domestic economic conditions
Interest Rates • Interest rates are the cost of borrowing money. • The higher the level of risk involved in lending to a business, the higher the interest rates. • Overseas interest rates can be lower than in Australia – it is possible for Australian businesses to borrow from countries with lower interest rates. The problem here is fluctuating exchange rates. • If the exchange rate moves unfavourably for the Australian borrow, they may end up paying back a lot more than they originally calculated. • Australian exporters love: o A weak Australian dollar o A strong global economy • Australian importers love: o A strong Australian dollar o A global economy in which prices are low.
Processes of Financial Management
Planning and Implementing Financial Needs • How much finance is needed for the plan of the business? • Will it be debt or equity and how much of each? • To determine where a business is headed and how it will get there, it is important to know what its needs are. • Important financial information needs to be collected before future plans can be made. • This financial information includes balance sheets, income statements, cash flow statements, sales and price forecasts, budgets, bank statements, weekly reports from departments, break-‐even analysis, reports from financial ratio analysis and interpretation. • The financial needs of a business will be determined by: o The size of the business o The current phase of the business cycle o Future plans for growth and development o Capacity to source finance – debt and/or equity o Management skills for assessing financial needs and planning.
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HSC STUDY BUDDY Budgets • A forecast of anything can be a budget. • Budgets are predictions made based upon past experiences. • Budgets are used in both the planning and the control aspects of a business. • Budgets provide information in quantitative (that is, as facts and figures) about requirements to achieve a particular purpose. • Budgets can be drawn up to show: o Cash required for planned outlays for a particular period o The cost of capital expenditure and associated expenses against earning capacity. o Estimated use and cost of raw materials or inventory. o Number and cost of labour hours required for production. • Budgets reflect the strategic planning decisions about how resources are to be used. • They provide financial information for a business’ specific goals and are used in strategic, tactical and operational planning. • Budgets enable constant monitoring of objectives and provide a basis for istrative control, direction of sales effort, production planning, control of stocks, price setting, financial requirements, control of expenses and of production cost. • Factors that need to be considered in creating a budget are: o Review of past figures and trends, and estimates gathered from relevant departments in the business. o Potential market or market share, and trends and seasonal fluctuations in the market. o Proposed expansion or discontinuation of projects. o Proposals to alter price or quality of products o Current orders and plant capacity o Considerations from the external environment – for example, financial trends from the external environment, availability of materials and labour. • Common budgets include: o Income and Sales o Expenses • Budgets can be made for: o Sick days o Customer complaints o New customers • Operating budgets relate to the main activities of a business and may include budgets relating to sales, production, raw materials, direct labour, expenses and cost of goods sold. • Project budgets relate to capital expenditure, and research and development. • Financial budgets relate to the financial data of a business. Record Systems
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HSC STUDY BUDDY •
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Record systems are the mechanisms employed by a business to ensure that data is recorded and the information provided by the record systems is accurate, reliable, efficient and accessible. In order to more accurately monitor budgets and the progress of the plan, businesses need a record/s/finance system. From the smallest one-‐person business to the largest public company, ing software such as MYOB and QUICKEN are used to store and retrieve information. Balance sheets, revenue statements and cash flow statements are produced always comparing planned vs. actual. Minimising errors in the recording process, and producing accurate and reliable financial statements are important aspects of maintaining record systems.
Financial Risks • Financial risk is the risk to a business of being unable to cover its financial obligations, such as the debts that a business incurs through borrowings, both short and long-‐term. • The financial risk is that businesses won’t be able to pay its bills as they fall due. • Debt incurs interest, the more debt the more interest must be paid. • The more debt the higher the financial risk to a business. • In assessing financial risk for a business, consideration must be given to: o The amount of the businesses borrowings o When borrowings are due to be repaid. o Interest rates o The required level of current assets needed to finance operations. • To minimise financial risk, businesses must consider the amount of profit that will be generated. The profit must be sufficient to cover the cost of debt as well as increasing profits to justify the amount of risk taken by owners and shareholders. • Note: This is why the debt to equity ratio and solvency is so important. Too much debt = too much financial risk = high business failure. Financial Controls • Budgets, regular data and comparing planned vs. actual are how businesses control and monitor their financial (and all) plans. • Financial problems and losses prevent a business from achieving its goals. Some examples include: o Theft and fraud o Damage or loss of assets o Errors in record systems • Financial controls ensure that the plans that have been determined will lead to the achievement of the business’s goals in the most efficient way. • The policies and procedures of a business are designed to ensure that management and employees follow them. Control is particularly important in assets such as s receivable, inventory and cash. • Some common policies and procedures that promote control within a business are:
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HSC STUDY BUDDY o o o o o o
Clear authorisation and responsibility for tasks in the business Separation of duties Rotation of duties Control of cash, such as the use of cash s and cash banked daily Protection of assets, such as buildings being locked at night Control of credit customers, such as following up on overdue s
Debt and Equity Financing • The amount of debt that is appropriate for a business depends upon how accurate the cash flow forecast/budget can be. • Businesses that can more accurately predict their income and expenses cash flow can increase debt (to a point) safely. Advantages
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Debt Funds are usually readily available. Increased funds should lead to increased earnings and profits. Debt attracts an interest liability and interest is tax deductible. Debt does not dilute ownership
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• Disadvantages •
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Increased risk if debt comes from • financial institutions because the interest, bank charges, government • charges and principal all have to be repaid. Security is required by the •
Equity Does not have to be repaid unless the owner leaves the business. Cheaper than other sources of finance as there are no interest payments. The owners who have contributed the equity retain control over how that finance is used (have a say) Low gearing (use resources of the owner and not external sources of finance) Less risk for the business and the owner. Lower profits and lower returns for the owner. The expectation that the owner will have about the return on investment (ROI) Perpetual claim on the assets Page | 12
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business. Regular repayments have to be paid. Lenders have first claim on any money if the business ends in bankruptcy.
Comparison of Debt and Equity Finance Debt Lenders have prior claim in the event of liquidation Debt must be repaid by periodic repayments Interest payments are tax deductible Lenders usually require a lower rate of return Interest payments are fixed
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and income of the business. Unlike debt, equity has no maturity date. Equity has no tax deductible.
Equity Shareholders have a residual claim on assets Equity has no maturity rate Dividends are not tax deductible Shareholders require higher return due to higher risk Dividend payments are not fixed and may be reduced through lack of funds Equity holders have voting rights
Debt providers have no voting rights Matching the and Source of Finance to Business Purpose • Choices of how to finance will be influenced by: o The of finance must be suitable for the structure of the business and the purpose for which funds are required. o The cost of each source of funding. o The structure of the business. o Costs including set up costs and interest rates. o Flexibility of the source of finance. o The availability of funds. o The level of control maintained by the business. Monitoring and Controlling When a business has a plan in place it needs to be monitored and controlled. In the financial sense, the balance sheet, cash flow and revenue statements need to be monitored carefully when it is evident that actual performance is varying too much
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HSC STUDY BUDDY from planned performance then changes to the plan need to be implemented. Changes could be: • Marketing • Expenses and Budgets • Even the goal could be changed • Personnel (Staff) Cash Flow Statement • A cash flow statement is one of the key financial reports that are part of effective financial planning. • It provides the link between the income statement and balance sheet, as it gives important information regarding a firm’s ability to pays its debts on time. • The cash flow statement indicates the movement of cash receipts and cash payments resulting from transactions over a period of time. • Potential shareholders check that a business has had positive cash flows over a number of years. A fluctuating pattern of cash flows might point to difficulties in the business. • Cash flows can be a better predictor of a business’ status than profitability. A statement of cash flows can show whether a firm can: o Generate a favourable cash glow (inflows exceed outflows) o Pay its financial commitments as they fall due o Have sufficient funds for future expansion or change o Obtain finance from external sources when needed o Pay drawings to owners or dividends to shareholders. • In preparing a cash flow statement, the activities of a business are generally divided into three categories – operating, investing and financing activities. • Operating activities are the cash inflows and outflows relating to the main activity of the business. Income from sales makes up the main operating inflow plus dividends and interest received. Outflows consist of payments to suppliers, employees and other expenses such as rent etc. • Investing activities are the cash inflows and outflows relating to the purchase and sale of non-‐current assets and investments. • Financing activities are the cash inflows and outflows relating to the borrowing activities of the business. • The cash flow statement, income statement and balance sheet are used to show how effectively finance is being used in a business. Income Statement • The income statement shows the operating efficiency – that is, income earned and expenses incurred over the ing period. • Income is the earnings from the main objectives of the business. • Expenses are recurring amounts that are paid out while the business earns its revenue. • The income statement shows: o Operating income earned from the main function of the business, such as sale of stock and non-‐operating revenue earned from other operations, such as interest rent and commission.
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o Operating expenses such as, the purchase of stock and other expenses incurred in the main operation of the business, such as advertising and rent. By examining figures from previous income statements, managers can make comparisons and analyse trends before making important financial decisions. They can see whether expenses are increasing, decreasing or remaining the same and why profits are increasing or decreasing.
Balance Sheet • A balance sheet represents a business’ assets and liabilities at a particular point in time and represents the net worth (equity) of the business. • The balance sheet shows the level of current and non-‐current assets, current and non-‐current liabilities, including investments and owners’ equity. • The balance sheet shows the financial stability of the business and analysis of the balance sheet can indicate whether: o The business has enough assets to cover its debts o The interest and money borrowed can be paid o The assets of the business are being used to maximise profits o The owners of the business are making a good return on their investment. o The year’s figures compare with the previous year. Financial Ratios Comparative Ratio Analysis • Comparing a business’ analysis against other figures, percentages and ratios allows for judgements to be made. This is known as comparative ratio analysis and is important for businesses. • Comparisons can be made in a number of ways. • Ratio analysis taken for a business over a number of years can be compared with similar businesses and again common industry standards or benchmarks. • Figures from at least the previous two years can indicate directions or trends and make ration analysis more meaningful. • Comparisons can be made over different time periods, against standards, or with similar businesses. • Analysis can also include budget figures so that predicted figures can be compared against actual figures. • Comparison with other businesses and benchmarking are common. However, care must be taken to ensure that the same things are compared. Also, each business has differences, and finding comparable firms may be difficult. Limitations of Financial Reports Normalised Earnings
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HSC STUDY BUDDY This is the process of removing one time or unusual influences from the balance sheet to show the true earnings of a company. An example of this would be the removal of a land sale, which would achieve a large capital gain. Capitalising Expenses • This is the process of adding a capital expense to the balance sheet that is regarded as an asset (in that it will add to the value of the company and is therefore recorded on the balance sheet) rather that an expense (in this situation, it would be recorded on the income statement). • Examples of capitalising expenses include: o Research and Development o Development Expenditure Valuing Assets • This is the process of estimating the market value of assets or liabilities. The valuations can be used in a variety of contexts for a business, including investment analysis, mergers and acquisitions and financial reporting. • Two main methods used for valuing assets include: o Discounted cash flow method. This method estimates the value of an asset based on its expected future cash flows, which are discounted to the present (i.e. the present value) o Guideline company method. This method determines the value of a business by observing the prices of similar companies (guideline companies) that are sold in the market. Timing Issues Financial reports cover activities over a period of time, usually one year. Therefore, the business’s financial position may not be a true representation if the business has experienced seasonal fluctuations. Debt Repayments • Financial reports can be limited because they do not have the capacity to disclose specific information about debt repayments such as: o How long the business has had or has been recovering the debt o The capacity of the business or its debtor to repay the amounts owed o The adequacy of provisions and methods the business has for the recovery of debt. o What provision does the business have in place for doubtful debts and how is this evident in the financial reports o Have debt repayments been held over until another ing period therefore giving a false impression of the situation • 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 favorable overview of the business at that point in time. Notes to the Financial Statements • Notes to the financial statements report the details and additional information
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that are left out of the main reporting documents, such as the balance sheet and income statement. These notes contain important information such as the ing methods used for recording and reporting transactions that can affect the bottom-‐line return expected from an investment in a company.
Ethical issues related to Financial Reports • If debt funds are used extensively to finance activities in a business, although debt funds may be used to increase profits, there is added risk for shareholders. The impact of debt funds on risks to shareholders is an ethical issue that must be considered. • In preparing budgets, the expenditures and revenues are estimated. The common practice in business is overestimating expenditures and understanding revenues to allow for unexpected and uncertain events is an ethical issue for a business. • Ethical considerations are closely related to legal aspects of financial management. Legislation is in place to guard against unethical business activity but there is often a time lag between the recognition of a problem and its implementation through law. Audited s • An audit: is an independent check of the accuracy of financial records and ing procedures. • Potential s of information include financial institutions, owners and shareholders and potential investors who rely on this information before making a decision about the business. • Audits are an important part of the control function and are generally used to examine the financial affairs of a business. • There are three types of Audits: o Internal Audits o Management Audits o External Audits • Internal and external audits assist in guarding against unnecessary waste, inefficient use of resources, misuse of funds, fraud and theft. • External auditors are used to provide an annual audit of ing practice and procedures. Record Keeping • All ing processes depend on how accurately and honestly data is recorded. • Source documents must be created for every transaction, even those in which cash has changed hands. Goods and Services Tax (GST) Obligations • Businesses have an ethical and legal obligation to comply with the GST reporting
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Reporting Practices • Not only are accurate financial reports necessary for taxation purposes, but other stakeholders are entitled to access to a business’ financial information • Shareholders in a private company are legally entitled to receive financial reports annually, even if the company is a small business and the shareholders are family .
Financial Management Strategies
Cash Flow Management • • •
•
Cash flow is the movement of cash in and out of a business over a period of time. If more money goes out than comes in, or if money must be paid out before cash payments have been received, there is a cash glow problem. Inflows include: o Sales o s Receivable o Commissions o Sale of Assets o Interest on investments o Dividends Outflows include: o Payments to suppliers o Interest on loans o Operating expenses o Purchase of Assets o Loan Repayments
Cash Flow Statements • The statement of cash flow indicates the movement of cash receipts and cash payments resulting from transactions over a period of time. • It can also identify trends and can be a useful predictor of change. Management Strategies • A business may have temporary shortfalls of cash. Many businesses use bank overdrafts to cover these shortages. • Shortfalls of cash over longer periods are of greater concern for a business as insolvency or bankruptcy may result. Distribution of Payments • An important strategy involves distributing payments throughout the month, year or other period so that cash shortfalls do not occur.
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HSC STUDY BUDDY •
A cash flow projection can assist in identifying periods of potential shortfalls and surpluses.
Discounts for Early Payment • Another cash flow management strategy is offering creditors a discount for early payments. • This strategy is most effective when targeted at those creditors who owe the largest amounts over the financial year period. • This is not only beneficial for the creditors who are able to save money and therefore improve their cash flow, but it also positively affects the business’ cash flow status. Factoring • Factoring is the selling of s receivable for a discounted price to a finance or specialist factoring company. • The business saves on the costs involved in following up on unpaid s and debt collection. • Factoring is growing in popularity as a strategy to improve working capital.
Working Capital Management •
• •
•
Short-‐term liquidity is important for businesses. It means a business can take advantage of profit opportunities when they arise, as well as meet short-‐term financial obligations. A business must have sufficient liquidity so that cash is available or current assts can be converted to cash to pay debts. A lack of short-‐term liquidity could result in the sale of non-‐current assets to raise cash. In the long-‐term this can lead to reduced profitability for owners and shareholders. Working capital management involves determining the best mix of current assets and current liabilities needed to achieve the objectives of the business.
Control of Current Assets • Management of current assets is important for monitoring working capital. • Excess inventories and lack of control over s receivable lead to an increased level of unused assets, leading in turn to increased costs and liquidity problems. • Excess cash is a cost if left idle and unused. • Control of current assets requires management to select the optimal amount of each current asset held, as well as raising the finance required to fund those assets. • The costs and benefits of holding too much or too little of each asset must be assessed. • Working capital must be sufficient to maintain liquidity and access to credit (overdraft) to meet unexpected and unforeseen circumstances. Cash
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HSC STUDY BUDDY • • • • •
Cash is critical for business success, and careful consideration must be given to the levels of cash receivables and inventories that are held by a business. Cash ensures that the business can pay its debts, repay loans and pay s in the short term, and that the business survives in the long term. Supplies of cash also enable management to take advantage of investment opportunities, such as the short-‐term money market. Planning for the timing of cash receipts, cash payments and asset purchases avoids the situation of cash shortages or excess cash. Cash shortages can, however, occur due to unforeseen expenses and they are a cost to the business.
s Receivable • The collection of receivables is important in the management of working capital. • Consequently, a business must monitor its s receivable and ensure that their timing allows the business to maintain adequate cash resources. • The quicker the debtors pay, the better the business’ cash position. • Procedures for managing s receivable include: o Checking the credit rating of prospective customers o Seeking customers statements monthly and at the same time each month so that debtors know when to expect s o Following up on s that are not paid by the due date o Stipulating a reasonable period for the payment of s o Putting policies in place for collecting bad debts, such as using a debt collection agency. • The disadvantage of operating a tight credit control policy is the possibility that customers might choose to buy from other firms. Management must weigh up the costs and benefits carefully. Inventories • 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. • Too much inventory or slow-‐moving inventory will lead to cash shortages. Insufficient inventory of quick-‐selling items may also lead to loss of customers, and hence lost sales. • Inventory is a cost to the business if it remains unsold. • Businesses must ensure that inventory turnover is sufficient to generate cash to pay for purchases and to pay suppliers o time so that they will be willing to give credit in the future. Control of Current Liabilities • Minimising the costs related to a firm’s current liabilities is an important part of the management of working capital. • This involves being able to convert current assets into cash to ensure that the business’ creditors (s payable, bank loans or overdrafts) are paid.
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HSC STUDY BUDDY s Payable • A business must monitor its payables and ensure that their timing allows the business to maintain adequate cash resources. • The holding back of s payable until their final due date can be a cheap means to improve a firm’s liquidity position, as some suppliers allow a period of interest-‐free trade credit before requiring payment for goods purchased. • It may also be possible to take advantage of discounts offered by some creditors. This reduces costs and assists with cash flow. • s must, however, be paid by their due dates to avoid any extra charges imposed for late payment and to ensure that trade credit will be extended to the business in the future. • Control of s payable involves periodic reviews of suppliers and the credit facilities they provide, for example: o Discounts o Interest free credit periods o Extended for payments, sometimes offered by established suppliers without interest or other penalties. Loans • Businesses may need to borrow funds in the short term for a number of purposes. • Management of loans is important, as costs for establishment, interest rates and ongoing charges must be investigated and monitored to minimise costs. • Short-‐term loans are generally an expensive form of borrowing for a business and their use should be minimised. • Control of loans involves investigating alternative sources of funds from different banks and financial institutions. • Positive, ongoing relationships with financial institutions ensure that the most appropriate short-‐term loan is used to meet the short-‐term financial commitments of the business. Overdrafts • Bank overdrafts are a convenient and relatively cheap form of short-‐term borrowing for a business. They enable a business to overcome temporary cash shortages. • Features of overdrafts differ between banks, but generally involve an arrangement with the bank that the business’ can be overdrawn to a certain amount. • Banks require that regular payments be made on overdrafts and may charge -‐keeping fees, establishment fees and interest. Interest payable for a bank overdraft is usually less than that for a loan. • Bank charges do, however, need to be carefully monitored, as charges vary depending on the type of overdraft established. • Businesses should have a policy for using and managing bank overdrafts and monitor budgets on a daily or weekly basis so that cash supplies can be
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HSC STUDY BUDDY controlled. Strategies Leasing • Leasing is the hiring of an asset from another person or company who has purchased the asset and retains ownership of it. • Leasing ‘frees up’ cash that can be used elsewhere in a business, so the level of working capital is improved. • It is an attractive strategy for some businesses as it is an expense and is tax deductible. • Firms can also increase their number of assets through leasing and this means that revenue, and therefore profits, can be increased. • Regular and fixed payments made for the lease can be planned to match the business cash flow. • While most loans require a deposit so that a firm can borrow only 90 to 95 per cent of the purchase price of the asset, leasing allows 100 per cent financing. Sale and Lease-‐Back • Sale and lease-‐back is the selling of an owned asset to a lesser and leasing the asset back through fixed payments for a specified number of years. • Sale and lease-‐back increases a business’ liquidity because the cash that is obtained from the sale is then used as working capital.
Profitability Management • •
Profitability management involves the control of both the business’s costs and its revenue. Accurate and up-‐to-‐date financial data and reports are essential tools for effective profitability management.
Cost Controls • Most business decisions are influenced by costs. • The costs associated with a decision need to be carefully examined before it is implemented. Fixed and Variable Costs • Before a business can control its costs, management must have a clear understanding of what those costs are. • Fixed costs are not dependent on the level of operating activity in a business. Fixed costs do not change when the level of activity changes — they must be paid regardless of what happens in the business. • Examples of fixed costs are salaries, depreciation, insurance and lease. • Variable costs are those that change proportionately with the level of operating activity in a business. For example, materials and labour used in the production of a particular item are variable costs, because they are often readily identifiable in a business and can be directly attributable to a particular product. • Monitoring the levels of both fixed and variable costs is important in a business. Changes in the volume of activity need to be managed in of the associated changes in costs.
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HSC STUDY BUDDY •
Comparisons of costs with budgets, standards and previous periods ensure that costs are minimised and profits maximised.
Cost Centers • A business’ costs and expenses must be ed for, and management needs to be able to identify their source and amounts. • A number of costs can be directly attributable to a particular department or section of a business, and these are termed cost centers. • Cost centers have direct and indirect costs. • Direct costs are those that can be allocated to a particular product, activity, department or region. • Indirect costs are those that are shared by more than one product, activity, department or region. Expense Minimisation • Profits can be weakened if the expenses of a business are high, as they consume valuable resources within a business. • Guidelines and policies should be established to encourage staff to minimise expenses where possible. • Savings can be substantial if people take a critical look at costs and eliminate waste and unnecessary spending. Revenue Controls • Revenue is the income earned from the main activity of a business. • For most businesses, revenue comes from sales or, in the case of a service business, from fees for professional services or commission. • In determining an acceptable level of revenue with a view to maximizing profits, a business must have clear ideas and policies, particularly about its marketing objectives including the sales objectives, sales mix or pricing policy. Marketing Objectives • Sales objectives must be pitched at a level of sales that will cover costs, both fixed and variable, and result in a profit. • A cost-‐volume-‐profit analysis can determine the level of revenue sufficient for a business to cover its fixed and variable costs to break even, and predict the effect on profit of changes in the level of activity, prices or costs. • Pricing policy affects revenue and, therefore, affects working capital. • Pricing decisions should be closely monitored and controlled. Overpricing could fail to attract buyers, while under pricing may bring higher sales but may still result in cash shortfalls and low profits. • Factors that influence pricing include: o The costs associated with producing the goods or service o Prices charged by the competition o Short and long term goals of the business o The image or level of quality that people associate with the goods or services o Government policies.
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