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

Owners and managers collect information relating to the decisions and plans

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

Objectives of financial management

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

RevenueCOGS=gross profitexpenses=net profit .

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

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

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

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Current assets need to be greater than current liabilities.

liquidity=

current assests
current liabilities

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

Short and long term

Businesses it must often prioritize objectives as they cannot always all be achieved at the same
time.
If another one of the businesss objectives is to be environmentally responsible then it must
sacrifice efficiency in the operations.
Consumers can also turn to a businesss competitors if a business is not seen to be environmentally
responsible.
Interdependence with other key business functions
The main functions that a business needs to perform are operations, human resources, marketing
and finance.
Middle management develops short-term plans (tactical).
The financial manager must allocate
The financial manager must allocate adequate funds to each department to be able to operate
successfully. The manager will also need to develop budgets and cost controls for each department.

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Chapter 12: influences on financial management

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

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

Commercial bill- a written order for a loan amount that is guaranteed

by the businesss bank. It is borrowed from businesses with surplus
funds. It is normally from 30-180 days.

Factoring- when a business sells its accounts receivable asset to a

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

Mortgage-a loan which is repaid over a set number of years with

interest. They are used to purchase land or properties. The property
asset becomes the security for the repayment.

Debenture- A type of long-term debt finance that a business can

acquire by offering a prospectus to the general public on the securities
exchange. The business is offering an investment opportunity to
people who want a good return from a more risky investment.

Unsecured notes- notes usually issued by finance companies to gain

funds. They offer higher interest rates reflecting the greater risk.
Unsecured notes are called bonds.

Leasing- where businesses lease non-current assets, such as cars and

equipment for payments to the owner. This reduces the cost of
acquiring these assets as full value of the asset in one transaction does
not have to be made instantly. This agreement can provide tax
advantages as the lease payments are usually tax deductible.

Long term

Equity- attached to the ownership of shares in an incorporated business. The

owners financial claim on the assets of the business. Some types are:

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Venture capital- Capital acquired from a specialist venture financial

institution that seeks to become a partowner in the business.
Private equity- when a business invites people/organizations to
invest in the business. Shareholders do not need to be paid instantly
and the owners do have so much control.

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

Ordinary shares- shares to the public through securities

exchanges. Shares can be issued with or without the right to
vote at the annual general meeting.

New issues- a security that has been issued and sold for the fi
rst time on a public market; sometimes referred to as primary
shares or new offerings. A prospectus (a document that
describes financial security) is issued through a stockbroker and
shares are made on the securities exchange.

Rights issue- the privilege granted to shareholders to buy new

shares in the same company

Placements- to offer additional shares to specific institutions

and specific investors. The company does this without a formal
prospectus. These funds may be used to expand activities or to
acquire businesses.

Share purchase plans- an offer to existing shareholders in a

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

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

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

Finance and life insurance companies- Finance and life insurance companies are nonbank financial intermediaries that specialise in smaller commercial finance. They provide

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loans to businesses and individuals through unsecured and secured loans. Finance
companies raise capital through share issues. Insurance companies provide loans through
ongoing insurance premiums. Generally, interest rates would be higher.
.
o

Superannuation funds- These organisations provide funds to the corporate sector through
investment of funds received from superannuation contributions and fees. Superannuation
funds earn returns by selling debt securities to businesses, which repay these loans with
interest.

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

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

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

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

Two important government influences on financial management are:

o The Australian Securities and Investments Commission (ASIC)- This was formed to
regulate corporations markets and the provision of financial services covered under the
Corporations Act 2001 (Cth). The aim of ASIC is to assist in reducing fraud and unfair
practices in financial markets and financial products. ASIC ensures that companies adhere to
the law, collects information about companies and makes it available to the public.
o

Company taxation- Companies and corporations in Australia pay company tax on profits.
Company tax is paid before profits are distributed to shareholders as dividends. Company
tax is presently 30% of net profit. The government plans to lower taxes to foreign
investment, and create new jobs.

Global market influences

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

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

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

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o

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

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Chapter 13: processes of financial management
Planning and implementing
Financial management is responsible for the financial planning of the business. This will help
determine the viability of the venture, make decisions about its future and make projections for
liquidity and performance.
Planning processes- the setting of goals and objectives, determining the strategies to achieve
those goals and objectives, identifying and evaluating alternative courses of action and choosing
the best alternative for the business.
Financial needs
A new business will have to determine its start-up costs; this will include such things as the
purchase of new equipment, staff and legal fees.
Once a business has begun operations financial information from balance sheets, income
statements, cash flow statements, sales need to be analyzed to determine if profits can be given to
shareholders.
Budgets
A budget - a plan for achieving set outcomes and is based on forecast figures or expectations of
future operations. A budget establishes standards and can be used as a control method, allowing
comparisons of actual results with the initial plan and an evaluation of progress.
Budgets show cash required for planned outlays for a particular period and the cost of capital
expenditure and associated expenses
There are 3 types of budgets:
o Operating budgets - the main activities of a business and may include budgets relating to
sales, production, raw materials.
o Project budgets - capital expenditure, and research and development. E.g. asset
purchase, life span of the asset and the revenue that would be generated from the purchase.
o Financial budgets - financial data of a business. They forecast of funds required to pay for
inputs and anticipated inflow of funds from future sales.
Record systems
Record systems - the mechanisms employed by a business to ensure that data are recorded and
the information provided by record systems is accurate, reliable, efficient and accessible.
Minimising errors in the recording process and producing accurate and reliable financial statements
are important aspects of maintaining records.
Accounting records of expenses and revenues are kept by law and an annual financial report is
presented to shareholders and the ATO (Australian tax office).
Management information systems (MIS) are often developed by larger businesses to allow
managers to access organised units of information appropriate to their needs.
Financial risks
These are the risk to a business of being unable to cover its financial obligations, such as the debts
that a business incurs through borrowings, both short term and longer term.
The owner needs to take some factors in like theft of goods, non-payment of accounts and interest
rate rises.
They can also take out insurance against possible risks or have liquid assets so that debts including
interest payments and the repayment of principal on loans can be covered.
Financial control
Financial controls -controls which ensure that the plans that have been determined will lead to
the achievement of the businesss goals in the most efficient way.

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This enables the manager to determine if the objectives set were not achievable or need to be
reassessed.

Debt and equity financing

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

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

Advantages of equity
Does not have to be repaid unless the owner
leaves the business
Cheaper than other sources of finance as there
is no interest
Less risk for the business and the owner

Disadvantages of Equity
Lower profits and lower returns for the owner
The expectation that the owner will have about
the return on investment (ROI)

Matching the terms and source of finance to business purpose

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

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

Fixed number of years

Number of years set by the issuing company
Up to 30 years

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

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

Balance sheets- give a snapshot or summary of what the business owns and owes on a
certain day. It shows the financial stability of the business and illustrates that:

A=L+ E

Assets = liabilities + equity

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

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

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

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

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

Efficiency- the ability of the firm to use its resources effectively in ensuring financial
stability and profitability of the business.

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Expense ratio- the amount of sales that are allocated to individual expenses, the
lower the better, the more efficient.
Expense Ratio = Expenses / Revenue

Accounts receivable turnover ratio- the effectiveness of a firms credit policy

and how efficiently it collects its debts High turnover ratios indicate the business
has efficient debt collection.
AR Turnover Ratio = 365 / ( Revenue / AR

Limitations of financial reports

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

Limit
Nominalised earnings
Capitalised expenses

Valuing assets

Timing issues

Debt repayments

Notes to the financial

statement

Limitations
Explanation
The earnings that are adjusted to the state of the economy to remove
influences. An example of this would be the removal of a land sale.
The costs incurred when financing a non-current asset and added to the
cost of the asset. They are originally added to the balance sheet under
the assets, instead they are deducted from the revenue.
This is the process of estimating the market value of assets or liabilities.
Some assets change value over time due to inflation and the market.
Therefore it would have been worth less in the past and would not reflect
the true value. This means assets have to be revalued to account for the
appreciation or depreciation.
Assets sometimes cannot be recorded, e.g. patents (a legal right that
gives the owner exclusive rights to sell, market license or to make a
profit).
Financial reports cover activities over a period of time, usually one year.
Therefore, the businesss financial position may not be a true
representation if the business has experienced seasonal fluctuations. This
is to make the business seem more profitable.
Each transaction is supposed to be recorded at the time that it actually
occurs. This is the matching principle.
By recording these transactions outside the current financial year they
will not appear on the current reports.
Reports do not have the capacity to disclose specific information about
debt repayments. Sometimes staff members are free to choose when
they take their holidays or may choose to take a payment for holidays.
These are the details and additional information that are left out of the
main reporting documents, such as the balance sheet and income
statement.

Ethical issues related to financial reports

Accountants must display integrity objectivity, confidentiality and a high level of professional and
technical ability.
Financial managers and accountants cannot be creative when recording transactions and
preparing financial reports in order to make the business appear more profitable.
Managers should not may use the businesss credit cards for personal expenses.
Business accounts must be audited or monitored by independent organizations. This is the checking
of accounts and procedures. Audited accounts are a legal requirement of all public companies.

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Corporate raiding - process of buying an undervalued company and increasing profit or selling off
the businesses assets. The personal wealth is increased at the cost of employees who lose their
jobs.
Australian Accounting Standards regulate how financial reports are to be prepared.

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Chapter 14: financial management strategies
Cash flow management
A business must always have enough cash available to pay bills and expenses. They must also
know how to manage the money coming in and out. Budgets and cash flow statements can
allow the business to do this.
Inflows
Outflows
Sales
Payments to suppliers- raw materials/finished
goods
Sales of assets
Operating expenses wages/salaries raw
materials/finished goods
Rents
Purchase of properties
Budget- a tool used to evaluate the performance of a business by comparing actual results with
planned results. It can help the financial manger anticipate how much cash the business needs to
pay expenses.
Cash flow statements
Cash flow statements the movement of cash receipts and cash payments resulting from
transactions over a period of time. They are used to show the trends of short and long term cash
inflows and outflows. They also summarize how the business will pay for short-term liabilities.
Management strategies
Distribution of payments- By spreading expenses over the whole year there is a more equal
cash outflow each month rather than one huge outflow during one month. Another strategy is to
prepay expenses, such as rent or interest.
Factoring - accounts can be sold to a factoring business at a discount. The factoring firm pays the
business the value of accounts minus its fee or commission.

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

Working capital management

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

Receivables- sums of money due to a business from customers to whom it has supplied
goods or services. The effectiveness of control over accounts receivable is measured using
the turnover ratio/formula:

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Turnover ratio = total sales accounts receivable

If this ratio is low then, customers take too long to pay. This slows down the collection
of revenue. There may also be a high number of bad debts (debtors who are
unlikely to pay debts). They manager may impose a credit limit on customers and
make credit checks.

Inventories- this is the total amount of goods or materials in a store or factory, e.g. raw
materials, work-in-progress and finished goods. The inventory must be monitored and
protected otherwise business will lose money. Methods of internal control are:
physical inspections and counts
security
limiting staff access

Control of current liabilities

o Payables- money the business owes to its suppliers, also known as creditors. The number of days
given to repay loans will depend on the credit rating (An assessment of a businesss ability to
repay loans based on its history.) Businesses should pay its invoices on the last day they are due,
thus keeping the money as long as possible.
o

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

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

Management strategies
o Leasing- the hiring of an asset from another person or company. Regular and fixed payments are
needed.
o Sale and lease back- Selling a non-current asset owned will provide a cash injection to pay
expenses as they fall due. They can enter into a sales agreement.
Profitability management
o A good accounting and financial system has effective controls to ensure the business:
o does not overspend
o does not lose assets
o Records financial records and transactions correctly.
Cost controls
Fixed and variable
o Businesses can reduce costs in two areas: labour and inputs.
o Outsourcing of non-core functions has been the most popular method, e.g. contracting a call centre
to handle customer inquiries or hiring a specialist firm to handle payroll, cleaning. These
organisations are aiming to achieve greater efficiency.
o Fixed costs do not change when a business produces more goods, e.g. salaries, rent, lease
payments.
o Variable costs do vary as output and sales change. Examples are employee wages and overtime

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o

payments, advertising.
Strategies to cut variable costs include:
o negotiating discounts with all suppliers
o reducing the number of suppliers
o switching to a cheaper supplier,

cost centres
o Cost centres - The expenses associated with each key business function. Management may provide
them with a budget and monitor their expenses to minimise waste and achieve maximum use of
resources. They can be used to identify which type of expense contributes most to the product.
o Cost centres use budgets as tools to evaluate the performance of by comparing actual to the real
amount spent.
Revenue controls
Marketing objectives
Revenue controls include sales forecasts, analyzing the sales mix and the pricing policy of a
business.
A sales budget (The predicted future sales a business expects to make during the year) is used to
predict future sales of the business based on:
o patterns of sales in previous years
o economic conditions
Sales mix is the marketing strategy used to sell the range of products a business supplies. It is a
report that can be used to identify which method of promotion works best.
Global financial management
When operating globally, there are factors or additional risks that must be considered, They include
exchange rates, interest rates, methods of international payment, hedging, derivatives.
o Exchange rates- the value of a countrys money calculated using another countrys
money. When costs are transferred it can decrease the value of net profit. If the Australian
dollar depreciates, it will cost more to import.
o Interest rates- It is important to find the lowest interest rate, as exchange rate fluctuations
can make repayments more costly. The advantages of overseas borrowing are:
the rate of interest can be cheaper
there are fewer restrictions
finance may be acquired more quickly and easily
o

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

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

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

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

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o

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

swap contracts- written allowing the Australian business to pay the US

supplier in euros at a spot rate