‘Topic 3:Financial Management Cash flow statements: Acash flow statement records all of the business's cash inflows and outfiows over a period of time. Financial managers can use the cash flow statement to monitor cash receipts and cash payments and ensure the business can meet its short term obligations. It can also be used to identify how much working capital the business has, helping making decision in regards to future borrowings, liquidity and drawings. The cash flow statement can be divided into three categories: © Cash flows from operating activities — this relates to all the cash inflows and outflows from everyday business activities. Under this category we would find cash receipts from customers, cash payments fo suppliers, cash payments to employees and interest paid on loans. It is any inflow or outflow of cash that is. related to operational activities. Cash flows from operating activities $ Cash receipts from customers 180,000 Cash payments to suppliers (80,000) Interest on loan (15,000) Tax payments (20,000) Net cash from operating activities 35,000 © Cash flows from investing activities — this relates to all the cash inflows and outflows from any purchase or sale of assets. Under this category we would find sale of motor vehicle or purchase of machinery. Cash flows from investing activities $ Proceeds from sale of property, plant and equipment 20,000 Purchase of property, plant and equipment (140,000) Net cash from investing activities (120,000) © Cash flows from financing activities — this relates to all the cash inflows and outflows from any activities related to the businesses borrowing. Under this, category we would find equity contributed by the owners and repayment of borrowings. Cash flows from financing activities $ Contributed equity 200,000 | Repayment of borrowings (80,000) Net cash from financing activities 140,000 104 Business Studies HSC Study Guide (© Five Senses Education‘Topic 3:Financial Management Combining the cash flow statements from Operating, Investing and Financing results in the combined cash fiow statement below: Cash flow statement for the period ended 30 June 2015 Cash flows from operating activities $ | Cash receipts from customers 150,000 Cash payments to suppliers (80,000) Interest on loan (15,000) Tax payments (20,000) Net cash from operating activities 35,000 Cash flows from investing activities Proceeds from sale of property, plant and equipment 20,000 Purchase of property, plant and equipment (140,000) ‘Net cash from investing activities (720,000) Cash flows from financing activities Contributed equity 200,000 Repayment of borrowings (60,000) Net cash from financing activities 140,000 Net increase in cash held 55,000 Cash at the beginning of the reporting period 25,000 Cash at the end of the reporting period 80,000 © Five Senses Education Business Studies HSC Study Guide 105Topic 3: Financial Management Income statements (profit and loss statements): Income statements (also known as profit and loss statements) measure @ business's financial performance over a set period of time (usually a financial year), displaying all of the business's income and expenses for that period and calculating whether the business has made a profit or a loss. Sales — COGS = Gross Profit Gross Profit— Expenses = Net Profit COGS (Cost of goods sold) is the cost attributable to a product that the business has sold. COGS can be calculated with the following formula: Opening Stock + Purchases ~ Closing Stock = COGS Income statement for period ended 30 June 2015 Asimple formula to remember the structure of an income statement is: $ Sales 150,000 (less) COGS Opening Inventory 20,000 Purchases 35,000 Closing Inventory (15,000) 40,000 Gross Profit 110,000 (less) Expenses Advertising Exp 3,000 Insurance Exp 2,000 Interest Exp 4,000 Other Exp 11,000 20,000 Net income before tax 90,000 Tax 30,000 Net income after tax 60,000 106 Business Studles -HSC Study Guide (© Five Senses EducationTopic 3: Financial Management Balance Sheet: The balance sheet gives a snapshot of the businesses financial position at a certain point in time. It is a summary of what the business owns and what the business owes. A balance sheet should always balance and a simple way of remembering this is through the accounting equation: Assets = Liabilities + Owners Equity Anything the business owns (assets) will always equal what the business owes (liabilities) plus any equity the owner has invested into the business (owners’ equity). An asset is anything the business owns of value that can be tuned into cash. Generally current assets can be tuned into cash within 12 months, such as; cash, accounts receivables and stock, Generally non-current assets cannot be turned into cash within 12 months, such as cars, machinery, factory and land. A liability is anything the business owes as a result of a financial transaction. Generally it is expected that a business would pay back a current liability within 12 months, such as credit cards, overdraft accounts and accounts payable. Non-current liabilities would generally take over 12 months to pay back, such as mortgages, debentures and long term loans. WHAT YOU OWN ... WHAT You Owe ... Cag Loan Ceaoir Cago 7 BALANCE: LINE oF Ceeorr -- PAYMENT PLAN Owners’ equity can be simply defined as the owners’ share of the businesses assets. Owners’ equity can be calculated by deducting the value of the businesses liabilities from the value of the businesses assets. © Five Senses Education Business Studies -HSC Study Guide 107‘Topic: Financial Management Balance sheet as at 30 June 2015 | Current Assets s Current Liabilities $s | Cash 15,000 | Credit cards 5,000 Accounts receivable 12,000 | Accounts payable 9,000 Stock 40,000 | Overdraft 16,000 | Non-current Assets Non-current Liabilities : Car 30,000 | Mortgage 160,000 Machinery 80,000 | Long term loan 40,000 Factory 180,000 ‘Owners’ Equity Contributed equity 90,000 Retained profits 37,000 Total Assets 357,000 | Total Liabilities + 357,000 Owners’ Equity i | Financial ratios | © liquidity © current ratio (current assets + current liabilities) | © gearing ' © debt to equity ratio (total liabilities + total equity) © profitability i © gross profit ratio (gross profit + sales) © net profit ratio (net profit + sales); © return on equity ratio (net profit + total equity) © efficiency © expense ratio (total expenses + sales), © accounts receivable turnover ratio (sales + accounts receivable) I I i i 108 Business Studies -HSC Study Guide © Five Senses Education“Topic 3 Financial Management Comparative ratio analysis — over different time periods, against standards, with similar businesses Financial managers use financial statements to measure the businesses performance, gain an understanding of the businesses financial position and make informed decisions based on accounting data. Businesses may also wish to take financial HCASUTE analysis further to find more specific detailed information that fe ane, will help with decision making. There are a variety of financial g. x i Profitability ratios managers can use to assess liquidity, gearing, t rallos; i profitability and efficiency. iad a Liquidi Liquidity can be measured using the current ratio (also known as the working capital ratio). Current Ratio = Current Assets / Current Liabilities Measuring liquidity will help managers assess their ability to meet liabilities in the short term. A current ratio of 2:1 is generally accepted as a financially sound position for a business to be in. This means that a business has $2 of current assets for every $1 of current liabilities, which means they] should quite easily be able to pay short term liabilities as they fall due. A very high current ratio, for example 4:1, could be argued to be inefficient as managers have too much money tied up in current assets that could be invested or used elsewhere to pay off loans, Gearing: Gearing can be calculated using the debt to equity ratio, Debt to Equity = Total Liabilities / Total Equity Gearing is a measurement of debt to equity within the business. Managers will use the gearing ratio to see every dollar of debt they have to every dollar of equity. The data from this ratio can be used to measure how solvent the business is (whether it can survive in the long term). A gearing ratio of 1:1 (meaning the business has $1 of debt for every $1 of equity) indicates a sound financial position for a business to be in, As a general rule, a business would not want to have more debt than equity in the business. This would show the business is potentially at risk as they have more external debt than internal debt and would be vulnerable to interest rate rises. (© Five Senses Education Business Studies -HSCStudy Guide 109Topic 3:Financel Management Profitability: Profitability can be calculated using the gross profit ratio, the net profit ratio and the return on equity ratio. Gross Profit Ratio = Gross Profit / Sales Gross profit ratio is a measurement of the businesses sales against the businesses gross profit. Gross profit is calculated as sales less COGS. So the gross profit ratio compares how much profit the business makes after it has paid COGS against the sales, Ifthe business generates a low gross profit ratio, managers will have to devise strategies to reduce the COGS. Net Profit Ratio = Net Profit / Sales Net profit ratio is a measurement of the businesses sales against the businesses net profit. Net profit is calculated as gross profit less expenses. A net profit ratio of 40% would indicate that for every $1 in sales the business is making 40 cents in net profit. Ifa business is concemed that their net profit ratio is too low they would need to. examine ways to reduce expenses. Return on Equity Ratio = Net Profit / Total Equity Return on equity ratio indicates how much return the owner has received for their investment into the business. If the return is high (more than 10% is a good indication depending on the businesses type and age) the owner may consider expanding the business. Owners may compare results with other potential investment returns in the current market to ensure their equity could not be earning more profits elsewhere. Efficiency: The efficiency of a business can be calculated using the expense ratio and the accounts receivable turnover ratio. Efficiency is important as it based on the business using its resources effectively to minimise expenses and maximise profits. Expense Ratio = Total Expenses / Sales ‘The expense ratio compares the business expenses with the relevant sales. A high expense ratio would indicate to owners that expenses are too high and they may need to look at ways to reduce them. It could also indicate that sales are too low in comparison with the spending. Businesses are always looking for ways to use resources more efficiently, reducing expenses and increasing sales. Accounts Receivable Turnover Ratio = (Accounts Receivable / Sales) x 365 110 Business Studies~ HSC Study Guide (© Five Senses EducationTopic 3: Financial Management Accounts receivable turnover ratio measures how efficiently businesses are receiving money for their accounts receivable. It indicates how quickly they are collecting cash from debtors. A high ratio indicates a business is collecting debts efficiently. Businesses can multiply the ratio by 365 to calculate how many days on average it is taking to recover accounts receivable. For example, a business with $50,000 in sales and $10,000 in accounts receivable would look like the following: $10,000 / $50,000 = 20% 20% x 365 = 73 days This would indicate the business taking an average of 73 days to recover its debts. ‘This is not ideal as most businesses would have 30 day billing cycles and would need this money to pay their own debts. This business would need to look at strategies to recover its accounts receivable faster. Comparative ratio analysis: Financial ratios provide owners with current information on the businesses liquidity, gearing, profitability and efficiency that will help with decision making and understanding of the financial position of the business. It is important however, to use these calculated ratios as a comparison tool to measure the businesses performance {J over different time periods, against standards and against similar ~ businesses, By comparing current financial ratio data with financial data from different periods, overs can track the businesses progress and identify any trends that may be evident. This would be critical in making sure the business is achieving financial goals and whether of not new strategies need to be put in place. Its also important to measure financial performance against both industry standards and similar businesses performances. Using industry standards and similar businesses to compare financial results will help the owners identify if they are above or below current averages in the same industry. If they are below industry averages they will need devise strategies and consider ways to improve the businesses financial performance. ‘© Five Senses Education Business Seudles —HSC Study Guide 111Topic 3: Financial Management Income statement for Ed's Motorbikes for years ended 30 June 2015 and 30 June 2016 : 6 i ‘NetPro ee [be 2 Balance Sheet for Ed's Motorbikes for years [aaa Answer these questions from the information in the tables. Q1) Calculate and comment on the change in the working capital ratio for Ed's Motorbikes for 2015 and 2016. Q2) Calculate and comment on the change in the debt to equity ratio for Ed's Motorbikes for 2015 and 2016. Q3) Calculate and comment on the change in the gross profit ratio for Ed's Motorbikes for 2015 and 2016. Q4) Calculate and comment on the change in the expense ratio for Ed's Motorbikes for 2015 and 2016. 112 Business Studies ~ HSC Study Guide ‘© Five Senses Education; “Topic 3:Financial Management Limitations of financial reports — normalised earnings, capitalising expenses, valuing assets, timing issues, debt repayments, notes to the financial statements It is important to note that financial reports do not always give a completely accurate representation of the businesses financial position. As they are used fo make informed business decisions it is important that we consider the variety of potential - limitations when analysing financial reports. Some of these limitations include: a Normalised earnings are earnings adjusted to remove unusual or a Normalised | one-time influences. A large one-time gain or loss would dramatically earings affect a business's profit or loss for a given period and would need to be taken into account and adjusted for. 1 Capitalising expenses is the process of adding expenses associated : Capitalsing | With a fixed asset into the price of the asset (onto the balance expenses » | Sfeet). The expenses are not recorded in the accounting period they occurred in, they are expensed over a longer period of time (the life of the asset) as depreciation. a Abusinesses balance sheet may not always represent an accurate value of assets owned, The value of assets will change over time. Valuing Some assets will generally appreciate over time (like real estate) assets, and some assets will depreciate over time (like tools or vehicles) Businesses must have external assessors revalue assets to ensure their paper value is on par with their market value As financial reporting is done in periods (quarterly, half yearly or yearly) it is possible to distort the current financial position of a Timing business. A business can hold off on a large expense or revenue issues being recorded so it does not show up in the current accounting ’ period ~ meaning the current financial statements are not a true representation of the business's financial position Money that is owed to the business may not be accurately Debt recorded on the balance sheet. Information on debts and debiors is repayments | generally not included in financial statements and would need to be investigated to ensure accurate debt repayments are being recorded. Notes to Notes to the financial statements are additional notes that are added the financial | at the end of financial statements. They display important information statement | 2D0ut the accounting techniques used and any extra information about specific items. For further information on accounting standards see the AASB (Australian Accounting Standards Board) http:/Avww.aasb.gov.au/Pronouncements/Current-standards.aspx © Five Senses Education Business Studies -HSC Study Guide 113‘Topic 3: Financial Management When it comes to financial reporting there will always be the issue of ethical practice. Itis expected that all businesses abide by current legislation and provide accurate i financial reports, There have been a variety of cases over the last 10 years that i have questioned the current legislation and the integrity of large businesses. Code of behavior must be continually reviewed and regulated to ensure businesses are abiding by the law and providing accurate financial information to stakeholders. | i Ethical issues related to financial reports | | ( Acommon grey area in financial reporting is in regards to creative accounting in which finance experts find loop holes in the law to manipulate figures to suit their own interests. This could be as simple as inaccurate valuing of assets to make the businesses financial position look more favorable to investors. A common practice to check the accuracy of financial reporting is called an audit | An audit is an examination of the accuracy of a business's financial reports and accounting methods. Audits can be undertaken by the business themselves or by third parties. An auditor's job is to closely examine the business itself, © inspect its financial reports, ask any appropriate questions ¢ that will help with the investigation, and follow current auditing standards. On completion of the audit, the auditor will write a report with their opinion on the disparity between the financial reports of the business and the actual financial position at that point in time. i 114 suse Suis - HSC Stuy Gide ive Senses Education |