Role of financial management •
Strategic role of financial management
Management of the business’s financial requirements into the long term and positioning the business in a competitive business world. •
Objectives of financial management
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Profitability, Profitability, growth, efficiency, liquidity, solvency Profitability: maximise profit, often a trade-off between short and long
term. Growth : sustained increase in size of business into future. Efficiency: maximising use of assets in most cost effective way. Liquidity: ability to meet short term financial obligations. Solvency (gearing): long term financial viability of business. -
Short-term and long-term Short-term: tactical (1-2 years) and operational (day-to-day) plans of
business, reviewed regularly. Long-term: determined for set period of time (often 5+ years), tend to be broad, require series of short-term goals. •
Interdependence with other key business functions
All other key business functions require adequate funds to complete necessary tasks e.g. stock, better staff, more/better promotions.
Influences on financial management •
Internal sources of finance
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Retained profits
Net profit kept within business instead of being distributed, often used to fund growth. -
Capital/owner’s equity
Capital in a business provided by owners i.e. owners’ contribution to business. •
External sources of finance
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Debt: short-term borrowing (overdraft, commercial bills, factoring), long-term borrowing (mortgage, debentures, unsecured notes, leasing). Short-term: overdraft allows a business to take out more money than they
have from bank, commercial bills drawn on financial institution ($100,000+ 90-180 days to pay back), factoring selling accounts receivables to a third party (the factor) at reduced value. Long-term: mortgage loan secured to an asset (usually property),
debentures business borrowing directly from company for fixed interest rates, unsecured notes loan not secured against anything, higher risk for lender therefore higher interest rate, leasing business doesn’t have to buy asset outright, can use it through lease agreement. -
Equity: ordinary shares (new issues, rights issues, placements, share purchase plans), private equity
Equity sourced outside of existing shareholders.
Ordinary shares: represents equity ownership in business. Shareholders can
vote and receive share of profits in form of dividends. New share issue allows a business to raise finance by issuing new shares. Rights issues existing shareholders can purchase new shares at discount rat e, first in line to buy new shares. Placements made to special investors/institutions without rules and regulations places upon new share issues. Share purchase plan similar to placement but offered at discount to existing shareholders. Private equity: (venture capitalist) capital provided to high risk firms who
are just starting out. Generally gives investor equity stake in business and some input into management decisions. Utilised where debt finance is difficult to raise due to high risk. •
Financial institutions
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Banks, investment banks, finance and life insurance companies, superannuation funds, unit trusts, ASX Banks: major source of finance for businesses. Investment (merchant) banks: borrow and lend with a business focus. Finance and insurance companies: non-bank financial institutions and act primary as financial
intermediaries. Superannuation: provides a pool of money to be invested in business. Unit trusts: takes funds from large number of smaller investors which provides sources of short-medium term funds f or business. ASX: provides a mechanism for public companies to float and the opportunity to raise external equity from general public. This encourages business growth and overall economic activity. •
Influence of government
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ASIC, company taxation ASIC: federal authority which regulates corporations to facilitate compliance
with Commonwealth law. Company tax: flat rate of taxation based on net profit of business. Reduces profit of business able to be retained. Lower taxation overseas may result in Australian businesses relocating overseas. •
Global market influences
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Economic outlook, availability of funds, interest rates Economic outlook: projected changes to the level of economic growth
throughout the world. Availability of funds : easy with which a business can access funds to borrow on the international financial markets. Interest rates: cost of borrowing money. May be higher or lower overseas.
Processes of financial management •
Planning and implementing
Essential if a business is to achieve its goal, involves setting goals, determining strategies to achieve them and evaluating progress. -
Financial needs, budgets, record systems, financial risks, financial controls Financial needs: information must be collected before future plans can be
made. Budgets: provide information in quantitative terms about
requirements to achieve a particular purpose. Record systems: mechanisms used by businesses to record information accurately, reliable, efficient and accessible. Financial Risks: risk of business not being able to cover its financial obligations. Financial controls: policies and procedures that ensure that the plans of a business will be achieved in the most cost effective way. -
Debt and equity finance: advantages and disadvantages of each Debt: can be attractive as funds are readily available however they are a
liability which must be repaid, higher risk. Equity: lower risk, lower gearing and doesn’t need to be repaid unless owners leave business however lower profits and lower returns for the owner. -
Matching the terms and source of finance to business people
It is necessary to match the terms of finance with its purpose. This requires a business to consider: the terms, flexibility and availability of finance, the cost of each source of funding and the structure of the business. •
Monitoring and controlling
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Cash flow statement
Movement of cash receipts and payments from transactions over a period of time.
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Income statement (revenue statement or profit and loss)
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Balance sheet Snapshot of business at specific point in time.
A = L + OE
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Financial ratios
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Liquidity: current ratio (working capital ratio)
Represents ability of a business to meet short term debts Current assets : current liabilities Ideal = 2:1 -
Gearing: debt to equity
Represents long term viability of business Total liabilities / owner’s equity (usually a percentage) -
Profitability: gross profit ratio, net profit ratio, return on equity ratio
Satisfactory level of profitability depends upon industry averages, current interest rates, historical trends, economic conditions. GPR: gross profit / sales (percentage) NPR: net profit / sales (percentage) ROE: net profit / owner’s equity
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Efficiency: expense ratio, accounts receivable turnover ratio Expense ratio: total expenses : sales A/C receivable turnover: 365 X accounts receivables / sales
Shows on average how long it takes to collect accounts receivables (how quickly invoices are settled). More efficient = lower average -
Comparative ratio analysis: over different times, against standards, with similar businesses
To fully understand the profitability, solvency, efficiency and liquidity of a business, the respective ratios must be compared and analysed. Comparing ratios is undertaken against the same ratios usually over time periods, against other businesses within the industry of against common benchmarks such as industry averages. •
Limitations of financial reports
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Normalised earnings, capitalising expenses, valuing assets, timing issues, debt repayments, notes to the financial statements Normalised earnings: Earnings being adjusted for cyclical ups and downs in
the economy to remove unusual or one-time influences. Capitalising expenses: adding a capital expense to the balance sheet that is
regarded as an asset rather than an expense e.g. R&D, development expenditure. Valuing assets: assets are valued at historical cost. However this is not
market value. Accountants will depreciate assets over the life of that asset – giving a realistic view of worth and has tax advantages. Timing issues: Expenses and earnings may be recorded at different times to
that in which they occur in order to ‘massage’ the accounts to suit the needs of the business. Debt repayments: A business needs to make provisions for the repayments
of debts. This is relevant for short term and long term debts. Notes to the financial statements: Additional information at the end of
financial reports which provide details and a deeper understanding of
particular items and the accounting methods used to determine the reported figures. •
Ethical issues related to financial reports
Corporations Act enforced by ASIC provides framework for regulation of corporations. External auditing is designed to establish a true and fair view of company accounts. All relevant information must be fully disclosed to stakeholders. Misuse of funds and large payments/bonuses to directors have to be avoided as there has been criticism of very high salary packs of some CEO’s for example.
Financial management strategies •
Cash flow management
Strategies to improve cash flow -
Cash flow statements
Details of cash inflows and outflows can help businesses effectively plan to meet cash requirements as required. -
Distribution of payments, discounts for early payments, factoring Distribution of payments: evening out payments across a financial period by
paying accounts payable in instalments. Discounts for early payment: offering debtors discounts to pay accounts
early or on time. Alternatively a business may invoke a late payment fee. Factoring: receiving a percentage of money owed by selling accounts
receivables to an external factoring company (factor). •
Working capital management
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Control of current assets: cash, receivables, inventories Cash: use of a cash budget Receivables: credit policy prompt payment of receivables e.g. 30 days.
Discounts for early payment linked to credit policy, can be beneficial for relationships with customers. Factoring short term fix to obtain cash for receivables immediately. Inventories: inventory policy ensuring inventory levels meet needs. Too
much stock = higher chance of wastage, too little stock = delays for customers, JIT avoids issues with holding stock. -
Control of current liabilities: payables, loans, overdrafts Payables: managing short term debts of business. Businesses will try and
stretch the time they have to pay so it is like an interest free loan. Loans: managing short term liabilities through taking out loans. Overdrafts: Safety valve where businesses can meet short term obligations
by overdrawing their accounts. -
Strategies: leasing, sale and lease back Leasing: meeting need for capital equipment through leasing instead of
purchasing to minimise amount of resources paying for non-current assets.
Sale and lease back: sale of an owned asset to a lessor and leasing the asset
back through fixed payments for a specified time period. •
Profitability management
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Cost controls: fixed and variable, cost centres, expense minimisation Fixed and variable costs: fixed are costs not dependent upon sales output
(rent). Variables are costs which depend upon sales output (electricity) Economies of scale can be utilised to lower per unit cost. Cost centres: individual departments are responsible for their own costs and
aim to lower them as much as they can. Expense minimisation: measures to reduce expenses.
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Revenue controls
Trying to maximise revenue to increase gross profit. Marketing (sales) objectives: Setting high but realistic targets for sales and
determining strategies to meet this (e.g. analysis of marketing mix). •
Global financial management
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Exchange rates
Exchange rates are ratio of one currency to another. Determined through foreign exchange market (forex or fx). For exporter, weaker currency is better as goods will be more desirable to overseas importer. -
Interest rates
Cost of borrowing money. Lower rates overseas can result in businesses borrowing money from overseas however exchange rate fluctuations make this very risky. -
Methods of international payment: payment in advance, letter of credit, clean payment, bill of exchange Payment in advance: transfer of payment prior to goods being sent. Safest
method for business exporting however can decrease business relationships with overseas importer. Letter of credit: Guarantee backed by financial institution that the payment
will be honoured within a certain time up to a specified amount. Clean payment: All title documents held by parties involved therefore
simple and cost effective. Can be in advance or through an accounts system where payment is sent but not received before goods are sent. Bill of exchange : involves exporter’s bank handling documentation (transfer
of receipts and payment). International banking system offers an established mechanism for this process. -
Hedging
Risk management strategy aimed to minimise the impact of currency fluctuation on overseas transactions. A forward contract which fixes the rate of exchange for goods exported so the business can be sure of the value of payment. Variations at time of transfer won’t affect amount being paid. -
Derivatives
Simple financial instruments that may be used to lessen the risk of currency fluctuations when exporting. Typically are different types of contracts that are put together for international transactions.
