Topic 3 finance (teaching) PDF

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Topic 3 finance 1.1. Role of financial management 1.1.1. Strategic role of financial management 

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The role of finance involves managing financial resources of the business to achieve its strategic goals which involves the analysis, interpretation and evaluation of all financial records to the business. The long-term or strategic role financial management is to ensure that a new business continues to operate, grow/ expand and is able to achieve its goals and objectives. Financial managers will plan the financial aspects of a business for years in the futures, being effective and efficient to achieve their goals. Strategic plan encompasses the strategies that a business will use to achieve its longterm goals. Some of the strategic roles of financial management include: o Preparing budgets and forecasting future finances o Preparing financial statements o Maintaining sufficient cash flow.

1.1.2. Objectives of financial management  Profitability The ability of a business to maximise its profits. To ensure profit is maximized, business must carefully monitor its revenue and pricing policies, costs and expenses, inventory levels and levels of assets Measured using net profit from income statement. o Costs of goods sold = opening stock + closing stock o Revenue - costs of goods sold = gross profit o Gross profit - expenses = net profit Measuring profitability using income statement and balance sheet o Return on equity = net profit / total equity The withdrawal of profits from a business owner to use personally is known as drawings. This reduces the owners’ equity on the balance sheet because owners are reducing their investment by withdrawing capital. Long term profit is vital to business survival; growth & investors return on capital.

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 Growth The ability of Increasing in size and value of a business over time. o More outputs = sales = profit  Growth can be achieved by: o Increasing market share o Increasing sales and profits o Expanding its range of products o Opening more branches or offices in Australia or overseas o The takeover or purchase of a competitor  Businesses must monitor levels of growth & manage cash flow effectively to ensure it is sustainable.  Measuring growth using income sheet and secondary data: o Market share

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 Efficiency The ability of a business to minimise costs and manage its assets to achieve maximum profits. Involves increasing the amount of outputs with same number of inputs, or achieving the same amount of profit with a smaller amount of assets. Measuring efficiency using (in cost minimisation) using the income sheet: o Expense ratio = total expense / total sales o Notes: lower expense ratio = higher efficiency Measuring efficiency using the income sheet and balance sheet: o Can be seen in a business’s ability to collect accounts receivable. This is when businesses allow customers to have an account, which it will pay later. This is done through invoice or bill. o Accounts receivable turnover ratio = sales/ accounts receivable o Note: higher accounts ratio = higher efficiency

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 Liquidity The ability of a business to convert their assets into cash, referring to the ability for a business to pay short term debts using current assets o Debtors- (accounts receivable) are expected to pay their accounts within a short time (usually 30 days) so it is a relatively liquid asset. o Inventory- can sometimes take time to sell and convert to cash, making it less liquid o Non-current assets – less liquid because it takes time to negotiate and advertise the sale of non-current assets to convert them to cash Essential to maintain current assets (e.g. cash in bank, accounts receivable) greater than current liabilities (less than 12 months e.g. short term loan, bank overdraft) Must have sufficient cash flow to meet its financial obligations or be able to quickly concert an asset into cash in in order to pay a liability e.g. selling inventory. Liquidity ratio = current assets / current liability

 Solvency The extent to which the business can meet its financial commitments Indicates if the business has long term financial stability Gearing (or leverage) tells you how much debt finance the business has acquired to fund its operations compared to its use of equity finance. Borrowed (debt) finance may be used to purchase capital, which will be used to earn revenue through sales of output and hopefully more enough profit to repay the loans. o Higher gearing= greater financial burden the firms has to deal with = greater risk involved  Measures the financial stability of a company  important for investors o Debts to equity (gearing) ratio = total liability/ total equity

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 Short-term and long-term Short-term  Tactical and operational goals o E.g. maintenance of liquidity, upgrading equipment  Reviewed regularly to see if targets are being met and if resources are being used  Within the accounting period ( financial year from July 1 to June 30). E.g. short term loan will be repaid within the accounting period. Long-term  Strategic goals  broad goals e.g. increasing profit or market share o Often involves a series of short-term goals

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Business reviews progress annually to determine if changes need to be implemented Period of time greater than the accounting period (15 months or 10 years). E.g. a mortgage (secured) loan taken out to buy a factory will be repaid over 10-15 years.

Potential conflicts between short-term and long-term financial objectives  The overall long-term objective of financial management is to increase shareholder’s wealth which requires investment in physical and human resources; this minimizes the business’s ability to meet its short-term objectives because these investments often takes a long time to pay off.  E.g. a common financial long-term objective is growth. The decision to expand would have the support of managers, employees, suppliers and the local community. However, expansion is often associated with increased costs and gearing, which will lead to lower overall profits in the short term.

1.1.3. Interdependence with other key business functions

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Operations Finance is required for inputs, machinery, land etc. to create value whilst receiving a return on investments Operations manages stock & outsourcing whilst finance monitors the cost of it

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Marketing Generates sales which assists with the short-term financial goal of managing cash flow Finance establishes budgets and forecasts marketing must follow

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Human Resources Finance provides funds for wages/salaries & HR strategies such as training/development

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Influences on financial management

1.2.1. Internal sources of finance- retained profits Internal funds are obtained from within the business: (i) Owner’s equity Funds contributed by owners/partners to establish and build the business, can be raised in other ways such as taking on another partner, issuing private shares or selling unproductive assets. (ii)

Retained profits = PART OF OWNERS EQUITY

Retained profits are money that has been earned by the business and not distributed to shareholders in dividends. Retained profits are added to equity because it increases the owner’s claim on the assets of a business.

1.2.2. External sources of finance External sources of finance come from outside of the business. Typically, this is money that people with a surplus of cash want to invest so that they will get a return from it. The owners of surplus finance may decide to lend the finance as debt or become owners in the business through equity finance.

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Any money that is loan - with short or long term maturity Often incur some form of interest- set and predictable Shareholders do not lose ownership/ control of business If business is liquidated, the follow investors are payed first; o Holders of preferred stock (do not have voting rights) o Debenture holders o Ordinary shareholders o Unsecured notes Managers prefer to raise the money needed to grow or expand the business from debt rather than equity. This is due to: 1. Interest paid on the borrowed money is usually lower than the profits that result from the expanded business operations. 2. Interest paid on the borrowed money is tax deductible because it is an expense.

Short-term borrowing (overdraft, commercial bills, factoring) Short term-debt would be repayable within 12 months.

Bank overdraft Flexibility to borrow money from a bank at short notice through cheque account  Allows business to overdraw their account up to an agreed limit  Assists businesses with short-term liquidity problems- by providing working capital  Can have very high costs- interest (variable) is paid on the daily outstanding balance of the account.  However, interest rates on bank overdrafts are tax deductible in Australia.  Alternative: using business credit card- offer lower fixed interested rates. Commercial bills Borrowers receives an amount from another business with surplus funds  Promising to pay principal + interest back between 30-180 days  Can be rolled over for extended time period- reassessed each time it matures.  Bank does not provide the funds; it is borrowed from non-bank institutions. However, the bank guarantees its customer will repay the borrowed money. Factoring Business sells its accounts receivable (money owed by debtors) to an external business  Business receives up to 90% of amount of receivables within 48hrs of submitting its invoices to the factoring company which will take over management & collection of the unpaid accounts under terms agreed with the business.  Method of improving liquidity at the expense of some of the businesses working capital in the

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short term. Cash sale of a business's accounts receivable at a discount to a factoring company Factoring company will pay business the value of the accounts receivable minus a commission or fee according to credit risk. Analysed by credit sales and credit rating of accounts.

long-term borrowing (mortgage, debentures, unsecured notes, leasing) Loans with a term of repayment longer than 12 months. Can be secured or unsecured. Used to finance real estate, plant (factory/office) and equipment. Mortgage - Loan secured by the asset (being purchased) of the business - Business repays through regular repayment (often monthly) over agreed period (e.g. 15 yrs) o Includes interest rate charged on top - Interest only loan: only the interest is paid and then once a business resells the asset, which they keeping the excess capital gains.

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Debentures When a large business seeks to obtain finance by issuing debentures Large firms are invited to invest by lending finance o Become debenture holders A trustee is appointed to monitor the debenture- issuing business o Ensure it remains profitable and can therefore repay loans + interest Debenture holder’s loans are collateralised and given preference in the case of liquidation Used by large established companies to buy buildings, equipment. Debentures are very expensive to establish and are typically used by finance companies to borrow money and lend it at a higher interest rate. Unsecured notes Essentially corporate bonds that are uncollateralised. Issued by finance companies to gain funds Loan for a set period of time that is not secured by any assets Used to finance short term liquidity short falls Incur higher rate of interest- since there is greater risks for investor o Requires strong reputation and good credit ratings Leasing Payment of money for the use of (non-current) assets e.g. company car, delivery vehicles, equipment, office or factory space owned by another business. At the end of period, business can buy leased item at the agreed ‘residual value’. Operating lease: shorter than the life of the asset- owner carries out maintenance etc. Finance lease: lessor purchases the asset on behalf of the lessee. Repayments are fitted for the economic life of asset (e.g. 3-5 years for a TV) Often incur higher interest rates Incur penalties for cessation of lease. Payment includes insurance, maintenance etc. The advantages of leasing are: o No upfront payment conserves valuable cash o Payments can be flexible o Easier to update technology as payments are linked to the life of the asset

o Tax deductable

Equity finance Equity refers to the finance raised by a company by issuing shares to the public. Equity as a source of external finance includes private equity & ordinary shares (new issues, rights issues, placements, share purchase plans). ADVANTAGE- do not need to pay shareholders if the business does not earn a profit, whereas with debt finance you have to pay interest although it is quicker.   

Increase number of owners = less control over business = dilution of returns to owners No obligation to repay an initial capital investment More difficult to secure: prospectus must be filled, approved by ASX and ASIC

ordinary shares (new issues, right issues, placements, share purchase plans) Ordinary Shares Buying part ownership of a publicly listed company. Shareholder may be entitled to vote on issues raised at general meetings & receive dividends. 

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New issues: o First issue is known as primary market o Prospectus is issued through a stockbroker: this provides a potential investor in the business with all the information they need to make a reasoned decision. It outlines the business idea, the strategies to achieve the business goals and the financial projections o Shares are made available on the securities exchange o Underwriter such as an investment bank is enlisted o Shareholders pay for each share they purchase o Payments go straight to the business o Shareholders receive a dividend (proportion of company’s profits) o Secondary market: shares are sold by previous owner Rights issues: o Additional shares are offered to the existing shareholders of a company. o The number of shares an owner can buy is proportional to the number they own o Shares will be at a discounted rate yet shareholders are not obligated to buy  However, if they do not, their rights will be diluted. Placements: o Offering specific shares to specific institutions/investors o Does not requires formal prospectus or general shareholder approval o Can raise up to 15% of current capital base o Funds can raised quickly, and without minimal publicity o Great for businesses seeking to expand or seek funding to perform a takeover. Share purchase plan: o Allow existing companies to issue new shares (max $5000) to existing shareholders o Similar to a rights issue, yet whoever wants shares puts their hand to buy o Thus, ownership is almost always diluted o Does not require a prospectus, however does require permission from ASIC

1.2.3. Financial institutions- banks, investment banks, finance companies, superannuation funds, life insurance companies, unit trusts and the Australian Securities Exchange 

Bank: Receive savings as deposits from individuals and then make investments and loans to borrower o Supervised by the RBA o Since 08-09 GFC, banks have adopted more cautious lending policies  Provide a range of financial products for clients: e.g. online banking, credit facilities, legal/ tax advice. Investment banks: o Serve large institutional clients/governments seeking to raise substantial amounts of capitals  Underwriter: 3rd party which provides a business with the assurance that it will buy excess shares which aren’t sold in the IPO  Investment banks:  Trade in money, securities and financial futures  Provide working capital  Offer advice for merging, takeovers and other financial decisions  Offer to underwrite shares for businesses in their IPO, often asking for equity in return Finance companies: o Raise capital through debenture (company bond) issue and are major providers of loans, lease finance & factoring. They typically have higher interest rates than banks but have a less strict criteria.  The largest finance company in Australia is GE Capital Australia (GECFA), and provides the interest free finance offered by businesses such as Harvey Norman. GE borrows money from small investors by selling debentures (loans to the general public secured by the assets of GE) and uses this money to provide consumer credit and small business loans Superannuation funds: o Have large amounts of capital that needs to be invested to generate returns for the investors  Used to invest in long-term security (company shares, Gov./company debt etc.)  Superannuation heavily influences financial management through liquidity, efficiency and solvency  Provide an investment that people can use as a source of income once they stop working and reduce the need for aged pension Life insurance companies: o Life insurance is a contract between the policy owner and the insuring company, where the insuring company promises to pay a nominated beneficiary a sum of money when the insured person dies. Annual premiums are paid and create a reservoir of money for the company to invest. In return, the policyowner has peace of mind o Gain large amounts of funds from policy & premiums payments, which they then use to invest and provide loans to other businesses. Unit trust: o Individuals trust a trustee with their funds 

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Types of unit trusts: property trust, equity trust, mortgage trusts, fixed-interest trusts o Trustee places funds into various investments in hope to generate the highest yield for investors. o A unit trust is a way individual investors can pool their resources so the total investment can purchase growth assets that the individual could not. The Australian Security Exchange (ASX): o As a primary market, enabling business to raise new capital through the issue of shares o As a secondary market, transaction of existing shares between individuals o Initial public offering (IPO): process a business must initially undergo to list on the ASX  Must be of reasonable size, and have been successful in operations for a reasonable time  Must be issue a prospectus  Gives potential investors a detail depiction of the business and its finances  Comprehensive outline of key functions, past finances and predicted performance  Investors can then apply for a share allocation  Investment bank is usually hired as a underwriter  According to supplier and demand, the stock may become oversubscribed, or undersubscribed.  Funds received are then used by the business to expand or invest  Shares may then be re-traded on the secondary market by shareholders

1.2.4. Influence of government- Australian Securities and Investments Commission, company Taxation 

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Monetary policy: the RBA uses the cash rate to influence the interest rate of banks o This in turn will influence economic activity o Increase interest rate = higher costs of debt finance = less borrowing =less spending Fiscal policy: the government uses fiscal policy to influence the economy by adjusting revenue and spending levels. Can be expansional or contractionary

Australian securities and investments commission (ASIC)    

Regulates corporations, markets and the provision of financial services – corporation Act 2001 Protects consumers, investors & creditors by ensuring companies adhere to law and conduct fair transactions Aims to assist in reducing fraud and unfair practices in financial market Primary legal instrument that oversees business operations and financial reporting, ensuring that company directors and financial service providers carry out duties honestly.

Company taxation Australian business pay 30% (flat rat...