Business_-_Financial_Planning

HSC Topic 2- Financial Planning and Management • The Role of Financial Planning ≥ Financial Management refers to how businesses raise, use and monitor funds. It involves the process of Planning, Monitoring and Controlling the business’s financial position and performance. ≥ Effective financial management will allow a business to maximise profits. • Strategic Role of Financial Management ≥ To give the business long-term, big picture goals to aim for, as wells as the specific objectives needed to reach these goals. • Objectives of Financial Management (GELPROC) ≥ Liquidity ✓ Liquidity is the ease with which an asset can be concerted into cash ✓ Liquidity measures the ability of a business to repay its debts as they fall due. ✓ It is a short term indicator of the financial stability of a business. ✓ Assets that can be transformed into cash within a year are called “current” assets ✓ Current Assets include inventory (stock), accounts receivable (debtors) and cash. ✓ The stability of the external environment may influence a business’s liquidity( An uncertain external environment will force management to increase its liquidity by maintaining large excess cash reserves or increasing its proportion of current assets, in case large demands are placed on the business. ≥ Profitability ✓ Profitability is an objective of financial management concerned with the earning performance of the business. It can be measured as a proportion of sales or owner’s equity. ✓ Revenues are the returns generated by the ownership and use of assets ✓ Profit = Revenue (money in) – Expenses (money out) ✓ Profits created by a business will be used to reimburse the owners of the business and/or to create further opportunities for the business to grow. ✓ The objectives of profitability and liquidity often come into conflict (the more liquid an asset, the lower the revenue s it can generate. ✓ A business must hold a range of assets. ≥ Efficiency ✓ Efficiency is the ability of a business to maximise its output from its level of inputs or vice versa. ✓ Productivity is the output generated by each input into the production process, including capital and labour. ✓ Funds should be allocated to investments or operations of the business that generate maximum returns. ✓ Budgets can play a crucial role in the planning and maintenance of cost-efficient strategies. They allow for analyses of revenues and expenses, highlighting possible growth areas for revenues and other loss areas of the business that should be discarded. ≥ Growth ✓ Growth occurs when a business achieves a positive increase in the size of its operations. ✓ It can be in the form of increases in earnings, market share or number of products. ✓ A business can achieve growth in key ways: • Internal Growth (organic/natural growth)(occurs when a business uses retained profits to invest in projects that still only involve the business in question. E.g. introducing a new product or expanding into new markets. • External Growth (acquisitive growth)( occurs when a business becomes involved with another business, and the two form one organisation ✓ A merger occurs when 2 businesses agree to combine their assets. ✓ A take-over occurs when one business obtains a controlling interest in another business’s shares. ✓ A diversification occurs when a business merges with, or takes over, a business in an unrelated industry. ✓ External growth techniques may be strategic moves that result in large cost savings. When 2 businesses combine, the costs savings associated with the combined entity are known as “synergy”. ✓ Methods of external Growth: • Horizontal Integration- which occurs when 2 businesses offering similar products, combine. • Vertical Integration- which occurs when 2 businesses, at a different levels in the production or distribution chain, combine. ≥ Return on Capital ✓ Return on Capital is an objective of financial management concerned with the financial return on an investment expressed as a percentage of the amount invested in the business. Returns on capital are paid as dividends, interest or other income. ✓ Return on capital is not a discrete(separate) business objective. In order for a business to make strong returns on capital, it must operate efficiently and be profitable. By generating a profit, the business is creating a return on capital. • The Planning Cycle ✓ the financial planning cycle is the continual process that all businesses must go through to manage their finances efficiently and achieve their financial goals. ≥ Addressing Present Financial Position ✓ 1st stage of cycle(it involves an evaluation of the business’s current financial position and it helps highlight possible risks that the business is carrying. The idea here is to minimise financial risks and the possibility of losses. ✓ Financial information must be collected before future plans can be made. This includes balances sheets, revenue sheets, cash flow statements, sales and price forecasts, budgets, bank statements, weekly reports from departments, break-even analysis, reports from financial ratio analysis and interpretation. ≥ Determining Financial Elements of the Business Plan ✓ It is important that planning occurs and a business plan is drawn up. This ensures that the organization knows what it aims to achieve, the processes it will use to achieve its aims and the benchmarks that show that it has been successful. A business plan sets out finance required, proposed sources of finance and a range of financial statements. ✓ Financial information is needed to show that the organization can generate an acceptable return for the investment being sought and should, therefore, include an analysis of financial performance, revenue statements, cash flow statements, balance sheet and financial ratio analysis reports. Budgets and cost-volume-profit reports will also be included as part of the analysis of the risk. ≥ Developing Budgets Budgets provide information in quantitative terms ( facts and figures) about requirements to achieve a particular purpose. Budgets signal where things are not going to plan so that adjustments can be made, and show where achievement towards objectives has occurred. Budgets are important in the planning process, and various factors needs to be considered in preparing it, such as: - review of past figures and trends - potential market or market share, seasonal fluctuation in the market - proposed expansion or discontinuation of projects - proposals to alter price or quality of products - current orders and plant capacity ✓ There are three types of budgets, that relate to short-term and long-term plans and activities. ▪ Operating budgets relate to the main activities of an organization and may include budgets relating to sales, production, raw materials, direct labour, expenses and cost of goods sold. Information from operating budgets is used in preparing budgeted financial statements. ▪ Project budgets relate to capital expenditure and research and development. Capital expenditure budgets in an organisation’s strategic plan include information about the purpose of the asset purchase, life span of the asset and the revenue that would be generated from the purchase. Information from project budgets is included in budgeted financial statements. ▪ Financial budgets relate to the financial data of an organization. The predictions of the operating and project budgets are included in the budgeted financial statements. Financial budgets include the budgeted revenue statement, balance sheet and cash flows. The revenue statement and balance sheet reflect the results of operating activities and the cash flow statement shows the liquidity of an organization. ≥ Cash Flows ➢ Cash is important in the planning cycle, and can show whether the business has a surplus or a shortage of cash. Cash flow budgets can be prepared for varying periods of time, but it is usual to prepare over short periods of one to three months. Most organization operate on a cash and credit basis, which means receipts do not occur until after payment, meaning planning for anticipated cash flows is important. ≥ Financial Reports ➢ Financial reports show what the organization plans to achieve by the end of the period. Data from the operating and project budgets are used to prepare projected financial reports. The results or financial outcomes of an organisation’s planning are reflected in a budgeted revenue statement, budgeted balance sheet and budgeted cash flows. A cash budget can predict the organisation’s liquidity situation over a period. Cash shortfalls or cash surpluses enable decisions to be made about financing activities in the short term. ≥ Interpretation ➢ Budgets provide invaluable information in the planning process to achieve financial objectives and reflect the assumptions that an organization makes about the future. It will evaluate plans and to make changes if predicted results do not satisfactorily reflect the goals of the organization. It must be remembered that the budgeted financial reports are estimates only and that the reality may be different to the plans. ≥ Maintaining Record Systems ➢ Record systems are the mechanisms employed by an organization to ensure that data are recorded and the information provided by record systems is accurate, reliable and efficient, accessible. The double entry system is an important control aspect, as it can quickly find errors and correct it. ≥ Planning Financial Controls ➢ Financial controls are the policies and procedures that ensure that the plans of an organization will be achieved in the most efficient way. Some policies and procedures that promote control within an organization are: • clear authorisation and responsibility for tasks in the organization • separation of duties; one person write checks, one person signs,… • rotation of duties; staff are skilled in more than one area • control of cash; cash banked daily • protection of assets; building locked up, security surveillance • control of credit procedures; overdue accounts follow up ≥ Minimising Financial Risks and Losses ➢ Financial risk is the risk to a business of being unable to cover its financial obligations. To minimise, organization must consider the amount of profit that will be generated. The profit must be sufficient to cover most of debt as well as increasing profits to justify the amount of risk taken by owners and shareholders. If the debt is short term, it must have liquid assets so debt can be paid including interest payments and repayment of principal on loans. • Financial Markets Relevant to Business Financial Needs ✓ Financial markets are places where people and institutions with surplus funds can make transactions directly with the businesses as they provide investments. ✓ Financial markets are important for businesses as they provide: ▪ Access to funds ▪ Investment opportunities and contacts in managing funds ▪ Expertise in financial market dealings ✓ Primary Markets: where securities such as shares, stocks and bonds are sold for the first time. It allows a business to raise funds through the creation and release of debt or equity to individuals and the general public. ✓ Secondary Markets: where shares, stocks and bonds are resold. ✓ There are 4 main financial markets in Australia |Share/Equity Market |Where ownership shares in companies are issued and exchanged. | |The Debt Market |Split into the fixed-interest (bond) market and the short-term money market. Fixed interest | | |securities give the holder an entitlement to a regular stream of interest payments on a sum of| | |money, as well as the value of the security itself. The short-term money market is where cash | | |is lent or borrowed for periods of up to a year. | |The Derivatives Market |People buy and sell securities that are based on other securities. E.g. options and futures | |The Foreign Exchange Market |Where financial assets defined in one currency are exchanged for assets defined in another | | |country’s currency. | • Major Participants in Financial Markets ≥ Banks ▪ Banks facilitate the movement of excess funds in the economy to those who require funds, through all manner of debt instruments. ▪ Banks also facilitate the use and movement of funds for simple purchase transactions through cheque accounts and electronic systems such as EFTPOS. ▪ The Big Four: ✓ Australia and New Zealand Bank (ANZ) ✓ Commonwealth Bank of Australia (CBA) ✓ National Australia Bank (NAB) ✓ Westpac Banking Corporation (Westpac) ▪ Deregulation has allowed banks to offer a range of financial services at market rates. ▪ The big four accounts for about two thirds of all banking assets in Australia(huge influence on availability of funds. ≥ Financial and Insurance Companies ▪ Finance companies are intermediaries and are often categorised as non-depository institutions because they make loans without taking in deposits. ▪ Finance companies acquire funds to make loans by issuing short-term promissory notes, debt securities and asset backed securities(then reloan at higher price. ▪ This kind of loan is usually short-to-medium-term ▪ Insurance companies guarantee the assets of their policy holders in return for a fee. ▪ Insurance companies are required by law to hold the assets of policy holders in special trusts. The funds in these trusts are then invested in a range of financial assets such as shares, property and debt. ≥ Merchant Banks ▪ Merchant/Investment banks deal directly with large businesses and are not accessible to small businesses and private borrowers. ▪ Merchant banks will not only act as an intermediary between the business and the market, but they will often also provide an “underwriting” service where they guarantee the value of the required funds for the business should the market fail to purchase all the securities on offer. ▪ Merchant banks also provide research services for large businesses and provide an advisory service on mergers and take-overs. ≥ Superannuation/Mutual Funds ▪ Every Australian employee earning over $450 per month from their employer must have an amount equal to 9% of their income paid as superannuation savings. ▪ Compulsory superannuation has been largely responsible for the strong growth of managed funds in Australia. ▪ Investors’ funds will be used to generate returns by: ✓ Purchasing property ✓ Buying shares in domestic and overseas companies ✓ Investing in other lucrative assets ▪ Most employees are not able to access their super funds until they reach the age of 60. ▪ Fund managers attempt to “balance” a portfolio (a group) of financial assets to produce a return for the fund. ▪ Mutual funds are forms of collective investments that pool money from many investors and invest the money in stocks, bonds etc. They operate the same way as superannuation funds, only they can be withdrawn at any time. ≥ Companies ▪ Companies will require funds at particular times throughout the year. They can acquire these funds in financial markets by issuing equity or debt securities or simple borrowing. ▪ A company’s excess funds will be invested through financial markets in short-term interest-bearing securities such as bank bills. ▪ Companies that trade overseas can also use financial markets for foreign exchange purposes. ≥ Government (Reserve Bank of Australia) ▪ Prior to deregulation of financial industry, the RBA was the major regulator of the financial system. ▪ Financial deregulation gave regulatory powers to a number of different bodies. ▪ There are 3 major financial regulators of the system: ✓ The Reserve Bank (RBA)(responsibility for monetary policy, payments system regulation and the stability of the financial system. ✓ The Australian Prudential Regulation Authority (APRA)(responsible for the supervision and regulation of all deposit-taking institutions, insurance companies and superannuation funds. ✓ The Australian Securities and Investments Commission (ASIC)(with responsibility for corporate regulation, consumer protection and oversight of financial service products. ▪ RBA also acts as an ordinary participant in financial markets, buying and selling Australian dollars to help fulfil its objectives. • Role of the Australian Stock Exchange as a Primary Market The significance of the Australian stock exchange within the overall financial system has grown, due to the increasing involvement of the Australian public in purchasing shares in businesses that previously had been in government or private hands. When shares are sold or floated for the first time, the stock exchange is fulfilling its role as a primary market. The role of ASX as a primary market is a particularly important source of external funds for businesses wishing to acquire more capital to expand. • Overseas and Domestic market Influences and Trends in financial Markets and their implications for business financial needs. 1. Deregulation of financial industry in mid 1980s: Removal of numerous rules governing the operation of Australia’s financial institutions, and overseas companies were allowed to list in Australia. The ease with which business could obtain finance became greater, and helped increase competition for businesses. Deregulation also heightened the efficiency of the financial system by advancing competition and allowing market forces to have a greater say as to how the market operated. This increased the ability of Australian to own shares. Turnover rate: - Australian financial markets:$170 billion a day in 2000-01, increase in 11% - Greatest proportion of turnover in 2000-01 came from FOREX market: $105 billion per day in April 2001 2. Introduction of compulsory superannuation in 1980s: Australians able to gain an indirect shareholding through investments in superannuation funds. It saw growth of managed funds, forced savings. Compulsory rate of superannuation rose in July 2002 from 8.5%-9%. Managed superannuation funds will continue to grow and become an increasingly powerful source of funds for investment in the economy. This has substantially increased costs for businesses. 3. Privatisation: Sale of government-owned businesses to the public. During 1990s, privatisation of Commonwealth Bank, Qantas and parts of Telstra has enormous impact on Australian financial markets. ASX estimates almost 500,000 out of 600,000 members entered the share market for the first time via the demutualisation. By end of 1990s, over half of the adult population were holding shares. The average value of all shares on the ASX grew from less than $200 billion in 1991 to almost $700 billion in 2001. 4. The growth of technology: facilitates the ease and efficiency with which financial transactions can take place. Australian financial system primarily operates on a “bid-offer” system using computer systems to bring distant markets together. Dealers now trade electronically across computer systems that reduce the need for physical meetings. - Electronic trade now represents 50% of stockbroker trade, up from 30% in 1998. - Online equity brokers now account for about 15-20% of volume of trades on ASX. - Technological advances mean increased productivity levels, lower business costs and opening up of previously inaccessible markets. 5. Globalisation: created a 24/7 market for financial assets. Financial assets in USA can now be brought and sold in AUS. In 2000, ASX talked about possibility of creating a global equity market by linking existing systems. Growth of internet trading + merging of international financial markets means that Australia’s financial system is ever more influenced by international markets. • Management of Funds • Sources of Funds Internal( from within the business ≥ Owner’s Equity Owner’s equity is money contributed by people in exchange for ownership rights or “equity share” in the business, making them part owners. If a business decides to be listed on the stock exchange and become a public company, it will be raising new funds in exchange for equity in the business (a.k.a as in Initial Public Offering [IPO] or float) ≥ Retained Profits Retained profits are accumulated profits of a company that have not been distributed to shareholders as dividends. Retained profits are usually reinvested into the business. External( from people or institutions other than the owners (debt financing) Short term borrowing (less than 12 months) ≥ Overdraft Overdrafts are agreements between a business and a bank, where the business is allowed to withdraw more money than is actually available in the business’s cheque account. Overdrafts incur interest that must be paid on a regular basis but there is no time frame on when it must be repaid. ≥ Bank bills A bank bill is where a business writes a bill to a bank, agreeing to repay the amount borrowed after a particular length of time. If the bank is satisfied the business will be able to repay the bill amount when the expiration date arrives, it will accept the bill for a fee. These bills can be traded on secondary markets. Long-term Borrowing (repaid overtime in regular instalments; over 12 months) ≥ Mortgage Mortgages are long-term loans, where the security for the loan is a piece of property. If the mortgagee is unable to meet its interest and principle payments each month, the mortgagor has the right to take ownership of the property and sell it to regain any money owed. Mortgages have lower interest rates than short-term debt instruments. ≥ Debentures Debentures are repayment guarantees, issued in return for a loan. The debenture, written by the business borrowing the money, guarantees the repayment of the funds at a particular date, as well as regular interest payments on the amount borrowed. Security on the debenture is provided by the business when issued, and can be fixed (on an asset) or floating. It is possible for the debenture to be renewed at maturity. Debentures are costly to issue, as the business must issue a legal prospectus giving financial information on the business to investors. The legal and administrative costs associated make them unattractive to small businesses. Other sources of Funds: ≥ Leasing Leasing is a long term sources of borrowing in that it allows a business to use certain long term assets. It involves the payment of money for the use of equipment that is owned by another party. It enables a business to borrow funds and use the equipment without the large capital outlay required. A lessor is someone who buys an item, or someone who owns the item, whist a lessee is someone who leases the item for a cost. There are two types of leases: |Operating Lease |Finance Lease | |Lease term is shorter than life of the asset |Least term is shorter than life of the asset | |Lessor is responsible for maintenance |At the end of the lease, the lessee has the option to purchase| | |the asset at a reduced price | |Lease payments are tax deductible |Lessee is responsible for maintenance costs | |Lessee can “update” assets more easily by cancelling current |Expensive to cancel | |leases for little cost and leasing new equipment | | ≥ Factoring Factoring is a short term source of borrowing which enables a business to raise funds immediately by selling accounts receivables to a third party, with the expense of a fee. A factoring company may offer its services with or without recourse. “With recourse” means that bad debts will still be the responsibility of the business. “Without recourse” means that the business transfers responsibility for non-collection to the factoring company. One advantage of factoring to a small business is that payments are received immediately, eliminating a major source of cash flow problems. One disadvantage is that the factoring company withholds a commission, sometimes up to 20%. ≥ Venture Capital Venture capital is money provided by firms or individuals for investment in young, rapidly-growing companies that exhibit the potential to develop into significant business competitors. Venture capital companies will most commonly purchase equity in these businesses and their investment is usually considered to be long-term. Venture capitalists invest in business that are considered high risk because of their short history and because they are often in high-risk industries, e.g. mining start ups. Venture capital is a form of equity funding, as the venture capital company takes shares in the business. ≥ Grants Grants are funding packages provided to businesses from governments or other funding institutions where the business is not required to repay the grant funds. It is usually given to further the creation of a product that is seen as being in the interest of the nation as a whole. There are a range of grants: e.g. cultural art grants; research and development grants...etc. • Financial Considerations 1. How long are the funds required for' ≥ Repayment time frame for sourced funds should be similar to the length of time the funds are required for (short term debt). 2. Are we confident we can meet all our debt repayments' ≥ Any debt is exposed to credit risk (unable to meet their debt repayments(defaulting) ≥ Business must be confident that it will be able to meet the debt repayments associated with this debt. 3. How easy will it be for us to obtain finance with our history' ≥ Newly established business will often need to seek private funding ≥ A business must have an existing financial position and credible financial statements before it is allowed to list on the ASX and gain public funding. 4. Where is the economy going' ≥ Economic conditions may affect interest payments on existing debt. The RBA uses interest rates to affect the level of demand and growth in the economy. ≥ If RBA raises the level of interest rates to limit spending and growth, businesses with existing debt will incur additional demands on their cash reserves due to higher debt repayments. ≥ Economic conditions may also affect the income of the business, its cash flows and ability to meet debt repayments as some industries and businesses are easily affected by movements in levels of growth and confidence in the economy. 5. What could we do if we did get into trouble' ≥ A strong asset base will affect how easily a business will be able to obtain finance, using these assets as security. 6. What tax benefits could we gain' ≥ Different forms of financing have different tax policies associated with them. The tax benefits associated with one form of funding may alter its value to the business, making it more or less attractive. (e.g. leasing is tax deductible) • Comparison of Debt and Equity Financing ≥ Gearing Gearing is a measure of a business’s debt relative to its assets or equity. When a business is highly geared (a.k.a Leveraged), it has a high level of debt relative to equity. The level of gearing can determine how stable a business is in different economic conditions. A high level of gearing will expose the business to increased risk in an environment of uncertainty over interest rates and general economic conditions. (Investors downgrade their confidence in highly geared businesses in times of downturn.) |Equity Finance |Debt Finance | |- funds provided by owners of a business (shares if company is|-funds borrowed from outside the business which must be repaid| |public) |(including interest) | |-includes owners equity, shares, retained earnings |-includes bank overdrafts, bank loans, mortgages etc. | |-funds do not have to be repaid for |-funds MUST be repaid, including interest | |- rate of return on investments paid to equity holders is |- rate of return is higher because they are awarded by the | |lower than for debt holders |increase in the value of their share ownership. | |-lower risk |-higher risk of being liquidated | |-better in weak external conditions |-better in strong external conditions | |-take longer time to arrange, limited |-easier to arrange, can organise on short notice | |-management needs to share decision-making due to shareholders|-management is able to make decisions with more freedom | |(power decreases) | | |-adds additional costs to a business. Floating a company costs|- does not add additional cost, except for interest payments. | |a business large amount of money for legal and administrative | | |fees. | | |-become a public company causes a business to adhere to |-some debt holders may only issue debt that places | |specific disclosure requirements, which may place them at a |restrictions on a business’s actions. This puts a strain on | |competitive disadvantage to non-listed competitors. |the business’s operations and decision making. | |-not exposed to risk of sudden interest rate rises |-exposed to risk of sudden interest rate rises | | |Acquiring additional debt may send a negative message to the | | |business’s owners and thus cause a downward trend in the value| | |of equity. | • Using Financial Information • The Accounting Framework The accounting framework is the set of rules and assumptions that govern the process of recording and transforming raw data into reports that satisfy the needs of all stakeholders. The accounting framework is designed with three questions in mind: 1. What information is required' Accountants analyse the financial information created by the daily operations of a business, e.g. tax invoices, mortgage payments, lease payments…etc. The information is written up or electronically recorded into financial accounts. Financial information comprises transactions generated by a business and other events. “Other events” will only involve people and items currently involved with the business, such as when a business devalues and asset or discards bad debts. 2. Who is the information for' Internal stakeholders require in-depth reports, detailing trends in daily operations as wells as reports showing the business’s overall financial position. External stakeholders require more general information on businesses. 3. How should the information be presented' Information can be presented as General Purpose Financial Reports (GPFRs), comprising the Balance Sheet, the Revenue Statement, and the Statement of Cash Flows. Financial Statements: ≥ Revenue Statement The revenue statement summarises the flows of revenues and expenses in and out of a business over a period of time, calculating the business’s profit. PROFIT = REVENUE – EXPENSES GROSS PROFIT = TOTAL REVENUE – COGS COGS = OPENING STOCK + PURCHASES – CLOSING STOCK NET PROFIT = GROSS PROFIT – EXPENSES ≥ Balance Sheet The balance sheet gives information about an entity’s financial position at a particular point in time. It is a snapshot of the business’s financial structure and stability at the moment. It is based on the accounting equation, which is given by A = L+OE The Accounting Equation and Relationships The accounting equation describes the relationship between a business’s assets and liabilities. The accounting equation states that a company’s assets equal the sum of its liabilities and owner’s equity. ASSETS = LIABILITIES + OWNER’S EQUITY The balance sheet is based on the accounting equation. • Types of Financial Ratios ≥ Liquidity Liquidity ratios measure the ability of a business to meet its short-term financial commitments (debts) when they fall due. CURRENT RATIO: [pic] A ratio of less than one means that the business has insufficient current assets to meet current liabilities. Alternatively, a current ratio that is relatively high suggest that the business has invested too heavily in short term assets and could be ignoring long term projects or opportunities. A ratio of 2:1 or higher is preferred. ≥ Solvency (gearing debt to equity) Solvency refers to the ability to meet long-term debts. They analyse a business’s level of gearing. DEBT TO EQUITY RATIO: Being highly geared means that shareholders benefit in good times, but in weak economic conditions, being highly geared can be dangerous. ≥ Profitability Profitability ratios give a perspective to the level of profit generated by a business, by comparing profits with figures such as sales and owner’s equity. GROSS PROFIT RATIO: ≥ Efficiency Efficiency ratios look at how well the business is managing its operations to generate returns. A business may generate high sales revenue but it doesn’t necessarily be achieving high revenues at the lowest cost possible. EXPENSE RATIO: It shoes us the expenses of a business as a PROPORTION of total sales. ACCOUNTS RECEIVABLE TURNOVER RATIO: There are 2 ways of doing this: OR • Comparative Ratio Analysis ≥ Overtime Historical analysis or trend analysis is the comparison of financial ratios over time. Comparing current and past ratios allows us to analyse two features: a. How well current performance rates, given the financial history of the business. (comparing past performances to current performance) b. Possible future trends in the ratios and financial performance of the business. (predicting what the future financial performance of a business might look like.) Problems: Firstly, if there is a change in external environment (e.g. shift in accounting policy), and secondly, factors affecting past years, such as business structure, may have changed significantly in recent years. ≥ With similar businesses - The comparison business must be in a similar industry and life cycle phase, as economic conditions may affect businesses in different ways. - Accounting methods are rarely identical across large businesses. The differences in accounting policies must be accounted for when comparing ratios across businesses. ≥ Against common standards o It is more desirable to compare a business’s performance against some common standard or benchmark. o Frequently used common standard is the industry average for particular ratio. o Useful to help direct management’s attention to potential operating or financial problems o However, financial performance of a business is affected by so many factors that to ignore the entire factors specific to each business would be a grave error. • Limitations of Financial Reports ≥ Historical costs Historical cost means that the assets of a business are recorded at their original or purchase cost. This prevents over-inflating the value of some assets, but it in an issue when preparing financial reports because the true value of the company cannot be calculated (appreciating and depreciating of value). Thus, a modified historical cost method is currently employed in Australia. ≥ Value of intangibles Intangible assets are rights rather than objects and include such assets as copyrights and goodwill. They are particularly difficult to value as they are often unique, making it hard to identify their replacement value. • Effective Working Capital(Liquidity) Management Working Capital refers to the short term assets of a business not currently committed to people outside the business. It allows a business to carry on its daily operations, ordering stock, paying staff...etc WORKING CAPITAL = CURRENT ASSETS – CURRENT LIABILITIES • The Working Capital Ratio The working capital ratio is a quick measure of a business’s working capital: WORKING CAPITAL RATIO: [pic] The average desirable level of the working capital ratio is 2:1 as its assets is equal to twice its level of current liabilities. If the working capital of a business gets too low, it will be faced with a number of problems: ❖ It may have insufficient funds to purchase stock. Without stock, the business will be unable to generate sales revenue, and working capital will deteriorate further. ❖ The business may become unpopular with its suppliers. Suppliers may then cancel the business credit facility making it even more difficult for the business to purchase stock, or they may begin legal proceedings to recover the money owed to them. ❖ The business will lose discounts associated with bulk buying or early payment. ❖ Persistent failure to effectively manage working capital could cause the business to reach insolvency. At this point, the business must appoint a liquidator and cease trading. • Control of Current Assets Businesses must have systems in place to manage their current assets such as cash, accounts receivable (TRADE DEBTORS) and inventories. ≥ Cash Controlling cash within a business requires the preparation of a cash budget Controlling Cash/Cash should be treated with a high degree of security: 1. Large companies, e.g. banks, separating the duties of people who are involved with the inflow of funds is an attempt to remove the potential for fraud. Physical measures to prevent theft in office, e.g. safes, are also used. 2. In smaller business, e.g. retail food outlets, the person serving and using the cash register must often perform a cash reconciliation at the end of the day. 3. Important tool for controlling cash is a bank reconciliation statement. It checks whether the business’s and the bank’s figured agree on how much cash is in the business’s account. Discrepancies may occur due to customers not yet banking cheques, but banks can also make mistakes and it is important for a business to make sure it is not being short-changed. 4. Efficient cash management also deals with how a business treats any excessive surpluses of cash it may have. Management should transfer excess funds to higher interest bearing accounts, e.g. term deposits or cash management accounts. ≥ Accounts Receivables Ways to control receivables: 1. Credit policy [shortening credit policy/sending out reminders] Managers need to make decisions about the terms on which credit is to be allowed. The most important is the length of time for which credit will be extended, called the credit period. It will also be necessary to decide on a credit limit for each customer sending out reminder notices may be effective. Shortening the length of time you allow for payment should see funds paid more quickly. The danger is that customers may take their business to competitors with more favourable credit terms. 2. Factoring Factoring is the sale of accounts receivables (debtors) to a third party. It is a method of gaining instant cash flow. However, a factoring company may withhold a commission, sometimes up to 20% 3. Invoice discounting Invoice discounting is similar to factoring in the sense that the business offers a discount on the invoice value for early payment. However, the task of collecting the accounts receivables is kept within the business. In other words, discounts are offered TO customers, thus customers are happier, and may be willing to pay more quickly. ≥ Inventories Ways to manage existing inventory: 1. Stocktaking. It involves the comparison of physical levels of inventory with recorded levels. Small discrepancies between existing levels and recorded levels are commonly due to mistakes or theft. A stocktake picks up discrepancies and allows management to take corrective action. 2. The perpetual inventory system: goods are electronically scanned when received from suppliers and then rescanned at the point of sale. Many large businesses will use a perpetual inventory system because of the high volumes of inventory that flows through their stores. This system saves time 3. Periodic inventory system: continuous inventory records are not kept, and the business relies heavily on physical stocktakes to verify inventory levels. For smaller businesses this might only occur on an annual basis. Deciding on how much inventory to keep on hand is also an important working capital decision for businesses. Holding a high level of inventory costs money. [it is an opportunity cost.] Inventory gains no interest revenue. Also large amounts of inventory will increase the business’s costs, as it is forced to rent additional storage space to store its inventory. Just-in-time inventory system is a method of managing inventory as inventory is brought into the business JUST-IN-TIME to be used. No stock is held, there are no storage costs and no obsolete [past used-by date/outdated stock] or damaged inventory. • Control of Current Liabilities ≥ Accounts Payables Controlling Payables: 1. Simplest and most effective control is for payment to be made by cheque. 2. If payment is made by cash, it is essential that each payment is recorded in the books of business, and that each transaction is backed up by a source document and a copy of the invoice, and a receipt. Invoices are particularly important for tax purposes. 3. A business should manage when it pays its creditors within this credit period, considering the costs and benefits of early or late payments (TRADE CREDIT(can normally delay up to 30 days) |WHY PAY IMMEDIATELY' |WHY DELAY PAYMENT' | |Suppliers may give discounts for early payments. Discount > |Delaying payment will boost a business’s cash reserves in | |interest earned if delayed |the short term and can help if a business is worried about| | |external conditions | |Paying creditors quickly allows a business to be certain of |There is an opportunity cost associated with early | |its outgoings and debt obligations. Owners may feel more |payment- the interest the business could earn on the money| |comfortable not having any outstanding debts. |during the credit period. | |It helps build a strong credit reputation for the business. |Business may receive cash inflows during the credit | | |period, which will soften the impact of the cash outflow. | |Consistently being late with payments may damage a |Many businesses are simple averse to paying out funds | |business’s credit reputation. |until they have to. | | |The managers may only process invoices once a month a pay | | |all bills together at the end of the month to minimise | | |administration costs. | ≥ Loans The key to managing loans is to ensure they are prepared to manage their risks and take preventative measures: 1. Credit risk (risk of default): a business must carefully consider how highly geared it should be, and whether it needs additional equity funding to offset some of its debt. It must also manage its cash flows effectively to make sure it can meet all the upcoming interest and principal repayments on its debt. 2. Interest rate risk (risk that interest rate will increase): if the business feels there is a risk of interest rate rises it could hedge against this risk using options or other hedging instruments ≥ Overdrafts An overdraft limit is established by negotiation between the bank and the business, and they count as an effective loan to the business. Overdrafts attract a high rate of interest, which can sometimes push a business further into trouble. A business must ensure it is not relying on an overdraft as a constant source of funds. A business may be better off organising a short-term loan if it is going to require debt financing in more than the immediate short term. Also overdrafts are open to the risk that the banks can ask for repayment of the overdraft at ANYTIME, although this is uncommon. • Strategies for managing working capital ≥ Leasing ❖ Leases are a way of obtaining access to assets without having to raise further debt or equity financing, or deplete current cash reserves. ❖ An operating lease allows a business to use the asset without having to pay for maintenance costs, as well as having lease payments that are tax deductible. ❖ Leases are a strategic way of managing working capital, as they give the business access to non-current assets without any significant impact on cash reserves. It spreads the impact on working capital across a far greater time period. ❖ As the lease payments are tax-deductible, the tax burden on working capital at the end of the financial year is further reduced. ❖ ≥ Factoring ❖ Factoring is both a short-term and a long-term measure to manage cash flow. ❖ Businesses use factoring as a short-term measure to improve their working capital ratio as the business could sell the accounts receivable to a third party at a slight discount. The cash from this factoring sale could then used to pay off any immediate liabilities. ❖ Factoring can also be used as a long-term strategy to improve working capital. It saves businesses administration costs associated with recovering debt, but it allows a business certainty over its current assets and their liquidity. ≥ Sale and Lease Back ❖ One method of improving working capital using non-current assets is through a sale and lease back arrangement. ❖ The business sells the asset to a third party and then leases it back immediately (increasing cash, thus increasing working capital. ❖ This is also an attractive option for the business as it has gained access to short-term funds, which improve working capital without losing access to important assets. • Effective Financial Planning • Effective Cash Flow Management Cash Flow Statements ❖ Cash flow management refers to the balancing of cash inflows and outflows to give the business enough cash pay for short-term operating costs and to meet debt obligations. ❖ Management must ensure that the business is not holding excess reserves of cash for no reason, as they generate very low returns. ❖ Cash flow cycle is rarely smooth. Projected cash inflows may not be as large as originally predicted; customers may fail to pay on time. Management will need to take corrective action at these circumstances. ❖ Cash flow statement provides information about the inflows and outflows of cash through a business over a year, and is useful for analysing past performance, but to effectively plan for the future; managers must construct cash flow budgets. [they predict the cash inflows and outflows of the business over a period] ❖ Cash flows activities: - Operating cash flows: relating to the business’s general trading of goods and services. - Investing cash flows: relating to the purchas and sale of non-current assets (e.g. purchasing of equipment) - Financing cash flows: relating to cash flows from or to owners and cash flows related to borrowings (e.g. bank loan) Management Strategies Cash management strategies focus on accelerating cash inflows from various customers, and balancing the business’s cash outflows after inflows have been accounted for. ≥ Distribution of Payments A business will defer the payment of its accounts until the end of its credit period, unless the benefits offered by early payment discounts are far greater than the benefits of holding the cash until the end of the credit term. ≥ Discounts for early payments This is a strategy for accelerating the cash inflows from sales. Discounts are offered to customers who pay within a specific period of time under the credit terms. This will bring forwards cash inflows without pushing some customers towards competitors. ≥ Credit terms Credit terms are the time limits set by a business for the payment of customer purchases. If a business wishes to improve its cash inflows it may want to assess the credit terms it gives its clients. However, a business must be careful that it does not push customers towards competitors with more forgiving credit terms. • Effective Profitability Management To effectively maximise profits, management must effectively plan the finances and direction of the business to minimise costs and maximise revenues. Management’s aim will be to minimise costs to levels that maintain the desired level of quality. If costs cuts begin to impact on the quality of the product, sales will begin to decline, and the profitability benefits of minimising costs is offset by the failure to maximise revenues. Cost Control ≥ Fixed and variable ❖ Fixed costs are costs that the business incurs regardless of how much it produces. E.g. rent space and interest on borrowed funds. ❖ Variable costs are the costs of the business associated with changes in the level of production. E.g. wages, electricity. ❖ As the business produces more, its total costs increase because its variable costs increase Fixed and Variable Costs: + = ≥ Cost centres ❖ Cost centres are an attempt to make each person within a business accountable for the business’s costs. A cost centre is a functional area of the business, responsible for meeting a budget. ❖ Cost centres aim to make each employee more accountable for the costs incurred by their area of the business, thereby reducing costs. ≥ Expense minimisation In an effort to minimise the business’s expenses, managers will make cost-cutting targets for the business and for cost centres that must be met. Each level of management is then responsible for minimising the expenses incurred by their functional area. Expense minimising techniques include: ❖ Limiting use of business equipment, e.g. phones for personal use. ❖ Changing office plans from individual offices to open-plan divisions, lowering rent expenses ❖ Outsourcing inefficiently performed duties ❖ Reducing staff members ❖ Relocating offices to less expensive premises. Revenue Controls ≥ Sales objectives Setting clear sales objectives gives sales consultants a clear, identifiable target to work towards. It will normally be expressed in dollar or customer terms. These objectives will motivate the salesperson to a specific target, and will be the level of sales required to meet the business’s overall sale and profit objectives. ≥ Sales mix A business can take two approaches to their product base: 1. Concentrate on small, specific skill areas. By concentrating on a small range of products, the business has a clear control over the quality of its products and can easily create a consistent branding across its products. 2. Diversify the product range as much as possible to maximise revenues. This allows the business to create a sort-of insurance for itself, so that even when one product is not performing well, other products will still generate sufficient revenues to maintain profits. ≥ Pricing policy The price of a product will be an important indicator of a business’s revenues, as revenue is equal to price times quantity sold. The use of low prices in the short term may improve longer term cash flows, as the business gains additional customers and market share. However, such tactics may force a business to rely on revenue streams from other products. • Ethical and Legal Aspects • Audited Accounts Auditing is the examination of a business’s operations and records by an independent third party. They are designed to determine whether: 1. The business has complied with all relevant regulation 2. The business’s financial accounts represent a “true and fair” view of its financial position Auditors will determine if the business has satisfied these criteria and, if so, will sign a report to this effect. If not, they will require changes to be made. ❖ External stakeholders rely on the auditor to verify the financial position of the business. Many people question the role of auditing in ensuring the stability of the financial system. Many companies were found to have created illegal accounting methods that turned large losses into profits for the company. ❖ Auditing businesses have come under criticism for creating conflicts of interest. It has emerged that many large auditing businesses also provide business consulting services to the companies they audit. This has the potential to sway the judgement of auditors as they would be unwilling to criticise management if it could mean losing lucrative business consulting contracts. • Inappropriate cut off periods A business may refrain from recording a transaction until a later period, in order to alter profit levels. The use of inappropriate cut-off periods allows a business to distort the “true and fair” view of its financial position. This practice is unethical. Investors, creditors, and regulators all use the accounts of a business to make investment or regulatory decisions. Accrual accounting is based on the notion that transactions are recorded at the time they occur, not at the time that is most convenient for the business. • Misuse of funds The misuse of funds is the abuse of a business’s funds by agents of the business, such as managers, for personal gain or unlawful purposes. A common cause of the misuse of funds is the difficulty top management and owners often have in separating business funds from their own, personal funds. • Australian Securities and Investment Commission ASIC enforces company and financial services laws to protect consumers, investors and creditors. It regulates the financial system by: ❖ Ensuring laws are upheld throughout the financial system ❖ Informing consumers and investors about developments in the financial system ❖ Improving the performance of the financial system. ASIC has the power to investigate and prosecute any participant in the financial system found to have mislead investors or broken any laws. To uphold the ethical and legal fabric of the financial system, any person or institution wishing to act as an advisor or seller of financial products must apply to ASIC for a licence. • Corporate Raiders and Asset Stripping Corporate Raiders: ❖ A corporate raider purchases larger numbers or shares in company, attempting to gain a controlling interest, over 50% shares. These takeovers are usually hostile – unwanted by existing management. After that, the assets of the purchased company are immediately sold off. ❖ It is common for a large proportion of employees and management to lose their jobs, which can obviously lead to difficulties for these now redundant workers. ❖ Also, corporate raiders are only interested in improving the share price of the company in the short-term, allowing them to quickly sell their stake in the business and move on. ❖ On the other hand, defenders argue that the economy benefits from the increased efficiency. The treat of corporate raiders can also help to push managers to maintain high profits and high share pries, which ultimately benefits shareholders. Asset Stripping: ❖ Asset stripping is the PROCESS selling off the assets of a company for quick profit, rather than running the company for extended gains. Asset stripping may also be seen as a way to maximise the short-term value of a company. It can be used by corporate raiders once they gain control of a company. ❖ It raises clear ethical concerns, the stakeholders and the economy lose out in the long term, as the company is left with no source for growth and thus profits.[pic] ----------------------- Fixed Costs Quantity Produced $ Costs Variable Costs Quantity Produced $ Costs Fixed Costs Total Costs Quantity Produced $ Costs