Business Studies Notes - Finance

Flashcards for Business Studies Notes on Finance.

Strategic Financial Management

A holistic, long-term view of where the business is going, how it will get there, and monitoring the process along the way.

• Ensuring funds are available for business activities and smooth day-to-day transactions.

Objectives of Financial Management

PLEGS

• Profitability

• Growth

• Efficiency

• Liquidity

• Solvency

Profitability

The earnings of a business after all expenses are accounted for.

• profit = revenue - expenses

McDonalds - aims for consistent margins in the mid-40% range.

Growth

The size of the business compared to its competitors and past performance.

• reflects increased output, revenue, and profit.

• can be internal or external (acquiring other businesses).

McDonalds - goal of increasing systemwide sales growth annually by 3-5%.

Efficiency

The ability of a business to minimise costs and manage assets to achieve maximum profit with the lowest possible level of assets.

• how much revenue is spent

• how fast the business can collect its debts/accounts receivable

Liquidity

The measure of how quickly a current asset may be converted into cash, determining the business’ ability to pay short-term debts as they fall due,

• less than 12 months

• aiming to have more current assets than liabilities

• too much cash may be a sign of inefficiency

Solvency

The ability of a business to pay long-term liabilities as they fall due,

• indicates financial stability and the capacity to repay long-term debt (12 months+)

• shows ‘risk’ in the business

• can be referred to as gearing: ratio of debt to equity

Interdependence with Other Business Functions

Marketing: develops successful campaigns to generate profit through promotion of the product, finance allocates funds for this as well as market research.

Human Resources: hire the best and most efficient staff to reduce costs and maximise profits, finance budgets for wages, training and development, maintenance, and rewards

Operations: produces the products to maximise outputs, finance prepares budgets to source and supply the best inputs

Internal Finance

Profit generated by the business that is used for future expansion and growth

• retained profits - cheap and accessible

• sale of assets

McDonalds: uses profits to invest in capital expenditure, pay off debt, pay a dividend, or buy back shares.

External Finance

Money obtained from outside the business, such as banks, financial institutions, and shareholders

• Debt - borrowing from external sources

• Equity - giving up part ownership of the business

Types of Debt Finance

Short-term and long-term borrowing from external sources.

• overdraft (S)

• commercial bills (S)

• factoring (S)

• mortgage (L)

• debentures (L)

• unsecured notes (L)

• leasing (L)

Overdraft

A bank's allowance for a business to overdraw their account up to an agreed limit for a specified time to help overcome a temporary cash shortfall.

• lower interest rates and costs - paid on the daily outstanding balance of the account

• no regular repayment schedule

• used to assist with short-term liquidity problems

McDonalds - has an overdraft facility of US$4 billion.

Commercial Bills

Short-term loans used by financial institutions for larger amounts ($100,000+), usually secured against the business’ assets.

• repaid with interest at the end of the term

• flexible in relation to interest and the repayment period

Factoring

The selling of accounts receivable for a discounted price to a finance or factoring company.

• raise funds immediately → improves cash flow + gearing

• only receive 90% of funds in 48 hours

• greater risk of unpaid debts

• relatively expensive - business is usually still responsible for unpaid debts, and commission is paid on the debt.

Mortgage

A loan secured by the property of the borrower.

• must repaid with interest before the property is resold

• generally used to purchase business property

• repaid through regular payments over an agreed time

McDonalds - franchisees can take out a chattel mortgage for specific assets such as equipment - lender keeps a legal right to the financed asset while money is owed.

Debentures

A promise issued by a company to repay a loan for a fixed rate of interest and for a fixed period of time.

• business promises to provide regular interest payments and for the loan to be repaid by the maturity date

• usually provided by non-bank financial institutions

• security is offered to the lender - loan is secured to an asset

• company buys back the debenture on maturity

• MUST have a prospectus

Unsecured Notes

A loan from non-bank financial institutions for a set period of time that is not secured against any of the business’ assets.

• presents more risk to the investor

• higher interest rate

• used to generate money for initiatives such as acquisitions

Leasing

Paying money to use another enterprises’ equipment without the business having to purchase it outright.

• assists with cash flow

• can be used to monitor cash flow as repayments are fixed

• costs may be lower than other sources of finance

• repayments are tax deductible - may improve liquidity

Operating Lease: short period of time, owner carries out maintenance

Financial Lease: for the life of the asset, repayments are fixed

McDonalds - paid US$1.5 billion in 2023 in lease payments worldwide - reduces initial capital outlay required for new stores and retains cash in the business for other purposes.

Types of Equity Finance

Giving up part ownership of the business in exchange for capital - finance raised by the company through inviting new owners.

• ordinary shares

• private equity

Ordinary Shares

The purchase of shares by individuals, making them part-owners of a publicly listed company with voting rights and the potential to receive dividends.

• new issue

• rights issue

• placements

• share purchase plan

McDonalds - floated on the NYSE on April 21, 1965. Has issued 1,660 million shares; held by 4.5 million individuals.

New Issue

Issuing and selling the business shares for the first time on the ASX, requiring a prospectus.

• An ‘IPO’ or float is when a private company lists on a stock exchange for the first time.

Rights Issue

Giving existing shareholders the privilege to buy new shares in the company at a discounted price.

• Used to raise additional funds or pay down debt.

Placements

Shares given at a discounted value to specific shareholders/investors.

• Creating new shares in return for capital.

• Can potentially dilute the interests of existing shareholders.

Share Purchase Plan

Allowing existing shareholders to buy more shares without brokerage fees and/or at a discounted value, without requiring a prospectus.

• Can only issue a max of $30,000 in new shares to each shareholder.

Private Equity

Selling business shares to private investors (private company).

• Not listed on the ASX

• aim is to raise capital for future expansion or investment.

• large part of the business is handed over to the equity firm.

• VENTURE CAPITALISM - eg Shark Tank.

Financial Institutions

Provide funds for businesses to start up and grow, offer financial services such as loans, and are a source of information, advice and guidance in financial management.

• banks

• investment banks

• finance companies

• life insurance companies

• super funds

• unit trusts

• ASX

Banks

Main source of debt finance for small businesses.

• charge interest

• offer a wide range of financial services and products including credit cards, overdrafts, cheques, internet banking, advice, stockbroking, etc.

• intermediaries between lenders and borrows

E.g., CBA, Westpac, NAB, ANZ

Investment Banks

Provide loans that are customised to the needs of the business.

• short and long term debt finance

• provide advice on merges and acquisitions

• provide working capital

• arrange overseas finance

• operate unit trusts

Finance Companies

Non-bank financial intermediaries that specialise in smaller commercial finance, e.g., factoring.

• offer debentures, unsecured notes, and leasing - quick access to funds.

• mainly provide short and medium term loans to businesses through consumer hire-purchase loans, personal loans, and secured loans.

• can also offer equity finance.

• interest rate is usually higher.

E.g., AAMI, Nimble and RAM.

Life Insurance Companies

Non-bank financial intermediaries who provide cover and lump sum payment in the event of death.

• policy holders pay premiums which are invested by the company into financial assets - source of long-term equity or debt finance to businesses.

Super Funds

Super is a scheme set up by the government which requires all employees to make a financial contribution (11.5%) to a fund that will provide benefits to an employee when they retire.

• increase on-costs for businesses.

• super funds invest money received from contributions into shares, property and managed funds - source of long-term equity for businesses who the fund invests in.

Unit Trusts

Collect funds from a large number of small investors and invest them in specific types of financial assets - mutual funds.

• businesses can invest to increase levels of cash through dividends or capital gains.

• can be a source of equity or debt if the unit trust decided to invest in the business through the purchasing of shares, or the business borrows from them.

ASX

The primary stock exchange group in Australia - shares are bought and sold.

• Primary Market - enables business to raise capital through the issue of new shares

• Secondary Market - pre-owned securities are traded between individuals.

Monetary Policy

Influences interest rates (cost of borrowing money).

• purpose is to stabilise the economic cycle.

• low interest rates generally increase demand for borrowing.

Fiscal Policy

Federal budget (how the government allocated and spends their money).

• can be beneficial or disadvantageous depending on the industry - eg, subsidised solar panels will increase demand for those particular businesses.

Australian Securities and Investments Commission (ASIC)

Monitors and regulates activities by companies to ensure corporate laws are followed, protecting consumers and reducing fraud in financial markets.

• Enforces the Corporation Act 2001

• Protects consumers in the areas of investment, life and general insurance, superannuation, and banking.

• Reduces fraud and unfair trade practices.

McDonalds - must report names and personal details of directors, company share structure and resolutions to ASIC, must submit audited financial statements accessible to the general public.

Australian Taxation Office (ATO)

Enforces the collection of tax from businesses and individuals, impacting business profit and strategies to lower tax payable.

• 30% tax rate for business - levied at a flat rate.

• 27.5% for companies with a turnover of less than $50 mil

McDonalds - paid $115 million tax on its profit of $385 million in 2022, use inter-company transfer payments to shift profit from countries with higher taxes to those that have low or zero tax rates.

Global Economic Outlook

The projected changes to the level of economic growth throughout the world, affecting business investment and demand for exports.

• a positive outlook will increase demand for products and services, and decrease interest rates on funds borrowed.

• a poor outlook will have the opposite impact.

McDonalds - has experienced increase labour, material and energy costs as a result of inflation.

Availability of Funds

The ease with which a business can access funds on the international financial markets, impacting expansion opportunities.

• financial conditions are based on risk, demand and supply, and domestic economic conditions.

• financial deregulation in the 1970s-80s led to Australia becoming more integrated with the global financial system.

• Australians can borrow and invest overseas.

• Following the GFC of 2008-09, access to credit has been a challenge due to the reluctance of banks to lend money,

McDonalds - forecasted an 11% increase in interest payments from 2023-24.

Interest Rates

The cost of borrowing money, affecting the ease with which a business can source funds from overseas.

• the higher the level of risk, the higher the interest rates.

• Australian interest rates tend to be higher than other countries - businesses may be tempted to borrow overseas however they risk a fluctuation in exchange rates.

McDonalds - has fixed 96% of debt at 3.7% p.a - their interest rates range from 0.2% to 6.9% globally.

Processes of Financial Management

1. planning and implementing

2. monitoring and controlling

3. financial ratios

4. limitations of financial reports

5. ethical issues related to financial reports

Financial Needs

Used to determine where the business is headed and how it will get there.

• Financial information needs to be collected before future plans can be made.

• Need are determined by business size, current phase of business life cycle, future plans for growth and development, capacity to source funds, and management skills.

Budgets

A financial document used to estimate future revenue and expenses over a period of time.

• Can be both short and long-term.

• Operating Budget: main activities of a business, e.g. expenses.

• Project Budget: capital expenditure, research and development.

• Financial Budgets: financial data of a business; income statement, balance sheet, cash-flow statement.

McDonalds - budgeted US$2.5-2.7 billion in capital expenditure to open 8,000 stores by 2027.

Record Systems

The mechanisms employed by a business to ensure that data are recorded, and the information provided is accurate, reliable, efficient, and accessible.

• Both an obligation (tax purposes) and a tool for decision-making.

• Records of transactions must be kept for at least 5 years.

McDonalds - locally, McDonalds uses the NP6 Point of Sales system (POS) at the front counter to record sales, roster staff, order supplies, etc - globally, records are lodged with the NYSE annually.

Financial Risks

The possibility of financial loss to businesses - involves identifying internal and external risks to financial position

• Credit - danger associated with borrowing money, interest rate risks

• Market - risk of changing conditions in the marketplace, may affect profitability

• Liquidity - whether the business has sufficient funds to meet financial obligations (cash flow)

• Operational - dangers faced during day-to-day management including legal problems, fraud, HR issues.

Financial Controls

The procedures, policies and means by which a business monitors and controls the allocation and usage of its resources.

• clear authorisation and responsibility

• separation of duties – e.g., one person responsible for ordering

• control of cash – use of cash registers, cash banked daily, no money kept on premises overnight

• protection of assets – buildings are kept locked, registry of assets is maintained, regular checks of inventory

• control of credit procedures – following up overdue accounts and customer credit checks

• budgets and variance reporting

• comparison of actual results with planned outcomes

McDonalds - utilise interest rate swaps, foreign currency forwards and options, and cross-currency swaps.

Cash Flow Statement

A financial statement that indicates the movement of cash receipts and cash payments resulting from transactions over a period of time organised by operating, investing, and financing activities.

• opening balance: funds held from previous period

• net cash: cash inflows - cash outflows

• closing balance: opening balance + net cash

Income Statement

A summary of the income earned, and the expenses incurred over a period of trading.

• shows exactly how much money has come into the business, how much has gone out, and how much has been derived as profit.

• expenses can be broken down into selling, administrative, and financial.

• revenue: price of product x quantity

• COGS: opening stock + purchases - closing stock

• gross profit: sales - COGS

• net profit: gross profit - expenses

Balance Sheet

A summary of a business’ assets and liabilities at a particular point in time, expressed in money terms, and represents the net worth of the business.

• shows financial stability of the business and the owner’s return on investment.

• assets: liabilities + owner’s equity

• liabilities: assets - owner’s equity

• owner’s equity: assets - liabilities

Liquidity Ratio

Measures the business’ ability to meet its financial commitments in the short term (current assets/current liabilities).

• best range is 1.5:1 - 2:1.

• low ratio: indicates insufficient cash.

• high ratio: indicates inefficient use of assets.

McDonalds - 1.16:1 in 2023

Gearing Ratio

Shows the proportion of debt and equity that a business has to finance its activities (total liabilities/total equity).

• ratio above 1: less equity than debt, making it highly geared - greater risk but more opportunities for growth.

• ratio below 1: more equity than debt, making it lowly geared - less risk but limited opportunities for growth.

A ratio of 0.5:1 is regarded as safe.

Gross Profit Ratio

Shows what remains after the costs of goods sold have been subtracted from revenue (gross profit/sales).

• high gross profit ratio: indicates a sound financial position.

McDonalds - 68% gross profit ratio in 2023.

Net Profit Ratio

Shows the amount of sales revenue that remains after expenses have been deducted (net profit/sales).

• sales should be maximised, and costs should be minimised for a high level of net profit.

McDonalds - 33% net profit ratio in 2023.

Return on Equity Ratio

Shows the return a business owner receives on their investment (net profit/total equity).

• can be used by owners to calculate the effectiveness of their own funds invested in the business.

Expense Ratio

Shows a comparative view between sales and expenses (total expenses/sales).

• lower expense ratio: means the business is generating revenue with little input which is favourable.

McDonalds - 67% in 2023.

Accounts Receivable Turnover Ratio

Shows how well the business can collect their debt (sales/accounts receivable).

• measures how quickly accounts receivable can be converted into cash.

• ratio can be divided by 365 to show average length of time taken for the business’ accounts to be settled.

• higher ratio/lower number of days: indicates a more regular collection of debt, and a quicker return of credit.

Limitations of Financial Reports

• normalised earnings

• capitalising expenses

• valuing assets

• timing issues

• debt repayments

• notes to the financial statements

Normalised Earnings

The process of removing one off or unusual influences from the balance sheet to show the true earnings of a company.

• Can make it hard for investors to trust financial data presented by the business.

McDonalds - in 2022, the company removed the extraordinary expense of losing a tax case in France.

Capitalising Expenses

The process of adding a capitalised expense to the balance sheet that is regarded as an asset rather than an expense.

• Reduces the value of expenses in the income statement leading to overstated profits.

• Moved to the balance sheet as non-current assets.

• ATO allows $20,000 to be capitalised each financial year.

McDonalds - expenses for a new restaurant side at recorded as an asset and depreciated over the useful life of the asset - costs are spread over 40 years.

Valuing Assets

The process of estimating the market value of assets or liabilities for investment analysis, mergers and acquisitions, and financial reporting.

• Discounted Cash Flow Methods - estimated value of an asset based on expected future cash flows, which are discounted to the present value.

• Guideline Company Method - determines the value of a firm by observing the price of similar companies that sold in that market.

• May be subjective, affecting accuracy, e.g., goodwill.

Timing Issues

Financial reports cover activities over a period of time, usually one year - the business’ financial position may not be a true representation if they have experienced seasonal fluctuations.

• When the matching principle is breached, the business may understate income or expenses, leading to lower taxation and a misleading view of profitability.

McDonalds - uses straight-line depreciation, spreading expenses to be the same every year - does not reflect economic reality, potentially overstating current year profits.

Debt Repayments

Financial reports can be limited because they do not have the capacity to disclose specific information about debt repayments.

• how long the business had has the debt

• the capacity of the business to repay the amount owed

• investors may be unaware of risks

Notes to the Financial Statements

Notes report the details and additional information that are left out of the main reporting documents.

• not regulated and can hold subjective, misleading information.

• notes can be up to 80 pages long - lengthy and hard to understand, potentially hiding important information.

Ethical Issues Related to Financial Reports

Ethical issues arise when the law has ‘grey areas.’

• Audited Accounts: a means by which ethical issues can be identified - an independent check of the accuracy of financial records and accounting procedures.

• Record Keeping: a firm should keep records of all transactions for a min 5 years to comply with tax laws.

• Reporting Practices: accurate financial reporting is necessary for taxation purposes, and for stakeholders to access a business’ financial information.

Cash Flow Management Strategies

• distribution of payments

• discounts for early payments

• factoring

Distribution of Payments

‘Spreading out’ payments throughout the month/year to avoid lump sum or large payments at once for equal cash flow.

• ensures equal cash flow each month

• helps to avoid sudden cash shortfalls at time of payment.

Discounts for Early Payment

Offering discounts to debtors that owe the business money - increases inflow of cash in the short term to meet financial objectives.

• can increase efficiency.

• will negatively impact profits as the business won’t receive the entire amount and there is no guarantee of a faster payment.

Factoring

Selling of accounts receivable at a discounted price.

• increases cash flow in the short term to meet financial objectives.

• immediate cash injection.

• will negatively impact profits as the business won’t receive the entire amount - indicator of poor financial management.

Working Capital Management Strategies

Working Capital = current assets - current liabilities

• control of current assets (cash, receivables, inventories)

• control of current liabilities (payables, loans, overdrafts)

• leasing

• sale and lease back

Control of Current Assets

Ensuring assets are regularly converted into cash on a timely basis.

• Cash: if cash is in short supply, a business may take out on overdraft, offer discounts for early payments, or prepare cash budgets.

• Receivables: businesses should adopt a strict credit policy - send payment reminders, withhold further credit sales from customers until they pay, ‘blacklist’ customer. They may also offer discounts for early payments.

• Inventories: stock of raw materials, works-in-progress and finished goods - should be minimised as excess stock ties up cash needed for working capital.

Control of Current Liabilities

Ensure liabilities are paid on time and don’t exceed what the business can afford.

• Payables: distribution of payments can be manipulated to hold off paying until the last moment if needed - risk being charged overdue feeds or being withheld credit.

• Loans: short terms loans can assist a business in paying their bills, however creates further liability

• Overdrafts: allows accounts to go into negative amounts - can be quite expensive.

Leasing

Paying money to use equipment from another enterprise.

• payments are spread out

• access to a wide range of equipment

• tax deductible

• avoid technological obsolescence

• avoid maintenance and repair costs

• can be included in forecasts and budgets

• decrease initial capital outlay

McDonalds - lessee of 12,334 restaurant locations (2018), they have built US$12.5 billion worth of buildings on land that they lease.

Sale and Lease Back

The business sells its own assets to a lessor and then leases it back - the lessor retains ownership of the asset.

• large cash injection from sale

• able to use obtained cash as working capital

• asset price will be higher through monthly payments

Qantas - sold 13.8 ha of land near its Mascot headquarters to LOGOS Property Group for $802 million in 2021 - Qantas leases back portions of the land to continue using key facilities while transitioning operations elsewhere.

Profitability Management Strategies

• cost controls (fixed and variable costs, cost centres, expense minimisation)

• revenue controls (marketing objectives)

Cost Controls

• Fixed and Variable Costs: businesses should aim to minimise costs through budgets and may decide to transfer fixed to variable costs, e.g., casualisation of staff.

• Cost Centres: a specific area, department, or section of a business where costs can be directly attributed - business can identify where high expenses are coming from → clearer budgeting, cost control.

• Expense Minimisation: reducing the level of expenses in the business - inputs, locations, packaging, casualisation of staff.

McDonalds - ensure the correct number of staff members are rostered on for varying patterns, negotiate lower insurance premiums.

Revenue Controls

Marketing Objectives - should increase sales.

• Sales Objectives: consider level of sales needed to break-even

• Sales Mix: focus on target market and key customer base first

• Pricing Policy: overpricing may detract buyers while under-pricing may result in cash shortfalls

McDonalds - used AI pricing tools to change individual product prices and measure the impact on sales.

Global Financial Management Strategies

• exchange rates

• interest rates

• methods on international payment (payment in advance, letter of credit, clean payment, bill of exchange)

• hedging

• derivatives

Exchange Rates

The ratio of one currency to another – how much a unit of one currency is worth in terms of another determined by the foreign exchange market.

• Appreciation: an upward movement of the Australian dollar - each unit of foreign currency buys fewer Australian dollars, and one Australian dollar buys more foreign currency; reduced international competitiveness of Australian exporting businesses.

• Depreciation: a downward movement of the Australian dollar against another currency - each unit of foreign currency buys more Australian dollars; increased international competitiveness of Australian exporting businesses.

McDonalds - holds US$15 billion worth of debt in countries other than the USA (38%).

Interest Rates

The cost of borrowing money.

• Australian interest rates tend to be higher than other countries - Aus businesses may be tempted to borrow finance from an overseas source.

• Risk is a fluctuation in exchange rate movements - costs may be higher in the end.

McDonalds - interest rates vary from 0.2% to 6.9% - 96% of debts are fixed at 3.7% p.a.

Payment in Advance

Payment method that allows the exporter to receive payment and then arrange for the goods to be sent.

• least risky for the exporter

• very few importers agree to these terms because it exposed them to the most risk

Letter of Credit

A document that a buyer can request from the bank that guarantees the payment of goods will be transferred to the seller – issued by the importer’s bank to the exporter promising to pay them a specific amount once certain conditions have been met.

• seller has to present the bank the necessary documents proving shipment of the goods

• very popular with exporters as it relies on the overseas bank rather than the importer

Bill of Exchange

A document drawn up by the exporter demanding payment from the importer at a specified time – widely used as it allows the exporter to maintain control over the goods until the payment is made or guaranteed.

• document against payment - importer collects goods AFTER paying for them - less risky.

• document against acceptance - importer collects goods BEFORE paying for them - risk of delayed or no payment.

Clean Payment

When the exporter ships the goods directly to the importer before payment is received (open account payable method).

• importer doesn’t send payment until AFTER they receive the goods so they can inspect them first.

• usually only used when the exporter is confident the importer will pay by the agreed time - more risky.

Hedging

The process of minimising the risk of currency fluctuations WITHOUT using a spot exchange rate (no set contract).

• Natural Hedging: establishing offshore subsidiaries to reduce the risk of fluctuating exchange rates, arranging for import payments and export receipts to be denominated in the same currency, implementing effective marketing to minimise price fluctuations.

McDonalds - does business in local currencies to minimise risk, also use exchange rate financial derivative such as forward exchange rate contracts, options, and cross-currency swaps.

Derivatives

Simple financial instruments that may be used to lessen the exporting risks associated with currency fluctuations.

• a form of hedging - reduces risk.

• agreements are made BEFORE the action takes place.

• forward exchange contract, options contract, swap contract.

Forward Exchange Contract

A contract to exchange one currency for another at an agreed exchange rate on a specific future date.

• Obliged to follow through with the contract regardless of the changes in the exchange rate – guaranteed by the bank.

• Reduces risk for both parties.

Options Contract

Gives the buyer of the currency the right, but not the obligation, to buy or sell foreign currency in the future.

• Provides the buyer with protection from risky currency fluctuations.

Swap Contract

Exchange currency on the spot market price but with an agreement to reverse the transaction in the future.

• spot sale one currency + forward repurchase of the currency at a specific time in the future.

• e.g., swap $50 AUD today for USD → agree to swap back in July 2025.