Business Studies - Finance

Role of financial management

Financial management is the planning and monitoring of a business's financial resources to enable the business to achieve its financial objectives. Financial management is crucial if a business is to achieve its financial goals. The mismanagement of financial resources can lead to problems.

Strategic role of financial management

The long-term or strategic role of financial management is to ensure that a business achieves its goals and objectives. This can only be accomplished if the business's finances are managed effectively. The strategic role of financial management includes:

• setting financial objectives and ensuring the business is able to achieve these goals

• sourcing finance

• preparing budgets and forecasting future finances

• preparing financial statements

• maintaining sufficient cash flow

• distributing funds to other parts of the business.

Objectives of financial management

For a business to achieve its longer term goals it must have a number of shortterm, specific objectives. The objectives of financial management are to maximise

the business's:

• profitability

• growth

• efficiency

• liquidity

• solvency.

The responsibility of financial management is to make decisions about the best way to achieve those objectives. This will involve identifying and evaluating alternative courses of action and making recommendations.

Case Study: McDonald's

Objectives of financial management

McDonald's uses a combination of past-year results, overall future plans a general economic conditions to set objectives for future time periods. In 2017, McDonald's announced some long-term financial targets as well as some that relate specifically to 2017.

Profitability - increase profit

Growth - increase growth

Efficiency - increase efficiency

Liquidity - reduce by returning cash to shareholders

Solvency - increase debt/return equity to shareholders

Profitability

Profitability is another important financial objective of management. Profitability is the ability of a business to maximise its profits. Profits satisfy owners or shareholders in the short term but are also important for the longer term sustainability of a firm. To ensure that profit is maximised, a business must carefully monitor its revenue and pricing policies, costs and expenses, inventory levels and levels of assets.

Growth

Growth is the ability of the business to increase its size in the longer term. Growth of a business depends on its ability to develop and use its asset structure to increase sales, profits and market share. Growth is an important financial objective of management as it ensures that the business is sustainable into the future.

Efficiency

Efficiency is the ability of a business to minimise its costs and manage its assets so that maximum profit is achieved with the lowest possible level of assets. Efficiency generally relates to the operations or revenue-producing activities of the business. Achieving efficiency requires a firm to have control measures in place to monitor assets. A business that aims for efficiency must monitor the levels of inventories and cash and the collection of receivables.

Liquidity

Liquidity is an important financial objective of management. Liquidity is the extent to which a business can meet its financial commitments in the short-term (less than 12 months). A business must have sufficient cash flow to meet its financial obligations or be able to convert current assets into cash quickly, for example, by selling inventory. Cash shortfalls and excess or idle cash must be avoided as both involve loss of profitability for a business.

Solvency

Solvency is the extent to which the business can meet its financial commitments in the longer term (more than 12 months). Solvency indicates whether a business will be able to repay amounts that have been borrowed for investments in capital (such as equipment and machinery and/or premises). A good indicator to measure solvency is to use gearing, which measures the percentage of the assets of the business which are funded by external sources. This way, it measures the business's reliance on outside finance.

Short-term financial objectives

Short-term financial objectives are the tactical (one to two years) and operational (day-to-day) plans of a business. These would be reviewed regularly to see if targets are being met and if resources are being used to the best advantage to achieve the objectives.

Long-term financial objectives

Long-term financial objectives are the strategic plans of a business. They are determined for a set period of time, generally more than five years. They tend to be broad goals such as increasing profit or market share, and each will require a series of short-term goals to assist in its achievement. The business would review their progress annually to determine if changes need to be implemented.

Potential conflicts between short-term and

long-term financial objectives

Potential conflicts can arise between short-term and long-term financial objectives. For example, 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. This decision may therefore cause conflict with the business owners or shareholders as well as investors. In the longer term, however,

most business owners would be pleased to support an expansion if it increases the overall value of the business.

Interdependence with other key

business functions

The marketing, operations and human resources departments rely on financial managers to allocate them adequate funds i.e. the operations department requires funds to purchase inputs and carry out their transformation processes, the marketing department requires funds to undertake the various forms of promotion and the human resources department requires funds in order to pay for staff.

Influences on financial management

The influences on the financial management of a business include a range of external factors such as the domestic government's economic decisions and legislation, and the global economy, which has become a major influence on not just the financial function but all aspects of business operations. Internal factors also have an impact on the financial management of a business and these are more directly controlled and monitored by management through its short- and long-term planning.

Sources of finance — internal and external

In the establishment phase of a business, owners and/or shareholders usually contribute funds. In later years, when a business is in the growth stage, a number of options can be considered regarding sources of funds and how those sources will be used. Sources of funds may be internal or external. Finding the appropriate source of funds for the business's needs involves financial decision

making, which means that relevant information must be identified, collected and analysed to determine an appropriate course of action.

Internal sources

Internal finance refers to funds generated from inside the business. The most common source of internal finance is retained earnings or profits in which all profits are not distributed, but are kept in the business as a cheap and accessible source of finance for future activities. Most businesses keep some of their profit in the form of retained earnings. In Australian businesses, approximately 50 per cent of profits on average are retained to be reinvested.

Case Study: McDonald's

Internal sources - retained profits

McDonald's has significant retained profits that have built up since 1965. Retained profits are part of a company's equity. They represent current and prior-year business profits that have not been paid out to shareholders as dividends. The 2016 Annual Report shows retained profits of US$46.2 billion. McDonald's has been using a component of the cash associated with retained profits to fund share but backs and dividends.

External sources

External finance refers to the funds provided by sources outside the business, including banks, other financial institutions, government, suppliers or financial intermediaries. Finance provided from external sources through creditors or lenders is known as debt finance. There is an increase in risk for businesses using debt as the interest and bank and government charges have to be paid on top of the principal borrowed. However, Australia's tax system has promoted debt financing for businesses by providing tax deductions for interest payments.

Debt: short-term borrowing

Short-term borrowing is provided by financial institutions through overdrafts, commercial bills and bank loans. This type of borrowing is used to finance temporary shortages in cash flow or finance for working capital. Short-term debts are recorded as current liabilities on the balance sheet. Overdrafts assist businesses with short-term liquidity problems, for example a seasonal decrease in sales. Commercial bills are primarily short-term loans issued by financial institutions, for larger amounts (usually over $100000) for a period of generally between 30 to 180 days.

Case Study: McDonald's

External sources - short-term debt

Overdraft - McDonald's currently has available a US$2.5 billion overdraft, which it is currently not using. It could, however, provide a quick source of short-term finance if needed.

Commercial bills - McDonald's issues 'commercial paper' to the public to raise funds (short-term unsecured debt). In addition, McDonald's also raises funds though its global medium-term notes facility. In the last 2 years, the company has, significantly increased its overall long-term debt from approximately US$14 billion to US$26 billion. Total liabilities were over US$33 billion as at 32 December 2016.

Debt: long-term borrowing

Long-term borrowing is usually used to purchase major assets such as buildings and equipment, and the assets often serve as security on the loan. Despite some risks, long-term borrowing is a common source of financing for businesses. Long-term debts are recorded as non-current liabilities on the balance sheet. A mortgage is a loan secured by the property of the borrower (business). Debentures are issued by a company for a fixed rate of interest and for a fixed period of time. An unsecured note is a loan from investors for a set period of time. Leasing is usually a long-term source of borrowing for businesses.

Case Study: McDonald's

External sources - long-term debt

Mortgage - As McDonald's franchises rarely own the land upon which their restaurants sit, they would be unable to take out a traditional mortgage for their store. They may, however, take out a chattel mortgage for specific assets, whereby the lender keeps a legal right to the financed asset whilst money is owed.

Leasing - McDonald's makes use of leasing as a source of funding. In 2026, McDonald's leases 14,763 stores, playing close to US$2 billion in lease payments worldwide. These include leases for land and buildings that are usually 20 years. McDonald's Australis share of leases laid on property in 2016 was over AU$120 million.

Unsecured notes/debentures - McDonald's has borrowed cash at fixed interest rates for periods of up to 60 years using unsecured notes and debentures.

Equity

Equity as an external source of funds refers to the finance raised by a company through inviting new owners. For example, this can be done by issuing shares to the public through the Australian Securities Exchange (ASX). Equity as a source of external finance includes:

• ordinary shares (new issue, rights issue, placements, share purchase plan)

• private equity

Ordinary shares are the most commonly traded shares in Australia. The purchase of ordinary shares by individuals means they have become part-owners of a publicly listed company. Private equity is the money invested in a (private) company not listed on the Australian Securities Exchange (ASX).

Case Study: McDonald's

Equity

McDonald's consistently pays its shareholders a high dividend and at this stage does not appear to be interested in raising additional equity via share sales. In fact, it is buying back shares from shareholders. At a store level, McDonald's requires new franchises to have at least 25% of that total cost of a new McDonald's restaurant in cash.

Financial institutions

Financial institutions collect funds and invest them in financial assets. They provide financial services and focus on dealing with financial transactions such as investments, loans and deposits. While most businesses acquire funds from a bank, finance is also available from a variety of other institutions, such as investment banks, finance

companies, superannuation funds, life insurance companies, unit trusts and the Australian Securities Exchange.

Case Study: McDonald's

Financial institutions

McDonald's uses a range of bank and finance companies worldwide to fund its operations. The company must also abide by the rules of the NYSE, which include regularly disclosing financial and other important information publicly. Financial ratings agencies, such as Moody's and Standard & Poor's, also influence finance at McDonald's. These ratings agencies assess McDonald's financial position and performance and assign its financial instruments a credit rating. The lower rating, the harder these instruments are to sell and vice versa.

Banks

Banks are the major operators in financial markets and are the most important source of funds for businesses. Most of the funds provided through financial markets come from banks that operate on their own behalf or on behalf of other corporations, although other financial institutions also operate in the financial market. Banks are the largest form of financial institution in Australia, although their share has declined as the financial markets have become deregulated.

Investment banks

Investment banks provide services in both borrowing and lending, primarily to the business sector, for example, Macquarie Bank. They provide a wide variety of different types of loans for businesses and can therefore customise loans to suit the business's specific needs. Investment banks sometimes impose conditions when providing loans.

Finance companies

Finance companies are non-bank financial intermediaries that specialise in smaller commercial finance. They provide mainly short-term and medium-term loans to businesses through consumer hire-purchase loans, personal loans and secured loans. They are also the major providers of lease finance to businesses. Finance companies raise money through share issues (debentures). Debentures are for a fixed term and carry a fixed rate of interest.

Life Insurance companies

Life insurance companies are also non-bank financial intermediaries who provide cover and a lump sum payment in the event of death. Life insurance companies provide both equity and loans to the corporate sector through receipts of insurance premiums, which provide funds for investment. The funds received in premiums, called reserves, are invested in financial assets.

Superannuation funds

Superannuation funds have grown rapidly in Australia over the past 25 years due to tax incentives and compulsory superannuation, which was introduced by the government in 1992. Superannuation is a scheme set up by the federal government, which requires all employers to make a financial contribution to a fund that will provide benefits to an employee when they retire. Superannuation funds invest the money received from superannuation contributions in many things, such as company shares, property and managed funds.

Unit trusts

Unit trusts (also known as mutual funds) take funds from a large number of small investors and invest them in specific types of financial assets. Unit trusts invest in any mixture of cash, Australian or international shares, fixed interest securities (such as government bonds) or property. Unit trusts are usually connected to a management firm that manages a diversified investment portfolio for its investors.

Australian Securities Exchange

The ASX was created by the merger of the Australian Stock Exchange and the Sydney Futures Exchange in July 2006 and is the primary stock exchange group in Australia. The ASX acts as a primary market. This primary market enables a company to raise new capital through the issue of shares and through the receipt of proceeds from the sale of securities. The ASX also operates as a secondary market.

Influence of government

The government influences a business's financial management decision making with economic policies such as those relating to the monetary and fiscal policy, legislation and the various roles of government bodies or departments who are responsible for monitoring and administration.

Case Study: McDonald's

Government institutions

By operating in approximately 120 countries, McDonald's is influenced by the laws, policies and regulations of countries governments and government institutions. For example, most countries have different minimum rates of pay for employees, as well as minimum ages that employees must be before they can work. They also have different tax systems. The 2016 Annual Report stayed that the company faces increasing regulation in many parts of the world and that these regulations are often conflicting, inconsistent and highly prescriptive.

The Australian Securities and Investments

Commission (ASIC)

ASIC is an independent statutory commission accountable to the Commonwealth parliament. The aim of ASIC is to assist in reducing fraud and unfair practices in financial markets and financial products. ASIC ensures that companies adhere to the law, collects information about companies and makes it available to the public. This includes the financial information that companies must disclose in their annual report

Company taxation

All Australian businesses that have been incorporated are required to pay company tax on profits. This tax is levied at a flat rate of 30 per cent of net profit. From the 2016/17 tax year, the company tax rate was reduced to 27.5 per cent for small businesses with a turnover less than $10 million. Company tax is paid before profits are distributed to shareholders as dividends.

Case Study: McDonald's

Company taxation

McDonald's, along with other multinationals, has been the subject of media reports that claim it uses inter-company transfer payments to shift profit from Australia to countries that have low or zero tax rates. McDonald's make no secret of this. The 2016 Annual Report stayed that the company's tax rate is below the US tax rate (35%) because it makes use of global transfer pricing.

Global market influences

Financial risks associated with global markets are greater than those encountered domestically, but such risk-taking is necessary to implement a business strategy. Largely uncontrollable financial influences include the availability of funds, interest rates and the global economic outlook. However, a business can put in place appropriate financial management strategies to minimise the negative effects. One very significant influence in the past two decades is the impact of globalisation on world financial markets.

Global economic outlook

The global economic outlook refers specifically to the projected changes to the level of economic growth throughout the world. If the outlook is positive then this will have an impact on the financial decisions of a business. This may include:

• increasing demand for products and services.

• a decrease in the interest rates on funds borrowed internationally from the financial money market.

However, a poor economic outlook will have an impact on financial decisions of a business in the opposite way to those mentioned previously.

Case Study: McDonald's

Economic outlook

McDonald's has been viewed as somewhat 'recession-proof' in developed economies - and in fact, often performs better during periods of economic downturn, in part due to the perceived value for money of its food. Conversely, when economic conditions are improving, consumers may spend their extra disposable income elsewhere, and McDonald's sales may suffer. In developing economies, however, where eating at McDonald's may be viewed as a luxury, sales may decline when economic conditions are unfavourable.

Availability of funds

The availability of funds refers to the ease with which a business can access funds (for borrowing) on the international financial markets. The international financial markets are made up of a range of institutions, companies and governments that are prepared to lend money to individuals, companies or governments who may need to raise capital. Various conditions and rates apply and these will be based primarily on:

• risk

• demand and supply

• domestic economic conditions

Case Study: McDonald's

Availability of funds

McDonald's currently has available a US$2.5 billion line of credit should it be needed. Low interest rates globally have ensured that businesses like McDonald's have relatively easy access to funds if required. In fact, this is one of the reasons that McDonald's is moving away from equity financing to debt.

Interest rates

Interest rates are the cost of borrowing money. The higher the level of risk involved in lending to a business, the higher the interest rates. Traditionally, Australian interest rates tend to be above those of other countries, such as the United States and Japan. Therefore, Australian businesses could be tempted to borrow the necessary finance from an overseas source to gain the advantage of lower interest rates.

Analyse the influence of government and the

global market on financial management

There are a variety of implications for businesses in relation to the influence of the government:

• Legislation will influence the decisions businesses make about their finances.

• Legislation impacts on the choice of legal structure as different obligations are imposed on different types of businesses.

There are also various implications for businesses in relation to the influences of the global market:

• The global economic outlook will have a direct effect on the demand for Australian exports; that is, a positive outlook will increase demand for Australian products whereas a negative outlook will decrease demand.

Processes of financial management

An important part of financial management is establishing effective financial processes to monitor the financial health of the business and ensure the organisation meets its objectives. The main financial processes include:

• planning and implementing

• monitoring and controlling

• calculating financial ratios

• identifying limitations of financial reports

• identifying ethical issues related to financial reports.

Planning and implementing

Financial planning is essential if a business is to achieve its goals. Financial planning determines how a business's goals will be achieved.

- financial needs, budgets, record systems, financial risks, financial controls

Financial needs

Important financial information needs to be collected before future plans can be made. This financial information includes balance sheets, income statements, cash flow statements, sales and price forecasts, budgets, bank statements, weekly reports from departments, break-even analysis, reports from financial ratio analysis and interpretation. The financial needs of a business will be determined by:

• the size of the business

• the current phase of the business cycle

• future plans for growth and development

• capacity to source finance — debt and/or equity

• management skills for assessing financial needs and planning.

Budgets

Budgets provide information in quantitative terms about requirements to achieve a particular purpose. Budgets reflect the strategic planning decisions about how resources are to be used. They provide financial information for a business's specific goals and are used in strategic, tactical and operational planning. Budgets are used in both the planning and the control aspects of a business. As

a control measure, planned performance can be measured against actual performance and corrective action taken as needed.

Case Study: McDonald's

Assessing financial needs and budgets

McDonald's identified the need to reimage some existing restaurants, modernising big the exterior and the interior in order to compete more effectively. The company budgeting for this is in its capital expenditure budget.

Record systems

Managers need to set up a record system that allows them to record all the information they need. Record systems are the mechanisms employed by a business to ensure that data are recorded and the information provided by record systems is accurate, reliable, efficient and accessible. Minimising errors in the recording process, and producing accurate and reliable financial statements are important aspects of maintaining record systems.

Case Study: McDonald's

Using record systems

In such a large, complex business as McDonald's, a robust global record-keeping system is essential. For McDonald's, it all starts at the local store level. McDonalds franchisees have to agree to use McDonalds methods of operation - including bookkeeping and accounting. At the core of this record system is the Point of Sale system used at the front counter. Information from this system is used by stores to make sales, assemble food, roster staff, order supplies, and perform other operations activities. This system is used by McDonald's head offices to monitor sales at the store level and collect royalties and other associated payments from franchised stores.

Financial risks

Financial risk is the risk to a business of being unable to cover its financial obligations, such as the debts that a business incurs through borrowings, both short term and longer term. If the business is unable to meet its financial obligations, bankruptcy will result. To minimise financial risk, businesses must consider the amount of profit that will be generated. The profit must be sufficient to cover the cost of debt as well as increasing profits to justify the amount of risk taken by owners and shareholders.

Financial controls

Financial controls ensure that the plans that have been determined will lead to the achievement of the business's goals in the most efficient way. The policies and procedures of a business are designed to ensure they are followed by management and employees. Control is particularly important in assets such as accounts receivable, inventory and cash. Budgets and variance reporting are financial controls used in businesses.

Case Study: McDonald's

Implementing financial controls

Implementing effective financial controls in such a large organisation as McDonald's can be a challenge. McDonald's uses an external auditor to assess the effectiveness of its financial controls annually. Although McDonald's Australia financial system ultimately feeds into that of McDonald's Corporation, it also has its financial controls independently assessed each year by an external auditor thus adding a further level of assurance.

Debt and equity financing

External or debt finance is a liability to a business as it is money owed to external sources. Equity finance relates to the internal sources of finance in the business. Businesses must carefully consider whether to use debt or equity finance and how much of each is needed.

Debt finance

Debt can be attractive to businesses because funds are usually readily available and interest payments are tax deductible, therefore reducing the cost of debt financing.

ADVANTAGES:

• Funds are usually readily available and can be acquired at short notice.

• Increased funds should lead to increased earnings and profits.

• Interest payments are tax deductible.

DISADVANTAGES:

• Regular repayments have to be made

• There is an increased risk if debt comes from financial institutions because interest, bank charges and government charges may increase.

• Security is required by the business.

Equity finance

Equity finance is the most important source of funds for companies because it remains in the business for an indefinite time, because funds do not have to be repaid at a set date as with debt

financing.

ADVANTAGES:

- Does not have to be repaid unless the

owner leaves the business

- Cheaper than other sources of finance as

there are no interest payments

- The owners who have contributed the

equity retain control over how that finance

is used

DISADVANTAGES:

- Long, expensive process to obtain funds

this way

- Lower profits and lower returns for the

owner

- The expectation that the owner will have

about the return on investment (ROI)

Matching the terms and sources of finance to business purpose

The terms of finance must be suitable for the purpose for which the funds are required. Finance managers should match the length or term of the loan with the economic lifetime of the asset the finance is being used to purchase. This means that short-term finance should be used to purchase short-term assets and long-term finance should be used for long-term assets.

Monitoring and controlling

The process of monitoring and controlling is essential because inconsistent methods of review and systems of control will have an immediate impact on the viability of the business and requires managements to monitor the internal and external factors that will impact financially on business operations. This may include changes to the economic outlook, internal production methods and changes to workplace laws.

The main financial controls used for monitoring include:

1. cash flow statements

2. income statements

3. balance sheets.

Case Study: McDonald's

Monitoring and controlling

McDonald's provides annual reports which includes a cash flow statement, an income statement and a balance sheet. As the business is so large, these can be quite difficult to understand and interpret. The production of consistent, audited financial reports which adhere to accounting standards assists greatly in the monitoring and controlling of finances. Although the actual financial statements take up more than 50 pages.

Cash flow statements

A cash flow statement provides the link between the income statement and balance sheet, as it gives important information regarding a firm's ability to pay its debts on time. It indicates the movement of cash receipts and cash payments resulting from transactions over a period of time. It can also identify trends and can be a useful predictor of change. In preparing a cash flow statement, the activities of a business are generally divided into three categories — operating, investing and financing activities.

Income statements (statements of financial

performance)

The income statement is a summary of the income earned and the expenses incurred over a period of trading. It helps users of information see exactly how much money has come into the business as revenue, how much has gone out as expenditure and how much has been derived as profit. The income statement shows:

• operating income earned from the main function of the business,

• operating expenses

By examining figures from previous income statements, managers can make comparisons and analyse trends before making important financial decisions.

Balance sheets (statements of financial position)

The balance sheet shows the level of current and non-current assets, and current and non-current liabilities, including investments and owners' equity. The balance sheet shows the return on the owners' investment, the sources and extent of borrowings, the level of inventories, and so on. The figures also show whether the business has sufficient assets to continue to make profits in the longer term, how much of the assets are financed from outside borrowings, whether the business can expect to meet its financial obligations in the short and longer term, and how the year's figures compare with the previous year.

Assets = Liabilities + Owners' equity

Calculating financial ratios and strategies to improve performance

The methods of analysis involve calculations of figures, percentages and ratios. Ratios are one of the main tools used to analyse financial information and assist in answering more clearly the questions relating to profits, solvency/gearing, efficiency, growth and liquidity. But analysis without interpretation is meaningless. Interpretation is

making judgements and decisions using the data gathered from analysis.

Case Study: McDonald's

Financial ratios

For the purpose of comparison, McDonald's key financial ratios can be calculated and compared to Yum! Brands Inc. which is similar-sized global business with 43,500 stores, including Pizza Hut, KFC and Taco Bell. Yum! Brands Inc. also utilises a mix of company-owned and franchises stores. In fact, it will soon have nearly 98% of its stores franchised. Using comparative ratio analysis, the financial performance and position of McDonald's can be assessed. Relevant comparisons can be made with Yum Brands Inc. as well as past performance and prevails budget forecasts. Information for Yum! Brands Inc. comes from its 2016 Annual Report.

Liquidity - Current ratio (working capital)

Current ratio = Current assets/Current liabilities

The current ratio measures a business's ability to pay back their current liabilities with their current assets. The higher the current ratio, the more capable the business is of meeting their short-term obligations. It is generally accepted that a ratio of 2:1 indicates a sound financial position for a firm. That is, the firm should have double the amount of current assets to cover its current liabilities.

Case Study: McDonald's

Liquidity - current ratio

In 2015, the current ratio for McDonald's peaked at 3.26:1. This was mainly due to the company increasing cash on hand via debt to fund its return of capital program. In 2016, the current ratio returned to its more traditional level of around 1.4:1. McDonald's has a higher current ratio than Yum! Brands Inc., whose current ratio was 1.08:1 in 2016.

Gearing (solvency) - Debt to equity ratio

Debt to equity ratio = Total liabilities/Total equity

The debt to equity ratio shows the extent to which the firm is relying on debt or outside sources to finance the business. This ratio is an important control aspect for management because the relationship between debt and equity must be carefully balanced. A ratio of greater than 1 means that the business has less equity than debt. The higher the ratio, the less solvent the firm. That is, the higher the ratio of debt to equity, the higher the risk.

Case Study: McDonald's

Gearing - debt to equity ratio

Both McDonald's and Yum! Brands Inc. have embarked on campaigns to buy back stock from shareholders. As such, both companies in 2016, had negative equity - where liabilities are greater than assets. This situation can occur when companies buy back stock at the market rate - and a negative equity balance renders the calculation of the debt to equity ratio as useless.

Profitability - Gross profit ratio

Gross profit ratio = Gross profit/Sales

The gross profit ratio gives the percentage of sales revenue that results in gross profit. It is one way that a business can measure profitability. A business's gross profit must be sufficient to pay the expenses of a business and still provide a profit for the small business owner. It is important to note that the gross profit ratio is only calculated by businesses that sell stock and not service businesses.

Case Study: McDonald's

Profitability - gross profit ratio

McDonald's company stores have shown a steady increase in gross profit margin in 2016 and are marginally lower than Yum! Brands Inc., which has been improving as well. McDonald's recognises that many of its food inputs are commodities subject to price fluctuations, while the selling price in restaurants usually remains stable. This means that is it doing well to achieve consistent gross profits and management acknowledges that maintaining this will be a difficult task in the future.

Profitability - Net profit ratio

Net profit = net profit/sales

Net profit represents the profit or return to the owners, which is revenue less expenses. For sole traders and partnerships, net profit represents a return on their contribution to the business. It is usual for a company to return part of net profit to shareholders as dividends and retain a part for future expansion. The net profit ratio shows the amount of sales revenue that results in net profit.

Case Study: McDonald's

Profitability - net profit ratio

McDonald's company stores are now achieving their highest net profit percentage of 17% since 2013. This is the same as Yum! Brands Inc. company stores with 16%. For both companies, this is a direct result of the increase in gross profit. It may also be partially attributed to the refranchising and closing of underperforming stores.

Profitability - Return on equity ratio

Return on equity ratio = Net profit/Total equity

The return on equity ratio shows how effective the funds contributed by the owners have been in generating profit, and hence a return on their investment. The return for the owners has to be better than any return that could be gained from alternative investments, such as bank investments. The higher the ratio or percentage, the better the return for the owner.

Case Study: McDonald's

Profitability - return on equity ratio

2015 - 45%

Efficiency - Expense ratio

The expense ratio compares total expenses with sales. The ratio indicates the amount of sales that are allocated to individual expenses, such as selling, administration, cost of goods sold and financial expenses. The expense ratio indicates the day-to-day efficiency of the business. A business aims to keep expenses at a reasonable level.

Case Study: McDonald's

Efficiency - expense ratio

2016 - 83%

Efficiency - Accounts receivable turnover ratio

Accounts receivable turnover ratio = Sales/Accounts receivable

Accounts receivable turnover ratio measures the effectiveness of a firm's credit policy and how efficiently it collects its debts. It measures how many times the accounts receivable balance is converted into cash or how quickly debtors pay their accounts. By dividing the ratio into 365, businesses can determine the average length of time it takes to convert the balance into cash. If a firm's accounts receivable turnover is 84 days but its credit policy allows 30 days before payment, the firm would need to examine its cash flow, its credit policies, its credit collection procedures and costs, and its policies relating to doubtful debts.

Assess business performance using comparative ratio analysis

Judgements are made by comparing a firm's analysis against other figures, percentages and ratios. This is known as comparative ratio analysis and is important for firms. Businesses could compare ratios with their results from previous years, with similar businesses and against common industry standards or benchmarks. Analysis can also include budget figures so that predicted figures can be compared against actual figures, usually over short time periods such as per month.

Identifying the limitations of financial reporting

Financial reports and ratio analysis provide information on the state of the business and indicate trends in its operations. However, caution needs to be exercised when analysing financial reports because they may not give a completely accurate assessment of a business's financial position. Investors need to exercise caution when examining these reports. The following issues must be considered when analysing financial reports:

- Normalised earnings

- Capitalising expenses

- Valuing assets

- Timing issues

- Debt repayments

- Notes to the financial statement

Case Study: McDonald's

The limitations of financial reports - capitalising expenses

McDonald's Australia stated in its 2016 Annual Report that development costs for properties such as rates, taxes and legal fees are capitalised up to the date where future benefits are expected to exceed those costs. This means that expenses for a new restaurant site are recorded as an asset and depreciated over the useful life of that asset, therefore spreading the costs over periods of up to 40 years. Although this is in line with standard accounting practices, it can have an effect of overstating current net profit.

Ethical issues related to financial reports

Financial managers and accountants who prepare financial reports should ensure the decisions they make are ethical and that they act with the highest standards. Ethical considerations are closely related to legal aspects of financial management. Legislation is in place to guard against unethical business activity but there is often a time lag between the recognition of a problem and its implementation through law

Examine ethical financial reporting practices

The audit is an independent check of the accuracy of financial records and accounting procedures, and it has an important role in this process. All accounting processes depend on how accurately and honestly data is recorded in financial reports. Source documents must be created for every transaction, even those in which cash has changed hands. Prosecutions for tax evasion can harm the reputation of the business, and alienate customers who wish to deal with honest and ethical businesses. Not only are accurate financial reports necessary for taxation purposes, but other stakeholders are entitled to access to a business's financial information.

Financial management strategies

There are a variety of strategies financial managers can implement to address issues of concern.

- cash flow, working capital, profitability and global financial management

Cash flow management

Cash flow is the movement of cash in and out of a business over a period of time. If more money goes out than comes in, or if money must be paid out before cash payments have been received, there is a cash flow problem. Matching cash flow in with cash flow out is essential. By keeping records of cash flow, you know how much cash you have in your wallet or in the bank at a given time. However, this record does not tell you what debts you have or what is owed to you by others.

Management strategies

Shortfalls of cash over longer periods are of greater concern for a business as insolvency or bankruptcy may result. An important strategy involves distributing payments throughout the month, year or other period so that large expenses do not occur at the same time and cash shortfalls do not occur. Another cash flow management strategy is offering debtors a discount for early payments. Factoring is the selling of accounts receivable for a discounted price to a finance or specialist factoring company

Working capital (liquidity) management

Working capital is the term used in businesses to describe the funds available for the short-term financial commitments of a business. It represents those funds that are needed for the day-to-day operations of a business to produce profits and provide cash for short-term liquidity. It involves determining the best mix of current assets and current liabilities needed to achieve the objectives of the business. Management must achieve a balance between using funds to create profits and holding sufficient funds to cover payments.

The current (working capital) ratio

Current (working capital) ratio = Current assets/Current liabilities

The ratio indicates the amount of risk taken by a business in relation to profitability and liquidity, and can help determine whether the business's financial structure is acceptable. A high current ratio may indicate the business has invested too much in current assets that bring in a small return. A low current ratio may mean that the business is more profitable if it is investing its resources in longer term assets and generating more profits.

Control of current assets

Control of current assets requires management to select the optimal amount of each current asset held, as well as raising the finance required to fund those assets. Working capital must be sufficient to maintain liquidity and access to credit (overdraft) to meet unexpected and unforeseen circumstances. Cash is critical for business success, and careful consideration must be given to the levels of cash that are held by a business. A business must monitor its accounts receivable and ensure that their timing allows the business to maintain adequate cash resources. Inventories make up a significant amount of current assets, and their levels must be carefully monitored so that excess or insufficient levels of stock do not occur

Control of current liabilities

Minimising the costs related to a firm's current liabilities is an important part of the management of working capital. This involves being able to convert current assets into cash to ensure that the business's creditors are paid. The holding back of accounts payable until their final due date can be a cheap means to improve a firm's liquidity position, as some suppliers allow a period of interest-free trade credit before requiring payment for goods purchased. Businesses may need to borrow funds in the short term for a number of purposes. Funds may be required to cover the sale and purchase of property, unforeseen circumstances, and import and export commitments. Overdrafts are a convenient and relatively cheap form of short-term borrowing for a business.

Strategies for managing working capital

Strategies for working capital management include:

• leasing

• sale and lease-back.

Leasing involves the payment of money for the use of equipment that is owned by another party. A lease is a contract between the lessor (owner of the asset) and the lessee (user of the asset) that lets the lessee rent an asset for a period of time in exchange for periodical payments. Sale and lease-back refers to the process of selling an owned asset to a lessor and then leasing the asset back through fixed payments for a specified period of time. The lessor retains ownership of the asset as part of the agreement.

Profitability management

Profitability management involves the control of both the business's costs and its revenue. Accurate and up-to-date financial data and reports are essential tools for effective profitability management.

Cost controls

The costs associated with a decision need to be carefully examined before it is implemented. Monitoring the levels of both fixed and variable costs is important in a business. Changes in the volume of activity need to be managed in terms of the associated changes in costs. Comparisons of costs with budgets, standards and previous periods ensure that costs are minimised and profits maximised. A number of costs can be directly attributable to a particular department or section of a business, and these are termed cost centres. A cost centre is a department within a business that is responsible for a particular set of activities that benefits the organisation.

Revenue controls

In determining an acceptable level of revenue with a view to maximising profits, a business must have clear ideas and policies, particularly about its marketing objectives including the sales objectives, sales mix or pricing policy. Marketing strategies and objectives should lead to an increase in sales and hence an increase in revenue. Sales objectives must be pitched at a level of sales that will cover costs, both fixed and variable, and result in a profit.

Global financial management

- exchange rates

- interest rates

- methods of international payment - payment in advance, letter of credit, clean payment, bill of exchange

- hedging

- derivatives

Comparing the risks involved in domestic and

global financial transactions

The growth of global business has resulted in economic expansion for many countries, as well as bringing extra concerns. Global businesses, however, bring extra concerns and risks for financial managers — in particular, currency fluctuations/exchange rates, interest rates, methods of international payment, hedging and derivatives. Financial risks associated with global expansion are greater than those encountered domestically, but such risk taking is necessary for the business strategy to be implemented.

Exchange rates

Countries have their own currency, which they use for domestic purposes. This means that when transactions are conducted on a global scale, one currency must be converted to another. Therefore, in all global transactions it is necessary to convert one currency into another. This transaction is performed through the foreign exchange

market, commonly abbreviated to forex or fx, which determines the price of one currency relative to another.

Interest rates

A business that plans to either relocate offshore or expand domestic production facilities to increase direct exporting will normally need to raise finance to undertake these activities. A global business has the option of borrowing money from financial institutions in Australia, or they can borrow money from financial markets overseas. Traditionally, Australian interest rates tend to be above those of

other countries, especially the United States and Japan. Thus, Australian businesses could be tempted to borrow the necessary finance from an overseas source to gain the advantage of lower interest rates.

Methods of international payment

One of the most crucial aspects of global financial management is to select an appropriate method of payment. Payment can be complicated by the fact that the business may be dealing with someone they have never seen, who speaks another language, uses a different monetary system, who abides by a different legal system and/or who may prove difficult to deal with if problems occur later on. One major worry for the exporter is that if the products are shipped before payment is received, there may be no guarantee that the importer will pay. On the other hand, the buyer is faced with a similar situation. The importer may worry that if payment is sent before the products are received, there is similarly no guarantee that the exporter will send the products.