Business Studies - Financial Planning and Management Study Notes. Financial Planning and Management Study Notes:

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1 Business Studies - Financial Planning and Management Study Notes Financial Planning and Management Study Notes: The Role of Financial Planning: The strategic role of financial management: Organisational objectives provide a greater detail about the organisation s mission. Organisation objectives break down the business operations into achievable outcomes that can be measured and evaluated. Strategic Plans: Encompass a long term view of where the organisation is going, how it will get there and a monitoring process to keep track of progress along the way. Objectives of Financial Management: Liquidity: Refers to the ease with which an asset can be converted cash. More importantly it is the ease of a business to meet its short term liabilities. Profitability: Is the ability of a business to make a financial return from business activities. Efficiency: is generating maximum returns for the minimum costs. Growth: is the increase in the size and value of a business over time. Return on capital: Capital is the amount of funds that is invested in a business to create wealth. These funds are referred to as owner s equity. The Planning Cycle: The planning cycle is an integral part of the business plan. This cycle is ongoing and includes: Addressing the present financial position Determining financial elements of the business plan Developing budgets Cash flows Financial reports (2012) All Rights Reserved 1 of 10 For more info, go to

2 Interpretation of financial reports Maintaining record systems Planning financial controls Minimising financial risks and losses Addressing the preset financial position: A situational analysis of the current financial position is the basis for effective financial planning. Data driven identification of current financial issues and trends will assist the development of appropriate budgets, analyses, strategies and controls in the planning cycle. Determining financial elements: The business plan sets out goals and future direction (vision) of the business, including where the business expects to be at the end of a particular time period. The financial elements of the plan will identify the amount of finance needed, the sources of finance available and the methods of reporting financial data to support the strategies developed to achieve the vision, goals and objectives of the business plan. Developing Budgets: A budget is a plan predicting revenue (from sales and investments) and expenses of a business for a future time period. Budgets identify anticipated sources of revenue and expenses and are derived from the overall strategic business plan. There are various types of budgets, including: The operating budget, which relates to the day to day operation of the business and includes sales, labour costs and administrative expenses. Financial budgets, which include the balance sheet, cash flow and revenue (profit and loss statements) statements. Cash Flows: Cash flow is the difference between cash inflows and cash outflows. For a business to survive it is necessary to have more cash going in than is going out. A cash flow budget helps a business to predict the cash inflow and cash outflows over specified periods of time. Close monitoring of the cash flow position is important so that the business can meet its short term financial commitments. Financial Reports: Include statements of financial performance (Revenue statement), statement if financial position (Balance sheet). These standard reports communicate financial information about the business to stakeholders, including owners, shareholders, employees and government regulatory authorities. (2012) All Rights Reserved 2 of 10 For more info, go to

3 Interpretation of financial reports: Financial reports require interpretation for the position and performance of a business to be fully understood. Financial managers and accountants use the ratio analysis to assist their interpretation of this financial data. Maintaining record systems: Are the processes and practices that a business uses to store data such as sales, expenses, assets, liabilities and customer, supplier and product information. Planning Financial Controls: Is a tool that provides feedback on the financial performance of the business. Financial controls include budgets, cash flow statements, profit and loss statements and balance sheets. Minimising financial risks and losses: Is the chance that a financial decision will result in a financial loss. The main type of financial risk is that the business will not have enough cash flow to meet its financial commitments. Debt financing also raises the financial risk of a business. Financial Markets relevant to business financial needs: The financial market provides businesses access to a wide range of financial products. This allows a business to use the participants expertise and to customise the type and use to match the business purpose and structure. The two main types of financial markets are the: Capital market Short term money market The capital market deals with financial securities that help raise long term funds for business. This market includes the debt market and the equity market. The debt market involves the borrowing and repayments of funds such as mortgages and bonds. The equity market involves buying and selling of company shares. The money market involves the borrowing and lending of money in the short term. This is a highly liquid form of finance. Participants in the money market in debt products that have a maturity date of twelve months or less. Major participants in financial markets: Include financial intermediaries, which accept deposits from lenders and make loans to borrowers. Such intermediaries are vital in the provision of external funding for the establishment, growth and operations of businesses. The participants in the financial markets include: (2012) All Rights Reserved 3 of 10 For more info, go to

4 Banks Financial and insurance companies Merchant banks Superannuation/ mutual funds Companies Government (RBA) The role of the ASX as a primary market: The ASX has many roles including: Assisting companies to raise initial capital finance through the issue of shares, whereby those buying the shares become part owners in the business. Providing a market for existing company shares to be traded between buyers and sellers Overseas market influences and Trends: A number of overseas influences have affected the Australian financial markets including: US credit crisis in the subprime market. In 2007, US commercial and investment banks were affected by the inability of borrowers to repay their debts. The main domestic market influences are: Financial deregulation: The regulation of restriction in the Australian financial market began in 1983 with the floating of the Australian dollar. This deregulation led to an increase in the number of overseas financial institutions, such as /Barclay Bank and HSBC, coming to Australia. Interest Rates: The RBA sets the cash rate in response to the current economic conditions in Australia. An increase in interest rates will cause business revenue to decrease as a result of the increase in home loan expenditure on the common Australian consumer. Compulsory Superannuation: The Australian government requires employers to contribute an additional 9 per cent of an employee s salary to a superannuation fund assessable at retirement. (2012) All Rights Reserved 4 of 10 For more info, go to

5 Management of Funds: Businesses need to use a mix of both debt and equity finance to achieve their financial objectives. Sources of funds: Internal sources: Owners Equity- is the funds contributed by owners to establish and build the business. Retained profits: 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 accessible source of finance for future activities. External sources: External finance is the funds provided by sources outside the business including banks, other financial intermediaries, government, suppliers or financial institutions. Short term borrowing: includes overdraft and bank bills. Overdraft is when the bank allows a business to draw cheques a certain previously settled amount. Banks bills are short term loans of about days it involves the business getting the money immediately promising that it will pay the money back at the maturity of the period. Long term borrowing: Mortgage: a mortgage is a long term loan that is secured by the property of the borrower. The usual length of the loan is 15 years. Debentures: are issued by a company for a fixed rate of interest and for a fixed period of time. Debentures are usually not secured to specific property. Leasing: is a long term source of borrowing for a business. It involves the payment of money for the use of equipment that is owned by another party. Leasing enables an enterprise to borrow funds and use the equipment without large capital outlay required. Operating Leases: are leases for short periods, usually shorter than the life of the asset. Financial Leases: Under the conditions of a financial lease, the lessor purchases the asset on behalf of the lessee. Financial leases are usually for the life of the asset. Some advantages of leasing as a source of finance are as follows: (2012) All Rights Reserved 5 of 10 For more info, go to

6 The costs of establishing leases may be lower than other methods of financing It permits 100 percent financing of assets. Lease payments are a tax deduction. Factoring: Is where the factor purchases an account receivable from the business for nearly a full percentage of the price. It allows the business to gain the money owed to them quickly. Trade Credit: Is where a creditor allows the business extra time on the repayment of the funds. Comparing Debt and equity Finance: Debt Equity Lenders Have prior claim in the event of liquidation Debt must be repaid by periodic repayments Interest payments are tax deductable Lenders usually require a lower rate of return Shareholders have a residual claim on assets Equity has no maturity date Dividents are not tax deductible Shareholders require a higher rate of return due to risk Interest payments are fixed Dividend payments are not fixed and may be reduced through lack of funds Debt providers have no voting rights Equity holders have voting rights Gearing/ Leverage: Is the proportion of debt (external finance) and the proportion of equity that is used to finance the businesses activities. Gearing/ leverage is an important consideration for businesses as the more highly geared the business (using debt rather than equity), the greater the risk for the business. Using Financial Information: Types of financial Ratios: Analysis: is an important part of the accounting process. It involves working the financial information into significant and acceptable forms that make it more meaningful and highlighting relationships between aspects of an organization. The main types of analysis are vertical, horizontal and trend analysis. (2012) All Rights Reserved 6 of 10 For more info, go to

7 Vertical analysis compares figures within one financial year; for example expressing gross profit as a percentage of sales and comparing debt to equity. Horizontal analysis compares figures from different financial years; for example, comparing 2007 and Trend analysis compares figures for periods of three to five years. Interpretation: is making judgements and decisions using the data gathered from analysis. Liquidly: Is the extent to which the business can meet its current liabilities or short term debt. It is the relationship between current assets and current liabilities and indicates the liquidity position of the business. Solvency: refers to the long term stability of the business. Solvency indicates whether the business can meet its total financial commitments as they fall due. Profitability: is the ability to make a financial return from business activities. Effiency: means the amount of return that a business can produce for minimum costs. Efficiency ratios provide the basis for assessing how efficiently the business is using its assets and spending to create sales and profits. (Ratios and other information on table below) (2012) All Rights Reserved 7 of 10 For more info, go to

8 Ratio type Financial ratio Formula Reasons for the use of this ratio Liquidity Current ratio The ratio gives an indication of how well a business can meet its current assets. Solvency Gearing ratio Gearing is the relationship between the level of debt of the business and the level of owners' equity. If a business is highly geared it faces the possibility of not being able to repay its debt and becoming insolvent Profitability Gross profit ratio Net profit ratio Return on owners' equity This ratio measures what percentage of each dollar of sales is gross profit. It indicates the mark up on the goods that are sold by the business. The ratio measures what percentage of each dollar of sales is net profit. It takes into account the operating expenses. This is one of the most important indicators as it shows how much the owner's investment and risk in the business is earning. Suggested ratio level The generally preferred ratio level is 2:1. This means that for every $2 of current assets there is $1 of current liability. This means that the business is able to meet its short-term debts comfortably. The preferred ratio depends on the specific circumstances but for small business 60% is an acceptable level: for every 60 cents of liabilities there is $1 of owners' equity. The higher the % the greater the financial risk. Large companies may operate at over 100%. The suggested ratio level depends on the type of industry. A gross profit figure of 30 % indicates that every dollar of sales contributes 30 c of gross profit to the business. Falling figures or a low figure compared to similar businesses would be a concern. A high or at least increasing % is preferred but it depends on the industry. The higher the return the better. Usually over 20 % is a good return. (2012) All Rights Reserved 8 of 10 For more info, go to

9 Efficiency Expense ratio Accounts receivable turnover ratio Two steps to calculation: This shows the relationship between sales and the expenses that the business has made in making those sales. This ratio shows how long it takes for the business to receive cash for its credit sales from the debtors. This depends on the specific circumstances and strtegies that the business may be undertaking. However, increasing expenses over time will need closer review. The standard time to repay credit is between fourteen and thirsty days. If the accounts receivable rate is more than ten days above the standard payment time, then the business should be concerned. (2012) All Rights Reserved 9 of 10 For more info, go to

10 Comparative ratio analysis: There are three main benchmarks of which a business can compare its financial results to: 1) Past results historical analysis 2) Industry Average- are you above or below industry average for return on OE, NP, expense ratio, current ratio and gearing. 3) Benchmark to a standard such as bank interest rates. Eg, return on OE should be above 7% which is what could be earned if the money were in the bank. Limitations of financial reports: Caution needs to be exercised in reading the information. Misleading information impacts on business decision making and outs the business at risk. The first consideration that must be made is the effects of an external shock, if there is a recession then a profit ratio compared to the profit of a time when there was no recession is unreasonable. So it must be understood that when external shocks are taken into account the figures would look less serious. Historical costs: As time goes on prices change, for example if a business is on a property valued 20 years ago then there would be a large difference when the property is re valued. Value of intangibles: This can include licences, patents, trademarks, brand names, intellectual property and good will. These do not have a value on the balance sheet but can be worth millions for example the Coca Cola name would be worth millions. Strategies to Manage: Working Capital: The first consideration is cash, which should be minimised so an overdraft could be use to manage. The second is receivables or accounts rec. Factoring is used to speed up the relievable time. The final is inventory and a JIT inventory control system will minimise holdings of inventory. Profitability: Cont control and Expense minimisation. (2012) All Rights Reserved 10 of 10 For more info, go to

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