Chapter 11: Processes of financial management Flashcards
what does the financial planning process begin with
begins with long term or strategic financial plans which include planned capital expenditure and/or planned investments
(capital expenditure refers to spending on non-current or fixed assets such as plant and equipment)
what do long term financial plans cover
- cover planned sources of finance
- spending on research and debelopment
- market and product development
what do planning processes involve
planning processes involve the setting of goals and objectives, determining the strats to achieve those goals and objectives, identifying and evaluating courses of action and choosing the best alternative for the bus
what is the planning cycle
- addressing present financial position
- determining financial needs
- develoing budgets
- maintaining record systems
- identifying financial risks
- establishing financial controls
what are the financial needs of a bus determined by
- the size of bus
- its current stage in bus life cycle
- the current phase of the bus cycle
- future plans for growth and development
- its ability to source finance
what is a bus plan
the bus plan sets out the goals and future direction (vision) of a bus, including where bus expects to be at the end of time period and what strategies to get there
- req’d when seeking debt finance
what are budgets
plans predicting revenue (from sales and investments) and expenses of a bus for a future period of time
what info do budgets show
- funds required for planned expenditure for a particular period
- the cost of capital expenditure and other expenses against potential revenue
- estimated use and cost of raw materials or inventory
- amount and cost of labour hours required for scale of operations
what are the various tyoes of budgets
- operating budgets - day to day ops of a bus including sales, COGS, labour costs and other expenses
- project budgets - which relate to capital expenditure and R&D
- financial budgets - overall financial oerformance of the us (incorporate data from the operating and proj budgets to produce finance statements including income and cahs flows tstaements and the balance sheet
what are record systems
the processes and practices that a bus uses to store data such as sales figures, expenses, assets, liabilities and information on customer, suppliers and products
why are record systems important to management
a management bases its decision on such information, it is vital that the info provided by record systems is accurate, efficient and accessible
what does an effective record system allow
- allows a bus to improve efficiency
- continuously monitor its performance
- produce financial reports in a timely manner
- comply with taxation requirements
- identify issues of concerns or ops and respond faster
what is the double entry system of accounting
an important financial control mechanism - by recording all items twice, entries can be seen to balance (easy to find errors)
define financial risk
financial risk is the risk to a bus of being unable to cover its financial obligations - ie the debts incurred in short and long term liabilities
what factors must a bus consider in relation to financial risk
- what level of debt is acceptable for financing expansion of ops
- the willingness of owners/shareholders to contribute equity funds
- how to use excess funds - eg purchase assets, invest in other bsues
- how fast the bus can expand without encountering cash flow issues
- future interest rate movements
- ER fluctuations (can increase the cost of imported inputs, make exports less compeitive, etc)
- how the bus can protect itself from financial risk (eg insurance, hedging)
what must buses conasider when taking on debt to minimise financial risk
buses must consider the amount of profit liekly to be generated
- ie profits must be sufficient to cover the cost of debt as well as provide increasing returns
- the higher the risk (or gearing), the greater the expectation of profits or dividends
what must a bus have if its takes on short term debt
it must have an adequate mt of liquid assets so that short term liabilities can be covered
what are some egs of financial controls
- budgets
- financial statements such as incoem and cash flow statements and balance sheets
- the policies and procedures to be followed by management and employees
deifne financial controls
refer to the policies, procedures and other measures designed to ensure that bus goals met efficiently and to prevent financial problems and losses
what are the most common forms of financial problems and losses
- theft and fraud - unnecessary stock purchases for personal use, misuse of expense accounts, false invoices, etc
- damage or loss of assets
- errors in record systems
what are some common polcies and procedures that promote control within a bus
- clear authorisation and responsibility for tasks in the bus
- the double entry system of accounting
- separation of duties
- rotation of duties
- spending limits for different roles
- control of cash - eg cash registers, banking cash daily, no money kept on premises overnight
- protection of assets - buildings kept locked,
- control of credit procedures
define debt finance
debt finance is a liability to a bus involving short and long term borrowing from external sources
define equity finance
refers to funds contributed by the owners - eg start up capital, sale of new shares and retained profits
what are the adv of debt financing
- owners retain full ownership and control of the bus
- loan funds are ofte easier and quicker to obtain that equity
- profits not shared with lender
- interest repayments are tax deductible
what are the disadv of debt financing
- establishment cost of loans, ongoing fees and charges, interest repayments
- interest rates may rise (more exp)
- repayments made regularly, having less flexibility that with dividend payments
- cahs flow difficulties may arise, resulting in possible default on the loan
- the debt to equity (gearing/leverage) ratio increases, threatening solvency and long term stability fo the bus
what are the advs of equity financing
- funds dont have to be repaid within set time or with interest (flexibility in the timing)
- greater potnetial for growth as owners have interest in the success of the bus
- owners receive greater returns
- the debt to equity ratio decreases, lowering the risk to the bus
what are the disadv of equity financing
- increases the no# of owners, resulting in reduced control, decision making, sharing of profits, etc
- cna be more expensive in the long term as shareholders ecpect higher returns on capital investment
- equity is often ahrd to obtain, takes longer and has administrative costs
- shareholder demand for dovidends may reduce retained profits
- the bus vulnerable to takeovers if other individuals or buses acquire majority shareholding
what is gearing (or leverage)
the ratio of debt funding to equity funding in a bus important to the long-term stability fo the bus (80% - 80 cents of liabilities to every $1 of owners’ equity)
what does a high gearing ratio mean for a bus
a high level of risk - the amount of owners’ funds available to cover the liabilities of the business is low, increasing the risk of the bus not meeting its liabilities and becoming insolvent
what does a low gearing ratio means for a bus (30% - 30cents for every dollar of owners’ equity)
may indicate that the bus is issing out on oppps to expand using debt finance
what is the optimum gearing ratio based on
the size of the bus, legal/ownership structure, what industry the bus ops in, the state of the eco
what will the most appropriate terms and sources of finance be influlenced by
- the purpose for the funds are req’d
- the cost of each source of funding
- the structure of the bus
- flexibility of the source of finance
- the availability of funds
- the level of control maintained by the bus
what is the matching principle
the matching principle dictates that the term (duration) of a loan should be matched to the economic life of the asset purchased with the loan
- ie short term assets should be funded by short term finance
- eg a temporary shortfall in cash should be funded by a bank overdraft
whiy is the structure of a bus an influence for the bus to choose long term or short term funds
small buses have fewer opps for both debt and equity finance than larger buses due to more risk
why is the cost of each source of funding an influence for a bus to choose long vs short term funding
issuing shares will result in sharing profits, taking out loan will involve establishments costs and interest repayments
why is the felxibility of the osurce of finance an influence for a bus to chooose long or short term finance
- buses reqs may be prone to change within the bus environment
- bank overdrafts and credit cards proide a great source of short term flexibility
why is the availability of funds an influence for a bus to choose short or long term funds
- loans can be difficult to obtain if a bus has high lvls of gearing or poor credit ratings or due to cirumtsnaces beyond a bus’s control; eco conditions
why is the level of control maintained by the bus an influence for a bus to choose short or long term
- lenders may req a security reducing the ability of the bus to obtain finance in the future (mortgaged assets cant be used as secuirty on another loan), while obtaining equity funds req’s reduced control over decision-mking
what is cash flow
- the difference between cash inflows (money in
and cash outflows (money out).
what are cash flow statements
important financial reports used to forecast and document monthly cahs inflows and outflows
- forecasting allows managers to predict period of excess and low cash to prepare and respond quickly
- this enables bus to monitor and control their spending to ensure they are able to meet short-term financial commitments and take adv of excess cash periods to grow
cahs flows statements show whether a bus can
- consistently geenrate positive cash flow
- pay its financial commitments as they fall due
- have sufficient funds available for future expansion of change
- obtain finance from external sources when needed
- pay drawing to owners (funds taken out of the bus by owners)
what is the genral format for cash flow statements
-each period begins with the opening balance
- cash inflows (or reciepts) are added
- cash outflows (or payments) are subtracted
- the resulting closing balance for the period become the opening balance for the following period
what do income statements show
income statements shows a bus’s op results for a particular period of time - show:
- revenue earned (money in)
- COGS inccured (moeny out)
what is revenue on a income statement
revenue is usually “sales”
what is the formula for COGS
opening stock + purchases - closing stock
what is the formula for gross profit and net prodit
gross profit = sales - COGS
net profit = gross profit - expenses
what do balance sheets show
show the short and long term assets of a bus, its hsort term and long term liabilities and the owners’ equity at a particular point in time
what can a balance sheet can indicate
- whether a bus has enough current assets to meet its short term debts
- how the assets of the bus have been financed
- whether the owners are making a good return on their investment
- the ifnancial stability of the bus and ability to borrow further funds
- how the financial position of the bus has changed from prev yrs
what si the accounting equation
assets = liabilities + owners’ equity
or
owners’ equity = assets - liabilities
what are financial ratios used for
main tools used by managers to analyse financial info and examine the performance of a bus to determine if it is meeting financial obj and evaluate performance
what is the analysis of financial statements
using financial ratios to compare financial performance with prev yrs, with compeititors and against industry avgs
analysis is followed by interpretation which involves:
making judgements using the data gathered from analysis
what does the current ratio (for liquidity) measure
the ratio shows how well liabilities such as accs payable and bank overdrafts are covered by current assets such as cahs (or stock easily converted to cahs)
- indicates liquidity position
what is the formula of the current ratio
current ratio = current assets/ current liabilities
what is the ideal current ratio
2:1 (ie $2 current assets for every $1 of current liabilities)
- the higher the ratio, the more capable a bus to meet its short term financial obligations (can confortably meet short term debts without having large amounts of inefficient cash in the bank)
what is solvency
solvency refers to the long term stability fo a bus; a bus’s ability to meet its total financial commitments
what does the debt to equity ratio compare
compares the level of debt of a bus and the level of equity
what is the formula of the debt to equity ratio
total liabilities (current + non-current)/ owners’ equity
- often expressed as a %, in which case u would multiply the ratio by 100
which ratios are acceptable for debt to equity ratio
- greater than 1:1 means that a bus has more ebt than equity
- 0.5-0.6:1 is an acceptable lvl for small bus (for every 50-60 cents of liabilities there is $1 of total equity)
- larger, more established buses often operate above 100%
how can a bus improve its gearing
- reduce debts or increase equity (or both)
- to reduce liabilities, non-essential assets could be sold to repay debts or loans renegotiated to spread repayments
- lease assets instead of purchasing
- increasing equity thru selling new shares or inviting new owners
what does the gross profit ratio measure
- the gross profit ratio measures the % of each dollar of sales that is gross profit
- indicates the mark up on the goods sold by a bus (diff b/w cost of goods and what it got sold for)
- eg a gross profit ratio of 30% reps 30cents of gross profit for every dollar of sales
what is important to note about the gross profit ratio (defining feature)
- only used by trading buses (ones that buy stock from suppliers to sell to customers at higher price)
what is the formula for the gross profit ratio
gross profit/sales (generally % so x by 100)
is there a a generally acceptable % for gross profit ratio
- no but the higher the ratio the better
- a low % may indicate a need to swtich to cheaper suppliers or raise prices
what does the net profit ratio measure
measures the % of each dollar of sales that is net profit
how does net profit ratio differ from gross profit ratio
net profit ratio also takes into account the expenses of the bus (as opposed to COGS) compared to gross profit ratio
- thus net profit ratio always lower than its gross profit ratio (since NP = GP - expenses
what is the formula for net profit ratio
net profit/sales (expressed as % so multipy by 100)
is there an accpetable ratio for net profit ratio
no - the hgiher the % the better
- a falling net prof ratio or low compared to similar bus would be concerning
-
what does the return on equity ratio measure and which financial objective does it indicate
- shows how much the owners’ investment and risk in the bus is eanring
- return on equity ratio one of the most important indicators to profitability
what is the formula for return on equity ratio
return on equity ratio = net profit/owners’ equity (usually % so multiply by 100)
what is the acceptable ratio for return on equity ratio
the higher the percentage, the better return for the owner
- industries reqing fewer assets generate higher returns on equity and vice
- should be compared with industry avgs and prev yrs
define efficiency and efficiency ratios
- efficiency means that a bus is generating max retruns with minimum costs
- efficiency ratios provide a basis for assessing how efficicently a bus is using its resources and spending to create sales
what foes the expense ratio show
shows the proportion of expenses to sales
what is the formula for the expense ratio
expense/sales (expressed as %, so multiply by 100)
what is the generally acceptable ratio for the expense ratio
none - vary b/w industries
- generally the lower the expense ratio the better
- note expense ratio = GP ratio - NP ratio
what does the accs receivable turnover ratio show
shows how long it takes for a bus to collect money from its debtors
- measures the effectiveness of a bus’s credit policy and how efficiently it collects its debts
what are the two steps to calculating the accounts receivable turnover ratio
- step 1: sales/accounts receivable = accounts receivable turnover ratio (no# of times accs rec were turned over during the yr)
- step 2: 365/accs receivable turnover ratio = no# of days on avg it tales for the bus to collect accs receivable (the lower the better)
what is the acceptable credit period for buses to get accs receivable
- standard credit period for most buses is b/w 14 and 30 days
- a turnover ratio within 10 days of the industry avg is considered acceptable
what does the comparative ratio analysis compare
- compares ratios over different time periods
- compares ratio against common standards, such as industry avgs
- compares ratios with similar buses
what is the benefit of comparing and analysing ratios
- enables a bus to better identify trends and allows for more meaningful interpretation of ratio results
- insight into the financial performance of a bus
what are the limitations of interpreting financial reports (definition)
an issue that presents the bus’s financial position as nto accurate, which can lead to inappropriate decision making which may place the bus at risk
what are the factors that over come the limitations of finanial reports by enabling a better understanding of the bus’s finance
- normalised eanrings
- capitaslising expenses
- valuing assets
- timing issues
- debt repayments
- notes to the financial statement
how are normalised earnings a limitation for financial reports
- the process of removing one time or unusual events from financial statements to show the true earnings of a company
- unusual items of expenditure may similarly be normalised or omitted from financial reports however, included in statutory results, but excluded from underlying results
how are capitalising expenses limitations of financial reports
involves recording a transaction that would normally be recorded as an expense ont he inome statement as an asset on the balance sheet
how is the method of valuing assets a limitation of financial reports
the method used to estimate the value of assets has a significant impact on the balance sheet
- eg vehicle may be valued at the purchase price even tho its now worth significantly more or less
how are timing issues a limitation of financial reports
reports covering a shorter period of time (eg quarterly) may not give a true rep of the financial position of a bus cos its doesnt take into account seasonal fluctuations
- eg major item occur just outside the dates of a financial period
debt repayments - there are a no# of limitations related to debt repayments as financial reports do not disclose the following
- how long a bus has had its debt and how logn its has been recovering debts owed to the bus
- the vapacity of debtors to repay amounts owed
- the effectiveness of the methods the bus has for the recovery of debts
- whether debt reapyments have been delayed until the next financial period
how are notes to the financial statement a limitation of financial reports
imoprtant details and additional info that are left out of the main reporting docs such as baalnce sheet
what are the ethical issues concerning the interest of these stakeholders
- valuing of assets: eg inventories and accs receivable - overvaluation of these would suggest bus in better position than it is
- use of debt funds - though debt may be used to increase profits, its extensive use creates added risk
- budget estimates - common practice for buses to overestimate expenditures and underestimate revenues to allows for unexpected events
what is an audit
an audit is an independent check of the accuracy of financial records and accounting procedures of a bus
what do audits ususally include
physical counts of assets usch as cash, inventory, accs receivable and non-current assets
what are the 3 types of audits
- internal audits - check accounting procedures and the accurancy of financial records
- management audits - review of firm’s strategic plan and determine is chnages should be made
- external audits - carried out by independent accounting firms to guarantee the authenticity of financial reports
Why is accuracy in financial reporting important?
It ensures compliance with tax laws, builds trust with stakeholders, and prevents fraud.
What are the main purposes of internal and external audits?
They help prevent waste, inefficiency, and misuse of company assets, including fraud and theft.
What is the role of businesses in collecting GST?
Businesses collect GST at each stage of production and must report it to the government.
What are the consequences of understating profits?
It is illegal, makes it harder to attract investors or secure loans, and reduces the business’s sale value.
It is illegal, makes it harder to attract investors or secure loans, and reduces the business’s sale value.
It can lead to audits, loss of investor trust, reputational damage, and potential legal action.
