Processes of Financial Management Flashcards
What are the steps of financial planning
- Determing financial needs
- Developing budgets
- Maintaining record systems
- Identifying financial risks
- Establsihing financial controls
What forms basis of financial plan
Situtational analysis
Where does data for analysis come from
The financial statements
What determines a business’s financial needs
- Size of the business
- 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
What is a budget
A plan predicting revenue an expense of a business for a future time period
What does a budget provide
Information in quantitative terms about requirements to achieve a particular purpose
How does a budget act as a control measure
Allows businesses to compare planned performance against actual performance and taking corrective action when needed
What are three types of budgets
- Operating
- Project
- Financial
What is a operating budget
Budget concerned with main activities of a business such as sales
What is a project budget concerned with
- Capital expenditure and R&D
- Includes information on purpose of asset purchase and revenue generated from purchase
What is a financial budget
- Relates to financial data of the business
- Predictions of operating and project budgets are included in the budgeted financial statements
Example of a budgeted income statement
What are record systems mean
The mechanisms that ensure data is recorded & the information provided is accurate, reliable, efficient & accessible
Example of record systems
Paper based journals or electronic
What do record systems store
Data such as sales, expenses, assets, liabilities and customer, supplier and product information
What is a financial risk
The risk that a financial decision will result in a financial loss
If a business cannot meet its financial commitments what will it become
Insolvent
What are the steps to minimise risk
- Profit generated must be sufficient to cover cost of debt as well as increasing profits to justify the risk taken by the business owner.
- Consideration must also be given to the liquidity of a business’s assets à there must be sufficient liquid assets (cash) to cover interest and principal repayments
What are financial controls
Financial controls are the policies and procedures that ensure the plans of a business will be achieved in the most efficient way.
What are exmaples of policies and procedures that ensure business plans are achieved in most efficient way
- Clear authorisation for tasks in the business
- Separation of duties
- Control of cash
- Protection of assets
Examples of controls
- Budgets
- Cash flow statements
- Income statements
- Balance sheets
What is debt finance
Debt finance relates to the short term and long term borrowing from external sources by a business
What is equity finance
Equity finance relates to the internal sources of finance in the busines
What are advantages of debt financing
- Will not dilute current ownership of the business
- Funds are readily available and can be acquired at short notice
- Increased funds should lead to increased earning and profit
- Flexible payments and types of debt are available
- Interest payments are tax deductible
- Profits are not shared with lender of loan
What are advanatges of equity financing
- Capital does not have to be repaid with interest within a set time
- Owners receive returns through both dividend repayments and increase Ii share value
- Flexibility in timing and amount of dividend payments
- Cheaper than other sources of finance as interest does not have to be paid
- Greater potential for growth as owners has a vested interest in success of business
- Low gearing (debt/equity)
What are cost disadvantages of debt financing
- Initial establishment costs and ongoing fees and charges
- Interest has to be paid on funds borrowed
- Repayments often fixed and inflexible
- Security is required by the business
- Amount must be repaid within a set-period
- Creditors have first claim to any money should business go bankrupt
What are cost disadvantages of equity financing
- Increases number of owners, reducing level of control and increasing the sharing of profit and time taken to make decisions
- Longer term it is more expensive than debt à dividends paid to shareholders expect higher ROI
- Long expensive process to obtain funds this way
- Ownership is diluted
- Equity funding is not tax deductible
What are risk disadvanatges of debt financing
- Increased risk since interest, bank charges and govt charges may increase
- Cash flow difficulties may develop causing the business to have difficulties repaying the loan
- If loan is secured, defaulting on loan may lead to loss of asset
The debt `to equity ratio (gearing/leverage) may increase, affecting the solvency and long-term stability of business
What are risk disadvantages of equity financing
- Central control of ownership is reduced, causing a loss of control in decision-making
- Equity holders have voting rights
- High demand for dividend payments to shareholders may reduce level of retained profits
- The business is more open to takeover if a business buys a majority shareholding in the business
What does matching the terms and sources of finance to business purpose
- Businesses must find the source of finance that is most appropriate to fund activities (such as: purchase new equipment, purchase inventory, build new premises, buying a new factory or vehicles) which are required to achieve their financial objectives (e.g. profit growth, increased market share)
What does terms of finance involve
- Short term finance must match short term purpose of finance (e.g. temporary management of cash flow shortfall should be financed by bank overdraft) and
- Long-term finance should be obtained for long term purposes (e.g. expansion of the business overseas or buying a property)
Why should costs of each source of finance be determined
Because the required rate of return that can be expected from the use of the finance (e.g. machine purchase etc), should be balanced against the costs of each source of finance
How does business structure effect source of finance
It Influences decisions about finance
small businesses have fewer opportunities for equity capital for example, than larger businesses
Why should flexibility of funding source be considered
Businesses often require flexibility so that if they have excess funds, borrowings can be paid off more quickly Bank overdrafts for example provide greater flexibility than debentures
What costs of finance should be considered
Set-up costs and interest rates
What is the main way the availablity of finance is determined for businesses
- The higher the credit rating (track record in meeting its financial commitments), the greater number of available sources of finance (banks more willing to supply finance)
- The lower the credit rating, the more limited sources of finance available to a business
What impacts a businesses level of control over sources of finance
Conditions such as security and other restrictions
How does equity financing effect level of control for buisnesses
Further share issue dilutes ownership for existing owners/shareholders and hence voting rights
What are the main financial controls
- Cash-flow statements
- Income statement
- Balance sheet
What is cash flow
The difference between cash inflows (money going into business) and cash outflows (money leaving business)
What does a cash-flow statement record
Cash flow statement specifically records the movement of cash receipts and cash payments that result from transactions over a given time, for example a month
A cash flow statement shows whether a business can…
- generate a favourable cash flow
- pay its financial commitments as they fall due (e.g. interest and repayments of borrowings, accounts payable)
- have sufficient funds for future expansion
- pay drawings to owners or dividends to shareholders
- obtain finance from external sources when needed.
What are the three main categories activities are divided into
- Operating
- Investing
- Financing
What are operating activities in a cash flow statement
Cash inflows and outflows relating to the main activity of the business
What are investing activities in a cash flow statement
Cash inflows and outflows relating to purchase and sale of non-current assets and investments
What are financing activities in a cash flow statement
- Cash inflows and outflows relating to the borrowing activities of the business. Borrowing inflows relate to equity or debt.
- Cash outflows relate to the repayments of debt and cash drawings of the owner or payments of dividends
What is another word for income statement
Profit and loss statement
What does a income statement outline
The level of revenue, cost of goods sold (COGS) and operating expenses and calculates whether a business has made a profit or loss over a particular period of time
What does an income statement help businesses understand
Changes in profit and expenses during reported period of time and can be compared with other businesses and industry standards
What is sales revenue
Money generated from all goods sold
What does cost of goods sold refer to
The business expenses directly tied to the production and sale of a company’s goods and services à represent expenses directly incurred when a transaction takes place
What is equation for COGS
COGS = (opening stock + purchases) – closing stock
What are examples of COGS
Labour directly tied to production, Direct materials, needed for the production of goods and services, taxes on the production facilities
What are expenses
The total operating costs of the business
What do operating expenses refer to
- expenditures that are not directly tied to the production of goods or services
What are examples of operating expenses
Rent, Utilities, Office supplies, Legal costs, Sales and marketing, Insurance
What is gross profit
The profit a company makes after deducting the costs associated with making and selling its products
What is gross profit equation
Gross profit = sale revenue – COGS
What does gross profit assess
A company’s efficiency at using its labour and supplies in producing goods or services and mainly considers variable costs such as labour and materials. Net profit = gross profit – expense
What does net profit represent
How much money a company has after all expenses are paid, including operating expenses, taxes, interest
What is net profit equation
Net profit = gross profit – expenses
Where does net profit fit in a income statement
The last line
What does a balance sheet convey
The financial position of a business at a particular point in time (usually June 30)
What does a balance sheet show
The short- and long-term assets and short- and long-term liabilities and the equity (net worth) of the business
What is balance sheet based upon
The accounting equation
What does balance sheet assess
The level of liquidity, gearing and solvency
What are intangible assets
Assets that are not physical such as goodwill, they are usually harder to measure
What are current assets
Short-term assets that can be changed into cash within a year
Examples of short term assets
Cash at bank, inventory, accounts receivables
What are accounts receivable
Amounts owed to the business by people
What are non-current assets
Assets that are expected to provide economic benefits to the firm for more than 12 months
What is total assets
Current assets + non-current assets
What are current liabilities
Short-term debts that must be repaid within a year
What are accounts payable
- Amount business owes to people
- Usually repaid within 30-60 days
What are non-current liabilities
Debts to be repaid over periods greater than a year
What are total liabilities
Current liabilities + non-current liabilities
What is Owners equity
- The funds contributed by the owner(s) as well as retained profits and represents the business’s net worth (also referred to as capital)
What is accounting equation
Assets = Liabilities + Owners’ equity
How is balance sheet influenced by accounting equation
Balance sheets can be rearranged to represent different forms of accounting equation
How can balance sheet represent different versions of the accounting equation
Can either show:
- Assets = Liabilities + Owners equity
- OE = Assets - Liabilities
- Liabilities = Assets - OE
What form of accounting equation does this show
Assets = liabilities + owners’ equity
How does balance sheet link cash flow and income statement
- Retained profits comes from income statement
- Cash has come from cash flow statement
What are financial ratios
Calculations that help managers examine the performance of the business and whether it is meeting its financial objectives
What do ratios allow for
Comparisons to be made over time, with the previous year’s performance, with industry averages and competitors
What does analysis require
Interpretation
What does interpretation allow a business to do
Allows business to identify trends, make predictions and assists future planning
What are all the ratios
- current ratio
- debt to equity ratio
- gross profit ratio, net profit ratio, return on owners’ equity
- expense ratio, accounts receivable turnover ratio
What ratio shows liquidity
Current ratio
What ratio shows gearing
debt to equity ratio
What ratios show profitability
- gross profit ratio
- net profit ratio
- return on owners’ equity
What ratios show efficiency
- Expense ratio
- Accounts receivable turnover ratio
What does current ratio convey
Businesses ability to pay pack its short-term debts or current liabilities
What is current ratio also known as
Working capital ratio
What does current ratio measure
Measures a business’s ability to pay back their current liabilities with their current assets
What is current ratio formula
Current assets/Current liabilties
What is suggeested current ratio level
2:1
What do gearing ratios determined
The firm’s solvency — that is, its ability to meet its financial commitments in the longer term
What is gearing
The proportion of debt (external finance) and the proportion of equity (internal finance) that is used to finance the activities of a business
What is debt to equity ratio formula
Total liabilities/Total equity
Who are interested in gearing ratio
Potential investors and creditors
What must a business consider when determining the level of gearing
- ROI
- Cost of debt
- Size/stability of businesses earning capacity
- Liquidity
- Purposes of debt
What does it mean if a busines is highly geared
- Highly geared businesses have a bigger the risk of becoming insolvent however there is also potential for greater profits
What is preferred ratio for smal businesses
Aorund 60%
What is profitability
Profitability is the earning performance of the business and indicates its capacity to use its resources to maximise profits
What are the profit ratios
- Gross profit ratio
- Net profit ratio
- Return on equity (ROI) ratio
What is gross profit
The difference between sales revenue and the direct cost of goods sold. à it represents the amount of sales that is available to meet expenses resulting in net profit
What is gross profit ratio formula
Gross profit/Sales
What does gross profit ratio measure
Measures what percentage of each dollar of sales is gross profit, it indicates the mark-up on the goods
What is net profit formula
Net profit = gross profit - expenses
What does net profit represnent for owners and shareholders
ROI
What is net profit ratio
Net profit/Sales
What does net profit ratio measure
What percentage of each dollar of sales is net profit, it takes into account operating expenses
What is return on equity ratio formula
Net profit/Total equity
What does return on equity ratio show
How effective the funds contributed by the owners have been in generating profit, and hence a return on their investment
What does a higher ratio represent
A better return for the owner
What ratios show effiency
- Expense ratio
- Accounts recivebale turnover ratio
What does maximised efficiency lead to
Maximised profits
What is expense ratio formula
Total expenses/Sales
What does expense ratio showRe
Relationship between sales and the expenses the business has incurred in making those sales
What can expense ratio be used for
Indicate the amount of sales that are allocated to individual expenses, such as selling, administration, cost of goods sold and financial expenses.
What must managers do if expense ratio is too high
Managers must consider looking at monitoring and controlling their expenses
What is accounts receivable turnover ratio formula
Sales/Accounts receivable
What does Accounts Receivable Turnover Ratio measure
The effectiveness of a firm’s credit policy and how efficiently it collects its debts along with how many times the accounts receivable balance is converted into cash or how quickly debtors pay their accounts
How do you find how many days it takes a business to convert its accounts receivable balance into cash
Do 365 divided by accounts receivable turnover ratio
What is formula for the average length of time it takes to convert the balance into cash
365/(Sales/Accounts receivable)
In what ways are ratios compared
- Over different time periods
- Against common standards/benchmarks
- With similar businesses
What does comparing over different time periods involve
Businesses could compare ratios with their results from previous years
What does comparitive ratio analysis allow businesses to do
Gain meaning from analysis of ratio calculations
What does it mean for a business to compare against common standards
Involves comparing with standards such as industry standards and helps assess financial state of business
Who provides industry benchmarks
ATO
What does comparison with similar businesses involve
Involves comparison with businesses in the same industry and of the same size
What are issues that cause limitations of financial reports
- Normalised earnings
- Capitalising expenses
- Valuing assets
- Timing issues
- Debt repayments
- Notes to the financial statements
What are normalised earnings
Normalised earnings are earnings on the balance sheet that are adjusted to remove unusual one-off events
Whats an exmaple of a normalised earning
- Example of this would be where accounting business sold a block of land it owned in the CBD of a large yet à proceeds of sale would be substantial and might give unrealistic picture of profit for that business for that year à to normalise this event proceeds of sale would be removed from financial report for that year
What are other situtaions aside from asset sale which may lead to normalised earnings
- Inflation
- Economic cycles
What does it mean to capitalise an expense
To capitalise an expense is to change the expense from a ‘one-off’ operating expense into a capital item which can then be depreciated over time.
What does it mean if a business is able to capitalise an expense
Operating expense now becomes asset
What are impacts of capitalising expenses
- Operating expenses will reduce and therefore profit will increase
- Assets of business will increase
- Change in liabilities of business
Whats an example of capitalising expenses
An example might be including the legal costs and stamp duty in acquiring a large property as part of the asset value on the balance sheet to overstate this value
How does capitalisng expenses effect financial reports
- This distorts the financial reports of the business. By changing the expense into a capital item (asset), the business can claim depreciation of the capital item as a tax deduction over a number of years.
What does historical costs mean in relation to valuing assets
Values assets as equal to the cost of the asset at the time of purchase (the advantage of this is that it is easy to verify).
How is using historical costs a limitation of finacial reporting
If an asset is valued at its historical cost it may not reflect the true present-day value and the balance sheet will not accurately represent the true worth of the business’s assets
How can depreciation of assets act as a limitaton
Because there are several methods that a business is allowed to choose from and can potentially overstate or understate assets in the balance sheet and net profit in the income statement
How does the value of intangibles act as a limit of financial report
Not physical assets so it is difficult to determine their real value and various interpretations can be placed on their value as stated on the balance sheet
What limits businesses valuing intangibles too inaccurately
- Limited by Australia’s adoption of Intl Accounting Standards
- Accounting standards established by Australian Accounting Standards Board AASB which has responsibilities under Australian Securities and Investments Commission Act 2001 (Cth)
What are timing issues in relation to limitations of financial reports
Accountants and/or business owners may at times delay or fast track revenue items to suit their particular financial need (can be referred to as cash-based accounting meaning businesses record transaction when cash is received)
What is the matching principle as an accounting concept
Match expenses incurred for the accounting period in which the revenue to which those expenses relate, is earned (accrual accounting).
How may debt repayments act as a limit of financial reports
- The recording of debt repayments on financial reports can be used to distort the ‘reality’ of the business’s status and this may be done to provide a more favourable overview of the business at that point in time
- e.g. The business may renegotiate their debt repayments, therefore interest payments may increase or decrease for a particular financial statement period therefore affecting the net profit.
How can notes to financial statements impprove their transparency
- Report the details and additional information that are left out of the main reporting documents; for example, the accounting methodologies used
- Done mainly to make the financial documents clearer and it is important to read these to gain full understanding of financial statements
What legislation lays out the obligations of businesses in terms of how they must operate and record their finance
Corporations Act 2001 (Cth)
What are the main areas in which ethical issues arise in relation to financial report
- Audits
- Misuse of funds
- Record keeping
What is an audit
An audit is an independent examination of financial information
What type of audit are public businesses legally required to undertake under the corporations act 2001
External audit done by a certified public accountant (CPA)
Whats an exmaple of misuse of funds
Exorbitant salaries of directors could be argued to be unethical.
Which companies must declare their salaries to ensure transparency
Public companies
What are the three ethical issues of record keeping
- Cash payments
- Inappropriate cut off periods
- Shifting revenues and expenses globally
How could a business improve its accounts recievable turnover
- Implementing discounts for early payment which would encourage a business’s customers to pay before the due date
