2. Finance Flashcards

Question

What are the disadvantages of equity financing?

Answer 1

* Lower profits and lower returns for the owner * Long, expensive process to obtain funds this way * Ownership is diluted, i.e. the current owners will have less control

Answer 2

Finding the correct source of finance to fund activities related to business decisions and financial objectives is imperative. The terms of finance must be suitable for the purpose for which the funds are required. The use of short-term finance to fund long-term assets, for example, causes financial problems because the amount borrowed must be repaid before the long-term assets have had time to generate increased cash flow.

Answer 3

1. Cash flow statement 2. Income statement 3. Balance sheet

Answer 4

The cash flow statement gives important info regarding a firms 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. A cash flow statement shows whether a firm can: * Generate favourable cash flow (inflows exceed outflows) * Pay its financial commitments as they fall due * Have sufficient funds for future expansion or change.

Answer 5

It is the amount of cash at the beginning of the period e.g first day of the month.

Answer 6

It is the amount of cash at the end of the period e.g last day of the month.

Answer 7

Closing cash balance = opening cash balance + net cash flow

Answer 8

Net cash flow = total cash inflows + total cash outflows

Answer 9

The revenue 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. The revenue statement shows: * Operating income earned from the main function of the business. * Operating expenses incurred in the main operation of the business.

Answer 10

Gross profit = revenue - COGS

Answer 11

Net profit = gross profit - operating expenses

Answer 12

COGS = opening stock + purchases - closing stock

Answer 13

Cost of goods sold on an income statement represents the expenses a company has paid to manufacture, source and ship a product or service to the end customer.

Answer 14

Opening stock can be described as the initial quantity of any product held by a business during the start of any financial year or accounting period and is equal to the closing stock of the previous accounting period.

Answer 15

Closing stock is the amount of inventory that a business still has on hand at the end of a reporting period. This includes raw materials, work in process, and finished goods in inventory.

Answer 16

Profit before tax (PBT) is a measure that looks at a companies profits before they have to pay corporate income tax.

Answer 17

Profit after tax is a measure of earnings before interest and taxes, adjusted for the impact of taxes.

Answer 18

Extraordinary items are gains or losses in a company’s financial statements that are infrequent or unusual.

Answer 19

The balance sheet shows the financial stability of the business. Analysis of the balance sheet can indicate whether: * The business has enough assets to cover its debts * The interest and money borrowed can be paid * The assets of the business are being used to maximise profits * The owners of the business are making a good return on their investment.

Answer 20

Assets = liabilities + owners equity

Answer 21

Owners equity = assets - liabilities

Answer 22

Liabilities = assets - owners equity

Answer 23

Current assets are those that may be converted into cash within a period of 12 months. They include cash, accounts receivable, inventories, securities, pre-paid liabilities and other liquid assets.

Answer 24

Non current assets are those that require a period longer than 12 months to be converted into cash. They include, investments in other companies, intellectual property (e.g patents), property and equipment.

Answer 25

Current liabilities consist of short term financial obligations that are due typically within one year. They include wages, interest, accounts payable and other accrued expenses.

Answer 26

Non current liabilities are those obligations not due for settlement within 12 months. They include, long term lease obligations, long term loans, deferred revenue and bonds payable.

Answer 27

Accounts receivable is the amount owed to a seller by a customer. As such, it is an asset, since it is convertible into cash on a future date. It is listed under current assets as it is usually convertible into cash within less than one year.

Answer 28

Accounts payable is generated when a company purchases goods and services from its suppliers on credit. Accounts payable is expected to be paid off within a year and therefore is a current liability.

Answer 29

Owner’s equity (also referred to as net assets) is the owner’s claim to company assets after all go the liabilities have been paid off.

Answer 30

This refers to the withdrawals of a business’s assets by the owner for their personal use.

Answer 31

Retained profits (also referred to as retained earnings) is the amount of net income left over for the business to keep once it has paid expenses + dividends.

Answer 32

With an overdraft, the bank allows a business or individual to overdraw their account up to an agreed limit for a specified time, to help overcome temporary cash shortfall.

Answer 33

This ratio is used to assess the ability of a business to turn assets into cash in order to meet its short-term financial obligations. The ratio used to measure liquidity may be referred to as the current ratio, working capital ratio or liquidity ratio. Liquidity is generally measured through a balance sheet. **Ratio** Current ratio = _current assets_ current liabilities

Answer 34

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***.

Answer 35

This means that for every $1 of short term liabilities, the firm has 35 cents of short term assets to pay that debt. The firm can only pay 35 cents per $1.

Answer 36

* Factoring debtors * Sale and lease back of non-current assets * Sale of inventory

Answer 37

* Adopt just in time (JIT) inventory * Invest in non-current assets

Answer 38

Gearing ratios determine a business’s solvency, that is their ability to meet long term debts. It measures the relationship between debt and equity and therefore shows a firms financial stability. The ratio used to measure solvency may be referred to as the debt to equity ratio, working capital ratio or liquidity ratio. Gearing is generally measured through a balance sheet. Debt : Equity - should be kept at \<1 : 1. **Ratio** Debt to equity ratio = _total liabilities_ total equity

Answer 39

It is generally accepted that a ratio should show ***higher*** or equal to levels of ***equity*** to debt. A ratio of 1:1 indicates a conservative average of gearing. An interpretation of 25:75 is characterised as ***lowly*** geared; while a firm showing 75:25 is ***highly*** geared.

Answer 40

As 1.64 is greater than 1, assets are being funded by more debt than equity. This means the firm is highly geared.

Answer 41

* Increase debt financing * Control the balance between debt and equity

Answer 42

* Lower debt e.g by sale and leaseback, factoring * Increase equity funding * Using the cash raised to reduce liabilities

Answer 43

This objective is the most important. It consists of three ratios, the gross profit ratio, net profit ratio and return on owners equity. Profitability assesses whether the business is utilising its resources to achieve maximum profit.

Answer 44

The gross profit ratio indicates the proportion of sales revenue that is consumed by COGS. It assesses whether the business is maintaining an adequate margin between sales and purchases. Gross profit is generally measured through a revenue statement. **Ratio** Gross profit ratio = _gross profit_ x100 sales GP = Sales - COGS

Answer 45

GPR is usually expressed as a percentage. Clearly higher figures are better than lower. However, GPR figures are only useful when compared to similar businesses, industry averages or past performance. A falling figure or lower than industry average GPR may indicate a problem with pricing or costs of purchases.

Answer 46

This means, for every $1 of sales revenues, 32.25c became gross profit.

Answer 47

* Raise prices (as long as sales are not compromised) * Obtain stock at lower prices by finding cheaper supply or negotiating (keeping an eye of quality so sales are not compromised)

Answer 48

The net profit ratio takes into account expenses and therefore measures the percentage of each dollar of sales that is left after all expenses are paid. It assesses whether the business is maintaining an adequate margin between sales and purchases. Net profit is generally measured through a revenue statement. **Ratio** Net profit ratio = _net profit_ x100 sales NP = GP - expenses

Answer 49

NPR is usually expressed as a percentage. Clearly higher figures are better than lower. However, NPR figures are only useful when compared to similar businesses, industry averages or past performance. A falling figure or lower than industry average NPR is generally a concern.

Answer 50

This means that for ever $1 of sales revenue, 5.4c became net profit.

Answer 51

* Raise prices (as long as sales are not compromised) * Obtain stock at lower prices by finding cheaper supply or negotiating (keeping an eye of quality so sales are not compromised)

Answer 52

ROE indicates the returns the owner/shareholders receive on the money they have invested. It assesses whether the business is using its equity funds correctly. ROE is generally measured through a revenue statement and/or balance sheet. **Ratio** Return on owners’ equity = _net profit_ x100 owners’ equity NP = GP - expenses

Answer 53

ROE is usually expressed as a percentage. Clearly higher figures are better than lower. The return for owners has to be compared to what they could receive from alternative investments. Low rates and declining rates of ROE would indicate that the owners’ assets are not generating adequate returns.

Answer 54

This means that for every $1 of owners’ equity there was 6.5c net profit generated.

Answer 55

* Any strategy that will improve net profit e.g lower COGS, increase sales revenue, reduce expenses, increase prices, improve efficiency. * Remove or exit areas of poor return and concentrate on areas with higher growth potential

Answer 56

This objective consists of two ratios, the expense ratio and the accounts receivable turnover ratio. Profitability assesses whether the business is utilising its resources to achieve maximum profit.

Answer 57

The expense ratio assesses whether the business is managing its operating expenses efficiently. The ratio expresses the amount of every sales dollar that is absorbed by operating expenses. This indicates the day-to-day efficiency of management. The expense ratio is generally measured through a revenue statement. **Ratio** Equity ratio = _expenses_ x10 sales

Answer 58

The expense ratio is generally expensed as a percentage. The lower the expense ratio, the more efficient the business. A high ratio may indicate poor control over operating expenses however to understand what is a high or normal expense ratio, figures must be compared to industry averages & budgeted ratios.

Answer 59

In this case, for every $1 of sales revenue, 26.99c was absorbed by operating expenses.

Answer 60

The main strategies to improve the expenses ratio centre around reducing expenses required to generate the level of sales by: * Carefully monitoring cost centres * Being aware that indiscriminate cost-cutting can damage the competitive situation by damaging quality and reputation (with extreme consequences).

Answer 61

This ART ratio assesses whether the business is collecting its accounts receivable efficiently. The accounts receivables turnover ratio measures the effectiveness of a business’ credit policy and collection procedures i.e how efficiently it collects the debts owed to it. ART is generally measured through a revenue statement and/or balance sheet. **Ratio** Accounts receivable turnover ratio = _credit sales_ accounts receivable = no. of times accounts receivable turned over in one year No. of days on av. that acc rec were outstanding = _365_ ART

Answer 62

Quicker turnover means more efficient collection procedures. Generally, businesses allow 30-60 days which reflects an ART ratio of 4-6 times a year. Longer periods than this indicate poor credit control, poor credit policy, liquidity problems and potential cash flow issues.

Answer 63

In this case, it takes about 16.24 days on average to collect the accounts receivable. This is just over 2 weeks weeks - this is quite a quick turnover of accounts.

Answer 64

Managers can avoid accounts receivable problems by: * Carefully monitoring their accounts and who they give credit to * Be vigilant with credit collection procedures * Provide discounts for early payments and penalty (interest charges) for late payments * Using factoring if the cash flow problem becomes serious

Answer 65

Ratios calculated are used to make comparisons over different time periods, against standards & with similar businesses. * By comparing previous & current year results, financial managers can identify trends in profits, costs & overall financial stability. * Managers can determine whether the business is meeting its goals of increasing profitability, efficiency, liquidity and solvency. * They can benchmark (see if business performance is above the industry average).

Answer 66

* Normalised earnings * Capitalising expenses * Valuing assets * Timing issues * Debt repayments * Notes to the financial statements

Answer 67

Normalised earnings are adjusted to remove the effects of seasonality, revenue and expenses that are unusual or one-time influences. Normalised earnings help business owners understand a company’s true earnings from its normal operations.

Answer 68

This refers to an accounting method where a business records an expense as an asset on the balance sheet rather than as an expense on the income statement. This does not accurately represent the true financial condition of the business as it understates the expenses and overstates the profits as well as the assets of the business.

Answer 69

Asset valuation is the process of determining the current value of a company's assets, such as stocks, buildings, equipment, etc. Asset-based valuation allows a business to calculate their net worth.

Answer 70

Under the matching principle, when an accountant records revenue, they should also record at the same time any expenses that were directly related to that revenue. When this principle is followed, the revenue earned will match the costs that were incurred to earn that revenue.

Answer 71

Financial reports can be limited because they do not have the capacity to disclose specific information about debt repayments. The recording of debt repayments on financial reports can be used to distort the ‘reality’ of the business’s financial position.

Answer 72

Notes to the financial statements report the details and additional information that are left out of the main reporting documents. These notes contain important information such as the accounting methodologies used for recording transactions that can affect the overall return expected from an investment in a company.

Answer 73

* Audited accounts * Record keeping * Reporting practices

Answer 74

The audit is an independent check of the accuracy of financial records and accounting procedures, and it has an important role in this process. Audits are an important part of the control function and are generally used to examine the financial affairs of a business. There are three types, internal audits, management audits and external audits.

Answer 75

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. There is a temptation to take cash payments, and not record the transaction, lessening tax.

Answer 76

Not only are accurate financial reports necessary for taxation purposes, but stakeholders are entitled to access a business’s financial information. To pretend that profit is lower than it should be is to attempt to defraud the ATO and is illegal.

Answer 77

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.

Answer 78

Cash flow statements indicate the movement of cash receipts and cash payments resulting from transactions over a period of time. They can also identify trends and can be a useful predictor of change.

Answer 79

Management must implement strategies to ensure that cash is available to make payments when they are due, these include: **Discounts for early payment** * This strategy is most effective when targeted at those debtors who owe the largest amounts over the financial year period. This is not only beneficial for the debtors who are able to save money but it also positively affects the business’s cash flow status. **Factoring** * Factoring is the selling of accounts receivable for a discounted price to a finance or specialist factoring company. The business saves on the costs involved in following up on unpaid accounts and debt collection. **Distribution of payments** * Distributing payments throughout the year means there is a more equal cash outflow each month rather than large outflows in particular months. This ensures large expenses are not incurred all at once, preventing cash shortfalls.

Answer 80

Working capital management involves determining the best mix of current assets and current liabilities needed to achieve the objectives of the business. A business must have sufficient liquidity so that cash is available or current assets can be converted to cash to pay debts.

Answer 81

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. **Cash** * Cash ensures that the business can pay its debts, repay loans and pay accounts in the short term and that the business survives in the long term. **Receivables** * A business must monitor its accounts receivable and ensure that its timing allows the business to maintain adequate cash resources. **Inventories** * Inventories make up a significant amount of current assets, and their levels must be carefully monitored. Too much inventory or slow-moving inventory will lead to cash shortages. Insufficient inventory of quick-selling items may also lead to loss of customers, and hence lost sales.

Answer 82

This involves being able to convert current assets into cash to ensure that the business’s creditors (accounts payable, bank loans or overdrafts) are paid. **Payables** * A business must monitor its payables and ensure that its timing allows the business to maintain adequate cash resources. The holding back of accounts payable until their final due date can be a cheap means to improve a firm’s liquidity position. **Loans** * Management of loans is important, as costs for establishment, interest rates and ongoing charges must be investigated and monitored to minimise costs. **Overdrafts** * Overdrafts are a convenient and relatively cheap form of short-term borrowing for business. They enable a business to overcome temporary cash shortages.

Answer 83

Businesses use a number of strategies to manage working capital, which is required to fund the day-to-day operations of a business. Strategies for working capital management include: **Leasing** * Leasing involves the payment of money for the use of equipment that is owned by another party. Advantages include: It allows the business to make use of good quality assets, which might have been unaffordable. **Sale and leaseback** * 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.

Answer 84

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.

Answer 85

**Fixed and variable** * Fixed costs do not change when the level of activity changes. Examples of fixed costs are salaries. Variable costs are those that vary in direct relationship to the levels of operating activity or production in a business. Such costs include labour costs and materials. **Cost centres** * A cost centre is a department within a business that is responsible for a particular set of activities that benefits the organisation. By treating the cost centre as a separate unit, the business can measure how much they are spending on that function each year. **Expense minimisation** * Profits can be weakened if the expenses of a business are high, as they consume valuable resources within a business. Guidelines and policies should be established to encourage staff to minimise expenses where possible.

Answer 86

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 objectives** * *Sales objectives -* Sales objectives must be pitched at a level of sales that will cover costs, both fixed and variable, and result in a profit. * *Sales mix -* Changes to the sales mix can affect revenue. Businesses should control this by maintaining a clear focus on the important customer base on which most of the revenue depends before diversifying products. * *Pricing policy -* Pricing policy affects revenue and, therefore, affects working capital. Pricing decisions should be closely monitored and controlled. E.g overpricing could fail to attract buyers.

Answer 87

* Exchange rates * Interest rates * Methods of international payment * Hedging * Financial instrument hedging

Answer 88

Exchange rates fluctuate over time due to variations in demand and supply. In terms of an appreciation, the value of AUD increases relative to foreign dollars; while a depreciation will decrease the value of AUD when dominated in foreign currency terms.

Answer 89

A business that plans to either relocate offshore or expand domestic production will generally need to raise finances 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.

Answer 90

**Payment in advance** * The payment in advance method allows the exporter to receive payment and then arrange for the goods to be sent. **Letter of credit** * A letter of credit is a document that a buyer can request from their bank that guarantees the payment of goods will be transferred to the seller. **Clean payment** * Under this method, the exporter ships the goods directly to the importer before payment is received. **Bill of exchange** * A bill of exchange is a document drawn up by the exporter demanding payment from the importer at a specified time.

Answer 91

When two parties agree to exchange currency and finalise the deal immediately the transaction is called a spot exchange. However, it’s possible for a business to minimise the risk of currency fluctuation through hedging.

Answer 92

**Derivatives** Derivatives are simple financial instruments that may be used to lessen the exporting risks associated with currency fluctuations. The three main derivatives available for exporters: * *Forward exchange contract -* A forward contract will lock in an exchange rate today at which the currency transaction will occur at the future date. * *Options contract -* Gives the buyer (option holder) the right, but not the obligation, to buy or sell foreign currency at some time in the future. * *Swap contract -* A currency swap is an agreement to exchange currency in the spot market with an agreement to reverse the transaction in the future.

2. Finance Flashcards

(116 cards)