Finance - Influences on financial management

Question 1

Outline the sources of finance

Answer 1

• internal finance: funds generated from inside the business e.g. retained profits
• external finance: funds provided by sources outside the business e.g. banks, governments
• external (debt): short term and long term
• external (equity): ordinary shares and private equity

Question 2

Outline the two major external sources of finance

Answer 2

• debt finance refers to funds borrowed from outside sources. It can be:
• short term: repaid <12 months
• long term: repaid >12 months
• equity finance refers to the funds raised by a company through inviting new owners

Question 3

Describe retained profits as an internal source of finance

Answer 3

• where the business has made profits in prior years which have not all been distributed to shareholders as dividends
• may not distribute profits as dividends but instead retain profits which can then be used as an internal source of finance for growth and expansion
• retained profits are considered equity as it is part of the business and shareholders own parts of the business

Question 4

Identify the external sources of debt finance

Answer 4

short term:
- overdraft
- commercial bills
- factoring
long term:
- mortgage
- debentures
- unsecured notes
- leasing

Question 5

Outline overdrafts as short-term borrowing of debt finance

Answer 5

• an arrangement a business makes with their bank which allows them to overdraw from their bank account up to an agreed limit
• interest is charged on the amount of the overdraft used and there is no fixed repayment schedule
• can be secured against assets (when a loan is tied to an asset)
• the bank allows the business to have a negative account balance to avoid a
  temporary cash shortfall.

Question 6

Outline commercial bills as short-term borrowing of debt finance

Answer 6

• loans that businesses can get from financial institutions for larger amounts, usually over $100k for a period of 30-180 days
• the business receives the sum immediately and pays interest over the life of the bill and repays the principal at a fixed date
• commercial bills are flexible in terms of the interest rate paid and repayment period and can be rolled over until the business has the funds to repay the principal
• can be secured against assets

Question 7

Outline factoring as short-term borrowing of debt finance

Answer 7

• where a business sells its accounts receivable for a discounted price to a finance or factoring firm
• the business will receive up to 90% of the amount of receivables within 48 hours of selling it to the factor, allowing the business to obtain funds more quickly, rather than waiting until the receivable to be paid
• more expensive and risky source finance as the business cannot get the full amount of receivables and are subject to the chance of unpaid debts

Question 8

Outline factoring with recourse

Answer 8

with recourse:
- bad debt is the responsibility of the business
- the business has to pay the factoring firm for any unpaid debt
without recourse:
- bad debt is NOT the responsibility of the business and has been transferred to the factoring firm
- the business does NOT have to pay the factoring firm for unpaid debts
- if there is no recourse, the factoring firm will pay less for accounts receivable and receive higher profit.

Question 9

Outline mortgage as long-term borrowing of debt finance

Answer 9

• a loan that a business can get from a bank to purchase property such as a new premise, factory, office or land
• mortgage loans are repaid with interest through regular payments over 15-30 years
• it is secured against the property as long as the loan is less than the property value

Question 10

Outline debenture as long-term borrowing of debt finance

Answer 10

• a debt agreement used by large companies to borrow money from investors/ lenders at a fixed interest rate over a fixed period of time, between 1-5 years
• may/ may not be secured against the business assets, but often they are secured in order to make them more attractive to potential investors
• interest rates depend on the creditworthiness of the business and whether the debentures are secured or not

Question 11

Describe the advantages and disadvantages of debenture

Answer 11

• advantages: fixed interest rate for a fixed period of time
• disadvantages: must be secured against collateral as it is risky for investors
• when public companies issue/ sell debentures directly to investors via the primary financial market in the ASX, they must create a prospectus (formal legal document)
• after the initial sale of the debenture, it can be traded in the secondary financial market (like shares). Whoever holds the debenture will be paid the regular interest payments and the principal at the end of the term (maturity date) by the business

Question 12

Outline unsecured notes as long-term borrowing of debt finance

Answer 12

• similar to debentures in that they are loans a business gets from investors/ lenders, but they are different in that they are not secured against the business assets
• as the risk is higher, the interest rates are also higher than secured notes. This makes unsecured notes more expensive as a source of finance for businesses. Rates will depend on the creditworthiness of the business
• advantages: no collateral
• disadvantages: higher interest rates to compensate for no collateral secured

Question 13

Outline leasing as long-term borrowing of debt finance

Answer 13

• where a business pays to use or borrow equipment (e.g. vehicles, machinery) that is owned by another party
• businesses choose the equipment and arrange for a finance company to purchase and lease it out to them
• leasing avoids the large outflow of cash incurred from purchasing equipment outright and instead spreads out the payments over a period of time
• although leasing does not involve borrowing money like the other methods, it is still considered a source of finance as it frees up cash for the business to use

Question 13

Outline the two main types of leases

Answer 13

operating leases:
- assets are leased for short periods, usually for less than the life of the asset
- the lessor is responsible for all maintenance and repairs
- can be cancelled, often without penalty
financial leases:
- assets are leased usually for the life of the asset
- the lessor is responsible for all maintenance and repairs
- cancellation normally attracts penalties
- the lessee has the option to acquire the asset at the end of the lease
- usually cheaper than operating leases over a longer period of time

Question 14

Define equity in external financing and identify two main types of equity

Answer 14

• refers to when a company raises funds by offering new shares for investors to purchase
• shares are financial assets that represent part ownership of a company
• when investors buy the shares, this becomes a source of finance for the company
• ordinary shares are for public companies (Ltd)
• private equity are for private companies (Pty Ltd)

Question 15

Describe ordinary shares and identify its four main ways

Answer 15

• public companies can raise funds by issuing shares on the market for investors to buy
• the value of shares are determined by a company’s current or future performance
• ordinary shares give shareholders voting rights and the entitlement but not guarantee to dividend payments
• issued in new issues, right issues, placements and share purchase plan

Question 16

Outline new issues as a type of ordinary shares

Answer 16

• a security that has been issued or sold for the first time on ASX.
• issued as an Initial Public Offering (IPO) - ‘Primary shares’
• a prospectus must be issued, a document containing information about
  the company for investment purposes.
• offered to all potential investors

Question 17

Describe rights issues as a type of ordinary shares

Answer 17

• opportunity after the IPO issued to existing shareholders to buy new
  shares in the same company
• gives the shareholders the right to purchase additional shares at a discounted price in proportion to the number of shares already held
• e.g. 1 for 10 issue: 1 share can be purchased for every 10 shares already held
• prospectus is required

Question 18

Describe placements as a type of ordinary shares

Answer 18

• additional shares offered by the business at a discount to selected investors (banks, superannuation, life insurance companies)
• normally more than $500000 in total value of shared offered to the investor
• prospectus not required

Question 19

Describe a share purchase plan as a type of ordinary shares

Answer 19

• shares offered to existing shareholders in a listed company to purchase more with no brokerage fees.
• can be offered at a discount so companies can issue new shares to current shareholders without a prospectus.
• only a maximum of $30000 in new shares can be issued to each shareholder

Question 20

Describe private equity as an external source of finance

Answer 20

• money invested in a business that is not listed on the ASX
• private companies can raise funds by also issuing ordinary shares for select investors to buy
• offered to selected investors
• investor will generally have a significant degree of ownership and control of the business
• no prospectus required

Question 20

List advantages and disadvantages of debt

Answer 20

advantages:
- funds are usually readily available
- profits are not shared with lenders
- various types of debt available to use
- lenders do not gain ownership, therefore is ownership is not diluted
disadvantages:
- funds can be difficult to obtain
- interest and repayments must be made regardless of profit levels
- expensive due to the continuous payment of interest

Question 21

List advantages and disadvantages of equity

Answer 21

advantages:
- does not have to be repaid unless the owner leaves the business
- dividends do not have to be paid
- owners have some control over the business
disadvantages:
- pressure from owners expecting a good return on investment
- dividends are not tax deductible
- ownership and control is diluted, profits for each owner is lowered with more owners

Question 22

Describe financial institutions and list them

Answer 22

• collect funds and invest them in financial assets, providing financial services and dealing with transactions e.g. investments, loans, deposits
• businesses usually acquire funds from a bank, but funds and important financial services can also be acquired through other financial institutions
• banks, finance companies, super funds, life insurance companies, unit trusts and ASX

Question 23

Outline banks as a financial institution

Answer 23

- provides borrowing and lending services, primarily for individuals and smaller businesses and are focused on everyday banking needs - important to businesses as they provide products and services such as credit cards, accounts, EFTPOS terminals, loans and overdrafts - deposits, overdrafts, mortgages, leases - e.g. Commonwealth, ANZ

Question 24

Outline investment banks as a financial institution

Answer 24

- banks that provide borrowing and lending services, primarily for high net-worth clients and larger businesses - helps with capital raising and offer services such as mergers and acquisitions advisory, portfolio investment management, arranging overseas finance and operating unit trusts - e.g. Macquarie bank

Question 25

Describe finance companies as a financial institution

Answer 25

- non-bank financial intermediaries that specialise in smaller commercial finance for individuals and businesses - provides loans, leasing, factoring and cash flow financing --> quick access to funds and typically charges higher loan interests - providers of debt finance for businesses

Question 26

Describe life insurance companies as a financial institution

Answer 26

- non-bank financial intermediaries that provide protection and reimbursement against losses - life insurance provides cover in the event of critical illness and/or death - invest funds received into things such as debentures and shares - e.g. NRMA, GIO

Question 27

Describe superannuation funds as a financial institution

Answer 27

- organisations that oversee funds saved up for retirement - employees are mandated to contribute 11% of their income into superannuation - funds can be invested into shares to provide equity finance to businesses

Question 28

Describe unit trusts as a financial institution

Answer 28

- an arrangement or legal structure that takes funds from a large number of small investors and invests them into specific types of financial assets - common investment options include cash, shares, property and commodities - usually connected to a management firm that manages the investors' investment portfolio

Question 29

Describe the Australian Securities Exchange (ASX) as a financial institution

Answer 29

- a market where shares and other securities are traded - acts as a primary market where companies can issue shares for the first time and a secondary market where existing shares and securities can be traded - also offers shares, futures, exchange traded funds, interest rates securities

Question 30

Outline the influence of governments on financial management and identify its two main influences

Answer 30

- the government influences a business' financial management decision making with economic policies (monetary and fiscal), legislation and monitoring by regulatory bodies - regulates what companies can and cannot do and can impost penalties for noncompliance - the two main influences are the Australian Securities and Investments Commission (ASIC) and company taxation

Question 31

Describe the Australian Securities and Investments Commission (ASIC) as a government influence

Answer 31

- an independent statutory commission accountable to the Commonwealth parliament that enforces and administers the Corporations Act 2001 - protects potential and existing investors in the areas of investment, insurance, superannuation and banking - collects information about companies and makes it available to the public e.g. annual reports - able to investigate and implement disciplinary action

Question 32

Describe company taxation as a government influence

Answer 32

- all Australian businesses that have been incorporated are required to pay company tax on profits - 30% net profit tax is paid before profits are distributed to shareholders as dividends - multinational anti-avoidance laws in 2017 designed to stop multinational corporations from avoiding Australian tax

Question 33

Explain how company taxation influences debt finance and equity finance

Answer 33

- debt finance: interest payments are considered an expense and reduces the taxable income of a business - equity finance: dividend payments is NOT considered an expense and does not reduce the taxable income of a business

Question 33

Compare tax evasion and tax avoidance

Answer 33

- tax avoidance is a legal strategy to minimise tax liabilities by using available deductions, credits, and leveraging tax laws - tax evasion involves illegal methods such as underreporting income or falsifying financial records to avoid paying taxes

Question 34

Outline global market influences on financial management and identify three impacted areas (IEA)

Answer 34

- global market influences are largely uncontrollable as they are external to the business - financial risks associated with global markets are generally greater than those encountered domestically - three areas impacted are economic outlook, availability of funds and interest rates

Question 35

Outline the global economic outlook as a global market influence

Answer 35

- refers to the projected changes to the level of economic growth throughout the world - globalisation has created more interdependence between economies, meaning businesses are more impacted by circumstances in other countries

Question 36

Compare a positive economic outlook and a negative economic outlook

Answer 36

positive: - increase consumer demand for g/s which increases business production and revenue - increase in employment to meet demand - purchasing additional equipment & resources negative (recession): - businesses delay large expenditure and other growth strategies - decrease in revenue due to lowering of consumer confidence and spending - businesses may restructure operations e.g. fewer permanent full time employees

Question 37

Outline availability of funds as a global market influence

Answer 37

- refers to the ease with which a business can access funds for borrowing - globally, refers to how easily a business can access funds on international financial markets - availability of funds depends on factors such as risk, supply and demand and domestic economic conditions - Global Financial Crisis (GFC) and Covid-19 lowered international availability of funds --> higher interest rates and risks

Question 38

Compare the impact of availability of funds in debt and equity finance

Answer 38

- dependent on economic outlook - if the economic outlook is negative, there will be a lower availability of funds - debt: financial institutions restrict lending to businesses as there is higher risk in the business’s inability to pay - equity: many investors will not purchase shares when share prices are falling (share prices are reflective of the position of a business at a current time)