Answers
Topic 3: Finance
Chapter 14: Processes of financial management
14.2 Planning and implementing
Revision
1
The financial elements of the planning cycle are:
 addressing the present financial position; for example, debts/equity levels
 determining the financial needs as influenced by the size of the business
 developing budgets in the form of anticipated revenue and expenditure on raw
materials or inventory
 maintaining financial record systems such as those available in software programs
that allow for accurate recording of information
 identifying the financial risks, such as the decision to borrow funds
 establishing financial controls to prevent losses, such as authorisation procedures.
2
The factors that determine a business’s financial needs include the size of the business,
the phase of the business cycle, future plans for growth and development, capacity to
source finance, and management skills for assessing financial needs and plans.
3
The preparation of financial information is essential as part of the business plan because
it can show that the business is able to generate an acceptable return for the investment
being sought.
4
The financial information that should be collected by a business when determining its
future financial needs includes an analysis of financial performance, income statement,
cash flow statement, balance sheet, cost–volume–profit analysis and financial ratio
analysis report.
5
The different types of budgets are:
 operating budgets — sales production, expenses, and raw materials and labour
 project budgets — capital expenditure, and research and development
 financial budgets — income statements, balance sheets and cash flow statements.
Each of these budgets is important for financial planning as they provide information in
quantitative terms about the requirements to achieve a particular purpose, as well as
reflecting the strategic planning decisions about how resources will be used.
6
Record keeping is important to a business’s success because reliable, accurate, efficient
and accessible information ensures that management decisions are based on data that
is the best available at the time. Management base their financial decisions on the
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Chapter 14: Processes of financial management
information contained in their record keeping system. If this information is not accurate or
reliable, then managers may make uninformed decisions, which will affect their success.
7
Risk and the level of borrowings are related as the business will in some way be financed
from borrowings and therefore it must ensure that it can cover the costs associated with
these borrowings. Further, these borrowings will finance the investment and, the higher
the level of risk, the greater the expectation of higher returns.
8
Financial controls need to be implemented because as a consequence there will be an
established set of policies and procedures that ensure the plans of the business will be
achieved in the most effective way.
9
Budget and variance analysis will assist the business in estimating resource requirements
for a specified future period and also help them to uncover reasons for any variations that
may have occurred in the process.
10
Some of the most common financial risks for businesses include:
 Credit risk — this is the danger associated with borrowing money.
 Market risk — this involves the risk of changing conditions in the specific
marketplace in which a company competes for business.
 Liquidity risk — this refers to a business’s cash flow and whether the business has
sufficient funds to meet their financial obligations
 Operational risk — this refers to the various dangers faced during the day-to-day
management of a business.
11
The areas where performance can be improved are:
 accounts payable. This is something that should be monitored. Look for creditor
incentives, such as a discount for early payment.
 wages. These need to be assessed and some thought given to defraying these costs
unless sales exceed actual expectations. Perhaps a move to employing part-time
and/or casual workers is needed.
 advertising. This can lead to increased sales, but need to justify advertising
expenditure and more effective methods sought, for example, the use of social
media, which is much more cost-effective.
Read the ‘Record keeping — financial management’ case study and answer questions
12 to 14.
12
The benefits of a good record keeping system are:
 Good business records help owners manage their business and make sound
business decisions.
 It ensures staff comply with legal requirements.
 Good record keeping systems allow financial managers to easily generate reports,
orders, invoices, pay records, financial statements, and so on.
13
A manual record keeping system consists of paper-based journals, which are divided into
sections. Under this system, financial managers record business transactions manually,
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Chapter 14: Processes of financial management
in the appropriate sections. An electronic record keeping system is where financial
managers use an electronic spreadsheet or a software accounting package to record
business transactions.
14
The table below summarises the advantages and disadvantages of both manual and
electronic record keeping systems.
Advantages
Disadvantages
Manual record
 Less expensive to set up
keeping
 Less risk of data loss
 More onerous and
time consuming for
managers
 Need space to store
manual records
system
 More efficient
Electronic
record keeping
system
 Allows financial managers
to easily generate orders,
reports, invoices, financial
statements, pay records,
etc.
 Allows users to easily
send financial information
to others
 Data could be lost if it
is not secured or
backed up
 More complicated to
use and requires
training to understand
how the software
works
 Requires less storage
space
 Makes it easier for
businesses to meet their
tax and legal obligations
Extension
15
Product 1
(price $25)
Product 2
(price $15)
Total sales
Quarter 1
2 000
Quarter 2
2 600
Quarter 3
3 000
Quarter 4
3 300
Year
10 900
4 000
4 400
5 000
5 500
18 900
$110 000
$131 000
$150 000
$165 000
$556 000
16
Sound planning is crucial to achieving the financial objectives of a business because
financial planning determines how a business’s goals will be achieved. It determines the
strategies to achieve goals and objectives, and considers the best course of action for a
business. It is important to note, however, that some factors are beyond the business’s
control; the external influences that may bring about impacts could result in variations not
anticipated.
17
The stages of the planning cycle are:
 addressing the present financial position — how is the business presently placed?
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Chapter 14: Processes of financial management
 determining financial needs — an analysis of financial information in the form of
gross profit and net profit levels and ratios, as well as expense ratios from income
statements. Balance sheets will assist with profitability. Cash flow statements will
allow for an analysis of income and expenditure and the establishment of break-even
levels
 developing budgets, including those such as operating, project and financial forms
 keeping accurate, reliable, efficient and accessible record systems
 calculating and analysing financial risks, and establishing financial controls.
Note: These would be applied to case studies from the local business community as
identified.
18
(a) Additional information for Kennedy’s Gardening Supplies could be:
 income statements
 balance sheets
 financial ratios
 budgets; for example, operating and project budgets
 a risk analysis.
(b) Kennedy’s would most likely use a range of software programs that could bring
together this financial information with assistance from its accountant. There is also the
possibility of outsourcing this information to a specialist business consultant, who could
prepare a report and attach it to its funding application.
19
This is an individual activity requiring inquiry into a computerised accounting software
program and a judgement about its key features.
14.2 Exam questions
Question 1
Correct Answer is C
All planning, including financial planning, starts with identifying needs. Next is setting a
financial framework (budget), a system of keeping track of progress (maintain records),
watching for problems (risks) and intervening when and where required (control) to achieve
goals. [1 mark]
Question 2
Correct Answer is B [1 mark]
Question 3
Correct Answer is D
Financial controls are the policies and procedures that ensure that the plans of a business
will be achieved in the most efficient way. [1 mark]
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Chapter 14: Processes of financial management
Question 4
Definition and uses of budgets could include:
• cost estimates for a business activity
• target setting
• an instrument by which to measure performance.
Award 1 mark for defining a budget.
Award 1 mark for showing how a budget can be used by business.
Sample answer:
A budget is a financial estimate of the costs of a business activity. The budget is used to
measure the performance of this activity. It provides a framework for costs involved for the
activity and therefore gives a target for the activity. [2 marks]
Question 5
Evaluation could include:
• risk management
• budgets
• controls.
Award 1 mark for outlining planning.
Award 1 mark for outlining implementing.
Award 1 mark for providing a feature or example of planning.
Award 1 mark for providing a feature or example of implementing.
Award 1 mark for making a judgement with support of the use of planning for business
success.
Award 1 mark for making a judgement with support of the use of implementing for business
success.
Sample answer:
Financial planning and implementing is crucial to business success. Aspects of planning and
implementing include the establishment of financial needs, setting budgets, having a good
records system, assessing risk and controls to monitor and intervene as necessary.
A business needs to have a realistic idea of the amount of funds required and a clear vision
for its uses. The necessary business activities to fulfill this vision are then given a budget.
The financial team will work with representatives of the various activities and draft a budget.
This expected costing serves as a signpost and guides the activity. It is important to have a
record of the financial dealings for each of the activities. The system must be able to gather
appropriate information quickly and be accessible in a comprehendible format whenever
needed by the financial management team.
Every investment made by the business in its activities will carry risk. The close financial
monitoring of business activities helps to reduce waste, keep activities on track and therefore
reduces risk. Financial control is the term used for the evaluation of the business activities’
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Chapter 14: Processes of financial management
performance. It includes the intervention by the financial team as required to ensure that the
business activity is performing as expected.
The combination of each of these processes in the implementing and planning processes of
financial management are fundamental to the total business success. [6 marks]
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Chapter 14: Processes of financial management
14.3
Debt and equity financing
Revision
1
Debt finance refers to the short-term and long-term borrowing that businesses use from
external sources. Equity finance refers to the internal sources of finance in a business.
2
The relationship between risk and the source of finance is that if a business uses a high
level of debt finance it takes a greater risk than if it were to use the same level of equity
finance.
3
(a) The advantages of debt finance outweigh the disadvantages because, with funds
readily available for use and the tax advantages, a business is able to embark upon its
operations immediately and take advantage of the current business environment,
although the level of debt does need to be manageable.
(b) The advantages of equity finance outweigh the disadvantages because it is cheaper,
offers less risk and does not have to be repaid — all important considerations for a
business in its operations.
4
Equity finance is the most important source of funds for companies because it remains in
the business for an indefinite time and consequently does not have to be repaid (with
interest) by a set date.
Read the ‘Flowrite Plumbing — self-financing a business’ case study and answer
questions 5 to 7.
5
‘Bootstrapping’ refers to when entrepreneurs invest their own money into a business
without external help or credit.
6
Self-financing advantages:
 The owner benefits from complete financial and creative control over their business.
 The owner doesn’t need to worry about periodic loan repayments, interest or
creditors chasing them for repayments.
 Nothing is needed as security and so personal assets are not at risk.
 Owners get to retain all the profits.
Disadvantages:
 It may be difficult to save up enough money to start your own business.
 The budget and growth of the business are dictated by the owner’s own personal
finances.
7
Trade credit is an agreement between the supplier and the business that allows a
business to delay payment for goods and services which have already been delivered.
This means that the business gets the benefit of using any materials or services they
require without having to pay up front.
Extension
8
The decision for Miguel is about the balance of risk and return for his proposed $100 000
expansion. The use of debt finance, and the immediate access and tax deductibility that
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Chapter 14: Processes of financial management
goes with it, is attractive; however, interest charges, and the expectation that the financial
institution will require regular repayments, puts pressure on the business. The venture is
risky and requires the business to make an immediate return to meet debt payments.
If, on the other hand, he decided to go with equity finance, there is less of a requirement
for immediate repayment and it is cheaper as there is no interest component. It assumes
less risk; however, the source of the equity finance, for example taking on a new partner,
may offer him less of a return as it dilutes his ownership.
14.3 Exam questions
Question 1a
Debt financing can provide advantages to a business. An advantage is that interest, fees
and charges are tax deductible because they are expenses of the business. By using debt
financing, the business pays less in tax, which may lead to greater profits. [3 marks]
Marking guidelines:
Criteria
Marks
• Provides why and/or how debt finance is an advantage
3
• Provides characteristics and features of ONE advantage of debt financing
2
• Recognises ONE advantage of debt financing
1
Question 1b
A disadvantage associated with using equity financing is that a business uses owner’s equity
or retained profits to finance its key business functions. Because of this, they are unable to
claim a tax deduction as no funds are borrowed. As retained profits are re-invested into the
business, the investor is unable to invest in other opportunities, which may provide better
returns. [3 marks]
Criteria
Marks
• Provides why and/or how equity finance is a disadvantage
3
• Provides characteristics and features of ONE disadvantage of equity financing
2
• Recognises ONE disadvantage of equity financing
1
Question 2
Correct Answer is C [1 mark]
Question 3
Correct Answer is A
Debt finance can be attractive to businesses because it is usually quick to organise, funds
are usually readily available and interest payments are tax deductible, therefore reducing the
cost of debt financing. [1 mark]
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Chapter 14: Processes of financial management
Question 4
Comparison could include:
• debt: must pay interest, legal contract, providers have no voting rights, usually fast to
arrange, interest is tax deductible
• equity: no interest fees, no repayments, dividends are not fixed, have voting rights, may
take longer to arrange, can raise large amounts.
Award 1 mark for defining debt.
Award 1 mark for defining equity.
Award 1 mark each for providing two differences using comparison language (2 marks
possible).
Sample answer:
Debt finance incurs interest repayments regardless of business performance. This is
contractual and a legal obligation. However, it does allow the borrower to maintain total
ownership. It is usually quick to arrange and although interest must be paid, it is tax
deductible. This is very different to equity finance. Equity finance is funds provided by
owners or by acquiring new owners. In the case of new owners, there will be a loss of control
since equity holders have voting rights. Unlike debt it does not carry the burden of interest
rate charges and there are no repayments required. This allows the business to work
through difficult times and not have a debt repayment burden. While both sources do provide
funds for businesses such as farms, they do have many differences that need to be
understood. [4 marks]
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Chapter 14: Processes of financial management
14.4
Matching the terms and source of finance to business purpose
Revision
1
It is important to match the term of a loan to the life of the asset for which the finance was
obtained because short-term finance should be used for short-term purposes and longterm finance for long-term purposes. Those assets with a shorter economic life need to
have their value realised in a shorter time span than a longer-term asset. For example, a
computer has a shorter lifespan than a more expensive piece of machinery from which
the usefulness can be extracted over a much longer period.
2
The type of finance recommended for each of the following would be:
(a) payment of inventory — debt finance (e.g. overdraft as sales should realise income
that can be used to repay the loan)
(b) purchase of a new motor vehicle — debt finance (e.g. low-interest bank loan over a
number of years as the vehicle will be used over this time and its value realised)
(c) diversification of the business over the next five years — equity finance (e.g. share
issue as the venture is risky and investment funds do not have to be repaid if the venture
fails)
(d) takeover of a competitor — equity finance (e.g. share issue as it is risky and investment
funds do not have to be repaid if the venture fails)
(e) expansion to double the volume of sales — debt finance (e.g. bank loan as increased
sales can be used to repay the loan)
(f) purchase of new plant and equipment — debt finance (e.g. mortgage as the value of
the equipment will be realised over time and thus requires lower rates of interest. Income
generated from the equipment can then be used to repay the loan.)
Extension
3
For example, Westpac has a ‘Business ONE’ loan that has an interest rate of 5.60%, and
customers can borrow upwards of $250 000 for periods up to 25 years.
Other features include:
 selecting from either a line of credit or ‘term and repayment’ loan structure
 competitive interest rate aligned to money-market rates
 a variable rate-only option
 multiple ways to access your funds, including electronic and branch access
 convenient ways to make repayments and redraw funds
 various loan security options available.
4
Qantas uses a range of debt instruments to purchase assets such as airplanes and other
equipment.
5
The use of short-term finance to fund long-term assets would cause financial problems
because the amount borrowed must be repaid before the long-term assets have had time
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Chapter 14: Processes of financial management
to generate increased cash flow. If a business finances a non-current asset with shortterm finance, it may not generate enough cash from the asset to pay off the short-term
debt when it is due. For example, a business that purchases a vehicle with short-term
finance probably won't generate enough excess cash to pay it off in one or two months.
6
Long-term finance should be used to fund non-current assets because the maturity
associated with the long-term financing better coordinates with the typical lifespan of the
non-current asset.
14.4 Exam questions
Question 1
Correct Answer is D
A business must use appropriate sources of finance. Since stock is a current asset, finance
should be a current liability or readily available cash in the bank. In this example, bank
overdraft is the current liability and retained profit is cash earned by the business kept in the
bank and available for the owner to use. [1 mark]
Question 2
Correct answer is C [1 mark]
Question 3
Correct answer is B
An appropriate source of finance for this farmer is one that satisfies her short-term needs
such as commercial bills. [1 mark]
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Chapter 14: Processes of financial management
14.5 Monitoring and controlling
Revision
1
A business must monitor and control all business functions because inconsistent methods
of review and systems of control will have an immediate impact on the viability of the
business and its operations.
2
The three main financial controls are:
 cash flow statements
 income statements
 balance sheets.
3
Three stakeholders who would most likely view a cash flow statement are creditors,
lenders and owners/shareholders. The key information that these stakeholders would be
looking for is a positive cash flow over a number of years.
4
The three categories of activities of a cash flow statement are:
 operating activities — cash inflows and outflows relating to the main activities of the
business
 investing activities — cash inflows and outflows relating to the purchase and sale of
non-current assets and investments
 financing activities — cash inflows and outflows relating to the borrowing activities of
the business.
5
The purpose of an income statement is to show the operating results for a period. It shows
the revenue earned and expenses incurred over the accounting period with the resultant
profit and loss.
6
The relationship between income and expenses in respect to operating efficiency is
reflected in the income statement, as this statement records the income and expenses,
and how the business is performing in respect to profits or losses.
7
(a) The balance sheet is written ‘as at 30 June 2021’ because it is a statement of the
assets, liabilities and owners’ equity at that particular point in time.
(b) The business owners are Biq and Son. Their original investment was $100 000
(capital).
(c) The value of the owners’ investment on 30 June 2021 is $113 500 (Owners’ equity:
capital and profit).
(d) The assets of the business were financed by the loan and the owners’ capital
contribution.
(e) The business currently owes $59 500 (current and non-current liabilities).
(f) The business will pay its debts through sales and chasing up accounts receivable. It
has the option of selling off some of its assets and retaining its profit to also meet
these financial obligations.
(g) I would offer credit to this business as it is in a sound financial position with relatively
few liabilities relative to its assets and seems to be generating a reasonable profit.
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Chapter 14: Processes of financial management
8
A balance sheet represents a business’s assets and liabilities at a particular point in time
(expressed in money terms) and represents the net worth of the business. An income
statement shows the operating results for a period. It shows the revenue earned and
expenses incurred over the accounting period with the resultant profit or loss.
9
Assets are items of value owned by the business. Liabilities are claims by people other
than the owners against the assets (terms of debt) and represent what is owed by the
business.
10
Income Statement for the period ended 30 June 2021
$
$
5 000
Operating income
Cost of goods sold
Opening inventory
0
Purchases
2 000
Closing inventory
700
Gross Profit
1 300
3 700
Expenses
Selling
220
Administrative
730
Operating profit
950
2 750
11
Assets = Liabilities and Owners’ equity
12
The importance of the accounting equation is that it shows the relationship between
assets, liabilities and owners’ equity.
13
Business A — Owner’s equity (1 July) $140 000; Owner’s equity (30 June) $152 000;
Gross profit $99 000; Expenses $60 000
Business B — Liabilities (1 July) $107 000; Assets (30 June) $342 000; Cost of goods
sold $347 000; Net profit $39 000.
Business C — Assets (1 July) $559 000; Liabilities (30 June) $239 000; Sales $147 000;
Net profit $40 000.
14
(a) B $174 000
(b) C $40 000
(c) Business B provides the best return on owner's equity.
(d) Employees would be interested in the profit figures of a business. Strong profit
numbers may indicate that the business will remain in business and be in a position
to explore growth opportunities. If the business has poor profit figure (or losses) this
could mean the business is closed, or that expenses saving measures may need to
be employed.
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Chapter 14: Processes of financial management
(e) Business B would be most likely to be successful due to return on owner’s equity
and sales figures.
15
Eat Well Pty Ltd
Cash flow statement for year ended July 2021
$
Cash at beginning of year
15 400
Cash flows from operating activities

Rent
(2 000)

Wages
(3 200)

Receipts from customers
32 440

Payments to suppliers
(5 800)

Interest received
2 600
Net cash provided by operating activities
24 040
Cash flows from investing activities

Proceeds from sale of equipment
Net cash provided by investing activities
18 700
18 700
Cash flows from financing activities

Loan repayment

Dividends paid

Proceeds from issues of shares
(1 100)
(24 000)
75 650
Net cash provided by financing activities
50 550
Net increase in cash
93 290
Cash balance
108 690
16
In relation to the income statement provided, the value of purchases would be $109 850,
gross profit would be $103,900, cartage would be $8700 and the net profit would be $53
750.
17
In relation to the balance sheet provided, the total of the non-current assets would be
$588 060, the debtors would be $3250 and the mortgage would be $476 450.
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Chapter 14: Processes of financial management
Extension
18
The results indicated by the various financial statements are used by stakeholders to
assess the performance of the business and then used to make decisions that will form
the basis of the business’s future.
19
As evaluated by the individual. Other considerations may be employment relations
factors.
20
 Bank: Is income sufficient to cover borrowing costs?
 Employee: Is there sufficient income to cover wage/salary costs?
 Owner: Does the business generate sufficient profits relative to the capital
contribution?
 Investor: Is the profit, and hence returns generated, sufficient based on the owner/s
contribution?
 Customer: Are products reasonably priced?
14.5 Exam questions
Question 1
Correct Answer is D
Gross profit = Sales – Cost of Goods Sold
Net profit = Gross profit – Expenses.
Substitute the net profit figure in the net profit ratio to calculate expenses. [1 mark]
Question 2
Correct Answer is B
Total equity = Capital + Net profit
= $22 700 + 12 800
= $35 500
If Steve was a sole trader, he would have $35 500 worth of equity in the business. [1 mark]
Question 3
Correct Answer is A
The opening cash balance for April would be −$24 000 [1 mark]
Question 4
Correct Answer is B [1 mark]
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Chapter 14: Processes of financial management
Question 5a
10 000 [units ‘$’ are not necessary]
BOS 2014 HSC Business Studies Marking Guidelines:
Criteria
Marks
• States correct opening cash balance for March
1
BOS Notes from the Marking Centre:
Candidates showed strength in these areas:
• interpreting and calculating cash-flow statements. [1 mark]
Question 5b
May [and does not refer to any other month]
BOS 2014 HSC Business Studies Marking Guidelines:
Criteria
Marks
• States correct month
1
BOS Notes from the Marking Centre:
Candidates showed strength in these areas:
• interpreting and calculating cash-flow statements. [1 mark]
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Chapter 14: Processes of financial management
14.6
Financial ratios
Revision
1
Financial reports are analysed using calculations, percentages and ratios. Ratios are one
of the main tools used to analyse financial information and assist in answering more
clearly questions relating to profits, liquidity, solvency, efficiency and growth. The analysis
of financial reports involves working the financial information into significant and
acceptable forms that make it more meaningful and highlighting relationships between
different aspects of a business. The interpretation of financial reports involves making
judgements and decisions using the data gathered from the analysis.
2
The purpose of analysing financial ratios is to identify signals regarding the performance
of the business. Users will compare figures, percentages or ratios for departments,
products, branches of the business or against the industry. Trends over a number of years
might be identified or comparisons between items within a financial statement.
3
Financial
management
objective
Type of
ratio
Financial statement
Purpose
Gearing
Debt to
equity
Balance sheet
Solvency — ability to
meet long-term debt
Gross

profit ratio

Net profit

ratio
Income statement
Pricing of products
Income statement
Sales revenue
turned into net profit
Profitability


Efficiency

Return on
equity ratio

Expense 
ratio

Accounts
receivable
turnover
ratio

Balance sheet
Return on
investment
management relative
to sales
Income statement
Income
statement/balance
sheet
© John Wiley & Sons Australia, Ltd
Effectiveness of
expense
management relative
to sales
Effectiveness of
credit policy
17
Chapter 14: Processes of financial management
4
(a) Current ratio/return on owners’ equity
(b) Current ratio
(c) Debt to equity ratio
(d) Return on owners’ equity
(e) Accounts receivable turnover ratio
(f) Debt to equity ratio
5
(a) Return on owners’ equity — $7800/$50 000 x 100 = 15.6%; a satisfactory return
(b) Gross profit ratio — $15 000/$40 000 x 100 = 37.5%; that is, for every $1 of sales
37.5c is gross profit, which is an acceptable figure.
(c) Net profit ratio — $ 7800/$40 000 x 100 = 19.5%; that is, for every $1 of sales 19.5c
is net profit, which is acceptable and indicates that expenses are being met quite well.
6
It would appear that it is taking longer for Blossoms to chase up accounts receivable,
although it has stabilised in the last two years. This indicates an ineffective credit policy
and therefore places pressure on the business to use alternative cash sources, for
example overdraft, as it is not collecting money directly from its debtors.
The fact that it takes four months to settle an account for a good supplied means that, if
they were Blossoms Trucks, the product would be sold less frequently than tyres. This
would be more acceptable, but is still cause for concern. Tyres would be sold more
frequently and it would be reasonable to expect that accounts would be settled more
promptly by debtors.
7
It would appear that most figures are worse in 2021 than in 2020. The fall in the current
ratio would indicate that there are fewer current assets to current liabilities, which could
be a conscious decision by the business to use its current assets more effectively, for
example, levels of inventory, or that it is relying less on its overdraft due to better accounts
receivable turnover.
Profits have fallen which could be due to a number of factors, either internal (for example,
poor quality of products) or external economic factors.
The debt to equity ratio has increased, indicating a more highly leveraged/geared
approach, which could be to make up for the shortfalls in profits or an attempt to expand
production by investing new capital equipment.
The fact that it takes six weeks to chase up accounts receivables is worrying and an
indication that the business’s credit policy is not working and needs to be addressed.
8
(a) Expense ratio for 2020 is (total expenses/sales) $42 700/$130 000 = 32.84%
and for 2021 it is $47 800/$135 000 = 35.40%.
(b) It would appear that advertising has brought about a small increase in sales; however,
it has probably not increased sales as much as anticipated and alternative methods of
advertising that might generate higher sales could be considered. The higher motor
vehicle expenses could be a sign of ongoing problems, especially if the vehicles are
ageing.
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Chapter 14: Processes of financial management
(c) 2020 — $20 000/$130 000 x 100 = 15.38%
2021 — $23 000/$135 000 x 100 = 17.04%
It has increased over the two years.
(d) Profitability for 2020:
Gross profit — $50 000/$130 000 x 100 = 38.46%
Net profit — $7300/$130 000 x 100 = 5.61%
Profitability for 2021:
Gross profit — $53 000/$135 000 x 100 = 39.25%
Net profit — $5200/$135 000 x 100 = 3.85%
The gross profit figures are fairly stable over the two years; the main cause for concern is
the net profit figures, which have declined considerably (given that they were already quite
low). This can be attributed to the increase in expenses, which needs to be addressed.
9
(a) As illustrated in the figures, there is a decline in all profitability figures for Business
Z. It would appear that although sales have increased over the period (save for a
dip in 2020), the cost of goods sold figures have escalated between 2019 and 2021.
Expenses have remained consistent over the period; however, the net profit decline
for 2021 is of concern and is a reflection of the higher COGS figure. The decline in
net profit for 2021 has resulted in a lower return on owners’ equity and would be of
concern to owners.
(b) Gearing for 2019–21 — Debt to equity — $70 000/$80 000 x 100 = 87.5%
This represents a highly geared business, which would be exposed to a higher level
of risk, given its liabilities. As this figure shows no sign of falling, there would be
some concerns for its solvency; however, the most recent sales figures do give
cause for some optimism.
(c) Cost of goods sold need some consideration, perhaps by way of better stock
selection or cheaper suppliers as both would lower this figure. Growing sales could
also be considered. Although this would increase advertising expenses, it is worthy
of some thought. Both of these strategies should address profitability issues.
The gearing figures are of concern and could jeopardise solvency. Reducing
liabilities, especially the reliance upon the overdraft, could be a symptom of a poor
credit policy or type of the loan not matching its purpose.
10
(a) The current ratio is $4500/$1000 = 4.5 : 1; Debt to equity ratio is $6000/$4000 = 150%;
Return on equity = $3000/$1000 = 300%; Accounts receivable ratio is 60%, 365/60 = 6.08
days.
(b) Based on industry averages, the current ratio compares favourably (it may in fact be
too high), debt to equity is higher, accounts receivable is much lower and the return on
equity is much better. It could make better use of its current assets. For example, it is
holding a lot of inventory, and this would bring its current ratio down to a more appropriate
level. Its high gearing ratio may be of concern in the long term and it could look at reducing
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Chapter 14: Processes of financial management
its non-current liabilities. It is achieving an excellent return on owner’s funds and would
appear to have sound methods of chasing up outstanding accounts.
11
Liquidity: It would appear that the business is not achieving the desired current ratio of
2 : 1 but does still have an excess of current assets over current liabilities. The business
will need to continue to monitor this.
Gearing: This ratio is the most cause for concern and it would appear that the business
could be heading for solvency issues, which will need to be addressed.
Profitability: The decline in the owners’ return is of concern, especially the 2020–21 period
that has seen a marked decline.
12
It is difficult to compare businesses over time because businesses might not compare the
same things and/or businesses might be quite different from each other.
13
Businesses compare results with industry standards and benchmarks because it provides
a useful guide for business performance. Businesses can make decisions based on these
results.
14
It is often difficult to compare business ratios with industry averages because each firm is
different and the reasons for the figures are probably more significant. For example, two
different gearing figures may be attributed to a number of factors but may not be of
concern.
Read the ‘Harvey Norman’s gearing strategy’ case study and answer questions 15 and
16.
15
A rights issue is an invitation to existing shareholders to purchase additional new shares
in the same company. This type of issue gives existing shareholders securities called
rights. With the rights, the shareholder can purchase new shares at a discount to the
market price on a set future date. Until the set date at which the new shares can be
purchased, shareholders may trade the rights on the market in the same way that they
are able to trade ordinary shares. Rights are considered to be a type of option since it
gives shareholders the right, but not the obligation, to purchase additional shares in the
company. Usually the current shareholders will have the right to purchase new shares in
proportion to the number of shares they currently own. The shareholder does not have to
take up the rights issue.
16
Some impacts of this rights issue include:
 Helped Harvey Norman be in a strong position in the event of a downturn
 Led to the company raising a significant amount of capital ($165.6 million)
 Helped reduce Harvey Norman’s debt
 Helped improve their debt to equity ratio and decreased their gearing
 Helped improve solvency
 Helped position the company for the impending downturn
Extension
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Chapter 14: Processes of financial management
17
The objectives of financial management often conflict with one another because the quest
for one objective might cause difficulties for another. For example, the desire to maximise
growth and profitability might increase the debt-to-equity ratio, which could be reflected in
solvency issues.
18
The figures found in financial analysis are used by stakeholders to make judgements
about the business. The fuller the financial picture of the business, in the form of liquidity,
profitability, solvency and efficiency figures, the more accurate the analysis and the more
effective the interpretation of same.
19
Individual responses will vary.
20
Individual responses will vary.
14.6 Exam questions
Question 1
Correct Answer is D
The gearing for this business in 2020 indicates that it is worse than the industry average and
has worsened since 2019. [1 mark]
Question 2
Correct Answer is C [1 mark]
Suggested Answer:
Gross profit = Sales – COGS.
Gross profit 2020 = 275 000 – 145 000
= $130 000
Net profit = Gross profit – Expenses.
Net profit 2020 = 130 000 – 35 000
= $95 000
Net profit ratio = (net profit ÷ sales) x 100
Net profit ratio 2020 = (95 000 ÷ 275 000) x 100
= 34.5%
Question 3
Correct Answer is C
The gearing ratio is one measure of solvency. In this case, the ratio is the same as the
figures for dividing.
That is, total liabilities (current 15 000 + non-current 135 000) or 150 000 : total equity
(capital 184 000 + net profit 16 000) or 200 000, i.e. 150000 : 200000 or 0.75 : 1 [1 mark]
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Chapter 14: Processes of financial management
Question 4a
Correct Answer is B [1 mark]
Gross Profit = Sales − COGS
= 600 000 − 200 000
= 400 000
Gross Profit Ratio = GP/Sales %
= 400 000/600 000 %
= 67%
Question 4b
Correct Answer is B
To collect debts is an efficiency ratio. In this question it is the accounts receivable ratio. This
provides the number to then calculate the days to collect.
Accounts receivable ratio = sales/accounts receivable, that is 600 000/41 000 = 14.63.
We then use this number to divide into 365 (days of the year) to calculate the average
number of days to collect debts, that is 365/14.63 = 24.94 days (round up to 25 days). [1
mark]
Question 5
Correct Answer is C
Before investing it is best to gather as much information as possible. A crucial part of this
should be financial information/performance using ratios such as solvency, return on owners’
equity and efficiency. [1 mark]
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Chapter 14: Processes of financial management
14.7
Identify the limitations of financial reporting
Revision
1
Investors need to be aware of the limitations of financial reports. They can be misleading
and be misinterpreted, both of which will have an impact on the decision making of
management and potentially put the business at risk. This in turn will have an effect on
investors.
2
Read the ‘Retail Food Group’s valuation of goodwill’ case study and answer
questions 3 and 4.
3
The factors that led to a decrease in RFG’s profits are negative publicity, changing
consumer trends and intense competition.
4
The franchise inquiry report called into question the goodwill on RFG’s balance sheet and
recommended that the decline in profits needed to be reflected in the company’s goodwill
— if a business has no anticipated profit, then the goodwill will be devalued because of
the company’s poor financial position. RFG responded by cutting their goodwill down from
$270 million in 2017 to $52 million by the end of 2019.
Extension
5
The statement ‘Analysis of financial information identifies only symptoms, not causes’ is
not entirely accurate. With a full analysis of the information, causes can be identified and
addressed.
6
Individual responses will vary.
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Chapter 14: Processes of financial management
14.7 Exam questions
Question 1
Correct Answer is C
The limitation of financial reporting that is evident is normalised earnings. [1 mark]
Question 2
A limitation of this financial report may be capitalising expenses. Research and development
has been included as an asset rather than an expense thus making the balance sheet seem
to have greater assets.
Award 3 marks for answers that identify a limitation of this financial report and provide a
reason why it is a limitation.
Award 2 marks only for answers that describe in general terms a limitation of this financial
report.
Award 1 mark only for answers that make a relevant statement.
Bostes Notes from the Examination Centre:
Students showed strength in interpreting financial statements — in particular, balance sheets
and their limitations. [3 marks]
Question 3
Correct Answer is A [1 mark]
Question 4
Correct Answer is D
This situation describes capitalising assets. This is an accounting method in which a
business records an expense (in this case, the property next door) on the balance sheet as
an asset rather than an expense. 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. [1mark]
Question 5
Correct Answer is A
The manager is using notes to the financial statements to report the details and additional
information that is left out of the main reporting documents. [1 mark]
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Chapter 14: Processes of financial management
14.8
Ethical issues related to financial reports
Revision
1
Ethics in financial management are closely related to legal aspects; therefore, businesses
are expected to acknowledge both the business’s objectives and the interests of owners
and shareholders in the decision-making process. Unethical business behaviour is
frowned upon. There are growing calls for codes of behaviour to regulate the activities of
business in the area of financial management.
2
There is little advantage to undervaluing inventories and accounts receivable to indicate
a favourable working capital ratio and, therefore, the short-term financial stability of the
business. This would be regarded as unacceptable business practice. It would be prudent
to represent the true position of the business in order to provide stakeholders with a more
accurate portrait of the business. The real issue would be if the business decided to
overvalue the short-term financial stability, which would also demonstrate unethical
behaviour.
3
In respect to budgets, it is common business practice to overestimate budgets to allow for
uncertain or unknown risks as these are often beyond the business’s control.
4
Audits provide an independent check of the accuracy of financial records and accounting
procedures.
5
Internal audits are conducted internally by employees to check accounting procedures
and the accuracy of financial records. Management audits are conducted to review the
firm’s strategic plan and to determine if changes should be made. External audits are
required under the Corporations Act 2001 (Cwlth), whereby the firm’s financial reports are
investigated by independent and specialised audit accountants to guarantee their
authenticity.
6
Financial record keeping should be both accurate and honest because all aspects of the
business’s accounting processes are dependent on it.
Read the ’ATO reveals one-third of large companies pay no tax’ case study and answer
questions 7 to 10.
7
About one-third of large companies have once again failed to pay a cent of tax.
8
Some multinationals shift profits outside of Australia to reduce their local taxable income.
9
The Federal Government has introduced tougher anti-avoidance laws, including the
Multinational Anti-Avoidance Law (MAAL). The Diverted Profits Tax (DPT) is also helping
the ATO get the information it needs if companies are deliberately avoiding paying taxes.
And previous stronger transfer pricing laws passed under the former Labor government
have given the ATO an arsenal to fight companies it believes may be overstepping the
line.
10
 While some entities reported a taxable income, their prior-year losses were available
to deduct against that profit, so no tax was payable.
 Some entities reported an accounting loss.
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Chapter 14: Processes of financial management
 Some entities reported an accounting profit but reconciliation items (such as tax
deductions allowed at higher rates than accounting permits) resulted in a tax loss.
 Some entities reported a taxable income but were also entitled to offsets (such as
the research and development tax incentive) at least equal to the tax otherwise
payable.
Extension
11
Individual responses will vary.
12
Timely and valid internal and external audits are used by a number of businesses in the
course of their operation. Whether it is internal or external audits, this process is seen as
an important control procedure in the business, and their use does address the issue of
unethical financial behaviour.
13
The role of the Auditing and Assurance Standards Board (AUASB), and the reason why
the federal government would be involved in maintaining assurance standards, is so that
the AUASB can act as an independent, statutory agency of the Australian Government,
responsible for developing, issuing and maintaining auditing and assurance standards.
The mission of the AUASB is to develop, in the public interest, high-quality auditing and
assurance standards, and related guidance, in order to enhance the relevance, reliability
and timeliness of information provided to users of auditing and assurance services.
Further, sound public, interest-oriented auditing and assurance standards are necessary
to reinforce the credibility of the auditing and assurance processes for those who use
financial and other information.
14
KPMG’s financial statement audit services aim to provide independent financial statement
audits that enhance the reliability of the information provided by companies to investors,
creditors and other stakeholders in accordance with statutory requirements. In the
marketplace, credible financial statement audits reinforce investor confidence. Within
businesses, they add to board and management understanding of the business and the
risks it faces.
14.8 Exam questions
Question 1
An ethical issue related to the preparation of financial reports may be that businesses
overestimate their revenue and understate their expenditure to give a false impression of
their profitability. This false impression gives an inaccurate picture and may encourage
investors to invest in a business that appears to be in a stronger financial position than it
actually is. [2 marks]
Marking guidelines:
Criteria
Marks
• Sketches in general terms ONE ethical issue related to the preparation of
financial reports
2
• Recognises ONE ethical issue related to the preparation of financial reports
1
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Chapter 14: Processes of financial management
Question 2
Correct Answer is D [1 mark]
Question 3
Correct Answer is D
Financial managers and accountants who prepare financial reports should ensure the
decisions they make are ethical and that they act with the highest standards. They have an
ethical and legal obligation to ensure financial records are accurate. [1 mark]
Question 4
Explanation could include:
• meet community expectations
• provide true and accurate reports.
Award 1 mark for defining ethical financial reporting.
Award 1 mark for providing a feature or example of ethical reporting.
Award 1 mark for each method or reason why ethical reporting is used (2 marks possible).
Sample answer:
Ethical financial reporting provides the complete, true and accurate financial picture of the
business. The community expects that the figures they see regarding financial performance
are a proper indication of the business. Issues that Cherry Chase might consider include
value of assets. Assets should be presented at their current market value. As well,
intangibles should be independently assessed. Debts should show their due date, the
creditor and the interest rate. ASIC provides guidelines on how to present ethical financial
reports, so Cherry Chase could use their facilities. By following the suggestions made here
and by ASIC, Cherry Chase can ensure an ethical and true value of the business. This will
lead to trust within the community and enhance the business’s reputation. [4 marks]
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Chapter 14: Processes of financial management
14.9
Review
Exercise 1: Multiple choice questions
1
Answer is A. Expense ratio
2
Answer is D. Calculating the liquidity of the business using the current ratio
3
Answer is A. Profitability of the firm using a return on equity ratio
4
Answer is C. $43 000
5
Answer is D. Accounts receivable turnover ratio
6
Answer is A. Finance should be matched with an asset that has a similar lifetime; for
example, short-term finance should be used to buy short-term assets.
7
Answer is B. A lower level of gearing
8
Answer is B. $16 000
9
Answer is A. 63.6%
10
Answer is C. Liabilities = Assets – Owners’ equity
Exercise 2: Exam practice questions
Question 1 (4 marks)
Outline TWO processes of the planning and implementing cycle.
Students need to sketch in general terms two of the following:
 Financial needs
 Budgets
 Record systems
 Financial risks
 Financial controls
Question 2 (6 marks)
Use the Balance Sheet to answer questions a to c.
a.

Current ratio = current assets ÷ current liabilities

Current ratio = 505 000 ÷ 140 000

Current ratio = 3.6:1
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Chapter 14: Processes of financial management
b. This business has $3.60 of current assets for every $1 of current liabilities which means
they are well above the industry average of 2:1. They are therefore in a very good position to
repay their short-term debts as they fall due.
c.

Accounts receivable turnover ratio = sales ÷ accounts receivable

Accounts receivable turnover ratio = $2 100 000 ÷$135 000 = 15.6

365 ÷ 15.6 = 23.4 days

Therefore, this business takes on average 23.4 days to collect their accounts
receivable.
Question 3 (4 marks)
Explain ONE limitation of financial reports.
Students are required to relate the cause and effect of one of the following limitations of
financial reports:

Normalised earnings

Capitalising expenses

Valuing assets

Timing issues

Debt repayments

Notes to the financial statements
Question 4 (6 marks)
Analyse why it’s important for business owners to calculate financial ratios.
Students are required to draw out and relate the implications of why it’s important for business
owners to calculate financial ratios.
For example:

Many important questions cannot be answered by simply completing financial
statements.

Ratios help highlight relationships between different aspects of a business.

Ratios help make financial statements more meaningful.
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Chapter 14: Processes of financial management

Helps businesses determine whether they are meeting the financial objectives of
profitability, liquidity, solvency and efficiency.
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