Financial Management Strategies - PowerPoint Presentation

1. Financial Management Strategies

2. Cash flow management

3. Cash flow in a business needs to be carefully managed. Cash flow management refers to the way the movement (or flow) of cash from one aspect of the business to another is managed. Initially cash is needed to pay expenses, such as wages, as raw materials are transformed into finished goods. Cash is then locked up in inventory or stock. When those goods are sold to customers, cash is received. The cash can then be used again to pay expenses such as wages.

4. Most large manufacturing businesses sell their products to customers on credit. This means that the customer gets the goods with an invoice attached and will pay the account later. Unless the cash is collected from the customer, it will not be available to pay the next round of expenses! And it is not an easy task to collect debts as they fall due. People want to put off paying.

5. Cash flow statements The first aspect of effective financial planning is to construct a cash flow statement. A cash flow statement predicts the monthly inflows and outflows of cash. An inflow, for example, occurs when goods are sold or customers pay their debts if the goods were sold on credit. An outflow is a payment for expenses such as wages or an insurance premium. It is much easier to predict monthly outflows of cash than inflows. Think about why. However, even inflows can be reasonably accurately predicted on the basis of last year’s sales and sales budgets.

6. This is how a simplified cash flow statement would look.

7. Where do you think the opening balance of $28 000 in January came from? Of course that was the cash in the bank on the 31st December 2014 and it becomes the opening balance for the 1st January 2015. The cash inflows represent income from sales of goods or the collection of customer debts. The outflows represent payments to suppliers and for expenses such as wages, leasing payments, electricity usage and so on.

8. Did you notice the negative closing balances from July to October? Why were sales of ice cream so low from May to August? Obviously it is a seasonal thing - people buy less ice cream in winter. How will Magic Ice Creams Pty Ltd pay their bills in July, August and September? It is most important the managers of this business plan for this problem. Perhaps the quickest and most convenient way of dealing with the problem would be to arrange a $20,000 overdraft. Another aspect of the effective management of this cash flow is the large amounts of cash in the bank in December, January, February, March, April and May. If this cash were invested in marketable securities (loans to other businesses), it would earn additional cash. Obviously cash flows need to be carefully managed.

9. Distribution of payments Businesses often have a choice as to when many bills are paid. Lease payments, for example, can be linked to the cash flow cycle. Most wheat farmers link the lease payments for tractors and headers to the once-a-year payment for their wheat. Insurance premiums are another example where the payment can be made at any time of the year. It is important to link outflows, whenever possible, to months with surplus cash.

10. Discounts for early payment Discounts for early payments involve an offer where, for example, the customer can deduct, say 5 %, if the bill is paid in 7 days rather than the normal 30 days. In this way cash moves from one section of the business (accounts receivable) to another section of the business - accounts payable and expenses - more quickly. The cash is available to pay wages, for example, more quickly. Discounts for early payment can often be a cheaper option compared to using an overdraft when there is a cash deficit.

11. Factoring You will remember from the earlier section on short-term borrowing that factoring is an external source of finance. Factoring refers to the sale of customer debts to a financier. It is an important strategy for cash-flow management even though the cost of factoring adds to business expenses. Typically, this expense is about 3%, so it can be significant.

12. However, it can be a very important strategy for managing the cash flow of rapidly growing businesses. In this case, there is always a great deal of pressure to pay suppliers, and factoring provides quick cash. The pressure occurs because of the need to move cash from accounts receivable to accounts payable in a very short time period. It is important to augment a factoring strategy with an effective credit policy so that customer debts are collected efficiently and the need to factor is minimised.

13. Working capital management

14. Working capital is essential in nearly all businesses. Working capital or liquidity management is all about paying suppliers’ bills (or accounts payable) and other expenses as they fall due.The working capital ratio measures the ability of the business to pay short-term debts. We have already looked at the liquidity ratio in the financial ratios section of this topic. You will recall the liquidity ratio is the current ratio and the formula is: current ratio = current assets ÷ current liabilities.

15. The current ratio measures the business’s ability to pay short-term debts in terms of available current assets. However, liquidity in a business is the same concept as working capital. Another name for the current ratio is the working capital ratio.

16. Control of current assets - cash Cash is controlled by cash budgets. The cash budget sets out the anticipated sources and uses of cash on a monthly basis. The cash budget is both a planning and controlling tool. It enables managers to time the payment of significant ongoing expenses, such as insurance premiums, so that they are paid when there are cash surpluses. One important aspect of the cash budget is the fact that cash outflows are easier to predict accurately than cash inflows. This is because cash inflows depend on external factors such as customer demand.

17. Control of current assets - receivables Receivables are customer debts. Most businesses supply their customers on credit. When goods are sent to the customer, they include an invoice. The invoice sets out the type of good, the quantity and the price. There will also be a time period, usually ranging from 7 to 30 days, for payment of the invoice. The problem is that people are often reluctant to pay bills on time. Many businesses are also like this and customer debts need to be carefully managed to make sure that they are paid on time. There are a number of strategies that can be used.

18. They are: Credit PolicyFactoring

19. 1. Credit policy Businesses should have a credit policy. A credit policy is a set of guidelines to staff on how to monitor and collect customer debts. It is the most cost-effective way of managing customer debts. The credit policy manages customer debts by first setting a credit limit. The credit limit is the maximum value of credit the business is prepared to give to its customer. It is based on things like knowledge of the customer, past trading record and so on.

20. Next it is important to set the credit period. This refers to how long the customer can have the credit before the bill should be paid. Typically it is 30 days, but it varies with particular industries. For example, the grocery industry operates on a credit period of seven days.

21. The most important aspect of the credit policy is the collection policy. The collection policy is a guide to staff on what to do when customers fail to pay on time. The collection policy, for example, might advise staff to ring the customers and advise them of the trading period. Other customers who are badly overdue may need the threat of debt collectors. The collection policy provides advice to staff on a range of possible scenarios. It may be, for example, that when important customers are overdue on their payments, it is to be referred to senior management.

22. 2. Factoring When a business is growing rapidly, factoring can be an important control of current assets - receivables. Factoring is where customer debts are sold to a financial institution. The financial institution collects the customer debt when it is due to be paid and the business gets immediate cash. Financial institutions charge a fee for this service.

23. Control of current assets - inventories Inventories are often one of the largest assets for many businesses. Inventories refer to stored resources such as raw materials, work-in-progress, component parts or finished goods. Retail businesses have mostly finished goods as inventory. They tend to call it inventory stock. On the other hand, manufacturing businesses often hold a large amount of raw materials or component parts in their inventory because the finished goods are usually sent as soon as they are manufactured to customers.

24. Businesses need inventory so they can respond quickly to customer orders. If the business cannot respond quickly, the customers may take their orders to competitors. One of the best ways to manage inventory is through an inventory policy.

25. 1. Inventory policyAn inventory policy manages inventory. It sets out such things as where, in the factory, the inventory is stored, what items are stored and how many of each. In addition, a good policy would comment on the condition or quality of the items. Inventory policies like this are usually computerised. This means that new orders can quickly be checked against inventories in stock.

26. 2. Just-in-time (JIT)Another method of controlling inventories is the just-in-time inventory system, where each inventory item is supplied just-in-time to be used. Coca-Cola use this system at their Northmead factory. Cans are delivered from Alcoa as they are needed and are unloaded directly on to the conveyor belts. The great advantage of this system is that there are no storage costs and no obsolete or damaged stock.

27. Activity!

28. Control of current liabilities

29. You will recall the concept of current liabilities from your work on the balance sheet. Current liabilities are bills that have to be paid in the short term (within the accounting period). Most of these are debts owed to the business’s suppliers and they need to be paid as they fall due. Typically this will be 30 days after receiving a statement, although it varies from industry to industry. The statement sets out sales to the business from a particular supplier for the current month.

30. Control of current liabilities - payables It is most important that suppliers’ bills are paid when they fall due - not before and not after. Payables refer to the money owed to the business’s suppliers. ‘Payables’ is a contraction of ‘accounts payable’. The control of payables is important, because there are both benefits and dangers associated with the way the business approaches payables. A strategy to maximise the benefits and eliminate the dangers is needed.

31. The most important aspect of controlling strategies is to ensure that these bills are paid on time and not before time. If they are paid before, the business is missing out on ‘free money’ from trade credit. Trade credit is used to describe a relationship where a business provides goods or services to a customer and agrees to receive payment at a later date. The extent of the time period before the debt has to be paid varies from industry to industry. Trade credit is a most important source of finance for many businesses, because this finance can be used for other purposes until it is needs to be paid. On the other hand, if debts are paid after they fall due, there is a serious ethical consideration. How can a business expect its bills to be paid on time if it, in turn, fails to pay on time?

32. Control of current liabilities - loans Loans are often used as a substitute for controlling receivables. When important customers are overdue in their payments, managers often use an overdraft to pay wages that should have been paid from customer debts. Some managers are concerned that ringing big clients about overdue bills might upset them.

33. A loan is also a cost. Interest is charged on loans and this adds to expenses and reduces profitability. Loans should be controlled through capital budgeting. Capital budgeting is concerned with the finance needed for particular projects. Projects are assessed in terms of their risk and returns.

34. Control of current liabilities - overdrafts The normal operations of a business usually result in surpluses and deficits of cash. A retailer, for example, does a lot of business over the Christmas period and cash surpluses result. Less business is conducted during winter and sometimes periods of deficit occur. An overdraft is a convenient way of dealing with the deficit. Budgeting cash is an excellent method of controlling overdrafts. The cash budget should be compiled from the cash flow statement. Overdrafts should not be used to cover problems such as failure to control customer debts effectively.

35. Strategies - leasing Leasing is a very popular way of financing assets. Leasing is a contract that enables a business to control an asset (owned by someone else) in return for regular payments to the owner of the asset. The owner of the asset is called the lessor and the business using the asset is called the lessee.

36. The great advantage of leasing is that the payments for the asset can be matched to the earnings of the asset. Leasing allows the business to control and use an asset owned by someone else in return for regular payments. Almost any asset can be leased and it conserves working capital because no upfront fees are paid. A strategy to lease an asset rather than purchase it is particularly important when a business is experiencing rapid growth.

37. Case Study

38. Strategies - sale and lease-back Sale and lease-back became very popular during the 1990s. It was very common for large businesses to sell the land and buildings they used for their operations to a financier such as a merchant bank. As part of the deal they agreed to lease the property back for a certain number of years in return for regular payments. David Jones, for example, sold their major city stores to Deutsche Bank and leased the premises back. Sale and lease-back improves or increases working capital, rather than just conserving it. The money received can be used for additional projects within the expertise of the business.

39. Profitability management

40. Profits are maximised by controlling costs. The most competitive businesses are those with a cost structure lower than their competitors. When Virgin entered the Australian airline industry it had new, highly efficient planes and its staff were employed on individual employment agreements, which were very cost effective. Virgin could fly a passenger more cheaply than Ansett and Qantas. Ansett had inherited labour agreements that meant its staffing costs were far greater than Virgin. Its planes were older and more expensive to run. Ansett needed to reduce its costs. It did not and, as a result, failed.

41. Cost controls Cost control is the single most important aspect of running a business. This is because cost control strongly influences both profitability and competitiveness. Companies like Telstra have limited opportunities to grow. The managers are looking to cost control to improve profits. Most successful companies are committed to cost control.

42. The key to effective cost control is benchmarking costs. Benchmarking is the process of comparing costs with the most efficient businesses in the industry. Toyota, for example, is often used as the benchmark business in the car making industry. Where costs are significantly above the benchmark business, it is important to find out why and develop strategies to reduce them. This involves a careful examination of fixed and variable costs in the business.

43. Cost controls - fixed and variable Two types of costs make up total cost: fixed costs and variable costs. Fixed costs do not vary with output. Purchasing a giant truck to cart iron ore is an example of a fixed cost. Once the purchase has been made, the cost has been incurred, even if the truck is never used. On the other hand, if the truck is driven 24 hours a day, it still has the same purchase price. However, every time that the truck is driven it uses fuel, and the more it is driven the more fuel it uses. Fuel is a variable cost. Variable costs increase with output. Typically, variable costs are things like labour costs, electricity costs and raw material costs.

44. Variable costs are the most important, simply because once the fixed cost has been incurred not a lot can be done about it. Controlling variable costs is critical because a reduction in variable costs enables managers to increase profits or to reduce their prices. The ability to reduce prices increases the competitiveness of the business.

45. Cost controls - cost centres Where there is a work unit (or part of a work unit) in a business that has a lot of variable costs, setting up a cost centre can be an effective way of controlling those costs. A cost centre may simply be a work area, a department or a whole factory, and the idea is to separate it from the rest of the business in terms of its costs. Whatever it is, it incurs significant costs. The costs may be associated with raw materials, storing inventory, overtime payments for labour and so on. It is critical that the costs are carefully controlled.

46. One effective method of doing this is to establish a cost centre where someone (a manager or a team) is responsible for the costs. This person would have the skills to record, measure and monitor cost usage effectively. Such an approach means that wastage is immediately picked up and something can be done about it.

47. Cost controls - expense minimisation Expense minimisation is one of the most important ways of establishing an advantage over competing businesses. Expense minimisation is all about reducing expenses such as wages, rent and leasing payments to the minimum possible. Again, it is important to understand that reducing expenses can either improve profitability or competitiveness.

48. The Fair Work Act places great importance on minimising expenses through negotiations and agreeing to a collective agreement. In industries such as mining, expense minimisation is achieved by negotiating individual agreements with employees to improve productivity through expense minimisation. You need to note, however, that individual agreements can only be negotiated with employees earning more than $100 000 a year.

49. Revenue controls - marketing objectives Controls to ensure that the maximum amount of revenue is generated in the business are just as important as cost controls. Revenue is the money a business receives from selling its products to customers. Revenue will be maximised when there are clearly defined marketing objectives relating to things like sales objectives, the sales mix and the pricing mix.

50. Sales objectives Perhaps the most important marketing objective is to continuously improve the processes that result in sales: for example, to improve the supply of customer orders without a problem from 78% to 95% within six months. This could be achieved if, for example, there was better communication between finance, marketing, sales and operations. Improving the supply of customer orders without problems is just one aspect of customer demand analysis or, in plain English, understanding what the business’s customers want. If the business meets its customers’ needs more effectively than its competitors, sales will improve. Setting sales objectives and budgets is not about optimistically adding 10% to last year’s sales figures. It is about working out how sales can be increased by more effectively meeting customer needs.

51. Customer needs may be more effectively met in a number of ways. It might be, for example, that customers want better quality, or perhaps an improved product, or better design, or faster and more reliable delivery.

52. Sales mix In many businesses the sales mix is the key to revenue and profit improvement. The sales mix refers to the breakdown of sales revenue by products, which are typically expressed in percentages. Woolworths, for example, has gained market share because this business is continually improving its sales mix. Think about the product groups in a typical Woolworths supermarket. They range from fruit and vegetables to dairy, canned goods, fresh meat, seafoods, frozen foods and so on.

53. Getting the mix right has given Kmart a clear advantage over Big W. Again we should use the phrase ‘customer demand analysis’. Kmart managers better understand the needs of their customers, and this has generated more revenue and higher profitability for their businesses.

54. Pricing mix Getting the right pricing mix is also critical for many businesses, particularly retail businesses such as Big W. The pricing mix refers to the breakdown of products on the basis of their contribution to profitability. Big W effectively use price points in their pricing mix. The price points are psychological reference points in the minds of consumers. Big W has been very effective in using entry-level prices for a range of similar products, such as the various brands of microwave ovens, to create an overall image of value-for-money.

55. Advertising an entry-level microwave oven, for example, at a very cheap price creates an overall perception of ‘value-for- money’. Other products will strongly contribute to profitability. The microwave ovens with all the features, for example, may well be priced to ensure a maximum contribution to profitability. Retailers, particularly, are always trying to improve the pricing mix to maximise profits while at the same time ensuring that the customer perception relates to ‘value-for-money’. It is not an easy task and requires great skill.

56. Pricing policy A pricing policy is a guide to staff on the overall pricing strategy that the business will adopt. There are a number of factors that will affect the pricing policy. One of the most important is the demand and supply for the products the business is selling. Another is how competitors are pricing their products. The pricing policy carefully balances the goals of revenue maximisation against profit maximisation.

57. Manufacturing businesses will base their pricing on things like the costs of production, the design features of the product, the success of the brand and so on. Think, for example, about why Nike can charge $200 for a pair of joggers while a similar pair in Target may cost $20. As with the pricing mix, setting the pricing policy for a business is a highly specialised area that directly impacts on the success or failure of the business.

58. Profitability management worksheet

59. Global financial management

60. There is greater complexity in global financial management compared to domestic financial management. This is because goods and services need to be paid for in the local currency and this currency needs to be purchased first. This aspect of global financial management creates uncertainty because exchange rates fluctuate and, as a result, make it difficult for a business to plan.

61. Exchange rates The management of a global business is made more difficult because of exchange rate risk. Exchange rate risk comes from dealing in foreign currencies that are subject to fluctuation. Just imagine, for example, an American business importing Australian wine. When the price was set, the American company agreed to pay in Australian dollars and an Australian dollar could be purchased for US$0.48. However, in the three months it took for the goods to arrive in the United States and the payment documents to arrive, the Australian dollar rose to US$0.73. In other words it now took 73 US cents to buy an Australian dollar rather than the 48 US cents at the time of the purchase.

62. A strong Australian dollar (where the value of the Australian dollar is greater than the value of the United States dollar) has a significant effect on a range of Australian businesses. These include manufacturing businesses, tourist businesses and businesses providing education to students from overseas. In every case the price of their products increases as the Australian dollar increases in value. Even retailing businesses experience increased competition from overseas on-line competitors.

63. Another difficulty with fluctuating exchange rates is that many contracts with global customers are written in US dollars. Large businesses such as Rio Tinto find their costs increasing because they are determined by the strong Australian dollar and their revenues reduced because the contracts are written in the weaker US dollar. However, the quite remarkable increases in the prices of coal and iron ore tend to more than compensate.

64. Interest rates We explained the importance of interest rates in the earlier section of the course where we looked at global influences on financial management. You will recall that an interest rate is simply the price of money. However, interest rates are not just influences on a business but can also be used as strategies in global financial management to gain a competitive advantage.

65. As we explained before, interest rates vary between countries, depending on the actions of the central bank in each individual country and the availability of funds. Large global businesses such as BHP Billiton require access to large amounts of cash to develop new mines, build mining infrastructure such as coal loading facilities and develop transport facilities. BHP Billiton has access to finance in a number of major global financial markets and is able to borrow in the Japanese market (with an interest rate of 0.1% in August 2011) or the United States market, where interest rates in August 2011 were 0.25%.

66. When global interest rates are used as a strategy to lower costs and gain a competitive advantage through a cost structure lower than competitors, it is important to ensure any advantage gained from a lower interest rate is not eroded by an exchange rate movement. Businesses like BHP Billiton use hedging to ensure against any risks in this area. Hedging, as you will learn a little later in this unit of work, is a strategy that enables a business to ensure against the effects of exchange rate fluctuation.

67. Methods of international payment Global financial management requires a range of methods to meet international payments. We have already explained that most business-to-business trade is conducted on credit. However, because of foreign exchange and collection issues, this creates a risk for both businesses. There is the risk the goods will not be delivered and there is the risk that the goods will not be paid for. A number of methods of international payment have been developed to deal with the different types of risk. They include payment in advance, letter of credit, clean payment and bill of exchange.

68. Methods of international payment - payment in advance The simplest method of international payment is payment in advance. Payment in advance is where the money is transferred to the exporters’ bank account before the goods are shipped. Obviously this method of payment minimises the risks for the exporter and maximises the risks for the importer. It should be noted, however, that the importer could minimise the risks by undertaking basic credit checks through the credit rating agencies.

69. Methods of international payment - letter of credit The letter of credit method of international payment is a more convenient way to deal with the risk for both importer and exporter, but it is more expensive. With a letter of credit, the importer’s bank guarantees that the agreed amounts will be paid as soon as the goods arrive in the importer’s warehouse. The exporter is satisfied because the bank is taking any risk of non- payment and the importer is satisfied because there is no risk of paying for goods that might not arrive. Letters of credit are very popular, but the fees charged by the bank for this service can be considerable.

70. Methods of international payment - clean payment We just explained that bank fees in handling letters of credit could be considerable. Clean payment is a way to avoid such fees. Clean payment is where the exporter and the importer handle all the shipping documentation and the bank’s role is limited to paying the amounts of money when required. It is much cheaper, because checking the shipping documents is quite time-consuming and there could be a degree of expertise needed to ensure everything is right. Shipping agents could do this task more cheaply and efficiently. Clean payment is similar to a letter of credit in that the bank still guarantees the amount, so the risk for both importer and exporter is greatly reduced.

71. Methods of international payment - bill of exchange A bill of exchange is a method of international payment that reduces the risk for the exporter by allowing the exporter to keep control of the goods until payment is made. A bill of exchange is a document that instructs the buyer to pay for the goods on a specified date. Usually this is when the goods are delivered.

72. The documentation in a bill of exchange is important. When the goods are sent the exporter gives their bank a document called a ‘bill of lading’, which is an agreement between the exporter and the transporting business that sets out not only where the goods are to be sent but also the legal ownership of the goods. The legal ownership of the goods will only be transferred to the importer after payment has been made. Again, the bill of exchange reduces the risk for both importer and exporter. The importer pays only when the goods have arrived in the country. The exporter keeps legal ownership until payment is made.

73. Hedging One effective way to deal with the uncertainty associated with global financial management is hedging. Hedging is a strategy that enables a business to ensure against the effects of exchange rate fluctuation. Imagine, for example, that a business borrows AUD$5 million in Japaneseyen at an exchange rate of AUD$1 = 100 yen and an interest rate of 1%. The low interest rate means costs are lower than if the money was borrowed in Australia. But what if the Japanese yen increased in value to an exchange rate of AUD$1 = 50 yen? The business that borrowed the money now has to pay back AUD$10 million. This, of course, would not be good business! The risk of currency fluctuation is called the credit risk.

74. If the risk of currency fluctuation is significant, a global business needs to ensure against it in the same way it insures against, say, the risk of fire. It can do that by entering into a contract with a hedge fund to provide whatever currency it needs, at the current price, in - say - 2 years’ time. The hedge fund calculates the risk and charges a fee for the contract in the same way as an insurance business charges a fee to protect against the risk of fire. The hedge funds are expert in risk and can manage risk more cheaply than the typical large business. Hedging enables the managers of a global business to plan without the danger of a negative movement in the currency impacting on their plans.

75. Derivatives Derivative is not an easy concept to understand. Imagine a scenario where an apple pie manufacturer is worried that the next crop of apples will increase significantly from the current $400 a tonne to a possible $1 000 a tonne. The lack of certainty makes it difficult for the apple pie manufacturer to effectively plan operations for the next 12 months. On the other hand, the apple grower is worried the price of apples might fall, because it looks like a very good season and supply might increase greatly, forcing the price from the current $400 a tonne to, say $200 a tonne. Of course both the manufacturer and the grower could agree to sell and buy the next crop of apples for $400 a tonne.

76. A derivative is a contract where the value of the contract is derived from, and dependent upon, the value of another product. In our previous example, the value of the apple contract is derived from the value of the apples. Derivatives can be used to hedge against increases in commodity prices such as oil, wheat and cotton, changes in interest rates, currency fluctuations and so on.

77. Currency swaps are one of the most important derivatives in the financial management of large businesses with global activities. They are used to minimise credit risk. Imagine a business in Australia that wants to borrow USD$100 million to expand its business in the United States. The risk is that the US dollar increases in value over the time of the loan and, consequently, the cost of the loan increases. But what if a United States business wanted to borrow AUD$100 million to expand its Australian interests?

78. The business faces the same risk – the value of the Australian dollar may increase in value. Would it not make sense to just swap the loans? Each business then repays the swapped loan in its own currency. There is much greater certainty. There is no credit risk of currency fluctuation. Of course this example is very simplified, and securitisation is used to simplify currency swaps, but this is the basic idea.

79. Revision worksheet