Review And Evaluate Financial Management Processes

REVIEW AND EVALUATE FINANCIAL MANAGEMENT PROCESSES

COLLECT, COLLATE AND ANALYSE DATA AND

INFORMATION ON THE EFFECTIVENESS OF FINANCIAL

MANAGEMENT PROCESSES WITHIN THE WORK TEAM AND IDENTIFY, DOCUMENT AND RECOMMEND ANY IMPROVEMENTS TO EXISTING PROCESSES

In order to evaluate the performance of a business, it is necessary to have a set of standards in which to measure and compare against.  This means of measurement should not change from one year to the next otherwise the effectiveness of the tool is lost.  Most businesses analyse their performance using the ratio analysis method which involves comparing their present results with one or more of the following:

  • Results obtained from previous years activity (this is best used when more than two years can be obtained to view trends)
  • Industry averages
  • Competitor’s results
  • Absolute standards

 

A comparison using the above standards enables the business to see its strengths and weaknesses which may lead to corrective action taken by management.  For example, if debtors are allowed 30 day terms, and an evaluation of the time taken to collect from debtors reveals that currently 55 days is being taken, then management should take measures to encourage quicker collections.  This shows that the absolute standard is not being achieved.

One of the most effective means of evaluating a business and in particular, comparing it from one year to the next, to competitors or to an industry standard is by the use of ratios.  Ratio analysis essentially eliminates the size of the business and brings all results down to its simplest form.  In essence, ratios can be used to compare Cole’s supermarkets with the local corner store to see which business is performing better.  The size of the profit is not necessarily an indicator of a better performing business.

Profitability ratios enable management to evaluate how profitable the activities of the business have been during the financial year.

Financial stability ratios indicate either short term or long term positions.  The short term ratios enable management to evaluate whether the business is likely to have difficulties in meeting financial commitments in the upcoming twelve months.  That is the solvency or cash position of the business.   Long term ratios enable management to determine whether the mix of funding between equity and debt capital is appropriate to ensure long-term growth and viability in the long term (greater than 12 months).

The main ratio groups can be classified as follows;

  • Liquidity (short term)
  • Activity (short term and profitability)
  • Leverage ( long term)
  • Profitability (profitability)
  • Market-related (profitability)

LIQUIDITY RATIOS

Liquidity ratios measure a business’s ability to meet its financial obligations in the short term.  The minimum ratios are the working capital ratio and the quick asset ratio.

Working Capital ratio (current ratio)                          Current Assets

                                                                                    Current Liabilities

This ratio tells of the businesses ability to cover current liabilities from current assets.  In the event that the creditors called in all the debts, could the business pay them off?  If the ratio is less than one (1), the business may have difficulties paying its debts in the short term.  Ideally this ratio should be 2 or more.  Obviously the higher the figure, the better the position of the business is in (with regard to this ratio).  If the ratio is 2, then it means that for every $1 of debt the business has $2 of current assets to cover the debt.

Quick Asset ratio                                                Current Assets – Stock

                                                                        Current Liabilities – Overdraft

This ratio relates to the businesses immediate ability to pay debts.  Should it be less than 1, the business will probably be in financial difficulty and could be susceptible to severe cash flow problems, legal action, wind up.

ACTIVITY RATIOS

Activity ratios measure the effectiveness of a businesses use of its assets, with a particular focus on the generating levels of turnover.

Inventory Turnover                                       Cost of Goods Sold

                                                                                    Average inventory

Accounts Receivable Turnover                    Credit Sales (at market prices)

                                                                        Average Accounts Receivable

These ratios indicate the number of times a year that inventory and debtors are turned over (obtained and then disposed of).  The more that these are turned over each year or each period, the better the position of the business is.  In both cases, the average is found by adding the opening and closing values and dividing by two.

Average Collection Period                Average Accounts Receivable

                                                              Average Daily Credit Sales

Where credit sales are divided by 365 to determine the average daily sales; OR

                                                                                                 365                                

                                                                        Accounts Receivables Turnover Ratio

This shows the amount of time taken to collect money from debtors in terms of days.  Most businesses request debts to be settled on 30-day terms, this would then be the standard to compare results to.  If debtors are taking 45 days to pay, (this is more than the 30 days provided), management should take corrective action.  To assist management in controlling accounts receivable, many businesses prepared an Aged Debtor listing to show the outstanding age of the debt.

Total Asset Turnover                                    Sales                  

                                                                        Average Total Assets

The asset turnover ratio gives the level of sales that has been generated by the average assets for the period.  Average assets are used because a business may not have all assets for the full year, so sales are based on opening and closing balances.  Average Total Assets is obtained using the following formula;

Total Assets opening balance plus Total Assets closing balance 

                                                2

Fixed Asset Turnover                                                Sales                  

                                                                        Average Fixed Assets

The fixed asset turnover ratio estimates the generation of sales from the average fixed assets held by the business. Ideally more non-current assets should generate more sales.

Average Fixed Assets is obtained using the following formula;

Fixed Asset opening balance plus Fixed Assets closing balance 

                                                2

LEVERAGE RATIOS

Leverage ratios measure the proportion of debt funds in a business’s capital structure to the total assets.  It is possible to determine the proportion of total assets that has been financed by debt (or capital).

There are a number of ratios which can be used;

Debt to Total Asset Ratio                             Total Debt                   *          100

(Gearing ratio)                                     Total Assets                               1  

Debt to Equity Ratio                         Non-Current Debt      *          100

                                                                        Shareholders’ funds                     1        

Earnings Coverage Ratio                  Earnings Before Interest and Tax (EBIT)

                                                                                    Interest

This last ratio indicates the number of times a business has the ability to cover the interest amount from Earnings (profit) before interest and tax.

PROFITABILITY RATIOS

These ratios measure the businesses ability to generate returns to the shareholders from financial resources.  In essence, it shows management’s ability to generate profits which may maximise the yield to shareholders.

Net Profit Margin Ratio                    Net Profit after Tax (NPAT) *

100

                                                                        Sales                  

This ratio specifically looks at the net profit generated from sales.

 

   1

Return on Shareholders’ Funds       Net Profit after Tax

*

100

                                                            Shareholders’ Funds

This shows the return on ownership.

 

  1

Gross Profit Ratio                              Gross Profit     

*

100

                                                                  Sales            

 

   1

This ratio shows the effectiveness of the business in relation the selling and purchasing price of the product(s).  The higher the ratio, the greater the gap between the selling price and the purchasing price.

Operating Expense Ratio                 Operating Expenses                 *          100

                                                                      Sales                                              1

This ratio shows the significance of individual expense groups to the total sales.

Return on Total Assets                      Net Profit after Tax                 *          100

                                                                Total Assets                            1

The return on total assets ratio shows the effectiveness of using the businesses assets to generate profits.

MARKET-RELATED OR PERFORMANCE RELATED RATIOS (PROFITABILITY)

These ratios look at how effectively the shareholders investments are performing.  They indicate the returns on their investments by way of profits and dividends.

Earnings per Ordinary Share            NPAT – Preference Dividends

                                                            No. of Ordinary Shares on Issue

This ratio informs the business (and shareholder) as to the amount of profit which COULD be distributed to each share.

Price Earnings Ratio             Share Market Price

                                                            Earnings per Share

This ratio shows the number of times the PER would have to be earned in order to meet the market value of the share.  

Dividend Yield Ratio             Dividends per Share

                                                            Share Market Price

This shows the proportion that the dividend represents of the current market share price.

ANALYSIS OF FINANCIAL STATEMENTS – ANALYSING AND PREPARING A FINANCIAL REPORT

Calculating the ratios for a business is useful for accountants and the actual people calculating the ratios, but not necessarily good for management.  It is often necessary (and generally required) to produce a report explaining the ratios and providing an overall outlook on the performance, results and profitability of the business.  

To do this, a number of areas need to be covered.

  • What is the short term position of the business (is the business in a position to pay its short-term debts and how has this changed from previous periods)?
  • What are the stock levels and how often are they being turned over?
  • What is the position of the businesses debtors? How does this compare to the businesses requirements?
  • What relationship do assets have to sales? How is the trend performing?
  • Where is finance being sourced from (shareholders or creditors)?
  • How is the liquidity of the business? Why is it as it is?
  • What major purchases/or sales (if any) have been made by the business?
  • What is the likely view from shareholders of the business? Why?
  • How is the business profit performance, what is affecting this?

It is also important to provide an overall conclusion on the business including the following points;

  • Is the business solvent (can it continue to operate successfully)
  • Areas for improvement and suggestions on how to
  • Areas of concern

IMPLEMENT AND MONITOR AGREED IMPROVEMENTS IN LINE WITH FINANCIAL OBJECTIVES OF THE WORK TEAM AND THE ORGANISATION

Implementing and monitoring agreed improvements is vital to ensure compliance with set budgets. Often the domain of senior management, the enforcement of budget audit mechanisms is a part of the financial calendar of every business.

Generally conducted by an external third party with approval from the Australian government to officially audit on behalf of the ATO (Australian Tax Office) annual audits are a requirement of publicly listed and privately held companies operating in Australia. 

Managers at office level need to know what is required of them when an audit takes place and what information they must provide access to, to ensure the process goes smoothly and effectively. 

Businesses that fear auditing are most often those that have poor financial record keeping and intentionally lower their recorded revenue in an attempt to pay less tax.

In reality, it is more commonly partnerships or sole traders that do so as the reporting requirements placed upon them by the ATO are less stringent.

ENSURE BUDGET COMPLIANCE 

Budget compliance is another area of financial control that is often the domain of senior management in CFO or CEO roles. 

Budgets must comply with both internal organisational standards and any governing legislation.

Again this is not unusual and is best guaranteed by adhering to guidelines throughout the budgeting development, approval, and implementation and monitoring process. Doing so will vastly increase the likelihood of your business or departmental budget being compliant.

It will be your responsibility to ensure that your work teams are working to their strict budgeting requirements and you will need to monitor this throughout the year at regular intervals.     

ADDITIONAL INFORMATION - GST

TYPES OF SUPPLY

There are three types of supply considered by the Australian GST legislation.  These supplies are:

  • Taxable supplies - most supplies made in Australia are taxable
  • GST-free supplies - includes education, food, health, exports
  • Input taxed supplies - residential rental, sales of residential properties, financial transactions, certain charity fund raising events

There are also a range of transactions that fall outside the GST regime - these are considered 'out-of-scope' and include donations, payment of rates and taxes, government appropriations etc.

TAXABLE SUPPLIES

As stated above, GST is payable by an entity that makes a taxable supply.  Section 9-5 of the GST Act outlines when a taxable supply arises:

  • There must be a supply. The concept of supply is very broad and includes goods, services, rights, information, and the entrance into an obligation to do something or to refrain from doing something.  This is an important concept, as many transactions the University enters will not involve supplies at all - including all donations, and many grants.
  • There must be consideration for the supply. Essentially this means there must be payment for the supply - again this concept is broad and not restricted to cash.  This includes any payment, act or forbearance and can include other supplies (contra or inkind) as well as some journal entries (such as the increase in a loan account).
  • The supply must be made in the course or furtherance of an enterprise. A supply must be related to the business or business-like activity of the entity before it will be a taxable supply.  Supplies made as part of a hobby or other private activity (not a business) cannot be subject to GST.
  • The supply must be connected with Australia. Supplies will be connected with Australia if they are made wholly within Australia, exported from Australia, imported into Australia, or made by a business established in Australia.
  • The supplier must be registered for GST (or required to register). Note this means that an entity must be registered for GST, not simply have an Australian Business Number (ABN).  It is common for small entities to have an ABN and not be registered for GST.
  • The supply must not be a GST-free supply or an input taxed supply. These are explained in more detail below.

It is important to remember that GST is payable by the entity making the supply.  If the price charged is not adjusted to account for this GST liability, the supplier will wear the GST cost themselves. 

Note that in most instances it is irrelevant who the recipient of the supply is.  A taxable supply will be subject to GST whether the recipient is an individual, a business, a government entity or even a charity. 

CREDITABLE ACQUISITIONS

As most supplies in Australia are taxable supplies, it is clear then that most purchases made within Australia will therefore include GST in the price.  This embedded GST may be recovered from the ATO as an input tax credit (a refund of the GST) when the purchase is regarded as a 'creditable acquisition'.  A creditable acquisition is defined in section 11-5 of the GST Act:

  • You must make an acquisition . The definition of acquisition mirrors the definition of supply - it is exceptionally broad, and can cover anything of value that may be received  including goods, services, rights, information, and the entrance into obligations to do or refrain from doing things. Importantly, the acquisition must be made by the entity seeking to claim the credit.  
  • The acquisition must have been a taxable supply. This ensures that you can only claim input tax credits on expenses that were actually subject to GST.  You cannot claim input tax credits on GST-free or input taxed acquisitions, or on transactions that are out of scope.
  • The acquisition must be for a creditable purpose. Essentially this means that the thing was purchased for the business (or business-like) activities of the entity. 

Acquisitions made for private or domestic purposes do not have a creditable purpose.

  • A special rule means acquisitions made for the purposes of making input taxed supplies (outlined below) do not have a creditable purpose.
  • You must provide consideration . This means that an input tax credit may only be claimed when the entity has actually provided something of value in exchange for the thing it is acquiring.  This is not normally an issue, but complications can arise in instances where an acquisition is made by one party, and paid by another.
  • The acquirer must be registered for GST. By requiring registration the GST Act ensures that only those entities that enter the tax system are able to claim a refund of the GST on expenses. 

There is additional requirement - any input tax credit claim must be supported by a valid tax invoice.  If the entity does not hold a valid tax invoice on an acquisition, the GST embedded in the cost cannot be claimed back, and effectively increases the price to the business.

GST-FREE SUPPLIES

A GST-free supply differs from a taxable supply in one critical manner - the supplier of a GSTfree supply does not have any GST liability.  This means that there is no need to charge GST to its customers.  The business making a GST-free supply is still entitled to claim the GST back on costs as an input tax credits.

There are a range of specific supplies that may be GST-free under the GST Act.  The following supplies will be GST-free if they satisfy all of the legislative requirements:

  • Health
  • Education
  • Certain charitable activities
  • Exports of goods
  • Other supplies made to entities who are outside of Australia

INPUT TAXED SUPPLIES

Much like a GST-free supply, a business making an input taxed supply does not have any GST liability.  Accordingly, there is no need to charge its customers any GST.  However unlike a taxable or GST-free supply, businesses who make input taxed supplies are not entitled to claim the input tax credits on any of the related acquisitions or costs.

This means that whilst there is no requirement to charge GST on input taxed supplies, the increased costs means that there is a pressure to increase prices by small margin.

TRANSACTIONS THAT ARE 'OUTSIDE THE SYSTEM'

There are a range of transactions that fall outside the GST system.  This may be due to the application of a special rule (such as a government appropriation), or simply because no supply or acquisition has been made (such as in the case of a donation).  These special cases include:

  • Donations
  • Grants and Appropriations[3]

REQUIREMENTS FOR FINANCIAL RECORD KEEPING

BUSINESS RECORDS YOU NEED TO KEEP

Income tax records

You must keep records of all your sales (income) and expenses to prepare your business activity statements (BAS) and annual income tax return, and to meet other tax obligations. You also need to keep year-end and bank records.

Records that all businesses need to keep are listed below.

  • Income and sales records - Records of all sales transactions - for example, invoices including tax invoices, receipt books, cash register tapes and records of cash sales.
  • Expense or purchase records - Records of all business expenses, including cash purchases. Records could include receipts, invoices including tax invoices, cheque book receipts, credit card vouchers and diaries to record small cash expenses.

Records showing how you worked out any private use of something you purchased.

  • Year-end records - These include lists of creditors (that you owe money to) or debtors (that owe you money), and worksheets to calculate the decreasing value of your assets, also called 'depreciating assets', stocktake sheets and capital gains tax records.
  • Bank records - Documents you receive from the bank such as bank statements, loan documents and bank deposit books.
  • Other records you may need to keep - As well as general records, you may need to keep other records depending on your tax obligations or the type of expense.

Other records you may need to keep are listed below.

  • Goods and services tax (GST) records - The main GST records you need to keep are tax invoices from your suppliers. Remember, you need a tax invoice to claim GST credits. You must keep any other document that records any adjustments, a decision or a calculation made for GST purposes.

SUMMARY

Now that you have completed this unit, you should have the skills and knowledge required to undertake financial management within a work team in an organisation.

A large part of the role of a business manager is the preparation, implementation and monitoring of budgets for sales and expenditure. 

Inputs and outputs must be assessed for the defined area of responsibility and attention must be paid to what can affect productivity and costs.

Depending on the size and type of organisation, you may have paper-based or e-business accounting and financial management systems. You need to understand your responsibilities in using these systems to record and report on budgets. You also need systems in place to monitor the activities of your area in terms of outputs and expenditures to track these against the predicted amounts. Comparing budgeted to actual amounts shows up variances that can be analysed to discover where and how discrepancies have arisen. Monitoring should be conducted regularly so that adjustments can be made to compensate for discrepancies. Budget reports showing actual figures against budget amounts will need to be generated and shared with key stakeholders.

If you have any questions about this resource, please ask your trainer. They will be only too happy to assist you when required.

GLOSSARY OF TERMS

Within accounting, there can be a number of terms used which mean the same thing.  This can be very confusing.  To assist in understanding the terminology definitions of the more commonly used terms is provided.

Asset - Regarded as service potential or future service potential, controlled by the business.  These include land, buildings, cash at bank, accounts receivable, stock or inventory, motor vehicles, machinery, etc.

Liabilities - Are the future sacrifices of service potential or future service that the business is presently obliged t make to other entities.  It is the amount owed by the business to others.  It includes utilities, rent, wages, accounts payable, loans, mortgages, bank overdraft, etc.

Current - Likely to change within one year.  i.e. Current assets are those assets which are likely to change within 12 months or are easily transferable into cash in a short amount of time. Cash, debtors, stock, prepaid rent, etc.

Fixed - Unlikely to change.  i.e. Fixed assets are those that are unlikely to change over a number of years.  Buildings, cars, offices, machinery, etc.

Non-Current - Same as Fixed

Capital - Owners contribution into the business.  

Proprietorship - Also known as Capital 

Equity (Owners’ Equity) - The ownership of the business, also known as Capital 

Retained Earnings - The sum of profits/losses from previous years less any dividends paid in previous years 

Addition Capital - Additional funds invested into the business by the owners.

Accumulated Depreciation - The sum of depreciation of the previous year’s relating to a particular asset 

Depreciation - The value associated to the decrease in value of an asset as it is used up, or as it ages.  The assumption is that as an asset gets older (or is used – in the case of machinery) it loses value.  It is the expense associated with the spreading of the cost of a non-current asset over its useful life.  

Prepaid Expense - An expense which has been paid before incurring the cost.  i.e. rent, insurance, etc. (This is a current asset).

Prepaid Revenue - Revenue received prior to goods being delivered or services rendered.  i.e. rent received.(This is a liability).

Accrued Expense - An expense which has been incurred but not yet paid for.  i.e. weekly salaries. (This is a liability).

Accrued Revenue - Revenue owed but goods or services already given.  Postpaid mobile. (This is an asset.)

Debtors/Accounts Receivable - People or businesses who owe the business money, usually relating to the sale of goods or services on credit.  These are current assets.

Credit Terms - The payment terms set out by the business for those who wish to purchase goods or services on credit.  It usually details the duration of the credit, i.e. 7 days, 30 days, etc. and may include penalties for non-compliance.

Creditors/Accounts Payable - People or businesses who are owed money by the business, usually for the purchase of stock/inventory.  These are short term loans which have credit terms which should be adhered to.  These are current liabilities

Stock/Inventory - The current assets held with the intention of selling to make a profit.

REFERENCES

Developing and managing internal budgets. (n.d.) Retrieved on 16-16 from:

http://www.anao.gov.au/~/media/Uploads/Documents/developing_and_managing_internal_ budgets1.pdf

GST fundamental concepts (n.d.) Retrieved on 16-16 from:

http://w3.unisa.edu.au/fin/Commercial_Support/Tax/GST/gst_fundamental_concepts.asp

[1] http://smallbusiness.chron.com/advantages-disadvantages-budget-contingencies-method-41296.html 

[2] http://www.anao.gov.au/~/media/Uploads/Documents/developing_and_managing_internal_budgets1.p df 

[3] http://w3.unisa.edu.au/fin/Commercial_Support/Tax/GST/gst_fundamental_concepts.asp 

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