MODULE 1

Finance in business

LEARNING OBJECTIVES

After studying this module, you should be able to: 1.1 understand the importance of finance, money and markets 1.2 identify the basic forms of business structures 1.3 discuss the financial goals of a business 1.4 identify the key financial decisions facing the financial manager 1.5 describe the typical organisation of the financial function in a large company 1.6 discuss the relevance of ethics in business.

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c01FinanceInBusiness 1 18 May 2017 7:25 AM Module preview This text provides an introduction to finance. In it we focus on the responsibilities of the financial manager, who oversees the accounting and treasury functions, and sets the overall financial strategy for the company. We pay special attention to the financial manager’s role as a decision‐maker. To that end, we emphasise the mastery of fundamental finance concepts and the use of a set of financial tools which will result in sound financial decisions that create value for shareholders. These financial concepts and tools apply not only to business organisations but also to other organisations, such as government entities, not‐for‐profit groups and sometimes even your own personal finances. We also examine the financial markets in terms of their roles, the types of markets and the financial instruments that are traded on them. Finally, the regulatory architecture is reviewed and the importance of having an efficient and effective financial system discussed.

We open this module by discussing the importance of understanding finance and the role that finance plays in society and in business. Next, we describe common forms of business structures. We then dis­ cuss the major responsibilities of the financial manager including the three major types of decisions that a financial manager makes: capital budgeting decisions, financing decisions and working capital management decisions. After next discussing how the financial function is managed in a large company, we explain why maximising the price of the company’s shares is an appropriate goal of the business. Finally, we discuss the importance of ethical conduct in business, describing the conflicts of interest that can arise between shareholders and financial managers, and the mechanisms that help align the interests of these two groups.

1.1 Understanding finance, money and markets

LEARNING OBJECTIVE 1.1 Understand the importance of finance, money and markets. Whether we like it or not, money is an important element of modern society. On one hand, money is required for transactions that allow us to conduct our daily affairs — to purchase food, pay the rent, buy the morning coffee or take the family out to the local fun park. On the other hand, accumulating money allows us to build savings and wealth for that next big purchase or activity, to prepare for retirement or to provide a degree of security and comfort that, if financial resources are needed, they are available.

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c01FinanceInBusiness 2 18 May 2017 7:25 AM Money is thus simply a means of exchanging value between parties; just imagine what it would be like with no money (neither hard currency nor electronic currency). We would be forced to barter in order to transact, which might work well for some transactions, but for everyday activity would be inefficient. It is therefore not surprising that transacting has moved with technology and now happens not just through our wallets, but through our phones, watches and the internet. Indeed, financial technology is one of the fastest growing industries in the world. The efficient, timely and reliable transfer of money between parties underpins economic activity and heavily influences how we conduct our daily activities. The importance of this becomes clear when we consider how many transactions occur on a daily basis across the nation. Even a small economy like Australia has over 975 000 points of access (e.g. ATMs, bank branches, EFTPOS terminals) to the financial system, through which more than 430 million debit card transactions worth more than $23 billion are transacted every month.1 Indeed, there are more than 16.6 million credit card accounts in Australia, through which a further 220 million transactions worth $27.6 billion take place.2 Without money to operationalise these transactions, there would need to be a lot of bartering going on! In order for this trade to occur, markets are required to facilitate buyers and sellers interacting, agreeing on the terms of a transaction and executing that transaction. This could be a physical market, such as a shopping centre, where buyers and sellers come together in person to exchange money for goods and services. Alternatively, there are online or virtual markets, where this interaction occurs elec­ tronically and thus buyers and sellers do not physically meet. Either way, markets are a key component of facilitating trade. There are a range of markets in the financial system, including the market for cash, the share market, the bond market and the foreign exchange market, where different financial products are bought and sold. Each has its own purpose, rules of trade and mechanisms for allowing that trade to occur. We look at the detail of these (and other) markets later to illustrate the diversity in market characteristics. The term finance is a broad term that is widely used in society. It refers to both the study of how money is managed and the process of acquiring money. This text deals with both of these com­ ponents by examining the elements of the financial system that facilitate individuals, businesses and governments managing and transacting their money. We also examine how these parties finance these activities, for example by borrowing money in the form of loans, accumulating internal resources (savings) or utilising the financial markets to raise funds by issuing shares, bonds or other financial instruments. The financial system offers a range of ways to finance our activities. The job of the finance manager at home, in business and in government is to work out the best way to structure our finances and thus make effective financial decisions. This is easy to say, but in practice is much more difficult! A key task of the financial system is to ensure finance, money and markets operate efficiently to allow the economy to work and individuals to make effective decisions. In many respects we often take these systems for granted. Many consumers live in blissful ignorance of the financial system archi­ tecture that allows us to transact in the modern economy — we simply put the card in the wall and wait for the cash to come out! To some extent this ignorance is a good thing, as it means the system is working and we have confidence in it. But all we have to do is recall the last time the EFTPOS machine was down and we had no cash in our wallet, and we realise how dependent we are on the financial system. This, of course, does not happen by itself. Rather, it is the result of the efficient operation of the components of the financial system — money, markets, financial institutions, financial regulation and market participants. In Australia, we are lucky that we have not had any major financial system failures in recent decades. While we have had our issues (the failure of HIH Insurance in the early 2000s, securities trader Opes Prime Stockbroking Limited’s failure in 2008 and Storm Financial Limited’s collapse in 2009), we have not had the large bank failures and the widespread lack of confidence in the system that much of the northern hemisphere has recently endured. As you progress through this text, you will encounter many of the reasons for this. You would be well advised to learn as much as you can about finance,

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c01FinanceInBusiness 3 18 May 2017 7:25 AM money and markets for both your own personal financial decision‐making and your career — because the financial system will influence both! Finance in society The importance of finance in society is driven by the economic principle ofscarcity . There is only so much money available in the economy and thus individuals, businesses and governments need to use what they have wisely and make decisions carefully in relation to the future acquisition and use of it. At the level of the economy, a key task of the financial system is to ensure this scarce resource is used effectively and thus allocated to purposes that will build wealth over time for the economy, maintaining and improving our living standards. The complexity of the financial system means this may not happen for every transaction, but over the longer term the system is designed to achieve this. It should also be noted that the financial system evolves over time as the economy develops, regu­ lation changes, technology advances and other factors, such as consumer trends and environmental change, shift. Examples of such changes that have affected the operation of the financial system include the complexity of products and services, technological advances, the ageing population and financial illiteracy. In terms of the complexity of the financial system, we just have to read a product disclosure statement (PDS) for an everyday financial product or service to understand this (look up a PDS for your bank and have a read!). They are typically long documents, written in legalese, that try to explain the terms and conditions of the product/service of relevance. While increased disclosure is generally a good thing, the complexity and length of these documents make them difficult for many consumers to use. This is exacerbated by the sheer range of financial products available, the heavy use of jargon and acronyms, and the general low knowledge base and lack of confidence that many consumers bring to financial decision‐making. Thus, the financial system has evolved to (for example) increase disclosure, place more obligation on product providers to explain their services to consumers, encourage consumers to obtain independent advice, and provide­ cooling‐off periods. At the same time, increased regulation and oversight of the finance sector have been put in place, all with a view to protecting consumers and building their confidence in the system. Technological advancement is occurring at a somewhat frightening pace: from branch banking to ATMs, online banking, micro/app‐based investing, paying with our mobile phones and robo advice in only a few decades. While these advances may have improved the efficiency of and access to the system, it is important that they maintain consumer confidence and protection at the same time. Thus, it is interesting to note that the regulatory environment is struggling to keep up with the pace of change in some jurisdictions and more innovative and more collaborative regulatory design approaches are being used (e.g. look up the Australian Securities and Investments Commission’s (ASIC) regulatory sandbox approach to financial technology). A compounding issue is the ageing population. As the baby boomer population bubble moves into retirement, the mix of retirees and workers is changing (more retirees and fewer workers). Further­ more, life expectancy is increasing and those in retirement are living more active lives. This places more emphasis on industries such as health services, aged care and the superannuation sector, while govern­ ments will simply not be able to afford to provide a pension system to meet the needs of the population as a result. Thus the move over time from a state‐funded retirement system to a self‐funded system is in motion. For individuals, this places significant emphasis on accumulating wealth to fund retirement, which in turn is a critical issue for society in relation to our overall living standards and the ability of the government to provide services. Hence, making long‐term financial decisions that allow individuals/ households to accumulate wealth is a societal imperative. The multi‐million‐dollar question for everyone to ask themselves is: How much will I need to save? (Look up a retirement calculator online to see your expected number!) A final issue is financial illiteracy. This has received a lot of attention from governments and other agencies around the world in recent years. Financial literacy is essentially the combination of

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c01FinanceInBusiness 4 18 May 2017 7:25 AM knowledge and behaviour that underpins effective financial decision‐making. Unfortunately, too many people are not sufficiently equipped in one or both of these areas, increasing the risk of insufficient wealth accumulation over time, greater susceptibility to schemes and scams, and higher levels of finan­ cial stress. Thus, improving financial literacy, protecting consumers through financial system design and encouraging consumers to seek financial advice are important economic and social elements of the financial system. In summary, finances are of great economic and social importance. At the macro level, they drive the operation and performance of the economy. For governments, they influence the fiscal position of the nation and the ability of the government to provide services, and thus influence our living standards. For business, finance heavily influences profitability and the long‐term sustainability of the enterprise, while for consumers our ability to make effective financial decisions and accumulate wealth over the long term is influenced. All in all, knowing more about the financial system is important for everyone. We hope this text will help you in this regard!

Finance in business Finance is a key factor in the success or otherwise of any business and, accordingly, a sound under­ standing of finance concepts and techniques is essential for any manager. Businesses need finance to: •• start up — this involves expenditures such as paying rent in advance on premises and purchasing the equipment and materials required to produce the business’s products or services •• operate — it is important that a business has sufficient cash on hand to pay staff wages and suppliers as these expenses fall due •• expand — this might necessitate the purchase of new machinery to increase production capacity, research and development costs for new products, or marketing costs associated with identifying and entering new markets. A major concern for all businesses is the way they are financed. It is important for managers to select appropriate funding, as all entities need funding, no matter how small or large their turnover or asset base. Australian businesses tend to look to the financial institutions, in the first instance, as suppliers of intermediated finance. While larger entities with standing in the community are able to access the financial markets and financial institutions for funds, smaller entities typically approach one or several financial institutions for long‐term funding. Entities wanting to raise debt finance from the Australian market have corporate bonds, notes and debentures to choose from as methods of finance. To a great extent, these securities are similar methods of financing; the differences mainly lie in their historical roles. Essentially, borrowing entities issue bonds, notes or debentures as proof that debts exist. After that, if these securities are traded, the security itself (the physical piece of paper) or the proof of registration with issues which is electronically recorded, merely acts as proof of current ownership. Naturally, the owner of a bond at maturity is the entity that receives the repayment of face value from the issuer. Owners may at times wish to expand their entities or liquidate some or all of their ownership rights. They achieve this by selling ownership rights to other investors; that is, raising equity finance. The media by which ownership rights are packaged, sold (and bought) and transferred are ordinary shares and preference shares. Ordinary shares are by far the more common of the two. All companies issue ordinary shares; some, but not all, companies issue preference shares. The size of a business and the nature of its ownership often determine the finance options available to it. Businesses can be owned by sole operators, partnerships of two to twenty people or perhaps some hundreds, or thousands of individual shareholders and large investment institutions in the case of listed public corporations. This text discusses the financial decisions faced by all these businesses, no matter how small or large and no matter how they are owned. In practice, however, it is likely that small businesses will take a less rigorous approach to decision‐making and financial analyses than is advocated here because these

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c01FinanceInBusiness 5 18 May 2017 7:25 AM businesses tend not to employ people trained in finance. Additionally, the managements of many small businesses judge that the benefits of employing a financial manager or a financial consultant do not exceed the costs. Every business has reasons for being. Because of their different sizes and ownership structures, it is to be expected that there are a range of goals among businesses. For example, a family partnership which owns a small auto‐electrical business might want to earn enough to live comfortably, put away some funds to educate the children, not work on Saturdays or Sundays, and develop a reputation for doing good work on time and at reasonable cost. Eventually, the family might want to sell the business to fund a comfortable retirement. In contrast, the ownership of a large corporation is much more removed from the operations of the company. The owners are you and me — through our direct shareholdings and indirectly through our superannuation funds and managed funds. Because the owners are not closely connected with the everyday operations of the business, it is likely that their goals are simplified and focused largely on financial metrics, such as profit maximisation and shareholder returns. This text presents the financial concepts and techniques that assist businesses to achieve their financial goals, whatever these may be.

BEFORE YOU GO ON

1. Explain the role of money in an economy. 2. Discuss the key functions of financial markets. 3. Why is it important for everyone to have at least a basic understanding of the financial system? 4. Explain why finances are important to society and business.

1.2 Business structures and finance

LEARNING OBJECTIVE 1.2 Identify the basic forms of business structures. In this section, we look at the ways companies organise in order to conduct their business activities. The owners of a business usually choose the structure that will help management to maximise the value of the business entity. Important considerations are the size of the business, the manner in which income from the business is taxed, the legal liability of the owners and their ability to raise cash to finance the business. Most start‐ups and small businesses operate as either sole traders or partnerships, because of their small operating scale and capital requirements. Large businesses in Australia, such as Woolworths ­Limited, are most often organised as companies. As a business grows larger, the benefits to organising as a company become greater and are more likely to outweigh any disadvantages. Sole traders A sole trader is a business owned by one person, typically consisting of the trader and a handful of employees. Becoming a sole trader offers several advantages. It is the simplest type of business to start and it is the least regulated. In addition, sole traders keep all the profits from the business and do not have to share decision‐making authority. From the taxation point of view, business losses can be written off against the sole trader’s tax from other employment under certain circumstances. On the downside, a sole trader has unlimited liability for all the business’s debts and other obli­ gations. This means that creditors can look beyond the assets of the business to the trader’s personal wealth for payment. Another disadvantage is that the amount of equity capital that can be invested in the business is limited to the owner’s personal wealth, which may restrict the possibilities for growth. Finally, it is difficult to transfer ownership of a sole trader because there are no shares or other such interests to sell.

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c01FinanceInBusiness 6 18 May 2017 7:25 AM Partnerships A partnership consists of two or more owners who have joined together legally in order to manage a business. Partnerships are typically larger than sole trader busi­ nesses. In forming a partnership, it is recommended that a formal partnership agreement is drawn up on the roles and authority of each partner, how much capital each partner will contribute, how key management decisions will be made, how the profits will be divided, who has limited lia­ bility, how the partnership will be closed down and assets distributed, and how disputes will be dealt with. The key advantages of partnerships are similar to those of sole traders. In addition, partnerships have access to more capital, and the pooling of knowledge, experience and skills. The key drawbacks of partnerships are possible disputes among the partners over profit‐ sharing, administration and business development. Also, each partner is personally responsible for business debts and liabilities incurred by the other partners. The problem of unlimited liability can be avoided in a limited partnership, which consists of general and limited partners. Here, one or more general partners have unlimited liability and actively manage the busi­ ness, while the limited partners are liable for business obligations only up to the amount of capital they have contributed to the partnership. In other words, the limited partners have limited liability. To qualify for limited‐partner status, a partner cannot be actively engaged in managing the business.

Companies Most large businesses are companies. A company is an independent legal entity able to do business in its own right. In a legal sense, it is a ‘person’ distinct from its owners. Companies can sue and be sued, enter into contracts, issue debt, borrow money and own assets. The owners of a company are its shareholders. Starting a company is more costly than starting a business as a sole trader or partnership. Those starting the company, for example, must set out a memorandum that details its powers and articles of association to describe who can use these powers. All companies are registered with and regulated by ASIC. A major advantage of the company form of business structure is that shareholders have limited liability for the debts and other obligations of the company. However, directors and employees are personally liable under the Corporations Act 2001 if found to be committing fraudulent, negligent or reckless acts. The major disadvantages of the company form are the cost of establishment and registration, and the higher compliance costs and stricter record‐keeping requirements as compared to other business structures. A company can also list on a stock exchange, such as the Australian Securities Exchange (ASX), as a public company in order to attract investors. In contrast, private companies are typically owned by a small number of key managers and shareholders. Over time, as the company grows in size and needs larger amounts of capital, management may decide that the company should ‘go public’ in order to gain access to the public markets.

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c01FinanceInBusiness 7 18 May 2017 7:25 AM BEFORE YOU GO ON

1. Why are many businesses operated as sole traders? 2. What are some advantages and disadvantages of operating as a partnership? 3. What are some advantages and disadvantages of operating as a company?

1.3 The financial goals of a business

LEARNING OBJECTIVE 1.3 Discuss the financial goals of a business. For business owners, it is important to determine the appropriate goal for financial management decisions. Should the goal be to keep costs as low as possible? Or to maximise sales or market share? Or to achieve steady growth and earnings? Let’s look at this fundamental question more closely.

What should management maximise? Suppose you own and manage a pizza restaurant. Depending on your preferences and tolerance for risk, you can set any goal for the business that you want. For example, you might have a fear of insolvency and losing money. To minimise the risk of insolvency, you could focus on keeping your costs as low as possible, by paying low wages, avoiding borrowing, advertising minimally and remaining cautious about expanding the business. In short, you avoid any action that increases your business’s risk. You will sleep well at night, but you may eat poorly because of meagre profits. Conversely, you could focus on maximising market share and becoming the largest pizza place in town. Your strategy might include cutting prices to increase sales, borrowing heavily to open new pizza outlets, spending lavishly on advertising and developing menu items using exotic toppings. In the short term, your high‐risk, high‐growth strategy will have you both eating poorly and sleeping poorly as you push the business to the edge. In the long term, you will either become very rich or become insolvent! There must be a better operational goal than either of these extremes. Why not maximise profits? One goal for financial decision‐making that seems reasonable is profit maximisation. After all, don’t shareholders and business owners want their companies to be profitable? However, although profit maximisation may seem a logical goal for a business, it has some serious drawbacks. One problem with profit maximisation is that it is hard to pin down what is meant by ‘profit’. To the average businessperson, profits are just revenues minus expenses. To an accountant, however, a decision that increases profit under one set of accounting rules can reduce it under another. This is the origin of the term creative accounting. A second problem is that accounting profits are notnecessarily ­ the same as cash flows. For example, many companies recognise revenues at the time a sale is made, which is typically before the cash payment for the sale is received. Ultimately the owners of a business want cash because only cash can be used to make investments or to buy goods and services. Yet another problem with profit maximisation as a goal is that it does not distinguish between ­getting a dollar today and getting a dollar sometime in the future. In finance, the timing of cash flows is extremely important. For example, the longer we go without paying our credit card balance, the more interest we must pay the bank for the use of the money. The interest accrues because of the time value of money; the longer we have access to money, the more we have to pay for it. The time value of money is one of the most important concepts in finance and is the focus of two modules in this text. Finally, profit maximisation ignores the uncertainty (or risk) associated with cash flows. A basic principle of finance is that there is a trade‐off between expected return and risk. When given a choice

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c01FinanceInBusiness 8 18 May 2017 7:25 AM between two investments that have the same expected returns but different risks, most people choose the less risky one. This makes sense because people do not like bearing risk and, as a result, must be com­ pensated for taking it. The profit maximisation goal ignores differences in value caused by differences in risk. We return to the important topics of risk, its measurement and the trade‐off between risk and return in a later module. What is important here is that you understand that investors do not like risk and must be compensated for bearing it. The timing of cash flows affects their value A dollar today is worth more than a dollar in the future because, if you have a dollar today, you can invest it and earn interest. For businesses, cash flows can involve large sums of money and receiving money just one day late can cost a great deal. For example, if a bank has $100 billion of consumer loans outstanding and the average annual interest payment is 5 per cent, it would cost the bank $13.7 million if every consumer decided to make an interest payment one day later. The riskiness of cash flows affects their value A risky dollar is worth less than a safe dollar. The reason is because investors do not like risk and so must be compensated for bearing it. For example, if two investments have the same return — say 5 per cent — most people will choose the investment with the lower risk. Thus, the more risky an investment’s cash flows, the less it is worth. In summary, it appears that profit maximisation is not an appropriate goal for a company because the concept is difficult to define and does not directly account for the company’s cash flows. What we need is a goal that looks at a company’s cash flows and considers both their timing and their riskiness. ­Fortunately, we have just such a measure: the market value of the company’s shares.

Maximise the value of the company’s shares The underlying value of any asset is determined by the future cash flows generated by that asset. This prin­ ciple holds whether we are buying a bank certificate of deposit, a corporate bond or an office building. Furthermore, as we will discuss in the module on share valuation, when security analysts and investors determine the value of a company’s shares, they consider: (1) the size of the expected cash flows; (2) the timing of the cash flows; and (3) the riskiness of the cash flows. Note that the mechanism for determining share values overcomes all the cash flow objections we raised with regard to profit maximisation as a goal. Thus, an appropriate goal for financial management is to maximise the current value of the company’s shares. By maximising the current share price, the financial manager is maximising the value of the shareholders’ shares. Note that maximising share value is an unambiguous objective and it is easy to measure. We simply look at the market value of the shares in the news on a given day to determine the value of the shareholders’ shares and whether it has gone up or down. Publicly traded securities are ideally suited for this task because public markets are wholesale markets with large numbers of buyers and sellers where securities trade near their true value. What about companies whose equity is not publicly traded, such as private companies and partner­ ships? The total value of the shares in such a company is equal to the value of the shareholders’ equity. Thus, our goal can be restated for these companies as: maximise the current value of equity. The only other restriction is that the entities must be for‐profit businesses. The financial manager’s goal is to maximise the value of the company’s shares The goal for financial managers is to make decisions that maximise the company’s share price. By maximising share price, management will help to maximise shareholders’ wealth. To do this, managers must make investment and financing decisions so that the total value of cash inflows exceeds the total value of cash outflows by the greatest possible amount (benefits > costs). Note that the focus is on maximising the value of cash flows, not profits.

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c01FinanceInBusiness 9 18 May 2017 7:25 AM Can management decisions affect share prices? An important question is whether management decisions actually affect the company’s share price. ­Fortunately, the answer is yes. As noted earlier, a basic principle in finance is that the value of an asset is determined by the future cash flows it is expected to generate. As shown in figure 1.1, a company’s management makes many decisions that affect its cash flows. For example, management decides what type of products or services to produce and what productive assets to purchase. The company’s share price is affected by a number of factors and management can control only some of them. Managers exercise little control over external conditions (blue boxes) such as the general economy, although they can closely observe these conditions and make appropriate changes in strategy. Managers make many other decisions that do directly affect the company’s expected cash flows (red boxes) — and hence the price of the company’s shares. Managers also make decisions concerning the mix of debt to equity, debt collection policies and policies for paying suppliers, to mention a few. In addition, cash flows are affected by how efficient management is in making products, the quality of the products, management’s sales and marketing skills, and the company’s investment in research and development of new products. Some of these decisions affect cash flows over the long term, such as a decision to build a new plant, while other decisions have a short‐term impact on cash flows, such as launching an advertising campaign. Of course, the company also must deal with a number of external factors over which it has little or no control, such as economic conditions (recession or expansion), war or peace and new government regulations. External factors are constantly changing and management must weigh the impact of these changes and adjust its strategy and decisions accordingly.

FIGURE 1.1 Major factors that affect share prices

Economic shocks 1. Wars 2. Natural disasters The economy Current 1. Level of economic Business environment share activity market 1. Corporate laws 2. Level of interest rates conditions 2. Environmental regulations 3. Consumer sentiment 3. Procedural and safety regulations 4. Tax

The company 1. Line of business 2. Financial management decisions Expected cash flows a. Capital budgeting 1. Magnitude Share b. Financing the company 2. Timing price c. Working capital 3. Risk management 3. Product quality and cost 4. Marketing and sales 5. Research and development

The important point here is that, over time, management makes a series of decisions when execu­ ting the company’s strategy that affect the company’s cash flows and, hence, the price of the com­ pany’s shares. Companies that have a better business strategy are more nimble, make better business

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c01FinanceInBusiness 10 18 May 2017 7:25 AM decisions and can execute their plans well will have a higher share price than similar companies that just can’t get these right. When taking into consideration a long‐term horizon, the only corporate objective that maximises the economic interests of all stakeholders over time is for management to make decisions that maximise the wealth of shareholders. For example, in April 2012 Telstra issued a press release announcing that it expected to generate $2–3 billion in excess free cash flows over the next three years. The company also confirmed that its capital management strategy priorities were to maximise returns for shareholders (through both dividends and capital growth), maintain financial strength and retain financial flexibility. If these priorities are executed well, this will enable Telstra to serve its existing customers better, grow customer numbers, maintain its A credit rating and build new growth businesses. As you can see from this example, even though Telstra’s main priority is to maximise the wealth of its shareholders, other stakeholders such as customers, employees and lenders will also benefit from the implementation of its capital management strategies.3 1.4 The financial manager

LEARNING OBJECTIVE 1.4 Identify the key financial decisions facing the financial manager. While the term corporate finance implies that these topics are only relevant to corporations, this is not the case. The topics covered in this section are basic financial principles that apply to all forms of busi­ ness structure. However, the corporate structure is used because it is easier to explain these topics when the parties involved are distinctly separate from each other, which is usually not the case in small busi­ ness entities. Now we look at the role of the financial manager and three fundamental decisions they make when running a business. These decisions will be covered throughout the text. We then discuss how the financial function is managed in large corporations. The ultimate goal of the business is then justified.

The financial manager The financial manager is responsible for making decisions that are in the best interests of the business’s owners, whether it is a start‐up business with a single owner or a billion‐dollar company owned by thousands of shareholders. The decisions made by the financial manager and owners should be one and the same. In most situations this means the financial manager should make decisions that maximise the value of the owners’ shares. This helps maximise the owners’ wealth. Our underlying assumption in this text is that most people who invest in businesses do so because they want to increase their wealth. In the following discussion, we describe the responsibilities of the financial manager in a new business in order to illustrate the types of decisions that such a manager makes.

Stakeholders Before we discuss the new business, you may want to look at figure 1.2, which shows the cash flows between a company and its owners (in a company, the shareholders) and various stakeholders. A ­stakeholder is someone other than an owner who has a claim on the cash flows of the company:man - agers, who want to be paid salaries and performance bonuses; creditors, who want to be paid interest and principal; employees, who want to be paid wages; suppliers, who want to be paid for goods or services; and the government, which wants the company to pay tax. Stakeholders may have interests that differ from those of the owners. When this is the case, they may exert pressure on management to make decisions that benefit them. We will return to these types of conflict of interest later. For now, we are primarily concerned with the overall flow of cash between the company and its shareholders and stakeholders.

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c01FinanceInBusiness 11 18 May 2017 7:25 AM FIGURE 1.2 Cash flows between the company and its stakeholders and owners

Stakeholders and The company shareholders Company’s A Managers management Cash paid as Cash ows are generated and other invests in assets wages and salaries by productive assets employees through the sale of Current assets goods and services. • Cash Cash paid to • Inventory Suppliers • Accounts suppliers receivable

Cash paid Productive assets Government • Plant as tax • Equipment • Buildings • Technology Cash paid as Creditors • Patents interest and principal

B Shareholders Residual cash ow

Cash ow reinvested Dividends paid to in business shareholders

It’s all about cash flows To produce its goods or services, a new company needs to acquire a variety of assets. Most will be long‐ term assets or productive assets. Productive assets can be tangible assets, such as equipment, machinery or a manufacturing facility, or intangible assets, such as patents, trademarks, technical expertise or other types of intellectual capital. Regardless of the type of asset, the company tries to select assets that will generate the greatest profits. The decision‐making process through which the company purchases long‐ term productive assets is called capital budgeting and it is one of the most important decision processes in a company. Making business decisions is all about cash flows, because only cash can be used to pay bills and to buy new assets. Cash initially flows into the company as a result of the sale of goods or services. The company uses these cash inflows in a number of ways: to invest in assets, to pay wages and salaries, to buy supplies, to pay taxes and to repay creditors. Any cash that is left over (residual cash flows) can be reinvested in the business or paid as dividends to shareholders. Once the company has selected its productive assets, it must raise money to pay for them. Financing decisions are concerned with the ways that companies obtain and manage long‐term financing to acquire and support their productive assets. There are two basic sources of funds: debt and equity. Every company has some equity, because equity represents ownership in the company. It consists of capital contributions by the owners plus earnings that have been reinvested in the company. In addition, most companies borrow from a bank or issue some type of long‐term debt to finance productive assets. After the productive assets have been purchased and the business is operating, the company tries to produce products at the lowest possible cost while maintaining quality. This means buying raw

12 Finance essentials

c01FinanceInBusiness 12 18 May 2017 7:25 AM materials at the lowest possible cost, holding production and labour costs down, keeping manage­ ment and administrative costs to a minimum, and seeing that shipping and delivery costs are com­ petitive. In addition, the company must manage its day‐to‐day finances so that it has sufficient cash on hand to pay salaries, purchase supplies, maintain inventories, pay tax and cover the myriad other expenses necessary to run a business. The management of current assets, such as money owed by customers who purchase on credit, and inventory, and current liabilities, such as money owed to suppliers, is called working capital management. From accounting, current assets are assets that will be converted into cash within 1 year and current liabilities are liabilities that must be paid within 1 year. A company generates cash flows by selling the goods and services it produces. A company is suc­ cessful when these cash inflows exceed the cash outflows needed to pay operating expenses, creditors and tax. After meeting these obligations, the company can pay the remaining cash, called residual cash flows, to the owners as a cash dividend or it can reinvest the cash in the business. The reinvestment of residual cash flows back into the business to buy more productive assets is a very important concept. If these funds are invested wisely, they provide the foundation for the company to grow and provide larger residual cash flows in the future for the owners. The reinvestment of cash flows (earnings) is the most fundamental way that businesses grow in size. Figure 1.2 illustrates how the revenue generated by productive assets ultimately becomes residual cash flow. A company is unprofitable when it fails to generate sufficient cash inflows to pay operating expenses, creditors and tax. Companies that are unprofitable over time will be forced intoinsolvency by their creditors if the owners do not shut them down first. In insolvency, the company will be reorganised or its assets will be liquidated, whichever is more valuable. If the company is liquidated, creditors are paid in a priority order according to the structure of the company’s financial contracts and prevailing insol­ vency law. If anything is left after all creditor and tax claims have been satisfied, which usually does not happen, the remaining cash, or residual value, is distributed to the owners.

Cash flows matter most to investors Cash is what investors ultimately care about when making an investment. The value of any asset — shares, bonds or a business — is determined by the future cash flows it will generate. To understand this concept, consider how much you would pay for an asset from which you could never expect to obtain any cash flows. Buying such an asset would be like giving your money away. It would have a value of exactly zero. Conversely, as the expected cash flows from an investment increase, you would be willing to pay more and more for it.

Three fundamental decisions in financial management Based on our discussion so far, we can see that financial managers are concerned with three fundamental decisions when running a business: 1. capital budgeting decisions — identifying the productive assets the company should buy 2. financing decisions — determining how the company should finance or pay for assets 3. working capital management decisions — determining how day‐to‐day financial matters should be managed so the company can pay its bills, and how surplus cash should be invested. Figure 1.3 shows the impact of each decision on the company’s balance sheet. (Note that the bal­ ance sheet can also be called the statement of financial position but the term balance sheet will be used throughout this text.) We briefly introduce each decision here and discuss them in greater detail in later modules.

MODULE 1 Finance in business 13

c01FinanceInBusiness 13 18 May 2017 7:25 AM FIGURE 1.3 How the financial manager’s decisions affect the balance sheet

Balance sheet

Assets Liabilities and equity

Working capital management decisions Current liabilities deal with day-to-day nancial (including Current assets matters and affect current short-term debt and (including cash, assets, current liabilities and accounts payable) inventory and net working capital. accounts receivable) Net working capital — the difference between current assets and current liabilities Long-term debt Capital budgeting (debt with a decisions maturity of over determine what long-term 1 year) productive assets the Long-term company will purchase. assets (including Financing decisions productive assets; determine the company’s may be tangible capital structure — the or intangible) combination of long-term Shareholders’ debt and equity that will equity be used to nance the company’s long-term productive assets.

Capital budgeting decisions A company’s capital budget is simply a list of the productive (capital) assets that management wants to purchase over a budget cycle, typically 1 year. The capital budgeting decision process addresses which productive assets the company should purchase and how much money it can afford to spend. As shown in figure 1.3, capital budgeting decisions affect the asset side of the balance sheet and are concerned with a company’s long‐term investments. Capital budgeting decisions, as we mentioned earlier, are among management’s most important decisions. Over the long run, they have a large impact on the company’s success or failure. The reason is twofold. First, capital assets generate most of the cash flows for the company. Second, capital assets are long term in nature. Once they are purchased, the company owns them for a long time and they may be hard to sell without taking a financial loss. The fundamental question in capital budgeting is this: Which productive assets should the company purchase? A capital budgeting decision may be as simple as a movie theatre’s decision to buy a pop­ corn machine or as complicated as Airbus’s decision to invest more than $10 billion into designing and building the A380 passenger jet. Capital investments may also involve the purchase of an entire busi­ ness, such as Woolworths Limited’s acquisition of hardware distributor Danks to compete with home‐ improvement giant Bunnings. Regardless of the project, a good capital budgeting decision is one in which the benefits are worth more to the company than the cost of the asset. Not all investment decisions are successful. Just open the business news on any day and you will find stories of bad decisions. For example, the 2011 film The Green Lantern turned out to be a flop despite the popularity of superhero movies, losing US$90 million

14 Finance essentials

c01FinanceInBusiness 14 18 May 2017 7:25 AM for the production company. After failing at the box office, it is unlikely that the movie’s overall cash flow (from box office takings, DVD sales, merchandise and so on) was worth more than its US$200 million cost. When, as in this case, the cost exceeds the value of the future cash flows, the project will decrease the value of the company by that amount.

Sound investments are those where the value of the benefits exceeds their costs Financial managers should invest in a capital project only if the value of its future cash flows exceeds the cost of the project (benefits > cost). Such investments increase the value of the company and thus increase shareholders’ (owners’) wealth. This rule holds whether you are making the decision to purchase new machinery, build a new plant or buy an entire business. Financing decisions Financing decisions concern how companies raise cash to pay for their investments, as shown in figure 1.3. Productive assets, which are long term in nature, are financed by long‐term borrowing, equity investment or both. Financing decisions involve trade‐offs between advantages and disadvantages to the company. A major advantage of debt financing is that debt payments are tax deductible for many companies. However, debt financing increases a company’s risk, because it creates a contractual obligation to make periodic interest payments and, at maturity, to repay the amount that is borrowed. Contractual obli­ gations must be paid regardless of the company’s operating cash flow, even if it suffers a financial loss. If the company fails to make payments as promised, it defaults on its debt obligation and could be forced into insolvency. In contrast, equity has no maturity and there are no guaranteed payments to equity investors. In a company, the board of directors has the right to decide whether dividends should be paid to share­ holders. This means that if the board decides to omit or reduce a dividend payment, the company will not be in default. Unlike interest payments, however, dividend payments to shareholders are not tax deductible. The mix of debt and equity on the balance sheet is known as a company’s capital structure. The term capital structure is used because long‐term funds are considered capital and these funds are raised in capital markets — financial markets where equity and debt instruments with maturities of greater than 1 year are traded.

Financing decisions affect the value of the company How a company is financed with debt and equity affects its value. The reason is that the mix between debt and equity affects the amount of tax the company pays and the probability that the company will become insolvent. The financial manager’s goal is to determine the exact combination of debt and equity that minimises the cost of financing the company. Working capital management decisions Management must also decide how to manage the company’s current assets, such as cash, inven­ tory and accounts receivable, and its current liabilities, such as trade credit and accounts payable. The dollar difference between current assets and current liabilities is called net working capital, as shown in figure 1.3. As we mentioned earlier, working capital management is the day‐to‐day manage­ ment of the company’s short‐term assets and liabilities. The goals of managing working capital are to ensure that the company has enough money to pay its bills and to profitably invest any spare cash to earn interest. The mismanagement of working capital can cause a company to default on its debt and become insolvent even though, over the long term, the company may be profitable. For example, a company that makes sales to customers on credit but is not diligent about collecting the accounts receivable can quickly find itself without enough cash to pay its bills. If this condition becomes chronic, trade creditors can force the company into insolvency if it cannot obtain alternative financing.

MODULE 1 Finance in business 15

c01FinanceInBusiness 15 18 May 2017 7:25 AM A company’s profitability can also be affected by its inventory level. If the company has more inventory than it needs to meet customer demands, it has too much money tied up in non‐earning assets. Conversely, if the company holds too little inventory, it can lose sales because it does not have products to sell when customers want them. The company must therefore determine the optimal inventory level.

1.5 Managing the financial function

LEARNING OBJECTIVE 1.5 Describe the typical organisation of the financial function in a large company. As we discussed earlier in the module, financial managers are concerned with a company’s investment, financing and working capital management decisions. The senior financial manager holds one of the top executive positions in the company. In a large company, the senior financial manager usually has the rank of deputy chief executive or senior executive and goes by the title of chief financial officer (CFO). In smaller companies, the job tends to focus more on the accounting function and the top finan­ cial officer may be called the controller or chief accountant. In this section, we focus on the financial function in a large company.

Organisation structure Figure 1.4 shows a typical organisational structure for a large company, with special attention to the financial function. As shown, the top management position in the company is the chief executive officer (CEO), who has the final decision‐making authority among all the company’s executives. The CEO’s most important responsibilities are to set the strategic direction of the company and to see that the man­ agement team executes the strategic plan. The CEO reports directly to the board of directors, which is accountable to the company’s shareholders. The board’s responsibility is to see that the top management makes decisions that are in the best interest of the shareholders. The CFO reports directly to the CEO and focuses on managing all aspects of the company’s financial side, as well as working closely with the CEO on strategic issues. A number of positions report directly to the CFO. In addition, the CFO often interacts with people in other functional areas on a regular basis, because all senior executives are involved in financial decisions that affect the company and their areas of responsibility.

Positions reporting to the CFO Figure 1.4 also shows the positions that typically report to the CFO in a large company and the activities managed in each area. •• The treasurer looks after the collection and disbursement of cash, investing excess cash so that it earns interest, raises new capital, handles foreign exchange transactions and oversees the company’s superannuation arrangements. The treasurer also assists the CFO in handling important financial relationships, such as those with investment bankers and credit rating agencies. •• The risk manager monitors and manages the company’s risk exposure in financial and commodity markets, and the company’s relationships with insurance providers. •• The controller is really the company’s chief accounting officer. The controller’s staff prepares the financial statements, maintains the company’s financial and cost accounting systems, prepares the tax returns and works closely with the company’s external auditors. •• The internal auditor is responsible for identifying and assessing the major risks facing the company and performing audits in areas where the company might incur substantial losses. The internal auditor reports to the board of directors as well as the CFO.

16 Finance essentials

c01FinanceInBusiness 16 18 May 2017 7:25 AM FIGURE 1.4 Simplified company organisation chart

Shareholders control Shareholders

Board controls Board of directors Audit committee CEO controls Chief executive CFO controls External auditor of cer (CEO)

Chief information of cer (CIO) Chief nancial of cer (CFO) Chief operating of cer (COO)

Treasurer Risk manager Controller Internal auditor

• Cash payments/ • Monitor company’s • Financial accounting • Audit high-risk collections risk exposure in • Cost accounting areas • Foreign exchange nancial and • Taxes • Prepare working • Superannuation commodities • Accounting papers for • Derivatives hedging markets information system external auditor • Marketable • Design strategies • Prepare nancial • Internal consulting securities portfolio for limiting risk statements for cost savings • Manage insurance • Internal fraud portfolio monitoring and investigation

External auditors Nearly every large business entity hires a licenced public accounting business to provide an indepen­ dent annual audit of the company’s financial statements. Through this audit, the accountant comes to a conclusion as to whether the company’s financial statements present fairly, in all material respects, its financial position and the results of its activities; in other words, whether the financial numbers are reasonably accurate, accounting principles have been consistently applied from year to year and do not significantly distort the company’s performance, and the accounting principles used conform to those generally accepted by the accounting profession. Creditors and investors require independent audits and ASIC requires large private companies and all public companies to supply audited finan­ cial statements.

The audit committee The audit committee, a powerful subcommittee of the board of directors, has the responsibility of over­ seeing the accounting function and the preparation of the company’s financial statements. In addition, the audit committee oversees or, if necessary, conducts investigations of significant fraud, theft or mal­ feasance in the company, especially if it is suspected that senior managers in the company may be involved. External auditors report directly to the audit committee to help ensure their independence from man­ agement. On a day‐to‐day basis, however, they work closely with the CFO staff. The internal auditor also reports to the audit committee so that the position is more independent from management, and the internal auditor’s ultimate responsibility is to the audit committee. On a day‐to‐day basis, however, the internal auditor, like the external auditors, works closely with the CFO staff.

MODULE 1 Finance in business 17

c01FinanceInBusiness 17 18 May 2017 7:25 AM 1.6 Ethics in business

LEARNING OBJECTIVE 1.6 Discuss the relevance of ethics in business. The term ethics describes a society’s ideas about what actions are right and wrong. Ethical values are not moral absolutes and they can and do vary across societies. Regardless of cultural differences, however, if we think about it, we would all probably prefer to live in a world where people behave ethically — where people try to do what is right. In our society, ethical rules include considering the impact of our actions on others, being willing to sometimes put the interests of others ahead of our own interests, and realising that we must follow the same rules we expect others to follow. The golden rule — ‘Do unto others as you would have them do unto you’ — is an example of a widely accepted ethical norm. A less noble version occasionally heard in business is ‘The one who has the gold makes the rules’. Are business ethics different from everyday ethics? Perhaps business is a dog‐eat‐dog world where ethics do not matter. People who take this point of view link business ethics to the ‘ethics of the poker game’ and not to the ethics of everyday morality. Poker players, they suggest, must practise cunning deception and must conceal their strengths and their inten­ tions. After all, they are playing the game to win. How far should we go to win? Normally, investors only learn the hard way about companies that have been behaving unethically. As noted previously, in 2008 Storm Financial Limited, a Queensland‐based financial advisory company with 13 000 clients around Australia, collapsed. Storm Financial Limited often advised clients to mort­ gage their homes in order to secure margin loans to invest in indexed share funds. Many of its clients, mostly elderly investors, lost their life savings and some lost their homes when the share market plum­ meted. Following investigations of Storm Financial Limited’s investment schemes, ASIC decided to sue the Commonwealth Bank, Macquarie Group and Bank of Queensland for their involvement in these unregistered schemes. ASIC is taking legal action against the three banks for approximately $1 billion as compensation for the investors, who lost more than $3 billion.4 Several months before the demise of Storm Financial Limited, Opes Prime Stockbroking Limited, a Victorian financial advisory company servicing 1200 investors, collapsed owing more than $1 billion.5 The collapse of Storm Financial Limited and Opes Prime Stockbroking Limited prompted investi­ gation into practices in the financial advisory industry and the role of commissions in creating conflicts of interest. A parliamentary inquiry resulted in eleven recommendations being made to parliament in November 2009. Many of these recommendations related to alterations to ASIC’s powers under the ­Corporations Act to help protect consumers.6 We believe those who argue that ethics do not matter in business are mistaken. Indeed, most academic studies on the topic suggest that traditions of morality are very relevant to business and to financial markets in particular. The reasons are practical as well as ethical. Corruption in business creates inef­ ficiencies in an economy, inhibits the growth of capital markets and slows a country’s rate of economic growth. For example, as Russia made the transition to a market economy, it had a difficult time establishing a share market and attracting foreign investment. The reason was a simple one: corruption was ram­ pant in local government and in business. Contractual agreements were not enforceable and there was no reliable financial information about Russian companies. Not until the mid 1990s did some Russian companies begin to display enough honesty and financial transparency to attract investment capital. In economics, transparency refers to openness and access to information. Types of ethical conflicts in business We turn next to a consideration of the ethical problems that arise in business dealings. Most such prob­ lems involve three related areas: agency obligations, conflicts of interest and information asymmetry.

18 Finance essentials

c01FinanceInBusiness 18 18 May 2017 7:25 AM Financial managers have agency obligations to act honestly and to see that their subordinates act honestly with respect to financial transactions. Of all the company officers, financial managers, when they are guilty of misconduct, present the most serious dangers to shareholder wealth. A product recall or environmental offence may cause temporary declines in share prices. However, revel­ ations of dishonesty, deception and fraud in finan­ cial matters have a huge impact on the share price. If the dishonesty is flagrant, the company may become insolvent, as we saw with the insolvency of Storm Financial Limited and Opes Prime Stockbroking Limited. Conflicts of interest often arise in business relationships. For example, suppose you’re inter­ ested in buying a house and a local real estate agent is helping you find the home of your dreams. As it turns out, your agent is also the listing agent for the dream house. Your agent has a conflict of interest because their professional obligation to help you find the right house at a fair price conflicts with their professional obligation to get the highest price possible for the client whose house they have listed. Organisations can be parties to conflicts of interest. In the past, for example, many large accounting practices provided both consulting services and audits for the same companies. This dual function might compromise the independence and objectivity of the audit opinion, even though the work is done by different parts of the accounting practice. For example, if consulting fees from an audit client become a large source of income, is the auditing arm of the practice less likely to render an adverse audit opinion and thereby risk losing the consulting business? Conflicts of interest are typically resolved in one of two ways. Sometimes complete disclosure is suf­ ficient. Thus, in real estate transactions it is not unusual for the same lawyer or realtor to represent both the buyer and the seller. This practice is not considered unethical as long as both sides are aware of the fact and give their consent. Alternatively, the conflicted party can withdraw from serving the interests of one of the parties. Sometimes the law mandates this solution. For example, Australian legislation requires that public accounting practices not provide certain consulting services to their audit clients, because safeguards cannot reduce threats to independence to an acceptable level.7 The existence of information asymmetry in business relationships is commonplace. Information asymmetry occurs when one party in a business transaction has information that is unavailable to the other parties in the transaction. For example, suppose you decide to sell your 10‐year‐old car. You know much more about the real condition of the car than does a prospective buyer. The moral issue is this: how much should you tell the prospective buyer? In other words, to what extent is the party with the information advantage obligated to reduce the amount of information asymmetry? Decisions in this area often centre on issues of fairness. Consider the insider trading of shares based on confidential information not available to the public. Using insider information is considered morally wrong and, as a result, has been made illegal. The rationale for the notion is ethical fairness. The central idea is that investment decisions should be made on a ‘level playing field’. What counts as fair and unfair is somewhat controversial, but there are a few ways to determine fairness. One relates to the golden rule and the notion of impartiality that underlies it. You treat another fairly when you ‘do unto others as you would have them do unto you’. Another test of fair­ ness is whether you are willing to publicly advocate the principle behind your decision. Actions based on principles­ that do not pass the golden rule test or that cannot be publicly advocated are not likely to be fair.

MODULE 1 Finance in business 19

c01FinanceInBusiness 19 18 May 2017 7:25 AM The importance of an ethical business culture Some economists have noted that the legal system and market forces impose substantial costs on indi­ viduals and institutions that engage in unethical behaviour. As a result, these forces provide important incentives that foster ethical behaviour in the business community. These incentives include financial losses, legal fines, jail time and destruction of companies (insolvency). Ethicists argue, however, that laws and market forces are not enough. For example, the financial sector is one of the most heavily regulated areas of the Australian economy. Yet, despite heavy regulation, the sector has a long and rich history of financial scandals. In addition to laws and market forces, then, it is important to create an ethical culture in the company. Why is this important? An ethical business culture means that people have a set of principles — a moral compass, so to speak — that helps them identify moral issues and make ethical judgements without being told what to do. The business culture has a powerful influence on the way people behave and the way they make decisions. An unethical business culture can lead to adverse consequences — not only to the management and investors, but also to the general public. For example, the consequences of the global financial crisis of 2007–08 continue to be felt in many ways, including by financial services business that have been investigated as a result. For example, in mid‐September 2016 it was announced that the US Department of Justice has asked Deutsche Bank (one of Germany’s key banks) to pay US$14 billion to settle an investigation into its dealings during the GFC. This is on top of the US$1.9 billion the bank had already agreed to pay to settle an earlier claim in 2013. The bank’s stock price fell 8 per cent as a result. It is also not alone. Citigroup paid a US$7 billion fine in 2014 and early in 2016 Goldman Sachs Group paid more than US$5 billion to settle the claims of investors who claimed to have been misled by them during mortgage bond purchases. Other institutions also continue to be investigated. This highlights the financial damage such behaviour can do, and suggests the equally significant reputational damage for the business and for confidence in the financial system as a whole. Clearly, business ethics is a topic of high interest and increasing importance in the business commu­ nity, and it is a topic that will be discussed throughout the text. More than likely, you will be confronted with ethical issues during your professional career. Knowing how to identify and deal with ethical issues is thus an important part of your professional ‘survival kit’.

BEFORE YOU GO ON

1. What is a conflict of interests in a business setting? 2. How would you define an ethical business culture?

20 Finance essentials

c01FinanceInBusiness 20 18 May 2017 7:25 AM SUMMARY 1.1 Understand the importance of finance, money and markets. We all use finance, money and markets on an almost daily basis. Many consumers have a low level of understanding of how the system operates, but benefit greatly from the efficiency and effective­ ness of the modern financial system. This confidence is based on an efficient and reliable system that allows them to transfer value between themselves and other parties using money, and to engage with other buyers and sellers in either physical or virtual markets to settle transactions in order to conduct their daily affairs and finance their long‐term activities. The sheer volume of transactions that occur on a daily basis underpins our reliance on the financial system. Finance impacts heavily on our lives. The ability to raise and use funds efficiently affects short‐ term and long‐term economic and social outcomes for households, businesses and governments. This is complicated by the complexity of financial products and services, the ageing population, the move from state‐funded to self‐funded retirement, high levels of financial illiteracy and our desire to maintain high living standards. Be it the government agency funding services for the community, the business finance manager generating returns for shareholders or the individual investing for a better financial future, the outcomes will be significantly influenced by the ability to make effective financial decisions. Finance is a key factor in the success or otherwise of any business and, accordingly, a sound understanding of finance concepts and techniques is essential for any manager. Businesses need finance to start up, operate and expand. A major concern for all businesses is the way they are financed. It is important for managers to select appropriate funding, as all business entities need funding, no matter how small or large their turnover or asset base. 1.2 Identify the basic forms of business structures. A business can organise in three basic ways: as a sole trader, a partnership or a company (public or private). The owners of a business select the form of organisation that they believe will best allow management to maximise the value of the business. Most large businesses elect to organise as public companies because of the ease of raising money; the major disadvantage is high regulation compliance costs. Smaller businesses tend to organise as sole traders or partnerships. The advan­ tages of these forms of organisation include ease of formation and taxation at the personal income tax rate; their major disadvantage is the owners’ unlimited personal liability. 1.3 Discuss the financial goals of a business. A business is no different to any other economic entity when it comes to the importance of plan­ ning and working towards outcomes. Traditionally business has focused on maximising returns to shareholders and, while this is still critical, the means of measuring this are varied and not just simply based on looking at bottom‐line profit. Factors such as the risk accepted in order to generate a given return, long‐term value versus short‐term profit and the overall sustainability of the business are also key considerations. Furthermore, the standing of the business in the eyes of the community (the so‐called social licence) is another key consideration for business and finance managers to consider. 1.4 Identify the key financial decisions facing the financial manager. In running a business, the financial manager faces three basic types of decisions: (1) which pro­ ductive assets the company should buy (capital budgeting); (2) how the company should finance the productive assets purchased (financing decisions); and (3) how the company should manage its day‐to‐day financial activities (working capital decisions). The financial manager should make these decisions in a way that maximises the current value of the company’s shares.

MODULE 1 Finance in business 21

c01FinanceInBusiness 21 18 May 2017 7:25 AM 1.5 Describe the typical organisation of the financial function in a large company. In a large company, the financial manager generally goes by the title of chief financial officer. The CFO reports directly to the company’s CEO. Positions reporting directly to the CFO generally include the treasurer, the risk manager, the controller and the internal auditor. The audit committee of the board of directors is also important in relation to the financial function. The committee hires the external auditor for the company, and the internal auditor, external auditor and compliance officer all report to the audit committee. 1.6 Discuss the relevance of ethics in business. If we lived in a world without ethical norms, we would soon discover that it was difficult to do business. As a practical matter, the law and market forces provide important incentives that foster ethical behaviour in the business community, but they are not enough to ensure ethical behav­ iour. An ethical culture is also needed, in which people have a set of moral principles — a moral compass — that help them identify ethical issues and make ethical judgements without being told what to do.

KEY TERMS capital markets financial markets where equity and debt instruments with maturities of greater than 1 year are traded capital structure the mix of debt and equity that is used to finance a company chief financial officer (CFO) the most senior financial manager in a company company an independent legal entity able to do business in its own right; in a legal sense, it is a ‘person’ distinct from its owners finance both the study of money management and the process of acquiring needed financial resources information asymmetry situation in which one party in a business transaction has information that is unavailable to the other parties in the transaction insolvency the inability to pay debts when they are due limited liability the legal liability of a limited partner or shareholder in a business, which extends only to the capital contributed or the amount invested markets a medium that allows buyers and sellers of a specific service or good to transact money a medium of exchange of value between parties net working capital the dollar difference between current assets and current liabilities partnership two or more owners who have joined together legally to manage a business and share in its profits productive assets the tangible and intangible assets a company uses to generate cash flows public company a company that lists on a stock exchange, such as the ASX, in which large amounts of debt and equity are publicly traded residual cash flows the cash remaining after a company has paid operating expenses and what it owes creditors and in taxes; can be paid to the owners as a cash dividend or reinvested in the business sole trader a business owned by a single individual stakeholder anyone other than an owner (shareholder) with a claim on the cash flows of a company, including employees, suppliers, creditors and the government wealth the economic value of the assets someone possesses

22 Finance essentials

c01FinanceInBusiness 22 18 May 2017 7:25 AM ENDNOTES 1. Reserve Bank of Australia, 2016, www.rba.gov.au/statistics/tables. 2. ibid. 3. Coleman, D 2012, ‘Telstra announces its capital management strategy, expected excess free cash of $2 to 3 billion over the next three years and its NBN plans’, media release, Telstra Limited, Melbourne, 19 April, www.telstra.com.au. 4. ABC News 2012, ‘Hope for Storm investors’ payout to top $1b’, 15 August, www.abc.net.au. 5. Butler, B 2011, ‘ASIC reveals case on Opes Prime collapse’, The Age, 1 March, www.theage.com.au. 6. Australian Securities & Investments Commission (ASIC) 2009, ‘Parliamentary inquiry into financial products and services in Australia’, 18 August, http://storm.asic.gov.au/resources/parliamentary-inquiry. 7. Joint Accounting Bodies 2008, ‘Independence guide: Interpretations in a co‐regulatory environment’, version 3, June, www.charteredaccountants.com.au.

ACKNOWLEDGEMENTS Photo: © John Lamb / Getty Images Photo: © wavebreakmedia / Shutterstock.com Photo: © marekuliasz / Shutterstock.com

MODULE 1 Finance in business 23

c01FinanceInBusiness 23 17 May 2018 12:39 PM