LECTURE PODS

(WEEK 1):
FORMS OF BUSINESS OWNERSHIP: CHOOSING THE
RIGHT FIT
INTRODUCTION
One of the fundamental decisions you must make when starting a
business is selecting a form of business ownership.
The decision can be complex and can have far-reaching
consequences for owners, employees, and customers.
Picking the right ownership structure involves knowing your long-
term goals and your tolerance for risk.
As your business evolves over time, you may need to modify the
original structure.

FORMS OF BUSINESS OWNERSHIP

There are three forms of business ownership:
1. Sole trader (Sole proprietorship)

2. Partnership
3. Corporation

The three most common forms of business ownership are sole

trader, partnership, and corporation. Each form has its own
characteristic internal structure, legal status, size, and fields to
which it is best suited. Each also has key advantages and
disadvantages for the owners.

SOLE TRADERS
LECTURE PODS

Sole traders: A business owners by a single person (Although it

may have many employees).
— Many farms, retail establishments, and small service
businesses are sole traders, as are many home-based
businesses, such as those operated by caterers, consultants,
and freelance writers.
— Many of the local businesses you frequent around your
university campus are likely to be sole traders.

ADVANTAGES OF SOLE TRADERS

Operating as a sole trader offers six key advantages:
— Simplicity: sole trader is easy to establish and requires far
less paperwork than other structures. About the only legal
requirement for establishing a sole trader is obtaining an
Australian Business number and registering for goods and
services tax (GST) if the annual GST turnover is $75,000 or
more.
— Single layer of taxation: Income tax is a straightforward
matter for sole traders. The federal government doesn’t
recognize the company as a taxable entity; all profit “flows
through” to the owner, where it is treated as personal
income and taxed accordingly.
— Privacy: Beyond filing tax returns and certain other
government reports that may apply to specific businesses,
sole traders generally aren’t required to report anything to
anyone. Your business is your business.
— Flexibility and control: As a sole trader, you aren’t required
to get approval from a business partner, your boss, or a
board of directors to change any aspect of your business
strategy or tactics. You can make your own decisions, from
setting your own hours to deciding how much of the work
you’ll do yourself and how much you’ll assign to employees.
It’s all up to you!
— Fewer limitations on personal income: As a sole trader, you
keep all the after-tax profits the business generates; if the
business does extremely well, you do extremely well. Of
course, if the business doesn’t generate any income, you
don’t get a paycheck.
— Personal satisfaction: For many sole traders, the main
advantage is the satisfaction of working for themselves—of
taking the risks and enjoying the rewards.

DISADVANTAGES OF SOLE TRADERS

For all of its advantages, sole trader also has six significant
disadvantages:
LECTURE PODS

— Financial liability: In a sole trader, the owner and the

business are legally inseparable, which gives the trader
Unlimited liability: A legal condition under which any
damages or debts incurred by a business are the owner’s
personal responsibility. you could lose not only the business
but everything else you own, including your house, your car,
and your personal investments.
— Demands on the owner: In addition to the potential for long
hours (certainly, not all sole traders work crazy hours), sole
traders often have the stress of making all the major
decisions, solving all the major problems, and being tied so
closely to the company that taking time off is sometimes
impossible. Plus, business owners can feel isolated and
unable to discuss problems with anyone.
— Limited managerial perspective: Running even a simple
business can be a complicated effort that requires expertise
in accounting, marketing, information technology, business
law, and many other fields. Few individual owners possess
enough skills and experience to make consistently good
decisions.
— Resource limitations: Because they depend on a single
owner, sole traders usually have fewer financial resources
and fewer ways to get additional funds from lenders or
investors. This lack of capital can hamper a small business
in many ways, limiting its ability to expand, to hire the best
employees, and to survive rough economic periods.
— No employee benefits for the owner: Moving from a
corporate job to sole trader can be a shock for employees
accustomed to paid vacation time, sick leave, health
insurance, and other benefits that many employers offer.
Sole traders get none of these perks without paying for
them out of their own pockets.
— Finite life span: A business run by a sole trader ceases to
operate once the owner passes away.

PARTNERSHIPS
Partnership: Is a company that is owned by two or more people
but is not a corporation.
The partnership structure is appropriate for firms that need more
resources and leadership talent than a sole trader but don’t need
the fundraising capabilities or other advantages of a corporation.
Many partnerships are small, with just a handful of owners,
although a few are very large (up to 10,000 partners).
Partnerships come in two basic types:
1) General Partnership:
a. A partnership in which all partners have joint authority
to make decisions for the firm and joint liability for the
firm’s financial obligations.
LECTURE PODS

b. If the partnership gets sued or goes bankrupt, all the

partners have to dig into their own pockets to pay the
bills, just as sole traders must.

2) Limited Partnership:
a. Under this type of partnership, one or more persons
act as general partners who run the business and have
the same unlimited liability as sole traders.
b. The remaining owners are limited partners who do not
participate in running the business and who have
limited liability—the maximum amount they are liable
for is whatever amount each invested in the business.

ADVANTAGES OF PARTNERSHIPS
Partnerships offer two of the same advantages as sole traders
plus four more than overcome some important disadvantages of
being a sole owner.
— Simplicity: Strictly speaking, establishing a partnership is
almost as simple as establishing a sole trader: You and your
partners just say you’re in business together, apply for the
necessary business licenses, and get to work.
However, while this approach is legal, it is not safe or
sensible. Partners need to protect themselves and the company
with a partnership agreement.
— Single layer of taxation: Income tax is straightforward for
partnerships. Profit is split between or among the owners
based on whatever percentages they have agreed to. Each
owner then treats his or her share as personal income.
— More resources: One of the key reasons to partner up with
one or more co-owners is to increase the amount of money
you have to launch, operate, and grow the business.
In addition to the money that owners invest themselves, a
partnership can potentially raise more money because
partners’ personal assets support a larger borrowing
capacity.
 Cost sharing: An important financial advantage in many
partnerships is the opportunity to share costs. For example,
a group of lawyers or doctors can share the cost of facilities
and support staff while continuing to work more or less
independently.
 Broader skill and experience base: Pooling the skills and
experience of two or more professionals can overcome one
of the major shortcomings of the sole trader. If your goal is
to build a business that can grow significantly over time, a
partnership can be much more effective than trying to build
it up as a sole owner.

DISADVANTAGES OF PARTNERSHIPS
LECTURE PODS

Anyone considering the partnership structure needs to be aware

of three potentially significant disadvantages:
— Unlimited liability: All owners in a general partnership and
the general partners in a limited partnership face the same
unlimited liability as sole traders.
However, the risk of financial wipeout can be even greater
because a partnership has more people making decisions
that could end in catastrophe.
— Potential for conflict: More bosses equals more chances for
disagreement and conflict. Partners can disagree over
business strategy, the division of profits (or the liability for
losses), hiring and firing of employees, and other significant
matters.
Even simple interpersonal conflict between partners can
hinder a company’s ability to succeed.
— Limited life: Similar to sole traders, if one of the partners
exits the partnership or dies; then the partnership is
automatically dissolved.

THE PARTNERSHIP AGREEMENT

A carefully written partnership agreement can maximise the
advantages of the partnership structure and minimise the
potential disadvantages.
A partnership agreement should address investment
percentages, profit-sharing percentages, management
responsibilities and other expectations of each owner, decision
make strategies, succession and exit strategies, criteria for
admitting new partners, and dispute resolution procedures.

CORPORATIONS
 Corporation: A legal entity, distinct from any individual
persons, that has the power to own property and conduct
business. A corporation is owned by shareholders.
 Shareholders: Investors who purchase shares in corporation.
 Public corporation: A corporation in which shares are sold to
anyone who has the means to buy them—individuals,
investment companies such as superannuation funds, not-
for-profit organizations, and other companies.
Such corporations are said to be publicly held or publicly
traded.
 Private corporation: A corporation in which all shares are
owned by only a few individuals or companies (maximum of
50 shareholders) and is not made available for purchase by
the public. It is also known as a proprietary company or
‘Pty’. Private corporations can be limited liability ‘Pty Ltd’ or
unlimited liability ‘Pty’

ADVANTAGES OF CORPORATION
LECTURE PODS

Corporations have become a major economic force because this

structure offers four major advantages over sole traders and
partnerships.
 Ability to raise capital: The ability to pool money by selling
shares (corporations can also raise money by selling bonds
which will be covered later in weeks 5) to outside investors
is the reason corporations first came into existence and
remains one of the key advantages of this structure.
The potential for raising vast amounts gives corporations an
unmatched ability to invest in research, marketing,
facilities, acquisitions, and other growth strategies.
 Liquidity: The shares of publicly traded companies have a
high degree of liquidity, which means that investors can
easily and quickly convert their shares into cash by selling
them on the open market.
In contrast, liquidating (selling) the assets of a sole trader
or a partnership can be slow and difficult.
Liquidity helps make corporate shares an attractive
investment, which increases the number of people and
institutions willing to invest in such companies.
— Longevity: Liquidity also helps give corporations a long life
span; when shareholders sell their shares, ownership simply
passes to a new generation, so to speak.
— Limited liability: A corporation itself has unlimited liability,
but the various shareholders who own the corporation face
only limited liability—their maximum potential loss is only as
great as the amount they have invested in the company.
Like liquidity, limited liability offers protection that helps
make corporate shares an attractive investment.

DISADVANTAGES OF CORPORATION
The advantages of the corporate structure are compelling, but six
significant disadvantages must be considered carefully.
— Cost and complexity: Starting a corporation is more
expensive and more complicated than starting a sole trader
or a partnership, and “taking a company public” (selling
shares to the public) can be extremely expensive for a firm
and time-consuming for upper managers.
— Reporting requirements: To help investors make informed
decisions about shares, government agencies require
publicly traded companies to publish extensive and detailed
financial reports. These reports can eat up a lot of staff and
management time, and they can expose strategic
information that might benefit competitors.
— Managerial demands: Top executives must devote
considerable time and energy to meeting with shareholders,
financial analysts, and the news media. By one estimate,
CEOs of large publicly held corporations can spend as much
LECTURE PODS

as 40 percent of their time on these externally focused

activities.
— Possible loss of control: Outside investors who acquire
enough of a company’s shares can gain seats on the board
of directors and therefore begin exerting their influence on
company management.
— Double taxation: A corporation must pay corporate tax on its
profits, and individual shareholders must pay income taxes
on their share of the company’s profits received as
dividends (periodic payments that some corporations opt to
make to shareholders).
However, under the new dividend imputation tax system
implemented in Australia since 1987, a shareholder has the
right to receive a credit for the tax paid by the corporation.
— Short-term orientation of the stock market: Publicly held
corporations release their financial results once every
quarter, and this seemingly simple requirement can have a
damaging effect on the way companies are managed. The
problem is that executives feel the pressure to constantly
show earnings growth from quarter to quarter so that the
share price keeps increasing—even if smart, strategic
reasons exist for sacrificing earnings in the short term, such
as investing in new product development or retaining
talented employees instead of laying them off during slow
periods.

TYPES OF CORPORATION
— Public companies limited by shares:
- A limited by shares company (also known as a
limited liability companies and usually denoted by
the word ‘Ltd’ beside its name) is a company where
the liability of the shareholders is limited to the
issue price of their fully paid shares. However, if the
shares are issued on a partly paid basis then the
shareholder is liable for the remaining amount when
it is called for or due.
— Public companies limited by guarantee:
- This form of enterprise is common for charitable or
not-for-profit organisations. In case the company is
wound up, the liability of the shareholders of a
limited by guarantee company is limited to the
amount they agreed to contribute.
 Unlimited public companies:
- This structure of enterprise is usually common for
professional and investment-type companies.
- The liability of the shareholders to the debts of the
company is unlimited.
- These companies are usually organised like a
partnership but with a corporate body.
LECTURE PODS

 No liability companies:
- In Australia, this form of corporation is restricted to
mining and resources companies. The reason for
that has to do with the high level of risk
shareholders face when investing in those
companies. Shares issued by a no liability company
are commonly on a partly paid basis. Shareholders
have no liability to pay any future calls on their
partly paid shares. However, by doing so they forfeit
such shares.

CORPORATE GOVERNANCE
— Although a corporation’s shareholders own the business,
few of them are typically involved in managing it,
particularly if the corporation is publicly traded. Instead,
shareholders elect a board of directors to represent them,
and the directors, in turn, select the corporation’s top
officers, who actually run the company (see Exhibit 1.1 on
the next slide).
— The term corporate governance can be used in a broad
sense to describe all the policies, procedures, relationships,
and systems in place to oversee the successful and legal
operation of the enterprise.
— Because serious corporate blunders can wreak havoc on
employees, investors, and the entire economy, effective
corporate governance has become a vital concern for society
as a whole, not just for the individual companies
themselves.
Shareholders of a corporation own the business, but their elected
representatives on the board of directors hire the corporate
officers who run the company and hire other employees to
perform the day-to-day work. (Note that corporate officers are
also employees)

SHAREHOLDERS
— Even though most don’t have any direct involvement in
company management, shareholders play a key role in
LECTURE PODS

corporate governance. All shareholders are invited to an

annual meeting where top executives present the previous
year’s results and plans for the coming year and
shareholders vote on various resolutions that may be before
the board.
— Those who cannot attend the annual meeting in person can
vote by proxy.
— A proxy is a document that authorizes another person to
vote on behalf of a shareholder in a corporation
— Because shareholders elect the directors, in theory they are
the ultimate governing body of the corporation. However, a
major corporation may have thousands or even millions of
shareholders, so unless they own a large number of shares,
individual shareholders usually have little influence.
— Shareholder activism
- Activities undertaken by shareholders to influence
executive decision making in areas ranging from
strategic planning to social responsibility

BOARD OF DIRECTORS
— As the representatives of the shareholders, the members of
the board of directors are responsible for selecting
corporate officers, guiding corporate affairs, reviewing long-
term plans, making major strategic decisions, and
overseeing financial performance.
— Boards are typically composed of major shareholders (both
individuals and representatives of institutional investors)
and executives from other corporations.
— Directors are often paid a combination of an annual fee and
share options, the right to buy company shares at an
advantageous price.

CORPORATE OFFICERS
The third and final group that plays a key role in governance are
the corporate officers, the top executives who run the company.
Because they implement major board decisions, make numerous
other business decisions, ensure compliance with a dizzying
range of government regulations, and perform other essential
tasks, the executive team is the major influence on a company’s
performance and financial health.
 Corporate officers: the top executives who run a
corporation.
 The highest-ranking officer is the chief executive officer
(CEO), and that person is aided by a team of other “C-level”
executives, such as the chief financial officer (CFO), chief
information officer (CIO), chief technology officer (CTO), and
chief operating officer (COO)—titles vary from one
corporation to the next.
LECTURE PODS

MERGERS AND ACQUISITIONS

In a merger, two companies join to form a single entity.
Companies can merge either by pooling their resources or by one
company purchasing the assets of the other. Although not strictly
a merger, a consolidation, in which two companies create a new,
third entity that then purchases the two original companies, is
often lumped together with the other two merger approaches.
In an acquisition, one company buys a controlling interest in the
voting stock of another company. In most acquisitions, the selling
parties agree to be purchased; management is in favor of the
deal and encourages shareholders to vote in favor of it as well.
Because buyers frequently offer shareholders more than their
shares are currently worth, sellers are often motivated to sell.
If a company determines that it doesn’t have the right mix of
resources and capabilities to achieve its goals and doesn’t have
the time to develop them internally, it can purchase or partner
with a firm that has what it needs. Businesses can combine
permanently through either mergers or acquisitions.
 Merger: An action taken by two companies to combine and
perform as a single entity.
 Acquisition: An action taken by one company to buy a
controlling interest in the voting stock of another company.

ADVANTAGES OF MERGERS AND ACQUISITIONS

A merger or an acquisition is a rare even for many firms, but
some other companies use acquisition as a strategic tool to expan
year after year. Companies pursue merges and acquisitions for a
variety of reasons.
— Increase their buying power as a result of their larger size.
— Increase revenue by cross-selling products to each other’s
customers.
— Increase market share by combining product lines .
— Gain access to new expertise, systems, and teams of
employees who already know how to work together.
— Bringing a company under new ownership can also be an
opportunity to replace or improve inept management and
thereby help a company improve its performance.
— In many cases, the primary goal is to reduce overlapping
investments and capacities in order to lower ongoing costs.

DISADVANTAGES OF MERGERS AND ACQUISITIONS

Although the advantages can be compelling, joining two
companies is a complex process because it involves virtually
every aspect of both organisations.
— Executives have to agree on how the merger will be financed
— and then come up with the money to make it happen.
— Managers need to decide who will be in charge after they
join forces.
LECTURE PODS

— Marketing departments need to figure out how to blend

product lines, branding strategies, and advertising and sales
efforts.
— Incompatible information systems (including everything
from email to websites to accounting software) may need to
be rebuilt or replaced in order to operate together
seamlessly.
— Companies must often deal with layoffs, transfers, and
changes in job titles and work assignments.
— The organizational cultures of the two firms must be
harmonised somehow, which can result in clashes between
different values, management styles, communication
practices, workplace atmosphere, and approaches to
managing the changes required to implement the merger.

TYPES OF MERGERS
A vertical merger occurs when a company purchases a
complementary company at a different stage or level in an
industry, such as a furniture maker buying a lumber supplier. A
horizontal merger involves two similar companies at the same
level; companies can merge to expand their product offerings or
their geographic market coverage. In a conglomerate merger, a
parent company buys companies in unrelated industries, often to
diversify its assets to protect against downturns in specific
industries.
In some situations, a buyer attempts to acquire a company
against the wishes of management. In such a hostile takeover,
the buyer tries to convince enough shareholders to go against
management and vote to sell.
 Hostile takeover: Acquisition of another company against
the wishes of management.
- A hostile takeover can be launched in one of two
ways: by tender offer or by proxy fight.
- In a tender offer, the buyer, or raider, as this party
is sometimes called, offers to buy a certain number
of shares in the corporation at a specific price. The
price offered is generally more than the current
share price, so that shareholders are motivated to
sell. The raider hopes to get enough shares to take
control of the corporation and to replace the
existing board of directors and management.
- In a proxy fight, the raider launches a public
relations battle for shareholder votes, to gain
enough votes to oust the board and management.
 Corporate boards and executives have devised a number of
schemes to defend themselves against unwanted takeovers:
- A poison pill defense, a targeted company invokes
some move that makes it less valuable to the
LECTURE PODS

potential raider, with the hope of discouraging the

takeover. A common technique is to sell newly
issued shares to current shareholders at prices
below the market value of the company’s existing
shares, thereby instantly increasing the number of
shares the raider has to buy.
- A white knight tactic, a third company is invited to
acquire a company that is in danger of being
swallowed up in a hostile takeover.
 Leveraged buyout (LBO): Acquisition of a company’s publicly
traded shares, using funds that are primarily borrowed,
usually with the intent of using some of the acquired assets
to pay back the loans used to acquire the company.

STRATEGIC ALLIANCES AND JOINT VENTURES

A strategic alliance is a long-term partnership between
companies to jointly develop, produce, or sell products, and a
joint venture as a separate legal
entity established by the strategic partners. Both of these
options can be more attractive than a merger or acquisition in
certain situations.
 Strategic alliance: A long-term partnership between
companies to jointly develop, produce, or sell products.
 Joint venture: A separate legal entity established by two or
more companies to pursue shared business objectives.
LECTURE PODS

OPTIONS FOR JOINING FORCES

(WEEK 2):
FINANCIAL STATEMENTS AND CASH FLOW: AN
UNDERSTANDING
WHY STUDY FIANNCIAL STATEMENTS:
LECTURE PODS

Analysing a firm’s financial statement can help managers carry

out three important tasks:
 Assess current performance: The basic objective of financial
statement analysis is to assess the financial condition of the
firm being analysed. In a sense, the analyst performs a
financial analysis so he or she can see the firm’s financial
performance the same way an outside investor would see it.
 Monitor and control operations: Managers use financial
statements to monitor and control the firm’s operations.
The performance of the firm is reported using accounting
measures that compare the prices of the firm’s products and
services with the estimated cost of providing them to
buyers. Moreover, the board of directors uses these
performance measures to determine executives’ bonuses.
- The company’s creditors also use performance
measures based on the firm’s financial statements
to determine whether or not to extend the
company’s loans.
 Plan and forecast future performance: Financial statements
provide a universally understood format for describing a
firm’s operations. Consequently, financial planning models
are typically built using the financial statements as a
prototype.

FINANCIAL STATEMENTS:
There are four basic financial statements:
 Income statement (also referred to as Statement of
Comprehensive Income)
 Balance Sheet (also referred to as Statement of Financial
Position)
 Cash Flow Statement
 Statement of Changes in Equity

WHAT ARE THE ACCOUNTING PRINCIPLES USED TO PREPARE

FINANCIAL STATEMENTS?
Accountants use the following two fundamental principles when
preparing financial statements:
1) Accrual basis:
- Revenues are recognised when earned, not
necessarily when received in cash
- Expenses are recognised when incurred, not
necessarily when paid in cash.
2) Historical cost principle:
- Record assets and liabilities at the price paid to
acquire them (historical cost), which is usually not
the price the asset could be sold for today (usually it
does not).

INCOME STATEMENT:
LECTURE PODS

An income statement provides the following information for a

specific period of time (for example, a full year or a quarter, or
month):
 Revenue earned
 Expenses incurred
 Profit generated
Revenue (or sales)- expenses = profit

— Cost of goods sold: The cost of producing or acquiring the

products or services that the firm sold during the period
covered by an income statement.
— Operating expenses: this includes the salaries paid to the
firm’s administrative staff, the firm’s electricity bills, and so
forth).One of the operating expense categories is
depreciation expense.
— Depreciation expense: is a non-cash expense used to
allocate the cost of the firm’s long-lived assets (such as its
plant and equipment) over the useful lives of the assets.
— The firm’s operating profit shows the firm’s ability to earn
profits from its ongoing operations—before it makes interest
payments and pays its tax. For our purposes, operating
profit will be synonymous with earnings before interest and
tax (EBIT).
— Interest expense: To this point, we have calculated the
profit resulting only from operating the business, without
regard for any financing costs, such as the interest paid on
money the firm might have borrowed.

CONNECTING THE INCOME STATEMENT AND THE BALANCE SHEET:

 What can the firm do with the net income?
“Pay
dividends to
shareholders,
and/or
reinvest in
the firm”
— Boswell
Ltd.
earned
net
LECTURE PODS

income of $204.75 million, of which $45 million was

distributed in dividends and $159.75 million was
retained and reinvested in the firm.
— As we will see later, in the balance sheet Boswell’s
retained earnings rise by exactly this amount. Thus,
the income statement feeds directly into the balance
sheet to record any profit or loss from the firm’s
operations for the period.
What does a firm do with Net Profit (also called Profit After Tax)?
 Pay a *dividend* to shareholders. *** Note: dividends are
not an expense of the business, but a distribution of profit
to shareholders.
 Reinvest in the business

INTERPRETING FIRM PROFITABILITY USING THE INCOME

STATEMENT:
From H.J. Boswell Ltd’s income statement we observe that the
firm appears to have been profitable.
We can identify three different measures of profit or income:
1) The gross profit is $675 million
2) The operating profit is $382.5 million
3) The net profit is only $204.75 million
These measures are often easier to compare and when written as
ratios.
It is common practice to divide gross profit, operating profit and
net profit by the level of the firm’s sales to calculate the firms
gross profit margin operating profit margin and net profit margin,
respectively.
(a) The gross profit margins (GPM)
= gross profit ÷ sales
= $675 ÷ $2700 million
= 25%
This means that for every dollar of sales the firms generate
25 cents of profit after paying the cost of goods sold.
(b) The operating profit margins
= net operating income ÷ sales
= $382.5 ÷ $2700 million
= 14.17%
The operating profit margin is equal to the ratio of net
operating income (or earnings before interest and tax, EBIT)
divided by the firm’s sales.
(c) The net profit margin
= net profits ÷ sales
= $204.75 million ÷ $2700 million
= 7.6%
The net profit margin indicates the percentage of revenues
left over after all expenses (including interest and taxes)
have been considered.
LECTURE PODS

By monitoring any changes in these margins and comparing these

margins to those of similar businesses, we can dissect and
identify a firm’s performance and identify areas that may require
further investigation.

EXAMPLE: Constructing an income statement:

Reconstruct H.J. Boswell Ltd’s income statement assuming that
the firm is able to cut its cost of goods sold by 10%, but the tax
rate rose from 35% to 40%.
How does the firm’s profitability change?

STEP 1: PICTURE THE PROBLEM

 The income statement can be expressed as follows:
Revenues – Expenses = Net profit
 We are given information on revenue and expenses (cost of
goods sold, operating expenses, interest expense and
corporate income tax) to fill the template given on next
slide.

STEP 2: DECIDE ON A SOLUTION STRATEGY

LECTURE PODS

STEP 3: SOLVE

STEP 4: ANALYSE
 The firm is now profitable
 Old Ratios are:
- The gross profit margin is 25%
- The operating profit margin is 14.17%
- The net profit margin is 7.6%
 New ratios are:
- The gross profit margin is 32.5%
LECTURE PODS

- The operating profit margin is 21.7%

- The net profit margin is 11.5%

BALANCE SHEET:
The balance sheet sheet (or statement of financial position)
contains information on a specific date (for example, as at 31
December 2015) in regard to the following:
 Assets (resources that will generate a future economic
benefits)
 Liabilities (debts)
 Owners or shareholders equity (investment by the owners)
The balance sheet provides a snapshot of the firm’s financial
position on a specific data. It is defined by the equation:
Total assets = total liabilities + total shareholders’ equity
This can also be written as:
Total assets – total liabilities = total shareholders equity

Assets and liabilities are generally shown on the Balance Sheet as

“current” and “non-current”.
 a “current” asset is one that is expected to be used up
within 12 months, while a “non-current” asset has a useful
life longer than 12 months.
 a “current” liability is one that is expected to be settled
within 12 months, while a “non-current” liability will be due
in greater than 12 months.
Some non-current (long-term) assets with long useful lives and
the firm is not expected to sell within 12 months (like
equipment) are reported on the Balance Sheet as “net”, for
example “net equipment”.
 This is cost of the asset less accumulated depreciation,
where accumulated
depreciation
represents the
value of the asset
which has already
been “used up”.
 Net value (also
known as carrying
amount or book
value) represents
the future benefit
expected from the
asset but could be
significantly
different from the
market value of the
asset.
LECTURE PODS
LECTURE PODS

FIRM LIQUIDITY AND NET WORKING CAPITAL:

Liquidity generally refers to the firm’s ability to convert its
current assets into cash so that it can pay its current liabilities on
time.
One measure of a firm’s liquidity is:
Net working capital = current assets – current liabilities
From H.J. Boswell Ltd’s Balance Sheet we observe that the firm
appears to be quite liquid and has shown an improvement in
2015, compared to 2014:
 In 2014, working capital is $477m - $292.5m
= $184.5m
 In 2015, working capital is $643.5m - $288m
= $355.5m
Higher levels of working capital indicate higher levels of liquidity,
as a firm is in a good position to pay its short-term debts on time.
Lenders consider the net working capital as an important
indicator of firm’s ability to repay its loans.
However, working capital levels which are extremely high may
indicate a poor use of resources (for example, holding too much
cash instead of investing excess cash in more profitable ways).
EXAMPLE: Constructing a balance sheet
Reconstruct H.J. Boswell Ltd’s Balance Sheet as at 31 December
2015 to reflect purchase of additional equipment with $25 million
in cash on 31 December 2015.
What has been the impact on H.J. Boswell’s liquidity?
STEP 1: PICTURE THE PROBLEM
The firms balance sheet can be expressed as follows:
Assets (current and non-current) = liabilities (current and non-
current) + owners’ equity
STEP 2: DECIDE ON A SOLUTION STRATEGY
LECTURE PODS

STEP 3: SOLVE

STEP 4: ANALYSE
We can make the following observations H.J. Boswell Ltd’s
updated Balance Sheet as at 31 December 2015:
— Total assets, total liabilities and equity have not
changed.
— However, current assets have decreased and non-
current assets have increased.
LECTURE PODS

— The decrease in current assets has caused the firm’s

liquidity to have declined, with working capital now
only $618.5m - $288m = $330.5m.
 But the firm has made an investment for the future, so it is
always useful to know why any change has occurred – the
Cash Flow Statement can help with identifying this

CASH FLOW STATEMENT:

— The cash flow statement is a report, like the income
statement and balance sheet, that firms use to explain
changes in their cash balances over a period of time by
identifying all of the sources and uses of cash for the period
spanned by the statement.
— The focus of the cash flow statement is the change in the
firm’s cash balance for the period of time covered by the
statement (i.e. one year or one quarter):
Change in cash balance = ending cash balance – beginning cash
balance

The cash flow statement reports cash inflows and cash outflows
over a specific period of time, and summarises these according
to:
 Cash flows from operating activities
- represent the company’s core business, including
cash received from sales and cash paid for
expenses.
 Cash flows from investing activities
- represent the cash flows that arise out of the
purchase and sale of long-term assets such as plant
and equipment.
 Cash flows from financing activities
- represent changes in the firm’s use of debt and
equity such as issue of new shares, the repurchase
of outstanding shares and the payment of dividends.
LECTURE PODS

CASH FLOW STATEMENT ANALYSIS:

The statement can be used to answer a number of important
questions such as:
 How much cash did the firm generate from its operation?
 How much did the firm invest in non-current assets?
 Did the firm raise additional funds, and if so, how much and
from what sources (i.e. debt or equity)?
 Is the firm able to generate positive cash flows?
An analysis of H.J. Boswell’s operations reveals the following:
 The main source of cash flow was from operating activities
$173.25 million
 The largest use of cash was for acquiring property, plant
and equipment at $175.5 million.
 The firm used more cash than it generated, resulting in a
deficit of $4.5 million
= However, the firm has invested in assets which should
help generate more cash flow in the future

STATEMENT OF CHANGES IN EQUITY:

The statement of changes in equity provides a detailed account of
the firm’s activities in relation to movements in equity for a
specific period of time.
This includes movements in accounts such as:
LECTURE PODS

 Ordinary shares
 Preference shares
 Retained earnings
 Reserves

(WEEK 3):
ENTREPRENEURSHIP AND SMALL-BUSINESS OWNERSHIP:
SOURCES OF FUNDS
(WEEK 4):
INTEREST RATES AND TIME VALUE OF MONEY
(WEEK 5):
FINANCING THE BUSINESS: SHORT AND LONG-TERM
SOURCES OF FUNDS
SOURCES OF FINANCE:
LECTURE PODS

• To examine the various sources of finance for a business it is

useful to distinguish between external and internal sources
of finance. By internal sources, we mean sources that do not
require the agreement of anyone beyond the directors and
managers of the business.
Internal- sources that do not require the approval of others
apart from managers or directors to obtain, e.g. retained
profit.
External- requires the approval of shareholders, e.g. issue of
new shares.
• Within each of these two categories just described, we can
further distinguish between long-term and short-term
sources of finance.
Long-term sources of finance– expected to provide finance
for at least one year.
Short- Term: sources of finance – typically for less than one
year.
Major internal sources of finance:
The major source of internal finance is the earning that are
retained rather than distributed to shareholders. The other major
internal sources of finance involve reducing the level or
receivables and inventories and increasing payables.

INTERNAL SOURCES OF LONG-TERM FINANCE:

 Retained Earnings:
- Is the main source of finance for most companies
- No issue or establishment costs
- No dilution of shareholder interest
- No waiting – funds are immediately available
- Often less scrutiny from investors
- Potential tax-efficiency for shareholders when
retained profits deliver increased share prices
LECTURE PODS

- Typically, the retention/dividend payout ratio is not

more than 50%-70% of profit (Although dividend
ratio tend to vary with profit).

INTERNAL SOURCES OF SHORT-TERM FINANCE:

 Tighter credit control:
- Reduces opportunity cost.
- Important to weigh the cost against the benefits
(Tighter credit control against the likely costs in the
form of lost customer goodwill and lost sales).
- Credit policy must be determined with consideration
to clients’ needs and of the credit policies adopted
by rival companies within the industry.
 Reduced inventory levels:
- Reduces opportunity cost.
- However, a business must ensure there is sufficient
inventory available to meet likely future demand
otherwise it will lose customer goodwill and sales.
- May not be easy to liquidate obsolete items.
 Delayed payment to supplies (Accounts payable)
- Extends period of interest-free loan but at the risk
of jeopardising relations with suppliers.
The major external source of finance: there are various external
sources of finance available to a business:

EXTERNAL SOURCES OF FINANCE:

 Ordinary Shares:
- From the investor’s perspective: high risk
investment, higher expected returns, voting rights,
and limited loss liability, unlimited return potential.
- From the company’s perspective: can be useful to
avoid paying a dividend, cost of financing can be
high over the long term, paying dividends does not
bring any tax relief, whereas paying interest on
LECTURE PODS

borrowings is tax-deductable. That means; making

$1 of dividend more expensive than $1 of loan
interest
 Preference Shares:
- Lower risk than ordinary shares:
 since preference shareholders have priority
over ordinary shares if company is wound
up.
 Normally given a fixed rate of dividend
which provides certainty about future
return.
- because of lower level of risk compared to ordinary
shares, they offer lower level of return than ordinary
shares
- May be cumulative or non-cumulative
- May be participating or non- participating
- No longer a major source of finance because:
 no tax advantage for the company.
 Interest rate on borrowing has been at
historically low levels.
 Borrowings:
- Specified interest rate, term and repayment
schedule
- Secured by assets held by the company which may
be either on the basis of:
 a ‘fixed charge’ over assets, e.g. land,
premises
 a ‘floating charge’ over the whole of a
company’s assets
- Not all assets are acceptable to lenders as security.
They must normally be non-perishable, easy to sell,
and of high and stable value. Property normally
meets these criteria and often favoured by lenders.
- In some cases, security offered may take the form of
a personal guarantee by the owners of the business
or, perhaps, some third party. This tends to be
particularly the case with small businesses.
- Lenders may seek further protection through the
use of loan covenants.
- Loan covenants: enforceable conditions contained
within a loan agreement which are designed to
protect the lenders. May deal with matters such as:
 access to financial statements
 approval required before taking on other
loans
 dividend payments may be required to be
limited
 liquidity may need to be maintained at a
prescribed level
LECTURE PODS

- Loan covenants and the availability of security can

lower the risk for lenders and can make the
difference between a successful and an unsuccessful
loan issue.
- They can also lower the cost of borrowing to the
business, as the rate of return that lenders require
will depend on the perceived level of risk to which
they are exposed.
The risk-return characteristics of long-term capital: from an
investors perspective, lending is normally the least risky
and ordinary shares the riskiest.

EXTERNAL SOURCES OF LONG- TERM FINANCE:

 Loans and debentures:
- Term loan: is offered by banks and other financial
institutions, and is usually tailored to a client’s
needs. The amount of the loan, the time period, the
repayment terms and the interest payable are all
open to negotiation and agreement, which can
provide more flexibility to the borrower.
A term loan can be an interest only loan when the
borrower pays only interest on the principle
borrowed and then pays a lump sum at maturity
(principle borrowed)
- Amortised loan: is a loan that is paid off in equal
periodic payments (say monthly) where cash
payment includes an interest component and a
principle component. By the end of the loan
contract, the periodic payments would have repaid
the principle and interest on that loan in full.
LECTURE PODS

- Mortgage loan: is a form of a term loan that is

secured by freehold property. Financial institutions
such as banks, insurance companies and
superannuation funds are often prepared to lend to
businesses on this basis. The mortgage loan may be
extended over a long period, often over 25–30 years.
- loan note: It is frequently divided into units (rather
like share capital), and investors are invited to
purchase the number of units they require. Loan
notes of public companies are issued without any
form of security attached to them. They are traded
on the Australian Securities Exchange (ASX), and
their listed value fluctuates according to a
company’s fortunes, movements in interest rates,
and so on.
- Debentures: are simply loan notes that are secured
by a fixed and/or a floating charge over the issuing
company’s assets and evidenced by a trust deed.
Loan notes and debentures are usually referred to
as ‘bonds’ in the United States and increasingly
elsewhere.
- Eurobonds: are issued by listed companies (and
other organisations) in various countries, and the
finance is raised in countries other than the country
of the denominated currency. Despite their name,
they are not necessarily linked to Europe or the euro
currency. They are bearer bonds, which are often
issued in US dollars but may also be issued in other
major currencies, such as Australian or New Zealand
dollars. Interest is normally paid on an annual basis.
 Interest rates on loan finance may be either floating or
fixed:
- A floating (variable) interest rate means that the
required rate of return from lenders will rise and fall
with market interest rates. However, the market
value of the lenders’ investment in the business is
likely to remain fairly stable over time.
- Loans with a fixed interest rate and debentures
have a constant interest payments that doesn’t
change with a rise or fall in the market rates of
interest, but the resale value of the investment (the
loan or debenture) will fall when interest rates rise
and will rise when interest rates fall.
- A business may issue redeemable loan capital which
offers a rate of interest below the market rate. In
some cases, the loan capital may have a zero rate of
interest (Zero coupon bonds). Such loans are issued
at a discount to their redeemable value and are
referred to as deep discount bonds.
LECTURE PODS

Thus, a company may issue loan capital at, say, $80

for every $100 of redeemable value. Although
lenders receive little or no interest during the period
of the loan, they receive a gain when the loan is
finally redeemed.
Deep discount bonds may have particular appeal to
companies with short-term cash flow problems. They
receive an immediate injection of cash, and the loan
incurs no significant cash outflows until the maturity
date.
-
 Convertible loan notes (A form of financial derivative):
- They give the investor the right to convert the loan
into equity shares at a future date and at a specified
exercise price.
- The investor remains a lender to the company and
receives interest until the conversion takes place.
- The investor is not obliged to convert the loan or
debenture to equity shares. Normally this is done
only if the market price of the shares at the
conversion date exceeds the agreed conversion
price.
- For an investor, this form can be a useful hedge
against risk with start-up companies.
- For a company, this form of financing may be
considered because:
 the loan is self-liquidating
 a lower rate of interest may be offered
because of future potential gain for the
investor resulting from the conversion.
 Financial issues:
- A finance lease is, in essence, a form of lending,
because if the lessee had borrowed the funds and
then used them to buy the asset itself, the effect
would be much the same. The lessee would have the
use of the asset but also a financial obligation to the
lender—much the same position as the leasing
agreement would lead to.
- Although legal ownership of the asset rests with the
financial institution (the lessor), finance lease
agreement transfers to the business (the lessee)
virtually all the rewards and risks associated with
leasing the item. The lease agreement covers a
significant part of the life of the leased item and
often cannot be cancelled.
- No longer a tax-efficient form of financing due to
changes in tax laws.
- Nevertheless, still growing in popularity because of:
LECTURE PODS

 Ease of borrowing- limited security and

records required.
 Cost- Leasing agreements may be offered at
reasonable cost.
 Flexibility – sometimes an option to cancel
may be included.
 Cash flow – large outflows can be avoided
and spread over the life of the asset.
- A finance lease should be distinguished from an
operating lease, where the rewards and risks of
ownership stay with the owner and where the lease
is short term.
 Sale & lease-back arrangement:
- Involves the business selling an asset to raise
finance, with an agreement to lease the asset back
so it can still be used by the business
- Usually agreements are reviewed periodically
throughout the lease, making future payments
difficult to predict
- At the end of the lease, the business must either
renew the lease or, in the case of property, find
alternative premises
- Although the sale of the premises will provide an
immediate cash injection to the business, it will lose
benefits from any future capital appreciation on the
property. Where a capital gain is made by selling the
premises to the lessor, a liability for taxation may
also arise. A sale and lease-back agreement can be
used to help a business focus on its core areas of
competence.
 Securitisation:
- Bundling together illiquid financial or physical assets
of the same type so as to provide financial backing
for an issue of bonds.
For example, mortgage loan receivables, credit card
receipts, water industry charges, rental income from
university accommodation.
- Securitisation may also be used to help manage risk.
Where, for example, a bank has lent heavily to a
particular industry, its industry exposure can be
reduced by bundling together some of the
outstanding loan contracts and making a
securitisation issue.
- Mortgage securitisation with ‘sub-prime’ loans a key
factor in financial crisis

EXTERNAL SOURCES OF SHORT- TERM FINANCE:

 Bank overdraft:
LECTURE PODS

- Flexible form of borrowing that allows a business to

have a negative balance on its bank account.
- Form of a revolving credit.
- Size of credit limit can be varied depending on
requirement.
- Relatively easy and inexpensive to arrange and
overdraft interest rates are often very competitive.
- Banks prefer to grant overdrafts that are self-
liquidating—that is, the funds applied will result in
cash inflows that will extinguish the overdraft
balance.
- One potential drawback with this form of finance is
that it is repayable on demand. This may pose
problems for a business that is illiquid.
- In practice, many businesses operate on an
overdraft, and this form of borrowing, although
theoretically short term, can often become
effectively a long-term source of finance.
 Promissory Notes:
- A promissory note is a financial instrument whereby
the borrower (also called the ‘issuer’ or ‘drawer’)
promises to pay a sum of money to the investor or
lender (also called the ‘holder’ or ‘bearer’) at a
specified future date.
- Usually, no added security is offered and so the debt
is only as good as the borrower’s promise—thus the
name. Because no one except the borrower has any
obligation to repay the debt, promissory notes are
often known as one-name paper; they are also called
commercial paper. That’s why their use is also
limited to ‘prime’ borrowers with very good credit
ratings.
- The investor or lender can sometimes sell the debt
to another person who then ‘holds’ the debt that is
payable by the borrower. Thus, the current holder
(or bearer) of the promissory note may be the
original lender or may be a subsequent buyer of the
debt.
 The investor or holder outlays a sum of money, the principal
P, for a period of n days. The future sum of money repayable
by the borrower, after n days, can be labelled V (which
represents the maturity value or face value). The amount V
is greater than P and thus includes an interest element. This
amount of interest is conventionally called the discount, D.
In other words, the face value V is ‘discounted’ by D to give
the principal P. That is:
D = V – P = interest
LECTURE PODS

The issue commercial papers are sometimes underwritten,

which means that there is an underwriter (such as the bank
or merchant bank) who agrees to make good any funds that
are not contributed by investors. The underwriter is paid a
fee for this service.

Cost of promissory note finance:

The following Equation calculates the annual interest rate
for a discounted type instrument such as a promissory note:
V -P 1
R A TE = ´
P (n / 3 6 5 )
Cost of promissory note finance:
Example: PN Company draws a promissory note with a face
value of $100 000. It is issued on 1 July and matures on 31
July.
What is the annual interest rate earned if the drawer
receives $99 023?
V - P 1
R A T E = ´ =
P (n / 3 6 5 )

=
($ 1 0 0 , 0 0 0 - $ 9 9 ,0 2 3 )
´
1
= 0 .1 2 = 1 2 % p .a .
$ 9 9 ,0 2 3 (3 0 / 3 6 5 )
LONG- TERM VS SHORT-TERM BORROWING:
 Bills of Exchange:
- A bill of exchange (also known as a commercial bill)
is another member of the family of discount-type
financial instruments. However, whereas a
promissory note contains a promise by the borrower
to repay the debt at maturity, a bill of exchange is a
written order that requires payment to be made,
either on demand or at a specified time. Typically,
bills have maturity values of $100 000 or $500 000.
- They are negotiable discounted short term financial
securities.
- The parties involved are: drawer/borrower,
accepter/guarantor, discounter/lender and endorser
(read example 5.2 on page 114 in the text).
- Bank bill A commercial bill that has been either
accepted or endorsed by a bank.
- Rollover facility: a chain of successive bills can be
arranged (on a rollover basis) to extend the term.
Typically, such rollovers are arranged between the
drawer and a bank.
 Debt factoring:
- Is a form of service offered by a financial institution
(a factor) – often a subsidiary of a commercial bank.
LECTURE PODS

- Involves the factor taking over a company’s sales

ledger (i.e. the accounts receivable).
- Besides collecting and operating normal credit
control procedures, a factor may offer to make
credit investigations and to provide protection for
approved credit sales.
- The factor is usually prepared to give a loan to the
company up to 85% of approved accounts
receivable.
- Fee is normally 2–3% of receivables turnover.
- Can deliver benefits such as more certain cash flows,
savings in credit management.
- Some negatives can include high cost and adverse
customer reaction. Also, some might see a factoring
arrangement as an indication that the company is in
financial difficulties. This may have an adverse effect
on people’s confidence in the company.
 Invoice discounting:
- Financial institution is approached for a loan for 75–
80% of the value of the approved credit sales
outstanding.
- Repayment is made usually within 60–90 days
- Business remains responsible for the receivables’
collection
- Is confidential – customers unaware of it
- Cost is cheap compared with factoring
- Allows company to retain control of sales ledger and
relationship with customers
- Invoice discounting may be a one-off arrangement,
whereas debt factoring usually involves a longer-
term arrangement between the company and the
financial institution
- Is growing in popularity more than factoring

There are several issues to take into account when deciding

between long-term and short-term borrowing including the
following:
- Matching:
 borrowing to match the nature of an asset
on the basis of time or permanency. Non-
current (Long term) and permanent current
assets are financed by long-term borrowing
and current (short term) assets are financed
by short-term borrowing (SEE GRAPH NEXT
SLIDE).
- Flexibility:
 Short-term borrowing may be useful to
postpone making a commitment to a long-
LECTURE PODS

term loan, especially if interest rates are

high but are forecast to fall in the future.
 Short-term borrowing does not usually incur
penalties if the business makes an early
repayment of the amount outstanding,
whereas some form of financial penalty may
be incurred if long-term borrowing is repaid
early.
- Re-funding risk:
 Short-term borrowing has to be renewed
more frequently than long-term borrowing.
This may create problems for a business in
financial difficulties or if there is a shortage
of funds available for lending.
- Interest rates:
 Interest payable on long-term debt is often
higher than for short-term debt because
lenders require a higher return when their
funds are locked up for a long period. This
may make short-term borrowing a more
attractive source of finance for a business.
Other set-up costs (such as; renewable fees)
should also be considered.
Short-term and long-term financing relationships: The broad
consensus on financing seems to be that all permanent financial
needs of the business should come from long-term sources. Only
that part of current assets that fluctuates on a short-term,
probably seasonal, basis should be financed from short-term
sources.
LECTURE PODS

RAISING LONG-TERM EQUITY FINANCE:

 The role of the Australian securities exchange:
 Share issues: A company may issue shares in various ways.
The most common methods of share issue are as follows:
- Rights issues:
 An issue of shares for cash to existing
shareholders on the basis of the number of
shares already held, at a price that is usually
lower than the current market price.
 Issue price is usually significantly below
current market value
 Rights issue can be renounceable or non-
renounceable
 Issue expenses are quite low, and issue
procedures are simpler than those of other
forms of share issue.
 No dilution of ownership control, diluted,
provided shareholders take up the rights
offer.
 Accelerated rights issues Rights issues of
this type are structured in two phases, with

an initial (accelerated) issue to institutional

investors (who will pay quickly) followed by
a (non-accelerated) issue to the retail (non-
institutional) component of the
shareholders.
 Shaw Holdings Ltd has 20 million ordinary
shares which were issued at 50¢ each and
are currently valued on the ASX at $1.60 per
share. The directors of Shaw Holdings
believe the company requires additional
long-term capital and have decided to make
a one-for-four issue (i.e. one new share for
every four shares held) at $1.30 per share.
 The first step in the valuation process is to
calculate the price of a share following the
rights issue. This is known as the ex-rights
price.
 In the Shaw example we have a one-for-four
rights issue. The theoretical ex-rights price
is, therefore, calculated as follows:
LECTURE PODS

As the price of each share, in theory, should

be $1.54 following the rights issue and given
that the price of the rights share is $1.30,
the value of the rights offer will be the
difference between the two:
$1.54 – $1.30 = $0.24 per
share

- Dividend reinvestment:
 With a dividend reinvestment plan,
shareholders are permitted to reinvest all or
part of their dividend payments in new
shares.
 Such a plan can be a very efficient source of
funds for a company that pays dividends.
Surprisingly large sums are raised. Many
companies listed on the ASX have plans of
this sort.
- Offer for sale:
 Involves a public limited company selling
shares to a financial institution known as an
issuing house. The issuing house, in turn,
sells the shares purchased from the
company to the public.
 The advantage of an offer for sale from the
company’s viewpoint is that the sale
proceeds of the shares are certain. The
issuing house takes on the risk of selling the
shares to investors.
 This type of issue is often used when a
company seeks a listing on the ASX and
wishes to raise a large amount of funds.
- Public issue:
 Where the company makes a direct
invitation to the public to purchase shares,
usually in a newspaper advertisement.
 Issuing house may be used to help
administer the issue of the shares to the
public and to advise on an appropriate
selling price.
 Price is either set upfront or can be set by a
‘tender issue’ process (not widely used, not
popular with investors)
- Private placing:
 Shares are ‘placed’ with selected investors
such as large financial institutions
 Quick and cheap way of raising equity funds
 May lead to concentrated ownership in a few
hands
LECTURE PODS

 Usually used by unlisted companies seeking

relatively small sums of cash
 ASX imposes a limitation on companies of
15% of their capital on these issues in a 12-
month period, or more than 15% if
accompanied by a share purchase plan (SPP)

TUTORIAL QUESTIONS:
5.1.1 Textbook Question 5-1
- Both preference shares and loan capital are forms of
finance which require the company to provide a
particular rate of return to investors. What factors may
be taken into account by a company deciding between
these two sources of finance?
- What advantages does a company gain by having a
floating charge rather than a fixed charge on its assets?
When a business borrows money from a lender such as a
bank or another financial institution, it is not unusual for
the lender to ask for security for the debt. This helps to
protect the lenders position as it can seize and sell the
asset that has been given as security if the loan cannot
be repaid.
The idea of providing security for a loan is a concept
most business owners will be familiar with, after all,
it’s something all homeowners do when arranging a
mortgage. However, the confusion often comes with
the two different types of charge, fixed and floating,
that are used to give lenders security over the assets
of a business.
** Fixed charge: if a det is subject to a fixed charge, the
borrowing will be secreted against a substantial and
identifiable physical asset such as land, property,
vehicles, plant and machinery. If the business is unable
to keep to the terms of the finance agreement, the lender
will take charge of the asset and look to sell it in order to
recoup the money it is owed.
When a lender has a fixed charge, it effectively has full
control over the asset the charge applies to. If the
business wants to see, transfer or dispose of the asset, it
will have to get permission from the lender first or pay
off the remaining debt. It is also important to note that a
fixed charge gives the lender a higher position in the que
than a floating charge for the repayment of the debt in
the event of the borrower’s insolvency.
Examples of financial arrangements that are commonly
subject to a fixed charge include: Mortgages, leases,
bank loans, and invoice factoring arrangements.
** Floating Charge: A floating charge applies to assets
with a quantity a value that can change periodically, such
as stock, debtors and moveable plant and machinery. It
gives the business much more freedom than a fixed
charge because the business can sell, transfer or dispose
LECTURE PODS

of those assets without seeking approval from the

lender, or having to repay the first debt.
From the lenders point of view, a floating charge leaves it
more exposed than a fixed charge because the value of
the assets can and will change over time. However, it is
not possible to attack a fixed change to every company
asset, which is why floating charges are used.
** Difference:
(1)A fixed charge applies to a specific identifiable asset,
while a floating charge is dynamic in nature and
generally applies to the whole of the company’s
property
- What type of asset is best suited to a sale and lease-back
arrangement?
- Are retained earnings a free source of finance to the
business?
5.1.2 Textbook Question 5-3
5.1.3 Textbook Question 5-6
5.1.4 Textbook Question 5-11
5.1.5 Textbook Question 5-13

(WEEK 6):
FINANCING THE BUSINESS: SHORT AND LONG-TERM
SOURCES OF FUNDS (CONTINUED)
(WEEK 7):
ENTREPRISE GEARING, COST OF CAPITAL, AND
PROFITABILITY: RATIO AND TREND ANALYSIS
(WEEK 8):
THE AUSTRALIAN AND GLOBAL FINANCIAL MARKETS
(WEEK 9):
INTRA SESSION BREAK
(WEEK 10):
LECTURE PODS

ENTREPRISE PERFORMANCE AND THE MACROECONOMIC

ENVIRONMENT / GDP: MEASURING TOTAL PRODUCTION,
INCOME AND ECONOMIC GROWTH
(WEEK 11):
UNEMPLOYMENT AND INFLATION
(WEEK 12):
MONEY, INTEREST RATES, BUSINESS CYCLE AND
ECONOMIC POLICY
(WEEK 13):
ENTREPRISES AND THE ECONOMIC POLICY