HSC BUSINESS STUDIES

Summary notes: HSC Business Studies

HSC Topic 3: Finance

Unit 3.1– Role of financial management

Strategic role of finance

 The strategic role of financial management is the planning, monitoring and controlling of the
business’ financial resources to ensure that it is achieving its financial objectives in both the
short and long term.
 The finance department ensures that financial assets are readily available when needed, and
are in charge of regulating financial data such as income statements and balance sheets.

Objectives of financial management

 Profitability is the ability of a business to maximise its profits, allowing the owner to
continue running the business in the long term.
 Efficiency is the ability for a business to use its resources to its maximum potential to ensure
financial stability and profitability.
 Growth is the ability to increase the size of the business in the longer term, and allows the
business to accumulate more profit as well as being competitive in the environment.
 Liquidity is the extent to which a business can meet its financial commitments in the short
term.
 Solvency is the extent to which a business can meet its financial commitments in the long
term.
 In the short term businesses will set financial objectives based on achieving something in a
year.
 Long term objectives are the strategic plans of the business, and tend to be broad goals in
which the business aims to achieve.
 Short term goals can be implemented in order to assist the business achieve its long term
financial objectives.
 However, short term and long term objectives can clash in terms of how much funding will
be placed into short-term commitments and how much will be placed into long term
commitments. Therefore, liquidity and solvency performance can clash depending on the
business’ short term and long term financial objectives.

Interdependence with other key business functions

 Interdependence refers to the mutual dependence of a business’ key functions in order to
achieve their long term goals.
 Operations manufacture the product, transforming the product from raw materials and
resources into finished goods or products.
 Marketing aims to meet the needs and wants of a consumer, looking at all aspects and
buying and selling, then developing marketing strategies to maximise their sales.
 Finance records and summarises financial transactions through reports such as balance
sheets and budgets, and generally manage the financial side of businesses. The finance
function is in charge with designating funds to certain business activities.
 Human resources ensure that the right people are employed by the business, as well as
ensuring that the employees are adequately trained to fit for purpose. HR plays an
important role as the efficiency and productivity which the business performs its activities is
significantly based on staff.
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Unit 3.2– Influences of financial management

Internal sources of finance

 Internal sources of finance is finance which either come from the business’ owner, such as
owner’s equity, or the achievements gained from the businesses activities, such as retained
profits.
 Retained profits are the earning of a business that is not distributed, though kept in the
business to be an accessible source of finance for future activities. Retained profits are
therefore used to further invest in the business to allow it to grow.

External sources of finance

 External sources of finance are fund that are provided from sources outside of the business
such as banks, the government, suppliers or financial intermediaries. External sources of
finance can be divided into debt finance as well as equity.
 Debt finance refers to obtaining finance from people or institutions other than the owners of
the business. The business may prefer to use this method of external financing due to being
tax deductible as well as retaining their ownership of the business.

Short-term debt financing

 Short term borrowing through financial institutions is used if a business is in temporary
shortages in cash flow or finance for working capital. This sort of debt will be repaid within a
year, and is usually used to fund short term projects of to assist in the business’ liquidity
issues.
 Bank overdrafts are a source of finance that allows a business to overdraw their account up
to an agreed limit. This source of finance is usually used to overcome short term liquidity
problems.
 Commercial bills are a type of exchange issued by institutions other than banks. Commercial
bills involve providing funds which need to be paid by the business at a designated time,
usually between 90 and 180 days. Commercial bills typically exceed $100,000 and are used
to fund short term projects.
 Factoring is the selling of accounts receivable for a discounted price to a finance or factoring
company. The business can use this if it needs an immediate source of funds to overcome
liquidity problems.

Long-term debt financing

 Long-term borrowing relates to fund borrowed for a period longer than the accounting
period. This type of borrowing is usually used to fund for non-current assets.
 Mortgages are loans secured by the property of the borrower, and that property cannot be
sold or used as security for further borrowing until the mortgage is repaid. Due to there
being less risk in this method of financing, interest rates are lower.
 Debentures are issued by a company for a fixed rate of interest and for a fixed period of
time, offering security to the lender over the company’s assets. Debentures are prominently
used by finance companies to borrow money that they could relend at a much higher
interest rate.
 Unsecured notes are loans for a set period of time but are not backed up by any assets,
therefore being a risk to investors. However, only businesses with a positive credit rating can
use this method of finance.
 Leasing is the long term source of borrowing for businesses where there is a payment of
money given by a business for the use of equipment that is owned by another party. This
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method has become increasingly popular for businesses, due to having no upfront payments
and being able to update technology more easily. Additionally, by leasing instead of
purchasing assets the business frees up cash that can be used for other means.

Equity financing
 Equity finance refers to the owner contributing to the funding of the business. This can be
raised through the Australian Securities Exchange, privately or internally through retained
profits.
 Ordinary shares are shares which are traded in Australia, and represent having part
ownership of the business. By purchasing shares, they receive a percentage of profits from
the business called a dividend.
 New issues are securities that are being sold or issued for the first time in the public market.
 Rights issue is the privilege granted to shareholders to buy new shares in the same company,
usually at a discount to the market price.
 A share placement is where the business arranges the sale of large blocks of shares to
investment institutions directly.
 A share purchase plan is an offer to existing shareholders in a listed company an opportunity
to purchase more shares in that company without brokerage fees, being a cheap and easy
way to raise additional finance. Additionally, the business can offer a discount.
 Private equity is the investment of businesses that are unlisted on the Australian Securities
Exchange.

Financial Institutions
 Financial institutions are businesses that buy and sell financial products, and there are
various examples outlined in the syllabus.
 Banks are major operators in the financial market which receive savings as deposits from
individuals and businesses, and in turn, make investments and loans to borrowers. These
banks provide financial products such as personal loans, overdrafts, bank bills and leasing.
 Investment banks are financial institutions that help individuals, businesses and the
government in raising capital, though do not take deposits. Investment banks conduct
actions including trades in money, securities and financial futures, providing working capital,
arranging project finance and arranging long-term finance for company expansion.
 Finance companies are a non-bank financial intermediary that specialises in smaller
commercial finance. Finance companies provide consumer credit and small business loans
and raise capital through the use of debentures. Additionally, finance companies are
becoming increasingly important for lease financing, providing the use of assets in return for
regular payments.
 Superannuation funds provide funds to individuals and the corporate sector through using
their superannuation contributions to invest in long-term securities, government and
company debt due to their long-term nature.
 Life insurance companies provide loans to the corporate sector through receipts of
insurance premiums. The insurer promises to pay a business or individual a sum or money
when the insured person dies, and in return the business owner pays annual premiums.
These premiums are used by these companies to invest in financial assets.
 Unit trusts take funds from a large amount of beneficiaries (investors) invest their funds in
specific types of financial assets. Therefore unit trusts are a type of investment vehicle for
pooling the investment resources of a number of individual investors.
 The Australian Securities Exchange was created after a merger of the Australian Stock
Exchange and the Sydney Futures Exchange in July 2006, and acts as a primary stock
exchange group in Australia. The ASX provides market-place services for investors to trade
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stock, bonds and other securities. They deal with both primary markets, where businesses
have the intention of raising capital through issuing debt instruments and secondary
markets, which deal with the buying and selling of existing securities.

Influence of Government
 The Australian Securities and investments commission is an independent statutory
commission accountable to the commonwealth parliament. ASIC holds various roles,
including:
o Protects consumers, investors and creditors and ensures that businesses have fair
financial practices by enforcing financial laws such as the Corporations Act.
o Assists in the minimisation of fraud and unfair practices in financial markets.
o The supervision of trading in Australia’s equity, derivatives and futures markets.
 Company taxation is the amount Australian businesses have to pay through their profits,
consisting of a flat rate of 30% taxable profit paid to the Australian Government. The federal
government may choose to reduce company taxation in order to drive up long-term
economic growth through making Australia look like a better place to invest.

Global market influences

 Due to globalisation creating more interdependence between economies and the business
sector, it is necessary for businesses to be aware of the risks associated with global markets.
 The economic outlook refers to the projected changes of the level of economic growth
throughout the world and how these events may impact the local economy and decisions of
the business. If the economy reflected unfavourably to customers, there would be a
decrease in confidence and spending. The economic outlook can therefore impact on the
level of demand for products and services, and thus, the level of production and
employment. A business must be aware of the economic outlook before making financial
decisions, due to their significant effect on customer confidence.
 Availability of funds refers to the ease in which a business can access funds in the
international market. When confidence is high, money for loans are readily available.
However, if the economy is in an unfavourable stage, there will be a decrease in the
availability of funds which can result in a sharp increase in interest rates due to increased
risk.
 Interest rates are the cost of borrowing money, with a higher risk business having a higher
interest rate when borrowing. These interest rates are based on the economic performance
of different countries. Because of this, businesses in Australia may be tempted to take
advantage of lower interest rates from overseas, though there is the risk of exchange rate
movement.

Unit 3.3– Processes of financial management

Planning and implementing

 There are various aspects of finance that the CFO needs to plan and implement in order to
most efficiently and effectively achieve its objectives. The business needs to determine
financial needs, develop budgets, implement a records system, investigate financial risks and
identify financial controls. Therefore financial planning is essential as it determines how a
business will achieve its financial goals.
 Firstly, a business needs to determine their financial needs, which is how much finance will
be needed to achieve the business’ objectives and when they will be needed. The collection
of data such as balance sheets, income statements and cash flow statements can assist in
the process by analysing the business’ current performance. This allows the business to
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identify how much funding is needed the most appropriate method of funding and to
determine whether the business can generate an acceptable return for the investment.
 The business then needs to develop budgets, which provide financial information in figures
and statistics about the requirements to achieve a particular goal. Budgets can reflect on the
business’ financial status through operating (production, sales, and raw material), project
(research and development) and financial (data such as income statements) budgets and
these are used to predict a range of activities relating to short and long term plans.
 Businesses have record systems which are mechanisms employed by a business to ensure
that data is recorded and the information provided by these systems is accurate, reliable,
efficient and accessible. Large businesses use Management Information Systems to monitor
all aspects of the budgetary process. By developing sophisticated record systems, the
business is able to minimise errors so that data is reliable and can be used to guide business
activities.
 A business needs to identify the financial risk of executing their future activities. Financial
risk refers to the possibility of the business not being able to repay its debts when required,
and bankruptcy would result. Therefore the business needs to evaluate the level of risk and
determine whether enough profit will be generated
 Financial controls are the policies and procedures that ensure that the plans of the business
will be achieved in the most efficient way. The purpose of controls is to ensure that if there
is a disparity between planned and actual results the business will take corrective action
through the implementation of policies and procedures.

Debt and equity financing

 The business will make their choice of what type of financing to use depending on the risk
the business is willing to take, how much funding is needed and the potential returns the
business can make from using these funds.
 Debt finance relates to the short and long term borrowing from external sources by a
business.
Advantages Disadvantages
 Funds are readily available for the  Lenders have first claim on any money
business if the business ends in bankruptcy.
 Increased funding usually leads to  Increased risk due to interest, bank
a higher potential to earn more charges, government charges and the
profit principal have to be repaid.
 Tax deductions can be made for  Regular payments have to be made to
interest payments the banks
 Equity finance relates to the finance raised by the business internally through the issuing of
shares or retained profits.

Advantages Disadvantages
 No interest payments and therefore  Lower profits and lower returns to
cheaper the owner.
 Owners contribute the equity and  The owner has less ownership of the
therefore have control on how it is company as they may have issued
used shares
 Low gearing  Dividends are not tax deductable

Matching terms and sources of finance with business purpose

 Simply this means that only short term funds should be used to pay short term debt while
long term funds should be used to pay long term debt.
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 Additionally, the business should only engage in long-term loans if it were to pay for long-
term investments, such as machinery or vehicles.
 The business must consider which one of the sources of financing, dent or equity is suitable
for its current position. This depends on what level of ownership the business wants to
maintain, the costs of setting up the finance and the availability of finance.

Monitoring and controlling

 The business monitors the business to ensure it is heading at the right position, as well as
monitoring internal and external factors that can affect the business. The business also
controls factors by taking advantage of opportunities and trying to avoid certain scenarios
which can lead to financial problems.
 A cash flow statement is a financial statement which shows the movement of cash receipts
and payments from transactions over a financial period, and is used to show how effectively
finance is being used, as well as showing if the business has the ability to repay funds in
unforeseen circumstances. Therefore a cash flow statement mainly reflects on the status of
the business. The cash flow statement records operating, investing and financing activities,
and can show the business whether they can generate a favourable cash flow, pay its
financial commitments and have sufficient funds for future expansion or change.
 Income statements are statements which show the operating result of the business period,
including revenue received, costs incurred and the gross and net profit. From these income
statements managers can analyse trends to help them make important financial decisions,
as well as showing why something has increased or decreased. Income statements show the
revenue made by the business, the cost of goods sold and operating expenses, all which are
used to calculate gross and net profit.
 Balance sheets are a financial representation of the value of the business’ assets and
liabilities at a particular point of time, showing the businesses financial stability in terms of
liquidity and solvency. The balance sheet shows if the business has enough assets to pay its
debt, how many assets are used to maximise profits and whether the interest and money
borrowed can be repaid. The balance sheet contains current assets, non-current assets,
current liabilities, non-current liabilities and owner’s equity.

Financial ratios
 Financial ratios are data used by businesses to analyse their performance over a period of
time, and this allows them to set their financial strategies according to the results. The
financial ratios in the syllabus assess the liquidity, solvency, profitability and efficiency of a
business.
Current Assets
 The current ratio measures liquidity, and is in the form of . A business
Current Liabilities
must find an optimum ratio in regards to their situation and industry, as too little assets may
result in a shortage of funds while a high ratio means that assets are not being used,
showing that the business can make more profit.
 The debt to equity ratio measures the solvency of a business, showing how reliant the
Total Liabilities
business is on outside sources of finance, and is in the form of . The higher
Owners Equity
the ratio, the less solvent the firm.
 The gross profit ratio represents the amount of sales the business has received and reflects
Gross Profit
on how well their policies have performed. The equation is . When the ratio is
Sales
higher, it shows that the business is performing better.
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 The net profit ratio represents the profit returned to the owner, and is expressed in the
Net Profit
form of . A business will be aiming to make this as high as possible, a low ratio
Sales
reflecting that the expenses should be examined to see if reductions can be made.
 The return on equity ratio shows how effective the funds contributed by the owner have
Net profit
been in generating profit, .The higher the ratio the better return the owner
Total Equity
receives.
 The expense ratio shows the expenses of the business to the sales, assessing the overall
Total Expenses
efficiency and showing the amount of sales allocated to individual expenses,
Sales
. This ratio performs in an operational basis and businesses aim to keep this ratio to a
reasonably low level, high expense ratios reflecting on poor management.
 The accounts receivable turnover ratio measures the effectiveness in the business’ credit
Sales
policy on how they collect its debts. The ratio is 365/ , and shows how
Accounts receiable
many days it takes for the business to collect debt.If the calculation in the denominator is
high than the business is efficient in collecting debt, as this leads to a lower amount of days.

Comparative ratio analysis

 Businesses have to compare their ratios for them to have any substance and to analyse the
business’ performance. Thus by comparing ratios the business can reflect upon its position in
the market as well as its performance opposed to prior years.
 This can be done by analysing the ratio performance of a business over a number of years or
being compared to businesses in the same industry.
 Additionally, a business can analyse the data through comparing predicted figures to actual
figures, also known as benchmarking.

Limitations of financial reports

 There are issues that the business needs to consider when analysing financial information, to
ensure that the business makes the right financial decisions.
 Normalising earnings is where the business needs to remove one abnormal influence from a
balance sheet to show the true earnings of a company.
 Capitalising expenses is where expenses are considered as a capital item and a put in
balance sheets rather than an income statement.
 Valuing assets is the process where the business estimates a particular asset or liability’s
value. and can be achieved through the use of different methods including:
o Discounted cash flow method – Valuing based on expected future cash flows,
discounted to the present value.
o Guide company method – Determining the value by observing prices of similar
companies that sold in the market.
 Timing issues are concerned with the false representation of a business’ financial position
due to seasonal fluctuations or other factors.
 Debt repayments – As financial reports do not disclose specific information on debt
repayments, it may be difficult to make a judgement. Examples include:
o The amount of time the business has recovered the debt.
o Have debts been held until another accounting period giving a false impression of
the situation.
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o Additional information may be left out of the main reporting documents, containing
important information such as accounting methodologies used for reporting and
recording transactions.

Ethical issues relating to financial reports

 Businesses have obligations to abide by their ethical and legal responsibilities in financial
management, and legislation is put in place to ensure that unethical practices are avoided.
 Auditing accounts - An audit is an independent check of the accuracy of financial records
and accounting procedures. Financial institutions, owners and shareholders rely on financial
records before making decisions about the business; therefore it is essential that auditing is
conducted to ensure that the information given is reliable. Through the Corporations Act
2001 (Cwlth) external audits are mandatory to guarantee authenticity.
 Record keeping - Source documents must be created for every transaction which happens in
a business. Businesses may avoid recording transactions to evade tax, though to ensure this
does not happen, the Australian Taxation Office monitors business operations, and those
found to be evading taxes will receive fines.
 Goods and services tax obligations - The GST was implemented to make it difficult for
businesses to avoid tax, as it is collected at every stage in the production of goods and
services sold to the public. The business therefore has the legal and ethical requirement to
comply with the tax.
 Reporting Practices - Shareholders are entitled to access a business’ financial information to
view its performance. A business may pretend that profit is lower than it should be in order
to reduce tax and pay less for dividends. This has negative consequences including making it
more difficult to acquire funding from financial institutions, as well as being unethical and
illegal.

Unit 3.4– Financial management strategies

Cash flow management

 Cash flow management is the monitoring and controlling of the movement of cash in and
out of a business over a period of time. This is important as it identifies to the business
periods where shortages and abundances of cash occur, allowing them to develop strategies
to deal with this. This process therefore summarises how the business will pay for short term
liabilities.
 Sources of cash flow includes operational flows, from producing and selling the product,
financial flows, through debt and equity financing, and investment flows, the buying and
selling of non-current assets.
Cash flow Management Strategies What they do
Distribution of payments Spreading expenses over a period of time to avoid cash
shortfalls. This is achieved when managers understand the
pattern of cash inflows and outflows for the business and link
their payments to when they have higher cash inflows. A
business that receives regular cash inflows would find it
desirable to spread payments evenly throughout the year. By
doing this the business is avoiding the excess fees of borrowing
funds through financing during times of excess outflows.
Discounts for early payments A business may offer discounts to businesses if they pay earlier
than required. This allows a quicker payment from customers
and stimulates cash flow for the business, especially for
customers who have spent large amounts.
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Factoring The selling of accounts receivable for an instant source of

funding and speeds up cash inflow. This is usually sold to a
factoring business at a discount; therefore the original total
current asset value would be lower, though the business will
have an immediate source of income.
Working Capital Management
 Working capital is needed so businesses can extend their financial commitments, such as
buying stock, meeting its current debts and extending credit to customers.
 The business needs to manage working capital effectively, as too little working capital will
lead to liquidity difficulties, while too much working capital negates the maximisation of
growth and profit for the business as the business does not utilising all of its current assets.
 Working capital management is associated with managing the overall liquidity of the
business, the overall mix of current assets and liabilities and the control of each component
of these assets and liabilities to ensure that there is a balance between using funds to make
profit and holding funds to cover payments.

Control of current assets

 A business needs to control its current assets effectively as too much of certain assets such
as inventories or accounts receivable can lead to an increase of unused assets, leading to
increased costs.
 Cash is used by the business to pay its debts, though cash shortages can create problems in
terms of liquidity to the business. Additionally, cash is needed for managers to further invest
into the business.
 However, the business must ensure they do not have an excess amount of cash due to not
being used to maximise products, yet needs enough cash to ensure they can cover
unforseen expenses.
Strategies to the control of cash
 A business can arrange a bank overdraft to overcome shortages
 The business can plan the timing of cash payments and asset purchases to avoid these
situations. This is achieved through a cash budget
 Receivables are customer debt owed to the business, giving them a certain amount of days
to pay it back. The business needs to ensure that receivables are paid in a time which it
would be needed. The firm’s position is strengthened if debtors pay faster.
Strategies to the control of Receivables
 Implementing a credit policy which sets guidelines on how staff monitors and collects
debt, setting a credit limit (maximum a business can borrow), a credit period (amount of
days to pay back), and collection policies, which has a guide to staff on how to deal with
collecting bad debt
 Factoring is the process where customer debts are sold to a financial institution for a
discounted price, and is used to gather a quick source of funds
 Inventories are the amount of stock that is stored within a business, and make up a large
amount of a business’ current assets. This need to be managed to ensure there is not an
excess or shortage of inventory for the business to efficiently function. They need to ensure
that their inventory turnover is sufficient enough to generate cash to pay their suppliers.
Strategies to the control of inventories
 The business can use the Just-In-Time management strategy to minimise storage costs or
obsolete and damaged stock, and is the process where stock is only ordered when
required
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Control of current liabilities

 Current liabilities are bills that have to be paid in the short term. The business needs to
ensure that they have sufficient funds to minimise their amount of debt.
 Accounts payable refers to the money the business owes to its suppliers, and the business
needs to develop strategies to maximise the benefits and eliminate potential dangers.

Strategies to the control of payables

 The business can attempt to receive extended terms for payments, sometimes offered
without interest of other penalties, which is known as stretching.
 The business can attempt to receive discounts for the early payment of payables.
 The business can pay the accounts payable at the latest date specified by the trade credit,
allowing them to accumulate the funds needed for longer while no incurring excess fees.
 Overdrafts are a form of short term borrowing which allows businesses to overdraw their
account to an agreed limit.
Strategies to the control of overdrafts
 Repaying overdrafts with retained profits, and the terms of an overdraft should be
negotiated.
 Budgeting cash to ensure that the use of overdrafts is not needed by the business
 Loans are an important source of finance in the short term and are used to cover unforeseen
circumstances and to cover export and import commitments.
Strategies to the control of loans
 The business should assess whether the project they need the loan for their potential
risks and returns to see whether it is worth it.
 Businesses can investigate alternative source of funds from different banks and financial
institutions to get the cheapest expense.

Strategies for managing working capital

 Leasing is a contract which allows a business to use an asset in return for regular payments
to the owner. This strategy is advantageous as it frees up cash and is an expense and
therefore tax deductible. Conserves working capital due to no upfront fees being paid.
 Sale and lease back is the process of selling an owned asset and then leasing it back, and is
used to increase liquidity as it increases cash on hand, which can be used by the business in
other means.

Profitability Management
 Profitability management is the control of the business’ costs and revenue, and the business
will aim to reduce costs and increase revenue to stay competitive in the market. It is usually
businesses that have lower cost structures that are the most competitive within their
industry, due to having more dominance over price.

Cost Controls
 To effectively manage cost controls the business should benchmark costs with their
competitors. By doing this the business identifies parts of their operations which there are
high difference in costs. Once they identify this the business develops strategies to minimise
them. There are various ways to achieve this, as shown below.
 The business will try control costs so that managers have the opportunity to either increase
profits or reduce prices.
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 Fixed costs are the expenses that do not vary with output, while variable costs increase with
output. The business needs to investigate areas where there are excessive variable costs
through the use of benchmarking, and implement strategies to decrease them.

 A cost centre is any department of the business that incurs significant costs.The business
tries to control these cost centres by recording and measuring the usage of finance in that
function and aim to pick up excessive expenses. The business then can take up corrective
action to minimise these costs.
 Expense minimisation is the process of reducing costs to the minimum possible. Expense
minimisation can be achieved through implementing guidelines and policies aimed at
minimising expenses and monitoring the costs of the business and eliminate waste and
unnecessary spending.

Revenue controls
 Businesses need to effectively manage revenue controls to ensure that the business
maximises its profits. A business needs to develop marketing objectives in order to get
direction on an acceptable level of revenue to maximise costs.
 The business must implement sales objectives that will cover costs and result in a margin of
profit. The business needs to consider an appropriate level in which sales can increase by
more effectively meeting customer needs.
 The sales mix is the breakdown of sales revenue by profit. Research needs to be conducted
by the business to assess the customer’s demands for certain products. From the
information, the business can continually improve these products and expand their quantity
in order to increase their revenue and maximise profits.
 Pricing policy is a guide to staff on the overall pricing strategy the business will adopt. The
business will need to determine the demand and supply of their product, as well as the price
of competitor products to develop a good price for their product. Businesses need to decide
on an optimal price that attracts buyers, while making a sufficient amount of profit as
outlined in their objectives.

Global financial management

 There are many benefits for businesses to expand their financial management globally, and
can help reduce costs. However, there are various financial risks associated with the
expansion to a global market. The business can implement appropriate financial strategies to
minimise their negative effects.
 Due to countries having their own currencies if a business were to do transactions with
another country they would need to convert their currency, and the value of this is
determined by exchange rates. Exchange rate fluctuations can create risks for the global
business in terms of trading. For example, an appreciation in Australia’s currency will make
exports more expensive while imports cheaper, and this affects the revenue profitability and
production costs of a business.
 Interest rates are the additional fees gained from borrowing from a financial industry.
Although borrowing from other countries will be cheaper for the business due overseas
rates being significantly lower than domestic interest rates, the business needs to analyse
the movement of the exchange rate to ensure that it does not fluctuate unfavourably. If the
Australian currency were to depreciate any cost benefits earned by the business due to
international borrowing will deteriorate. To combat this, many businesses such as BHP
Billiton use hedging to minimise the effect of these fluctuations.
 There are various methods of payment, and the business needs to choose the most
appropriate one for them and the other party. There are risks involve in payment, including
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foreign exchange and collection issues. There are many types of payment which vary in risk
levels for each party, and the business will make its choice depending on importer’s
credibility.
o Payment in advance–This is a situation where the money is transferred to the
exporter’s bank before the goods are shipped. Maximises the risk for the party
purchasing the product and minimises the risk for the exporter, though the importer
can minimise risk by undertaking basic credit checks.
o Letter of Credit –This is where the importer’s bank guarantees that the agreed
amounts will be paid as soon as the goods arrive into the importer’s warehouse. This
method is popular as the risk for both parties is minimised, though the fees charged
by the banks for this service tends to be high.
o Clean payment –This is where the payment is sent to, but not received by, the
exporter before goods are transported, and the bank’s role is to pay the amount of
money when required. This is a relatively cheaper option due to the businesses
handle the shipping documentation and the bank’s only role is to act as a
middleman.
o Bill of exchange – A document that instructs the buyer to pay for the goods on a
specific date, usually when the goods are delivered.This method is widely used due
to the exporter having control over the goods until payment is made or guaranteed.
There are two types bill of exchanges:
 Document against payment – Importer can collect the goods only after
payment.
 Document against acceptance –Importer may collect goods before paying
for them.
 Hedging is a strategy that enables a business to ensure against the effects of the exchange
rate fluctuations, minimising the risk. This can be achieved through entering a contract with
a hedge fund to provide what currency it needs for the spot exchange rate for a period of
time. The hedge fund managers calculate the credit risk (the risk of fluctuation) and charge a
fee for this contract. Hedging allowing the business to negate the danger of unfavourable
movement of the currency.
 Derivatives are simple financial instruments that may be used to lessen the exporting risks
associated with currency fluctuations. Another definition of derivatives is a contract where
the value of a product is derived from the value it had prior.
 Derivatives are used by businesses to hedge against increases in commodities such as oil, as
well as interest rates and currency fluctuations.
 A currency swap is an agreement to exchange currency in the current market with an
agreement to reverse the transaction for the future, therefore removing the credit risk of
currency fluctuation.
 A forward exchange contract is a contract to exchange one currency for another at an
agreed exchange rate on a future date; therefore the party can use the fixed rate for a
specified amount of time, not being affected by fluctuations. Since the Australian dollar has
strengthened against the USD, it means that a business which used this method would gain
more value. Let’s say an Australian business decides to purchase $100 USD for $100 AUD in a
year’s time (The exchange rate being at 1AUD:1USD). If the AUD has strengthened during
this period the exchange rate has changed from $100 AUD for $100 USD to $100 AUD for
$113 USD. Meaning that although it is now at 1: 1.13, the Australian business can purchase it
for 1: 1, therefore making a profit.
 An options contract gives the buyer the right to buy or sell foreign currency at some time in
the future, therefore are protected from unfavourable rate fluctuations though having the
opportunity for gain if favourable. Although businesses have this right there is no obligation
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for the business to buy the currency if it is unfavourable. In return, the people who offer this
receive a premium from the buyer based on the level of risk in initiating the contract, to
ensure that in this agreement they too have the possibility to make a profit.