♣ Clarkey’s Biso’s Notes ♣

Business Studies – Topic 2 – Financial Planning and Management

Chapter 5 (Textbook) – Financial Markets & Funds Management

Australian financial markets

Financial Systems are made up of markets and institutions that enable and encourage the
flow of funds throughout an economy.
The Australian financial system is a complex group of individuals, businesses, markets and
governments continually intermingling with one another.

There are 4 main financial markets in Australia

The SHARE (or The DEBT Market The derivatives The Foreign
equity) Market Market Exchange Market

Where ownership Split into fixed Where financial

shares (such as interest (bond) and assets defined in one
stocks) in companies short term money currency are
are issues and market. exchanged for assets
exchanger (for expresses in another
monetary value)

→ Financial Markets provide a means for the creation and exchange of financial assets.
They can have a physical location (such as Wall Street), but most are just a network of
individuals and institutions all electronically connected to form a market.

Financial Markets can either be primary or secondary markets:

PRIMARY MARKETS

◦ Facilitate the creation of financial assets and provide a means for a business to raise
funds through the creation and release of debt or equity to individuals and the general
public; Basically a means for a company to create shares to be able to sell them to the
public as equity finance.

SECONDARY MARKETS

◦ Provide a means for debt and equity to be exchanged. This is however between
individuals, and does not generate any further revenue for the business.

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 The major participants in financial markets are:
Banks
◦ The most dominant and recognised financial institutions in Australia.
◦ Facilitate use and movement of funds

NB – since DEREGULATION, many of the restraints put on banks by the Reserve Bank of
Australia (RBA) and the Australian Prudential and Regulatory Authority (APRA) have
been removed, allowing banks to offer a whole range of financial services they were once
limited to do (as there was a limit to interest/money to lend).
Deregulation has brought in overseas competition to the financial sector; market power has
been maintained by the ‘big four’:
• Australia and New Zealand Bank (ANZ)
• National Australia Bank (NAB)
•Commonwealth Bank of Australia (CBA)
•Westpac Banking Corporation (Westpac)

Finance Companies
◦ Supply credit to businesses and consumers
◦ Categorised as non-depository institutions, as they make loans without taking in deposits

Here is a table on how Finance Companies work:

Company issues short-

term promissory notes
(“IOU”s) to banks, as well
as debt securities and
asset-backed securities.
Using this newly acquired
funds and lend out to
those who require it
(public, etc.)
Get repaid by customers at
a higher rate of interest,
thus making a profit.

Insurance companies
◦ Guarantee the assets of their policy holders (customers) in return for a fee
◦ Ensures that customers continue to contribute to the economy even after a disaster
◦ RISK MINIMISATION STRATEGY FOR BUSINESS

Merchant Banks (or Investment banks)

◦ Deal directly with large businesses and are not accessible to small businesses or private
borrowers
◦ Businesses would use merchant banks to access capital markets to issue equity shares,
create debt securities for sale to the market, or to create various other securities in order
to raise funds

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Superannuation/mutual funds

◦ System (introduced in late 1980s) that makes every Australian employee earning
$450+ a month to contribute 9% (non tax-deductible) of their income into a
superannuation fund
◦ This money is all grouped together and invested into a range of assets in order to
generate large returns: - property purchasing
- purchasing shares in domestic and overseas companies
- investing in other profitable assets
◦ Most employees (except exceptions) are not able to access funds until the age of 60
◦ Mutual funds work in the same way, although they are voluntary funds which can be
withdrawn at any time

Companies
◦ At some point, companies will require funds. They can do this by using financial
markets to issue equity, debt securities, of simple borrowing.
◦ Companies manage their assets to insulate themselves against risks such as interest
rate rises and to ensure they can meet their debt obligations.

Stockbrokers
◦ Stockbrokers are a medium in the financial system for trading financial assets.
◦ They trade on behalf of individuals, companies, or themselves. They also provide
investment services and financial advice for clients.

Government
◦ There are 3 major regulators in the financial system:

♦ The Reserve Bank of Australia (RBA) – responsibility for monetary policy

(to influence the level of interest rates and, as a result, demand in the economy)
and the general stability of the financial system; in its establishment, it stated it
would best contribute to: - Stability of the currency of Australia
- Maintenance of full-employment in Australia
- Economic prosperity and welfare of the people of Aus.

♦ The Australian Prudential Regulation Authority (APRA) – responsible for

supervision and regulation of all deposit-taking institutions, insurance
companies and superannuation funds

♦ The Australian Securities and Investment Commission (ASIC) – accountable

for corporate regulation, consumer protection and oversight of financial service
products

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The Australian Stock Exchange

◦ The Australian Stock Exchange (ASX) comprises the largest primary and secondary
markets for companies and individuals wishing to create and exchange financial assets
in the economy

◦ Majority of transactions are considered secondary market transactions

◦ If a business wishes to use the ASX to raise funds, it must list itself on the ASX. This
means it must: - Become a public company
- Offer the public a chance to buy shares
- Issue a prospectus1 that has been approved by the ASIC
The initial listing of a business on the ASX is called a float, which is the first public
offering of shares in a company, changing its structure to a publicly owned company.

Financial market influences and trends

1) Deregulation
◦ It is the removal of numerous rules governing the operation of Australia’s financial
institutions, and the movement and ownership of financial assets
◦ Enormous impact on the financial industry
◦ Since then, overseas companies were allowed to list in Australia, and restrictions
governing the behaviour and structure of financial assets in and out of Australia were
removed
◦ This meant that it was much easier for companies to obtain finance (as funding could
now be sourced from overseas investors)
◦ Deregulation minimised the restrictions governing how banks managed their funds and
restrictions on the range of financial service offered by institutions

2) The Introduction of Compulsory Superannuation

◦ Has allowed the government to invest shares in domestic and overseas companies
◦ The fact that this amount will grow over the coming years will make it an increasingly
powerful source of funds for investment in the economy
◦ Substantially INCREASED COSTS FOR BUSINESSES as they are not able to offer
employees lower wages

3) Privatisation
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Prospectus = a legal document detailing the intentions of the company to raise funds, and its current
financial position

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◦ The sale of government owned businesses to the public2, which has had an enormous
impact on Aust. Financial markets
◦ Prvtstn. Has INCREASED COMPETITION, which was once forbidden in certain
industries

4) Growth of Technology

◦ Facilitates the ease and efficiency of financial transactions

◦ Allows deals to be done electronically across computer systems
◦ Made way for increased productivity levels, lower business costs and the opening up
of previously inaccessible markets

5) Globalisation (and the associated advs in tech)

◦ Allowed a 24-hour market for financial assets

◦ This growth allows for momentum in Australian market, increasing levels of investor
confidence in Australian shares

Sources of Funds

Internal Funds

Owner’s Equity: - Money contributed by people in exchange for ownership rights (or
‘equity share’) in the business, making them part- or full-owners
- Also money used to assist in start-up of the business

Retained Profits: - Profit made by a business either paid to the owners (dividends) or
kept and reinvested into the company (retained profits)
- Generate greater profits in the long-term if reinvested, and ensure the
financial stability of the business in the short-term

External Funds
Short Term Borrowing
There are 2 types of short term borrowing:

♦ Overdrafts – Agreement between a business and a bank which allows a business to

withdraw more money than it owns (in its cheque account). This is usually
only used when a business is experiencing liquidity problems, although it is
confident they will soon improve, however there is no time frame in which
the money must be repaid. They do have to pay interest on a regular basis.
A bank can make a business repay the overdraft at any given time.
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Examples include Commonwealth Bank of Australia (which bank?), Qantas, and parts of Telstra

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♦ Bank Bills – Occurs when a business writes a bill to a bank, agreeing to repay a loan
within 90-180 days. There is no interest, however there is a fee.

Long Term Borrowing

The 2 methods of long-term borrowing include:

♦ Mortgages – a loan where the security for it is a piece of property. Can be used to
purchase new, existing, or pre-owned property, and if the business cannot
pay back the interest and principal payments, the mortgager can seize the
property, and sell it to regain money owed. The dividends are returned to
the mortgagee. Mortgages have lower interest that short-term debt
instruments (however, the debt is spread over a greater period of time).

♦ Debentures – a guarantee to repay funds borrowed by a business at a particular date (+

regular interest payments). Usually between two businesses. This method is
costly to issue, as the business must issue a legal prospectus on the
business to investors. This method is unattractive to small businesses.

Other sources of funds

→ Leasing

This is a tax-effective way of raising funds without having to raise further debt or
equity. This agreement occurs when one party (lessor) buys an item and lets another (lessee)
use it at a cost. Example: when someone buys a house and rents it out to someone for a cost.

Two Types:
Operating Lease
• Lease term shorter than life of asset. Eg.
Machinery will last for 10 years, lease
only 5 years.
• Lessor responsible for upkeep of asset
• Lease payments tax deductable
• Lessee can update assets more easily, as
cancelling is inexpensive
Finance Lease
• Lease term equal or close to life of asset
• At the end of lease, lessee can (option)
buy asset at reduced price
• Lessee responsible for upkeep
• Expensive to cancel

→ Factoring

This is the sale of accounts receivable to a third party. Basically, if you give
someone the rights to money owed to you by other entities in exchange for cash, and they
have to go and chase up that money from your debtors.
Advantages Disadvantages
• Avoids a number of administration • Commision of up to 20%
costs • Time consuming, unpleasant (for
• Instant cash flow company receiving accounts
• Eliminate cash flow problems

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→ Trade Credit

This is when a business has an agreement with its supplier to pay for products any
time between the date of purchase and a specific time thereafter

→ Venture Capital

This is money provided by firms or individuals for investment in young

establishing companies that show potential to generate profit (basically a smart
investment). VC companies will most commonly purchase equity (ownership) in these
businesses, and usually considered a long-term investment. The problem with this is
high risk, yet there is a possibility for high returns

→ Grants

Funding packages provided to businesses from governments(or other funding

institutions) where the business in question does not have to pay back the grant funds.
This is in order to further develop a product, and it is in the belief that it is the interest of
the nation as a whole. The normal grants include: - Culture art grants
- Research/Develoment grants
- Export grants

Financial considerations for Funding

When considering its funding needs, a business should ask itself the following questions:

1) How long are the funds required for? → Repayment timeframes for sourced funds
should be similar to the length of time
the funds are required for

2) Are we confident we can meet all our debt repayments? → Any debt is exposed
to credit risk
(defaulting)

3) How easy will it be for us to obtain finance with our history?

4) Where is the economy going? → Any debt is open to interest risk – the risk that the
economy will change, changing interest
rates/payments on debt. Interest changes also in turn
change confident in the economy (recurring circle)

5) What could we do if we get into trouble? → A strong asset base determines safety in
case of a financial problem, using these
assets as security
 6) What tax benefits could we gain? → Different forms of financing have different tax
policies, making each more or possibly less
attractive

Comparison of debt/equity financing

Equity

• Capital contributed by owners

• Can be made in form of selling shares. Holders of shares entitled to vote on important
matters and profits.

Debt

• Must be repaid over a fixed period of time (with interest)

• These borrowed funds are liabilities
• These include : → Bank overdrafts
→ Bank loans
↔ Mortgages
NB – Debt holders do not have ownership rights to the business. If payments cannot be
made, they must liquidate business to pay what is owed

Type of Finance Advantages Disadvantages

Equity ♦ Owners do not have to be repaid
♦ Repaid with more ownership
♦ Low risk
♦ Better in weak external
(economic) conditions
Debt ♦ Easy to arrange on short notice
♦ Management has more freedom to
make decisions
♦ Looming threat of repayment acts
as incentive to make profit and
ensure adequate cash flow
♦ risk of sudden interest rate
♦ Dilution of control →
+owners = > control
♦ Long time to organise
♦ Adds cost to the business
♦ Time consuming
♦ Competitive disadvantage to
non-listed entities
♦ Company has higher risk of
being liquated
♦ Restrictions (possible)
♦ May send negative message
to owners and investors
♦ Remain exposed to open
rises

Gearing (measure of business debt relative to equity/assets)

• Highly geared ↔ high debt compared to equity. This means that external stakeholders
have more claims over business than internal. This can mean increased level of risk in
times of bad economic conditions (high interest rates). -
• Low geared ↔ low debt to equity. This means they rely on equity as its major source of
funds