chapter 6 - economics and Accounting Flashcards
(37 cards)
1
Q
- Causes of inflation (6)
- What is inflation
- What is deflation
- Stagflation
A
- Cost push inflation - Increased costs eg raw materials
- Demand pull - increased demand relative to supply
- Currency devaluation. Growth in money supply
- Higher wages - increased firm costs/increased disposable income for workers
- Expectations of inflation
- Lack of capacity
Inflation is general increase in prices and fall in spending power of money
Deflation : lack of spending, reduced consumption - leads to recession and lower GDP
STagflation - high unemployment, high interest rates
2
Q
Acronym for strong pound
Acronym for weak pound
A
- SPICED
- Strong pound imports cheap, exports dear
- foreign consumers need more of their currency to purchase £1.export company may not make as much profit - dividend may be at risk - share price could fall
- Imports will be cheaper and require less £1 to purchase foreign currency
- Importing-company will make more profit - increase dividends - share price rise
- WPIDEC (EXPORTERS DO WELL FROM A FALLING POUND)
- Weak imports dear, exports cheap
3
Q
Two way of measuring money
A
- Mo -= Narrow money: Notes and coins in circulation plus BoE operational deposits
Indicator of consumer spending/ retail sales.
Reflects economy but doesn’t influence. Growth = spending increasing ; Reduction = consumers not spending so much
- M4 - Broad money: Notes and coins in circulation plus money in savings and time deposit accounts of UK residents in UK Bank’s/Building Societies
Influence economic cycle.
Growth in M4 indicates increased lending activity from Banks - inflation likely to rise
M4 is indicator of economy
4
Q
What is a financial bubble
Crash
A
- Financial bubble occurs when investors stop paying attention to fundamental indicators of an investment ( liquidity, EPS etc) and invest speculatively, simply because they think as asset will continue to grow in value
Greater Fool Theory - Some idiot will buy it at a higher price than you have eg Dot.com boom & crypto
INVESTORS OVERESTIMATE POTENTIAL RETURNS AND UNDERESTIMATE COMPETITIVE PRESSURES
- Crash. When investors sell investments quickly because they believe price will continue to fall - or maybe forced sellers
5
Q
- Difference between Government receipts and spending known as…
- What would a high level of above possibly lead to
- If a Government receives more than it spends and makes debt repayment - called
A
- Net Cash requirement (NCR). Fiscal Policy : concerned with spending and taxes
- PSNDR public sector net debt repayment
6
Q
- How can a Central Bank take action to avoid deflation
A
- Reduce interest rates to stimulate consumer demand
- Quantitive Easing - Stimulate money supply to boost lending to individuals and business
- Increase Government spending
- Reduce taxes
7
Q
- Measures of inflation
- Government target
A
- RPI : Average price of basket of goods purchased by typical household (+mortgage interest / housing costs) Calculation - Add al up and divide by no. Items
- CPI : Took over from RPI in 2003. Geometric mean. Take nth route of all items multiplied together
2% target
8
Q
- Who sets interest rate
- consumer confidence vs interest rates
- How can Bof E use interest rates to control inflation
A
- Monetary policy committee sets interest rates\
- upturn in economy -consumer confidence rise/ consumer spending can fall off if interest rises
- Control inflation by increasing int rates to make borrowing more expensive
- increase int rates to provide higher returns on savings
- consumers and companies will have less disposable income and profits to invest
- consumers and companies will spend and invest less - thus demand should fall
HIGH INT RATES AND HIGH INFLATION - INVERSE RELATIONSHIP WITH BOND PRICES (THE PRICE FALLS AND RUNNING YIELD GO UP)
9
Q
Bof E may wish to keep interest rates low
For Government, companies and individuals…….
- How would increasing interest rates control economy (4)
A
Government- Lower cost of public borrowing - more for public services. Low int rates means higher gilts values/gilt values maintained
Companies : Encouraged to borrow money to invest
Lower int rates may lower value of sterling, meaning exports will be cheaper and more attractive
Individuals: Encouraged to borrow money to invest
- stimulate housing market (encourage people to take out mortgages
- “Wealth Effect” encourages people to spend more money
- Encourages business start ups and investment
Increase interest:
- borrowing more expensive
- higher int on savings encourages saving
- less disposable income and profits to invest
- consumers and companies will spend less, this demand should fall
10
Q
Unemployment:
Consequence of too high unemployment / too low
- Frictional Unemployment ?
- Structural Unemployment ?
- Cyclical Unemployment ?
A
- Too high = Fall in production and tax receipts/ Too low = Increased labour costs and increased inflation
- Frictional : caused by changes in economy, leading to qualified jobseekers unmatched - Time spent looking for employment or in between (voluntary unemployment)
- Structural: Structural change to economy eg declines in particular industry and skill no longer in demand eg Replaced by IT
- Cyclical: Changes in overalls economic activity associated with business cycle - drop in demand
11
Q
- Balance of Payments
- UK Current Account
- GDP
- Liquidity Trap
A
- Balance of payments :Trade figs of inflows and outflows to UK economy
- UK Current Account: shows trade position Exports - Imports.
Split into goods(tangible ) and services (egfinancial services).
Import more than export = Trade deficit. If long term, may need fall in currency to make imports expensive and exports cheaper to balance trade ( Imports- we buy currency, exports - they buy sterling) - GDP: Measure of economic activity. GDP, Gross National Product(GNP) and NAtional income are three key measures of economic activity in UK
GDP is output of UK based firms. Value of economic activity generated by factors within the domain - Liquidity Trap - Reduce interest rates to extent they cant be reduced any more. Consumers want to hold cash more than spend
12
Q
role of Bank of England
A
- Lender of last resort
- Control UK money supply. Act as banker to Government and other Banks
- Supervisor of banks and other major financial institutions
13
Q
What is Fiscal policy
Difference between Fiscal and monetary policy
A
- Government through Fiscal policy based on taxation and spending. Can run deficit, surplus or balanced between income (tax) and outgoings (public services).
Government spends more - Budget deficit.
Budget deficit - increases money supply within economy, drive aggregate demand: EXPANSIONARY Policy - Fiscal = tax and spending
- Monetary= int rates and money supply
GH: Fiscal. -during recession, Govt spending may increase or tax cuts to stimulate.Boom - spending may be reduced or taxation increased to dampen demand
Monetary- attempts to provide economic control through manipulation of interest rates & money supply. BofE responsible for int rate policy. Forward looking. Change in int rates would have impact 18-24 months time
Monetary policy - 9 economists, target 2 - 2.5% . Measure CPI
Meet twice a quarter
14
Q
Fixed Exchange rate
Floating Exchange rate
- Economic factors causing a fall in Country’s currency
A
- Fixed: fixed or :”puffed” against another country’s currency - moves in line or within a range
- Floating: not fixed and varies according to supply and demand
- Factors to cause fall in currency
Fall in UK interest rates compared to other countries
Falling productivity or GDP is growing faster than money in circulation
Government/Bof E increase money supply at faster rate than productivity in UK
Higher UK inflation when compared to other countries
UK current account deficit or negative balance of payments with other countries
UK current account surplus
15
Q
Stages of Economic Cycle
- How long last
A
- Expansion: int rates low. Inflation increasing due to increased demand for goods/services, which justifies price increases
- Boom: Int rate still low. Economy growing at its fastest
- Overheating: As prices rise and inflation rise, economy overheats. Bof E raises int rates to reduce demand and stop expansion - Government sells short duration, short term, Government bonds. reduces money in general circulation
- Contraction : growth reduced, but inflation still high. Bof E reluctant to cut interest. Consumers start to spend less and save more. Results in increased unemployment and companies failing
- recession. 2 quarters reduction in GDP -classed as recession. Inflation and interest rates falling, output slow, economy weak. High unemployment and business failure.
- recovery: Economy moves out of recession, consumers spend more/save less. Confidence returns , output accelerates, profits grow. Int rates and inflation still low
Last 10 - 20 years
16
Q
How do Equities behave in Business Cycle
- EXPANSION
- BOOM
- Contraction
- Recession
A
- Expansion: Equities grow at fastest due to low interest rates and low inflation
- Boom : Durinmg periods of high inflation, investors favour equity due to need for real long term growth
- Overheating - Equities falter in latter stages of boom as interest rates increase
- Contraction : Equities typically perform poorly due to reduced demand and confidence
- Recession : Equities perform poorly
- Recovery: Equities pick up again coming out of recession as investors and consumers regain confidence.
17
Q
- How do Bonds perform in Economic Cycle
- Expansion
- Boom
- Contraction
- Recession
A
- Expansion
- Boom: Bonds historically preform poorly when interest rates are raised to prevent overheating
- Overheating: Bond capital values fall when interest rates increased to prevent overheating
- Contraction: Bonds historically perform well to stimulate economy.Capital; values rise
- Recession: UK Gilts and `global bonds-do well as there is a flight to safety
18
Q
How do Property react to Business Cycle
- Expansion
- Boom
- Contraction
- Recession
\
A
Expansion: with int rates low, property prices are generally higher as mortgage rates low, so consumers and business more able to afford to pay higher prices
Boom: property falters as interest rates increase and mortgages become expensive. Property prices fall to compensate
Overheating: Inflation erodes fixed levels of rent, reducing rental yields
Recession- Income from rental at increased risk due to tenant unemployment/inability to afford rental
19
Q
- Monetary Policy Committee )Bof E)
- Describe mechanism of how Bof E manages money supply/overheating economy
A
- MPC raises interest rates to dampen economy (too much money moving around)
- Consumers rewarded for saving more cash, Real cost of debt increases( variable mortgages increase) which means disposable income reduced.New loans more expensive, reducing amount to borrow .Businbesses will invest less
- Bof E sells short term government bonds (Repo market). Gilts sold with promise seller will buy back at specified future date at a higher price. Classifies as Money MArket instrument.
- BAnk removes money from market (replacing with Repos) - reduces money supply
- Less money in circulation = Value of pound increases (money more expensive)
- More Bonds in market, value of Bond has reduced. Fixed interest on bond as percentage (yield) is now higher.Repos shorts term
Lower interest rates = Bof E does reverse
20
Q
Economic Cycle
- What happens in Boom
A
- National output is rising strongly
- Employment expanding
- Strong levels of demand
- Strong consumption
- Rising wages
- High demand for imports
- Government tax rev unmutes rise
- Danger of inflation if economy overheats
- Share prices begin to top out and plateau
21
Q
Economic Cycle
- What happens in Slowdown
- What happens in recovery
A
Slowdown:
- Rate of growth decelerates, but national output still rising.
- Share prices fall
Recovery:
- Real national output picks up from trough reached at low
- SHare prices rise strongly
22
Q
Return on Capital Employed (ROCE)
- What does it help measure
- What is formula
A
- Helps measure management effectiveness. How effectively and efficiently have company used their assets in given period
- Main measurement of profitability & management effectiveness
** Best measure to compare two different specific companies
GH: measures return being achieved on capital employed in the business, so helps show how well the company assets are being used to make money AND how ell costs are managed.
Capital employed includes ordinary shareholder funds (inc reserves) PLUS long term debt (as loans and any preference shareholder share value is being used to finance productivity
TOTAL Operating PROFIT (before tax and interest). X 100%
——————————-
TOTAL CAPITAL EMPLOYED (Equity + long term debt)
** Capital Employed is made up of All capital -Shareholders funds & Long term liabilities (not short term liabilities)
Can be described as margin
* Total profit figure is known as Operating profit (less tax,interest)
Killik: PBIT
———————————————————————
Debt (lenders)+ Equity capital employed (shareholders)
1. Comprehensive
2. How much return will I get on my investment
3 DuPont analysis - split out PBIT/Sales x Sales/CAp employed
Shortcomings
- out of date as soon as you look at it
- Scale - Big or small company
- No sense of risk
23
Q
What are main (4) things you look at when looking at Accounts
A
- Profitability
- Profit Volatility (how sensitive to int rate changes, how sensitive to changes in sales volume)
- Liquidity
- Operational Efficiency
24
Q
Profitability
- Sales
- Operating profit
- Net profit
- Profit Margin
A
- Sales (or revenue) Gross money in ….eg £1 Choc bar
- Operating Profit = Profit after business expenses and admin costs (doesn’t deduct tax or interest) ….eg 70 p expenses (EBIT expenses before interest and tax) = 30p operating profit
- Net profit = (also know as earnings) Operating profit less interest and tax
- profit margin can be on operating profit or net profit basis ( Profit/Sales)
Operating profit margin would be 30p/£1 x100 = 30%
Net profit Margin would be 16.2/£1 x 100 = 16.2%
25
Profitability:
- Return on Equity (ROE)
What is formula
Return on Equity (What is the return in my investment) How much bang ...
Net Profit/Shareholders funds - Shareholders funds represent investment into business
* Dividends get paid out of net profit*
* * Shareholder funds made up of 1. Share capital & premium (amount shares were sold for) 2. Retained earnings /profit.
Should be a major priority for any company! Consistent above average ROE is fundamental characteristic of good company - They are efficient at using shareholders funds
ROE measure %rate of return the company achieves on the investment funds provided by shareholders, which come from share purchase as well as retained earnings
retained earnings are accumulated over the years from profits not paid out as dividends. Indicates how efficiently company management has utilised shareholders funds
Doesnt tell us anything on own
- Gearing can mislead
- Doesnt consider risk
26
Definitions
- Profit Margin
- Operating and net profit
- Assets (how split)
- Liabilities
- Turnover
- Interest and tax
- retained profit
- Profit Margin : Profit as a percentage of total sales. Useful as can compare profitability one year to next
- Operating and Net: Operating = after operating and administration costs (excludes interest and tax ) EBIT. Net = After interest and tax
- Assets: Current (short term - held for conversion to cash within 1 year). Non - Current assets longer term more than 1 year
- Liabilities: Owed by company . Current liabilities opposite of current assets
- Turnover: Sales company has made. Represents income generated from goods & services. CAsh & credit sales included
- Interest & Tax : If company has debt finance, it will service through paying interest. This is paid out of operating profit. Corporation tax paid after deduction of interest from operating profit
retained profit: Prift remaining after all payments made. Added to P&L reserve
27
Profit Volatility
Three key measures
- 1. Financial leverage (debt to equity ratio / Gearing ratio)
Ratios of 100% or more considered high.Varies between industries
High gearing exaggerates changes to return on equity. Profits high= gearing boosts returns, profits fall faster in geared company
Long term loans + preference shares/ (total shareholder equity - preference shares)
- 2. Operating leverage: considers types of costs. High fixed costs compared to variable indicates more volatility around break even point. Profits increase/fall more quickly after
Lower operating leverage indicates lower volatility around break even. Over long term, particularly in boom, company will have higher total costs.
Fixed costs/ variable costs
- 3. Interest cover:
Profit before interest and tax
———————————-
Gross interest payable
28
Liquidity
- What is working capital
- Working Capital/Current ratio
- Liquidity ratio or acid test or quick ratio
- Z score
- Working capital = Current assets - current liabilities
- Current ratio = Current assets/current liabilities
If working capital/current ratio is less than 1 means that current liabilities are greater than current assets ie Company is using creditors to finance its ongoing capital requirements .
Healthy ratio considered to be 1.5 to 2 depends on industry.
If less could signal future insolvency. If too high, could mean company isn’t utilising its current assets as much as it could be.
- Liquidity ratio = (Current assets - stock) / current liabilities
Liquidity ratio only measures assets which can be turned into cash and sold quickly. It, therefore doesn’t include stock (more cautious version)
Should be at least one but depends on industry
- Z Score - predicts the collapse of a company over 1 year and is reasonably accurate (less so over 5 years)
29
Operational efficiency
Industry specific calculations: (5)
- Sales pert employee
- Wages as a percentage of sales
- Administration costs as a percentage of sales
- Distribution costs as a percentage of sales
- Assets per employee
- R&D as a percentage of sales
30
Public Sector. Net Cash Requirement (PSNCR)
| Use to be Public Sector Borrowing Requirement (PSBR
- official term for Government Budget Deficit
Rate at which Government must borrow to maintain financial commitments (over and above tax revenue)
Solved by borrowing - Selling Gilts or by printing money.
High PSNCR is inflationary
31
Factors affecting demand (6)
Factors demanding supply (4)
- Law of demand
- Elasticity of demand
- Inelastic demand
- State of balance between supply and demand called ....
- Factors affecting demand: Price , buyers income, alternatives available, demand for other goods and services, ease of buying, tastes
- Factors affecting supply: Price, costs of making and distribution, supply of alternatives, events that make supply easier/more difficult
Law of demand: inverse relationship between a product price and amount consumers buy
Law of supply : direct relationship between price of product and amount offered for sale
- State of balance called equilibrium
32
Limitations of using Accounting Ratios: (4)
- Historical data
- Used in isolation can be misleading
- No account of soft qualatitive factors eg management style
- can be manipulated
33
Quantative Easing
- Involves BofE introducing digital money into economy to encourage spending, following decrease in consumers spending
- Used to buy Government bonds
- Aim to create new money to boost spending and investment in economy
- Large scale purchase of government bonds lowers interest rates or yields
- encourages households and businesses to borrow
34
Deflation -what is it
Why damaging
- Deflation is when things are physically cheaper
- Disinflation is when inflation falls from 4% to 2%
Delays consumption
35
- Impact of Monetary policy
| - Easing
Easing:
- Rates reduced , assets price rise
Bonds - Int rates go down, capital value will go up (whatever way int rates go, capital value of fixed interest will go in opposite direction). If capital value of fixed interest goes up, yields will go down
property: interest goes down= greater demand for property
Equities: Harder to call. Lower interest rates will generally will increase equity (most companies who have debt)
Savers suffer
Business cab borrow and invest more
36
Exchange Rates - Effect on UK shares
Effect on UK shares
Rise in Pound Fall in pound
profitability of exports Reduces. Increases
Share price of exporters. Reduces. Increases
Value of profits earned overseas. Reduces. Increases
Firms benefiting. Firms that import heavily Exporters
37
Current Account v Capital Account
Economic consequences of current account and capital account being in deficit over medium /long term
Current Account:
Surplus or deficit Imports and exports / balance of payments
Goods and services
Income from overseas income generating assets
Capital Account:
Movement of money /assets
Into / out of country
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Deficit of Current A/C & Capital
- Rising interest
- Economy/growth falls
- Currency devalues
- Capital flight out of UK
Unemployment rises
- Inflation increase
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