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Paper F9: Financial Management

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Welcome to our download sample of the Tony Surridge +Add Vance E-book publication:

ACCA Paper F9 – Financial Management – Mnemonics and Charts

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Mnemonics: 160Charts and Diagrams: 122

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Type ofpresentation

Title Topic covered (briefly) Screennumber

Chart What is corporate finance? Financial management function 42

Chart 3 main financial decisions Financial management function

43Chart Capital structure Financial management function 44

Chart The financial management function Financial management function 45

Chart Finance function within a largecompany/group

Financial management function 46

Mnemonic The role of the Financial Controller Financial management function 47

Mnemonic The role of the Treasurer Financial management function 48

Chart The scope of financial management+AddVance activities - introduction

Financial management function49

Chart The scope of financial managementactivities - overview


Chart Cash flows between the firm and thefinancial markets


Chart The scope of financial management -recap


Chart The financial management planningprocess


Mnemonic The financial management process Financial management function 54

Chart The financial management planningprocess - overview


Chart A firm’s liquidity cycle Financial management function 56

Mnemonic Benefits of centralised treasurymanagement


Mnemonic Disadvantages of centralised treasury

management


Chart/mnemonic The principal financial objectives Financial objectives 59

Chart Stakeholder analysis for a typicalcompany

Financial objectives 60

Mnemonic Concept of ‘Principal-agency Theory’(PAT) applied to shareholders anddirectors


Mnemonic Difficulties associated with managingorganisations with multiple objectives


Mnemonic Reasons why maximising shareholders’profits is not the same as maximisingshareholders’ wealth


Mnemonic The main Corporate Governanceproposals


Electronic links -1

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MAPCopyright Tony Surridge Online Limited, 2010










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Type ofpresentation


Mnemonic Main focus of the LSE’s ‘Combined Code

of Corporate Governance’


Mnemonic The distinctive characteristics of publicservices in the context of corporategovernance


Mnemonic Remuneration schemes for managers Financial objectives 67

Chart Value for Money (VFM) Objectives in not-for-profitorganisations

68

Chart Measuring performance in a not-for-profitorganisation

Objectives in not-for-profitorganisations

69

Chart Financial performance analysis - overview Financial ratio analysis 70

Chart Financial performance analysis – categories of ratios

Financial ratio analysis 71

Chart The RONA Pyramid Financial ratio analysis 72

Mnemonic Implications/issues of the ROI measure Financial ratio analysis 73

Chart Measuring financial performance -overview


Mnemonic The FIVE main groupings for financialperformance analysis Financial ratio analysis 75

Mnemonic The implications for the growth measuresused by financial managers


Mnemonic Reasons/benefits of financial ratioanalysis


Mnemonic Limitations of ratio analysis Financial ratio analysis 78

Mnemonic Information required for meaningful ratioanalysis


Chart Combined analysis (Collection period) Financial ratio analysis 80

Chart Overtrading Financial ratio analysis 81

Mnemonic Characteristics of overtrading Financial ratio analysis 82

Mnemonic Ratios/measures that can be used toindicate overtrading


Mnemonic Parties who need to analyse corporatefinancial figures in addition tomanagement


Mnemonic Reasons why comparisons should bebased on companies in the same industryor market sector


Electronic links - 2

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Type ofpresentation


Mnemonic The difficulties involved in inter-firmcomparison


Mnemonic Macroeconomics Financial managementenvironment

87

Chart The economic goals of government Financial managementenvironment

88

Mnemonic Main economic goals of mostgovernments

Financial managementenvironment

89

Chart Main sources of inflation Financial management

environment

90

Mnemonic Sources of inflation Financial managementenvironment

91

Mnemonic Government policy : Full employment Financial managementenvironment

92

Mnemonic Examples of potential conflict withingovernment economic policies


93

Chart The Bank of England’s (Central Bank)‘Repo’ rate of interest


94

Chart Economic objectives of Government Financial managementenvironment

95

Chart Fiscal policies of central government Financial managementenvironment

96

Mnemonic Gilts Financial managementenvironment

97

Mnemonic The effects of a high PSBR (Public SectorBorrowing Requirement) on private sectorbusinesses


98

Mnemonic Factors that regulate the size of the ‘Bankreserve requirement’


99

Mnemonic Characteristics of the ‘perfectlycompetitive market’


100

Mnemonic Basis of monopoly power Financial managementenvironment

101

Mnemonic The effect of ‘green policies’ oncompanies


102

Mnemonic Ways that inflation can affect a company Financial management

environment

103

Mnemonic The central role of working capitalmanagement in financial management

Working capital management 104


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Type ofpresentation


Mnemonic Potential conflict between functional

managers and financial managers inworking capital decisions


Chart Example of the need for working capitalinvestment


Chart Working capital investment has a cost butthere is no direct money return


Chart The constituents of ‘Working capitalmanagement’


Mnemonic Sources of information available to help

credit assessment


Mnemonic Reasons for delays in invoicing Working capital management 110

Mnemonic Possible actions for dealing with slowpayers


Mnemonic Debtor management – general factors Working capital management 112

Mnemonic Steps that a company could use to reducebad debts


Chart Derivation of formula for calculating the

average ‘Accounts payable’ balance


Chart Offering discounts for early payment Working capital management 115

Chart Receiving payments from overseas sales Working capital management 116

Mnemonic Managing payments from overseascustomers


Mnemonic The workings of an effective credit controldepartment


Chart Factoring book debts Working capital management 119

Chart Factoring book debts: Ups and Downs Working capital management 120

Mnemonic Benefits of factoring debts Working capital management 121

Chart Overview on the management of accountsreceivable


Chart Overview on the management of accountsreceivable - 2


Mnemonic How risks of foreign trade (excluding

foreign exchange risks) might bemanaged


Mnemonic Terms of trade for overseas customers Working capital management 125


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Type ofpresentation


Chart Three main types of trade credit Working capital management 126

Chart Control of trade credit Working capital management 127

Chart Taking discount for early payment Working capital management 128

Mnemonic Advantages of using trade credit tofinance working capital


Mnemonic Factors that influence the amount oftrade-credit period taken


Chart Levels of inventory Working capital management 131

Mnemonic The costs of holding inventory (stock) Working capital management 132

Mnemonic Costs of acquiring inventory (purchaseorder costs)


Mnemonic Benefits of holding high levels of inventory(stock)


Mnemonic Disadvantages of holding high levels ofinventory (stocks)


Mnemonic Ways a manufacturing company can useto reduce its average raw materialinventory


Chart Characteristics of JIT systems Working capital management 137

Mnemonic The nature and characteristics of supplyin JIT


Mnemonic JIT. What is planned to be available justin time?


Mnemonic Aims of Just-In-Time (JIT) Working capital management 140

Mnemonic Pre-requisites for a successful JIT system Working capital management 141

Mnemonic Advantages associated with JIT systems Working capital management 142

Mnemonic Toyota Production System (TPS) Working capital management 143

Mnemonic Examples of waste (non-value-addingactivity and costs)


Chart The concept of ‘pull production’ linked to‘just in time (JIT)’


Chart Cash management Working capital management 146

Chart Calculation of ‘Cash conversion cycle

period’


Mnemonic Releasing cash from working capital todeal with short-term cash deficits



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Type ofpresentation


Mnemonic Reasons for a company to hold liquid

assets


Chart 6 Steps for cash budgeting Working capital management 150

Chart Cash budgeting: Receipts and paymentsmodel


Chart Cash flow statement Working capital management 152

Chart Baumol Cash Budget Model Working capital management 153

Mnemonic Potential problems associated with theBaumol model


Chart Miller-Orr Cash Budget Model Working capital management 155

Chart Management of short-term surplus cash Working capital management 156

Mnemonic Factors to consider before investingsurplus short-term funds on the moneymarket


Chart Management of short-term deficit cash Working capital management 158

Mnemonic Reasons why there are cash problems(cash deficits)


Mnemonic Overcoming short-term deficit cash Working capital management 160

Chart Dynamics between short- and long-terminterest rates


Chart Market segmentation theory Working capital management 162

Mnemonic 3 reasons why under normal economicconditions short-term interest rates arelower than long-term rates.


Chart Financing working capital: Three

approaches


Chart Financing working capital Working capital management 165

Mnemonic 3 different financing policies for workingcapital


Mnemonic The factors to consider before adoptingan ‘aggressive financing policy’


Mnemonic Balance between cash and short-terminvestments


Mnemonic Explanations for the shape of the ‘NormalInterest Yield Curve’


Chart Financial instruments (‘paper’) in themoney markets



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Type ofpresentation


Mnemonic Financial instruments used in the money

market

Nature and role of financial

markets and institutions

171

Chart The Bill of Exchange mechanism Nature and role of financialmarkets and institutions

172

Chart Letter of Credit Nature and role of financialmarkets and institutions

173

Mnemonic The main organisations acting as financialintermediaries

Nature and role of financialmarkets and institutions

174

Mnemonic The main functions (roles) served byfinancial intermediaries in the market


175

Chart Organisations operating as financialintermediaries


176

Chart The role of financial intermediaries - 1 Nature and role of financialmarkets and institutions

177


178


179

Chart The role of financial intermediaries - 4 Nature and role of financialmarkets and institutions 180


181

Mnemonic Ways that investors benefit from financialintermediation


182

Chart The financial markets Nature and role of financialmarkets and institutions

183

Chart Money Nature and role of financialmarkets and institutions

184

Chart The role of the Central Bank in the moneymarket


185

Chart The London Stock Exchange (LSE) - 1 Nature and role of financialmarkets and institutions

186


187


188

Chart Risk/return trade-off - 1 Nature and role of financialmarkets and institutions

189

Chart Risk/return trade-off - 2 Nature and role of financialmarkets and institutions

190


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Type ofpresentation


Mnemonic Types of risks concerning financial and

investment decisions

Nature and role of financial

markets and institutions

191

Mnemonic Key factors in choosing sources offinance

Business finance 192

Mnemonic The relative merits of short-term debtcompared with long-term debt


Mnemonic The problems of using short-term debtsources compared with long-term debt


Mnemonic Sources of short-term finance Business finance 194

Mnemonic Bank investigation concerning a loanapplication Business finance 195

Mnemonic Danger signs for a bank when assessinga bank loan application


Mnemonic Factors that influence the rate of interestcharged on a new bank loan


Mnemonic The ‘Sale and lease-back’ decision Business finance 198

Chart Public equity company raising long-termfinance


Chart Ordinary shares and their characteristics -1


Chart Ordinary shares and their characteristics -2


Chart Ordinary shares and other things to know- 1




Chart Ordinary shares and other things to know- 3 Business finance 204



Mnemonic Factors affecting a share price Business finance 206

Mnemonic Retained earnings compared with a newissue of equity


Mnemonic Factors relating to a public issue of equity Business finance 208

Chart Rights issue - overview Business finance 209

Chart Rights issue - 1 Business finance 210



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Type ofpresentation



Mnemonic Contents of a Prospectus for a Rightsissue Business finance 213

Mnemonic Benefits of a rights issue in a bull market Business finance 214

Mnemonic The drawbacks of a rights issue Business finance 215

Chart Initial Public Offering (IPO) - 1 Business finance 216



Mnemonic Advantages of getting listed on a stockexchange


Mnemonic Disadvantages of getting listed on a stockexchange


Mnemonic Methods for a company to obtain a listingon a stock exchange


Mnemonic Costs of an issue on the stock exchange Business finance 222

Mnemonic Ways investors use to assess a companythat is making an initial public offer (IPO)


Mnemonic Ways an unquoted company mightrestructure its balance sheet prior to theinitial offer (IPO)


Mnemonic Dividend policy – the practicalconsiderations


Chart The dividend decision - 1 Business finance 226





Mnemonic Different dividend policies Business finance 231

Mnemonic Reasons why dividend policy is important Business finance 232

Chart Main characteristics of bonds Business finance 233

Chart Bonds - 1 Business finance 234

Chart Bonds - 2 Business finance 235Chart Bonds - 3 Business finance 236

Mnemonic Different forms of corporate bond Business finance 237


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Type ofpresentation


Chart Internal sources of finance and dividendpolicy


Chart The influence of interest rates on themarket value of bonds


Chart Convertible bonds Business finance 240

Chart The floor value of a convertible bond Business finance 241

Mnemonic Factors relating to a public issue ofcorporate bonds


Mnemonic Advantages of eurobonds Business finance 243Mnemonic Drawbacks in the eurobond market Business finance 244

Mnemonic Factors that should be considered by alisted company when choosing betweenthe issue of debt and an issue of equity


Mnemonic Ways by which an unlisted company canobtain funds


Chart The financing of SMEs Business finance 247

Mnemonic Reasons why SMEs gave difficulty inraising finance


Mnemonic Source of funds for SMEs – using UK asan example


Mnemonic Problems faced by SMEs in respect ofcredit management


Mnemonic Steps that could be taken by SMEs tominimise the effects of their poor creditmanagement


Mnemonic Purposes of venture capital Business finance 252

Chart The main financial markets Business finance 253

Chart The capital budgeting process Investment appraisal 254

Chart The ‘rolling’ capital budget system Investment appraisal 255

Mnemonic Seven steps involved in successfullyevaluating and controlling a capital budget

Investment appraisal 256

Mnemonic Component parts of a ‘Business Case’ for

an investment proposal


Mnemonic Possible benefits of an investment project Investment appraisal 258


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12

Type ofpresentation


Mnemonic Main responsibilities of the ‘Capital

Expenditure Committee’


Mnemonic Relevant (or opportunity) costs that wouldaffect the future cash flow of a project


Mnemonic Costs which are not relevant whencarrying out a DCF appraisal


Chart Capital investment appraisal techniques Investment appraisal 262

Mnemonic The main capital investment evaluationtechniques and criteria


Mnemonic Limitations of the payback period methodof capital investment appraisal Investment appraisal 264

Mnemonic Advantages of the payback period methodof capital investment appraisal


Mnemonic Limitations of the Accountant’s Rate ofReturn (ARR) measure for evaluatingcapital investment proposals


Mnemonic Strengths of the ARR measure Investment appraisal 267

Mnemonic Advantages of using discounted cash flow

(DCFR) techniques for capital investmentappraisal


Mnemonic Data required to calculate the net presentvalue (NPV) of an investment project


Mnemonic Advantages of IRR over NPV Investment appraisal 270

Mnemonic Limitations of using the IRR measure forcapital investment appraisal


Mnemonic Advantages of NPV over other investmentappraisal techniques


Mnemonic General limitations of net present value(NPV) when applied to investmentappraisal


Mnemonic Steps taken to address the limitations ofNPV analysis


Chart Capital investment appraisal applications Investment appraisal 275


MAP

To manage a business well is to manage its future: and to manage the future is

to manage information.

Marion Harper











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Type ofpresentation


Chart Effects of inflation on NPV Investment appraisal 276

Chart NPV and risk Investment appraisal 277

Chart Business and financial risks Investment appraisal 278

Mnemonic Factors contributing to business risk Investment appraisal 279

Mnemonic Factors contributing to financial risk Investment appraisal 280

Mnemonic Ways that risk can be managed in capitalinvestment


Mnemonic Problems of using the ‘expected value’approach when making investment

decisions


Mnemonic Limitations of sensitivity analysis Investment appraisal 283

Chart The lease or borrow-to-buy decision Investment appraisal 284

Mnemonic Advantages of leasing assets Investment appraisal 285

Mnemonic Disadvantages of leasing assets Investment appraisal 286

Chart Capital rationing: Overview Investment appraisal 287

Mnemonic Hard capital rationing:

characteristics and reasons for


Mnemonic Soft capital rationing:characteristics and reasons for


Mnemonic Exploiting opportunities which arerejected because of capital rationing


Mnemonic Limitations of using the Profitability index(PI) in a capital rationing situation


Chart Capital Replacement Theory - 1 Investment appraisal 292

Chart Capital Replacement Theory - 2 Investment appraisal 293Mnemonic The factors to consider in a replacement

decisionInvestment appraisal 294

Chart The process of capital budgeting andinvestment appraisal: overview


Mnemonic Four different ways of valuing a company(or an equity share)

Business valuations 296

Mnemonic Purpose of company or share valuation Business valuations 297

Mnemonic The main implications of the ‘EfficientMarket Hypothesis’

Business valuations298

Chart Different methods of valuing a companyor its shares

Business valuations 299


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14

Type ofpresentation


Mnemonic Weaknesses of the dividend valuationmodel

Business valuations

300

Mnemonic Assumptions underlying CAPM Cost of capital 301

Chart Systematic and unsystematic risk Cost of capital 302

Mnemonic Limitations of using the beta factor Cost of capital 303

Chart Traditional gearing Cost of capital 304

Chart Traditional gearing ratios Cost of capital 305

Chart Managing foreign currency risk Cost of capital306

Mnemonic The uniqueness of the foreign exchange(FE) market

Risk management 307

Mnemonic Factors that affect a currency’s supplyand demand and thus its price

Risk management 308

Mnemonic Forecasting exchange rates Risk management 309

Mnemonic Four ways of forecasting (estimating)future currency rates

Risk management 310

Chart Four-way Equivalence Model Risk management

311Mnemonic Techniques available to help reduce

foreign exchange risk involved in foreigntrade or business

Risk management 312

Mnemonic The steps involved when using a moneymarket hedge to cover foreign currencypayments

Risk management 313

Mnemonic Advantages of using futures to hedgerisks compared with a forward exchangecontract

Risk management 314

Mnemonic Difficulties of using futures to hedge risks Risk management 315

Mnemonic The reasons for using currency options Risk management 316

Mnemonic Benefits of currency swaps Risk management 317

Mnemonic Drawbacks of currency options Risk management 318

Chart Currency and interest rate management Risk management 319

Mnemonic Pattern of interest rates Risk management 320Mnemonic Reasons why interest rates may be

expected to fallRisk management 321


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15

FinancialAnalysis

Who needsto

analyse?

Management Investors Potential investors Creditors Other lenders Employees

What data isused for theanalysis?

Profit and Loss Account(Income statement)

Balance Sheet

Other data are also useful:

Cash flow forecasts Industrial statistics Details of accountancy policies Post-balance sheet events

Government statistics Inflation adjusted figures

What basis ofanalysis?

Internal/ external

Stakeholders

Appraisal/ evaluation

Comparisons

Main comparisons:

Time series analysis(over different periods oftime)

Interfirm comparison Against objectives

(budgets, etc.)

What tomeasure?

Criteria

How tomeasure?

Analyticaltechniques

What tolearn?

Information

Five main areas of appraisal:

Earnings- profitability

- capital efficiency Growth Risk Control Shareholders’ investments

Three main techniques:

Common sizing(vertical analysis)

Horizontal analysis Ratio analysis

Scope forimprovement

Controlaction

required

Financialproblems

Managementaction

required

Overtrading

Danger ofliquidation

Financial performanceanalysis - overview

Start here andfollow the

numbers ….

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FINANCIALANALYSIS

Vertical analysis(Common-sizing)

Horizontal analysis

(Side-by-side)

Ratio analysis

Financial performance analysis – categories of ratios

Usually based on:

Income statement ……

1 year Balance sheet…… Assets

Basis for performancecomparisons:

Time-series analysis

(Trend analysis overperiods)

Cross-sectional analysis(inter-firm analysis)

Budgets Other objectives Inter-unit/ division/

department Geographical

Performance isnormally conducted by

comparisons

CRITERIAused for

comparisons

EARNINGSMEASURES

RONA (Net profit x 100/net assets) NET MARGIN (Net profit x 100)/

sales revenue) NET ASSET TURNOVER

(Profit x 100/net assets employed)

PROFITABILITY

GROSS MARGIN (Gross profit x 100/ sales revenue)

OPERATING MARGIN(Profit before interest and tax x 100/ sales revenue)

COST OF SALES PERCENTAGE(Cost of sales x 100/sales)

COST MEASURES (Each element of costx 100/sales)

CAPITALEFFICIENCY

FIXED ASSET TURNOVER(Profit x 100/fixed assets employed)

CURRENT ASSET TURNOVER(Profit x 100/current assets)

INVENTORY TURNOVERTHROUGH SALES

(Profit x 100/inventory)

GROWTHMEASURES

EARNINGS-PER-SHARE GROWTH (%) SALES REVENUE GROWTH (%) DIVIDEND COVER

(Profit after interest andtax/total dividend) (times)

RETENTION %(1 – (Dividends for the year x 100%/ profits after interest and tax))

DIVIDEND YIELD(Total dividend x 100/

earnings for ordinary shareholders)

RISK MEASURES

GEARING (Debt/equity value) (times)(There are other ways ofcalculating this ratio)

INTEREST COVER

(Profit before interest and tax/ interest payable)

GEARING

LIQUIDITY

CURRENT RATIO(Current assets/current liabilities) (times) QUICK RATIO

((Current assets – inventory)/ current liabilities)

WORKING CAPITALCONTROL

MEASURES

INVENTORY TURNOVER((Inventory value x 365)/purchases) (days)

CREDITORS PAYMENT PERIOD(Accounts payable x 365/purchases) (days)

DEBTORS COLLECTION PERIOD(Accounts receivable x 365/sales) (days)

INVESTORS’RATIOS

DIVIDEND YIELD(Dividend per share x 100/ market price per share)

PRICE EARNINGS RATIO(Market price per share/ earnings per share)

DIVIDEND COVER(Earnings per share/ dividend per share) (times)

EARNINGS YIELD

(Earnings per share x 100/ Market price per share)

RETURN ON EQUITY(Net profit x 100/ equity value (book or market value)

Starthereand

followthe

arrows












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RETURNON NET ASSETS

Profit marginCapital turnover

(Activity)

Sub-analysis

Sub-analysis Sub-analysis

Total cost/Sales x 100 Sales/Fixed assets = times

Fixed costs/Sales x 100 Variable cost/Sales x 100

Sub-analysis

Rent/Sales x 100 = %Rates/Sales x 100 = %Deprec./Sales x 100 = %Insurance/Sales x 100 = %Etc.

Material costs/Sales x 100 = %Labour costs/Sales x 100 = %

Variable overhead/Sales x 100 = %Insurance/Sales x 100 = %Etc.

Sub-analysis

Sales/Land value = timesSales/Property value = timesSales/Plant & Equip. value = timesSales/Vehicle values = timesSales/Fix. and Fittings = timesEtc.

Sales/Inventory value = timesSales/Receivables = times

Sales/Cash = timesEtc.

Net profit/Net assets x 100 = %

The RONA Pyramid

Sub-analysis

Sales/Current assets= times

Profit/Sales x 100 = % Sales/Net assets = times











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18

Implications/issues of the ROI measure

The ROI ratio (sometimes called RONA [return on net assets] or ROCE [return on capital employed])measures the overall effectiveness of management in generating profits with its available resources. It isa key, but rough, measure of performance. Although ROI shows the extent to which earnings areachieved on the investment in the business, the actual value is generally somewhat distorted.There are basically three ratios that evaluate the ROI. They are: net profit margin , net assets turnover , andreturn on equity .

The implications/issues of the ROI measure are:

C Company’s cost of capital. Is the ROI high enough with regard to the company's marginal cost

of capital (say the bank's overdraft rate)?

O Other companies/competitors/industrial norm. How does the ROI compare against other

companies (competitors) or divisions (within the company)?

A Asset valuation. Are assets correctly valued? (The ROI ratio is overstated if the assets are

under-valued.)

S Shareholders’ cost of capital. Consider the overall return. Is the ROI high enough with regard

to shareholders' cost of capital? (The return the shareholders could earn elsewhere at the samelevel of risk.)

T Trend of the ROI. Is the trend satisfactory/unsatisfactory?

A company can’t COAST along happily – even when the ROI is high!

The very best financial presentation is onethat’s well thought out and anticipates anyquestions … answering them in advance.

Nathan CollinsExecutive Vice

PresidentValley National Bank

CFO, August 1985









19

So ……

There are 5 main criteria for measuring financialperformance

1. Earnings measures- principal measures, sub-analysed as:

- profitability- capital efficiency

2. Growth measures3. Risk measures

- gearing- liquidity

4. Working capital control measures5. Investors’ ratios

And ……

There are 3 techniques for measuringfinancial performance

1. Vertical analysis (‘Common-sizing’)2. Horizontal analysis (‘Side-by-side’)

3. Ratio analysis

5 criteria ….

3 techniques ….

Measuringfinancial

performance -overview












20

The FIVE main groupings for financialperformance analysis

There are many ratios that an analyst can use, depending on what he or she considers to be importantrelationships. For our purposes we will classify ratios into five groups:

S Shareholders’ investment measures. The main measures are:

- Dividend yield (Dividend per share/market price per share x 100).- Earnings per share (Earnings for ordinary shareholders/number of shares eligible for dividend).- Price earnings ratio (Market value per share/earnings per share).- Dividend cover (Earnings per share/dividend per share).- Earnings yield (Earnings per share/market price per share x 100).- Return on equity (Earnings for ordinary shareholders/equity (book or market) value x 100).

U Underlying control measures. The main measures are:

- Inventory turnover (Inventory value x 365/purchases) (days).- Payables period (Payables’ value x 365/purchases) (days).- Receivables (Receivables’ value x 365/sales) (days).

R Risk measures. The main measures are:

- Gearing (Debt/equity). (There are other ways of calculating this ratio.)- Interest cover (Profit before interest and tax/interest payable).- Current ratio (Current assets/current liabilities)- Quick ratio (sometimes called ‘Acid test’) (Current assets – inventory value/current liabilities)

G Growth measures. The main measures are:

- Earnings-per-share growth (%).- Sales revenue growth (%).- Dividend cover (as shown above)- Retention % (1 – (dividends for year x 100/profits for ordinary shareholders).- Dividend yield (as shown above).

E Earnings measures. The main measures are:

- ROI (or RONA or ROCE) (Net profit/net assets x 100).- Net margin (Net profit/sales revenue x 100).- Net asset turnover (Net profit x 100/net assets employed).(Operating profit may be used in place of net profit in all three of these ratios.)

A company’s share price will SURGE ahead when these measures are

consistently favourable.









21

The implications of the growth measuresused by financial managers

R Retention percentage ratio. The retentions percentage is the inverse of the dividend cover

(explained below) and provides much the same information.

E Earnings per share growth %. This is an important ratio for the present and prospective

shareholders and management. The earnings per share represent the number of £s earned onbehalf of each outstanding share of equity capital. They are closely watched by the investingpublic and are considered an important indicator of corporate success. The value does not

represent the amount of earnings actually distributed to shareholders. Growth (year by year)suggests strong corporate performance.

D Dividend cover ratio. The dividend cover indicates (a) the proportion of distributable profits for

the year that is being retained by the company; and (b) the level of risk that the company will notbe able to maintain the same dividend payments in future years, should earnings fall. A highdividend cover means that a high proportion of profits are being retained, which might indicatethat the company is investing to achieve earnings growth in the future.

S Sales revenue growth %. The sales growth when measured against industry growth for the

same period can provide useful information about the company's share of the market. Salesgrowth can also be used to evaluate the company's marketing, such as the effectiveness of anadvertising campaign run during the period of report.

A company will usually keep out of the REDS on the stock exchange board

when these measures are strong.

Growth for the sake of growth is the ideology ofthe cancer cell.

Edward Abbey









22

Reasons/benefits of financial ratio analysis

Ratio analysis is widely used for analysing a company and is frequently employed by external stakeholders -creditors, investors and financial institutions, as well as by senior management for internal performanceappraisal. In more detail, the technique can help in the following ways:

I Identifies a moving picture of trends. A 'moving picture of the company' , i.e. trends over a

period of years can be analysed (‘time-series analysis’).

S Segregates performance. It segregates performance into distinct groups such as: earnings,

growth, control, risk and investment.

M Models and simulates. Ratios can be used for modelling and simulation purposes. Many large

corporate finance models are based on ratios.

A Accounting software facilitates the quick production of ratios.

G Government statistics. Ratios allow a company to compare its performance against macro-

economic indices produced by government.

I Industrial norms. Ratios allow for comparison of the company’s performance with other

companies or the industry average, and hence for management to make judgement about thecompany's position in the competitive arena. Most inter-firm comparison schemes are based onratios. Internal comparisons (between divisions/departments) are also made possible.

C Comparison with the budget for the same period. Management can use ratios to compare

results with the budget covering the same period.

It IS MAGIC the way ratios can reveal a picture of performance results.









23

Limitations of ratio analysis

The analytic approach used in ratio analysis must be used with circumspection and in conjunction with other

analytical tools and techniques as it has a number of limitations. The limitations include the following:

O Orientation that is historical. The approach is based on historical data and thus the ratios may

not be a good guide to the future;

F Financial measures are used. Ratios are normally based exclusively on finance, and reflect

only financial indicators of performance. There are, of course, non-financial implicationsassociated with performance.

T Trading environments change over time. The changing value of money and differences in

trading environments over time influence the ratios.

S Sub-optimal results might be encouraged. The use of ratios to measure performance may

encourage sub-optimal behaviour by managers, e.g. short term manipulation of results.

A Accountancy practice influences the ratios. Differences in accounting practices adopted by

companies over the treatment of fixed asset depreciation and revaluation, stock valuation,research and development expenditure, goodwill, write-off and profit recognition affect the ratios.

I Interpretation of change. Difficulties in deciding on a suitable yardstick and the interpretation of

change, e.g. is a higher return on net assets (ROI) good or bad?

D Distortion can be a result. The quality of the analysis is determined by the quality of the accounting information upon which it is based (consider here the distortion that can result from'creative accounting' , such as 'window dressing' of financial statements to hide short-termfluctuations).

It’s OFT SAID that too much emphasis is placed on only using ratio

analysis.

The numbers tell you how your business is going, not why.

Jonatghan P. SiegelSpeech, McLean, Virginia, 12 September, 1987








24

Information required for meaningful ratioanalysis

For meaningful financial ratio analysis and other performance analysis the following information would beuseful:

I Information and details concerning future plans of the company.

F Fixed assets. Details of fixed assets, with projected remaining lives and likely replacement costs.

A Accounts adjusted to take account of inflation during the period under review.

C Cash flow forecasts.

C Current financial statements. Balance sheet [Statement of Affairs], Profit and Loss Statement

[Income Statement] and Cash Flow Statement.

A Accountancy policy and changes to it. Details of the company's accounting policies and

changes to any basis of accounting.

B Budgets and associated variances. Details of the company's budget plans with a schedule of

variances.A After balance sheet events (post-balance sheet). Details of any post-balance sheet events,

and of any contingencies.

S Statistics provided within the industry. Statistics of the industry as a whole, and in particular

financial and other ratios showing best, industry average and worst results.

E Economic indicators and other macro-environmental factors. Government statistics

concerning inflation and interest levels and other economic indicators.

IF ACCA BASE a question on what information is required for financial

performance analysis to be meaningful then this is a useful list.









25

Key amounts, measure and ratios would be: YEAR 1 YEAR 2

Increase in sales revenue (%) XX %

Gross margin (Gross profit x 100)/sales revenue) XX % XX %

Increase in non-current assets ($) $XX

Non-current asset turnover ratio (Sales revenue x 100/

non-current assets employed) XX %

Total working capital ($) $XX $XX

Inventory turnover through sales (Sales revenue/average inventory) XX times XX times

Inventory turnover ((Inventory value x 365)/purchases) XX days XX days

Payables period ((Payables value x 365)/purchases) XX days XX days

Receivables collection period ((Receivables value x 365)/sales revenue) XX days XX days

Reduction in liquidity (cash and bank overdraft levels) $XX $XX

Current ratio (Current assets/current liabilities) XX times XX times Quick ratio (Current assets – inventory value)/current liabilities) XX times XX times

Financial gearing (Debt x 100/equity funds) XX % XX %

An exam question that requires you to assess the extent of a firm’s overtrading position would need to present;

Two or more years’ of financial data, and/or data concerning industrial/sector averages.

CHARACTERISTIC OF

OVERTRADING

The characteristics, or features of an overtrading situation

include the following:

The firm is under-capitalised (i.e. there are

insufficient funds or credit lines).

The firm is probably profitable.

The firm has problems maintaining its asset base

(non-current and current assets) with the level of its

activities.

Management may be focusing on sales (‘top line’) at

the expense of the costs (‘middle line’) and profit

(‘bottom line’).

The firm’s sales may be growing too fast and

outstripping the available working capital.

The firm’s quality is suffering (because of some of

the points raised above).

Inflation simply exacerbates the problems

SYMPTONS OF

OVERTRADING

Over the period ….

Growth in sales. Growth in the volume of assets.

Reduction in the firm’s liquidity.

Increase in inventory turnover period (days).

Increase in debtors’ assets (including the

Accounts receivable collection period [days]).

More use made of short-term credit (e.g.

increase in Accounts payable payment period

[days]).

Increase in financial gearing.

Quality problems

Measures for assessing the

extent of overtrading

Extending turnover too quickly

Overtrading is a problem which arises from a firm extending its turnover at too rapid a rate. The ultimate result is a serious

shortage of cash which means that wages, creditors and corporation tax cannot be met.

A typical pattern of events

A typical pattern of events commence when a firm takes on additional orders. This would then be followed by engaging

additional workers or working overtime. At the same time, extra materials would be purchased on credit. If the working capital

cycle is fairly long this means that although extra cash has to be paid out more or less immediately, additional revenue may not

be forthcoming for a considerable period. This assumes that the additional production will be sold without delay, but in some

circumstances the process may take the form of build up of stock. If this is the case, then the shortage of cash may

necessitate an emergency sale at greatly reduced prices and this is likely to have adverse effects on profitability.

YOUR COMMENTS WOULD BE AN IMPORTANT PART OF AN EXAM ANSWER.

OvertradingMAP NEXT CHART NEXT MNEMONIC








26

70

60

50

40

30

20

10

0

2006 2007 2008 2009 2010 1011Year

A v e r a g e c o l l e c t i o n p e r i o d

( d a y s )

Fairy Nuff Engineering plc

Industry average

Combined cross-sectional and time-series analysis of theaverage collection for the period 2006 - 2009

Average collection period for Fairy Nuff Engineering plc

The most informative approach to ratio analysis is one that combines cross-sectional (inter-firm)and time-series analysis. A combined view permits assessment of the trend of behaviour of theratio in relation to the trend for the industry. The diagram below depicts this type of approachusing a company's average debtor collection period in the years 2006 to 2009.

Combined analysis

There’s few things as uncommon as common sense.

Frank McKinney Hubbard, 1868 – 1930

American caricaturist and humorist












27

Characteristics of overtrading

Overtrading is a problem which arises from extending turnover at too rapid a rate. The ultimate result is aserious shortage of cash which means that wages, creditors and corporation tax cannot be met.

When a company is overtrading this is marked by large increases in sales which are not matched byincreases in the asset base to support the greater level of activity. Working capital is used moreintensively and there is little increase in the level of fixed assets. Expansion is financed by short termcredit, and stock and debtor turnover can slow as the company tries to secure additional sales on the basisof improved credit terms and as it tries to manufacture ahead of demand.

When analysing the situation shown on a Balance Sheet/Income Statement it is very important to watch forsigns of overtrading. Some of the more important of these signs are summarised below.

S Sales growing too fast. Very rapid growth in sale turnover. The ‘Growth of sales ratio’

would be a useful indicator.

A Asset maintenance. Inventories may increase more proportionately than the increase in sales

turnover with a deterioration in ‘Inventory turnover ratios’. Rapid growth in the volume of currentassets and possibly fixed assets. Consider here the ‘Asset turnover ratio’.

L Liquidity problems. Increased significance of credit in financing along with the growth in assets.

This may show in slower payment of payables and a bank overdraft which is close to itslimit. Similarly, a comparison of the period of credit being taken by the company with the norm forthe particular industry will be a guide. Look to see if there has been an increase in the ‘Payablesturnover ratio’. Also, look for any sudden upward or downward swing in cash figures, or theappearance of new items such as short-term loans. The ‘Current ratio’ and ‘Quick ratio’ would

indicate the liquidity problem.

E Excessive inflation causing capital replacement problems.

S Sales focus to the exclusion of other factors. Management focusing on sales (advertising

expenditure, generous credit terms, price reductions, etc.) possibly at the expense of profits andcash flow. The ‘Gross profit margin’ is an important indicator of sales to costs.

U Undercapitalisation. This often occurs because of a growth in the rate of borrowing so that the

proportion of borrowing in relation to the assets owned by shareholders is excessive.Reductions in the current and quick ratios, possibly leading to a liquid deficit. The ‘Gearing ratio’and ‘Cash Flow’ would be used here.

P Profitable, but! Total profit, gross and/or net, begins to diminish

A company’s SALES may be UP but its cash could be seriously down. It

might be overtrading.









28

Ratios/measures that can be used to indicateovertrading

When a company is overtrading this is marked by large increases in sales which are not matched byincreases in the asset base to support the greater level of activity. Working capital is used moreintensively and there is little increase in the level of fixed assets. Expansion is financed by short term

credit, and inventory and debtor turnover can slow as the company tries to secure additional sales on thebasis of improved credit terms and as it tries to manufacture ahead of demand.

To carry out a meaningful appraisal two or more years of data are required including industry/sectorstatistics.

Signs that a company may be overtrading include the following:

G Gross margin. (Gross profit/sales revenue x 100).

I Increase in bank overdraft $. (Current level – previous level).

A Asset turnover ratio (particularly fixed asset turnover) (Gross profit/fixed assets employed x 100)

N Net working capital size. (Current assets – Current liabilities). (Current compared with previous).

T Turnover of inventory through sales. (Sales revenue/inventory) (times)

C Current ratio. (Current assets/current liabilities) (times)

A Acid test (often called ‘Quick ratio’). Now (Current assets – inventory/current liabilities) (times).

R Reduction in liquidity ($). (Bank + cash – overdraft) (current compared with previous).

T Turnover of inventory in days. (Inventory value x 365/purchases or cost of goods sold) (days).

R Receivables payment days. (Receivables value x 365/sales) (days).

I Increase in fixed assets %. (Current fixed asset value – previous fixed asset value/previous

fixed asset value x 100)

P Payments days. (Payables x 365/purchases) (days).

S Sales revenue increase%. (Current sales – previous sales/previous sales x 100).

GIANT CAR TRIPS don’t have anything to do with overtrading, but the

mnemonic does give you a list of 13 ratios or other measures than can be used toassess whether a company is overtrading.









29

Parties who need to analyse corporatefinancial figures in addition to management

Financial analysis is an evaluation of both the company's past financial performance and its prospects for thefuture. Typically, it involves an analysis of the company's financial statements and its flow of funds. Financial

statement analysis involves the calculation of ratios and also uses other ways of measuring.

The analysis of a firm's financial statements is of interest to a number of different groups including present andprospective shareholders, creditors, and the firm's own employees.

S Shareholders - current. The present shareholders are interested in the current and future level

of risk , liquidity , activity , debt and return (profitability). These are the dimensions whichinfluence share price.

C Creditors. The firm's creditors, such as the bank, are primarily interested in the short-term

liquidity of the firm and its ability to service its debts over the long run. Present creditors want

to assure themselves that the firm is liquid and that it will be able to make scheduled interestand principal payments. Prospective creditors are concerned with determining whether the firmcan support the additional debt that would result if they extended credit to the firm.

O Other lenders, such as customers who pay forward on a contract would want to assess the

financial stability of the company.

P Potential investors. In the same way as the company’s present shareholders, prospective

shareholders are interested in the current and future level of risk , liquidity , activity , debt andreturn (profitability). For this reason, the business advisory group is also interested in carryingout performance analysis.

E Employees. Employees (present, past with pension, and potential)), like the shareholders, are

concerned with all aspects of the firm's financial situation. Employee representatives (such astrade unions) would need to evaluate the company’s position with regard to negotiating pay rises(pay increments).

There is a big SCOPE of different people who have an interest in the

financial standing and performance of a company

EVER ONWARD – EVER ONWARD

That’s the spirit that brought us fame!We’re big, but bigger we will be.We can’t fail for all to see,That to serve humanity has been our aim.Our products are now known in every zone.Our reputation sparkles like a gem.We’ve fought our way through, and newFields we’re sure to conquer too.Forever onward IBM.

IBM Company Song









30

Reasons why comparisons should be basedon companies in the same industry or market

sector

Comparison of the company’s performance with that of other companies operating in the same industry ormarket sector is a significant part of performance assessment. By carrying out inter-firm assessmentmanagement is able to (i) compare operating and financial performances and identify strengths andweaknesses in the organisation; (ii) contrast strategic structures and detect threats and opportunities,product-market gaps, competitive moves and market movements; (iii) plot take-over bids, or alternativelyplan defensive measures to avert possible take-over strikes by other companies; (iv) assess thecompany's worth (or the disposal worth of divisions) and (v) view the company through the eyes ofinterested parties, e.g., the capital market, trade unions, employees and creditors.

Methods of conducting inter-firm comparisons include: (i) subscription to a formal scheme; (ii) informal andinternal research (which uses data provided by the relevant trade association and central government);and (iii) benchmarking exercises.

It is centrally accepted that comparisons should be made with companies operating in the same industry orsector for the following reasons.

W Working capital. Different industries have different working capital requirements. For example,

the retail sector will have a much lower level of debtors than the manufacturing sector due to thedifferent levels of inventory. Similarly, manufacturing concerns generally require a much greaterinvestment in inventory than do service providers.

A Applicable for the ‘investor group’. Investors often group in sectors, and therefore the internal

comparison will be similar to the comparisons made by the company’s investors.

F Fixed costs level. Different industries have different levels of fixed costs. For example, the fixed

costs of service providers are generally a lot lower than for companies involved in heavyengineering.

E Earnings volatility. There will be different levels of earnings volatility in different industries and

market sectors influenced by seasonal fluctuations and cyclical changes. For example, thefurniture retail sector is more influenced by the business cycle (say a downturn in the economy)than the food retail sector.

R Risk. Leading from the last point, business risk is also different between industries making it

impossible to compare important performance indicators.

Without inter-firm (or inter-sectional) comparison within the same industry or

market sector the exercise of financial performance analysis is WAFER thin.









31

The difficulties involved in inter-firmcomparison.

The comparison of financial information (such as ratios) from one firm to another, even in the same industry,involves a number of difficulties, particularly in the following.

I Inventory valuation. The method of accounting for inventory (FIFO, average cost, etc.) may

vary.

D Depreciation. Depreciation calculations and rates may differ.

E Expenses. When comparison of different items of expense is possible, then there might be

inconsistency in the classification of costs under the main headings of operating costs, marketingcosts and administration costs, etc. and also in the method of apportioning common costs.

A Asset valuation. Where historical values are used the asset-based ratios will vary according to the

average age of the assets held which would be different company by company.

S Several ways of valuing work in progress and finished goods. The cost content of work in

progress and finished goods inventory may differ. Some companies will include a share ofadministration costs, others will cut off at factory cost or include direct costs only.

A number of trade associations or federations have prepared manuals of standard practices in accounting fortheir members (which are in additional to the GAAP standards) and these help to make reported resultsmore suitable for comparative analysis.

Financial managers need IDEAS on how to make the necessary corrections

for distortions caused by lack of uniformity in the way that financial information isreported by different companies.

A problem well stated is a problem half solved.

Charles F. Kettering









32

Macroeconomics

MacroeconomicsThis involves the study of the entire economy. (For accountancy students, the specific areas areanticipated government/central bank economic policy; and economic events and influences whichaffect decisions of financial/treasury managers, mainly changes, and anticipated changes in the rates of

interest, inflation and currency exchange rates.)

Macroeconomic policyThe conduct of government/central bank policy in such a way as to influence the performance andbehaviour of the national economy as a whole.

Macroeconomic models and the forecasts they provide are used by both governments and large companiesto assist in the development and evaluation of economic policy and business strategy.

Macroeconomics then is a branch of ‘Economics’ that deals with the performance, structure, and behaviourof the economy as a whole . Macroeconomists seek to understand the determinants of aggregate trends

in the economy with particular focus on the following:

N National income (Gross National Product, etc.), projections and targets.

A Aggregate unemployment and regional unemployment and causes of.

T Trends in foreign exchange rates, causes and lessons learned, etc.

I Interest rates and their effect on the economy.

O Outward investment, trends and implications.

N Net trade figures (exports less imports).A Accrued government debt and current public sector borrowing requirements.

L Level of inflation, causes and implications.

Macroeconomics has a NATIONAL prospective.

Reference:Wikipedia



http://en.wikipedia.org/wiki/File:Circulation_in_macroeconomics.svg








33

Eradicateextremepoverty

Increase/ maintaineconomic

growthAvoid

extremeeconomic

fluctuations

Sustain a‘healthy’

(controlled)balance of

payments

Achieve full

employment

Maintainprice stability

ECONOMICOBJECTIVES OF

UKGOVERNMENT

The economic goals of government

He slept beneath the moon,He basked beneath the sun,He lived a life of going-to-do,And died with nothing done.

James Albery, 1839 – 1889English playwrightEpitaph for himself









34

Main economic goals of most governments

The main economic aims of government (and the central bank which usually acts as an independent agency)are sixfold:

F Full employment. Government aims to reduce the number of involuntary unemployed people to an acceptable

level, or the creation of more jobs. (It is possible to create more jobswithout reducing unemployment, e.g. by moreschool leavers entering the jobs market than new jobs being created.)

I Inflation control and price stability. Government have a continuous policy of containing the rate of national

inflation at an acceptable level.

G Growth of gross national product. Economic growth happens when there is an expansion in national

income (gross national product) in relation to the size of the population. Measures of national income and output areused in economics to estimate the value of goods and services produced in an economy. They use a system ofnational accounts (or national accounting ) f irst developed in the 1940s. Some of the more common measures areGross National Product (GNP) , Gross Domestic Product (GDP) and Net National Income (NNI) . There are at leasttwo or three different ways of calculating these numbers. The expenditure approach determines aggregate demand(or Gross National Expenditure), by summing consumption, investment, government expenditure and net exports. On

the other hand, the income approach can be seen as the summation of wages, rents, interest, profits, non-incomecharges, and net foreign income earned.

H Healthy, controlled balance of payments. When the balance ofvisible (trading) and invisibles (investment

income) are combined they form what is effectively the nation'scurrent balance of payments .

(i) The capital account The flow of investment and capital flows provide (the concept of) acapital account .

(ii) Interaction of the two flows The two sets of flows are likely to move in the same direction, e.g. a balance of payments surplus would be takenas a sign of economic strength by other countries and attract capital; a deficit as a sign of weakness withmoney moving out of the currency.

Government/Central Bank policy to counteract these tendencies (i) The Central Bank might raise interest rates in an attempt to counteract the fall in the value of the home currency.

(ii) Convincing overseas financiers/merchants that the Government is taking effective action to reverse a weakeconomy.

(iii) Maintaining controls over the moment of money owned by its own nationals. (An unlikely policy in most countries,but it can happen.)

T Trim the economy – reduce the economic fluctuations. Unmanaged economies tend to grow in

cyclical fashion - periods of recession followed by recovery, then boom. Problems with this economic tendencyare:(i) In recession there are unemployed assets and lost output.(ii) In boom the economy is in danger of overheating leading to an increase in demand-inflation, with a consequent

loss of international competitiveness of the nation state.The Bank of England (BOE) (or central bank of most national economies) intervenes to avoid the economyoverheating with two main policy instruments(i) By increasing the BOE's 'repo' rate of interest (ii) By taking money out of the economy

S Share wealth and reduce extreme poverty. Government policy attempts to eradicate extreme poverty by

redistributing factor incomes - normally by transferring funds from profits, rents, interest and wages into social servicespayments, such as unemployment benefits, family aid and so on. The policy is usually achieved by taxation policye.g., corporate tax, value-added tax (VAT) and personal direct taxes.

The Government FIGHTS hard to improve economic conditions in the

country.









35

Main sources of inflationDemand inflation occurs when demand and purchasing power outstrips (exceeds) the rate of output (supply).

Options for government to reduce demand include: increasing taxation (corporate, VAT, direct taxes) - to cut consumer spending, lowering government expenditure (and lower government borrowing) with the aim of using the multiplier effect

to spread out in reverse. increasing interest rates (Bank of England policy).

Costs rise because of a shortage of factors of supply.Money is such a factor, but there are others,particularly labour. A shortage of labour tends tocause an increase in the level of wages.

Options for government to increase the factors ofsupply include: de-regulating labour markets (e.g. reducing the

power of trade unions to impose 'closed shops'),

encouraging greater productivity, applying controls over wages and price rises

(prices and incomes policy) encourage immigrant labour

Imported inflation is a consequence of prices risingbecause of the weakening (softening) value of thecountry's foreign exchange rate against othertrading currencies. The result of this is thatimports cost more..

Options for government to counter-balance foreignexchange disadvantages include:

appreciation or depreciation of the domesticcurrency rate (rare),

the Central Bank raising interest rates tocounteract fall in currency value,

trying to achieve a balance of trade (importsand exports).

Money supply inflation results from an over expansion of

the money supply. (A simplistic explanation of the'Monetarists' position on the relationship between moneysupply and the rate of inflation, is that inflation is caused bymoney supply growth - 'too much money chasing too few goods' .)

Options for government/Central Bank to reduce the rate ofmoney supply growth include:

cutting the public sector borrowing requirement (PSBR), funding the PSBR by borrowing from the non-bank

private sector (which would pull money from othercorporate and private investments),

control or reduction of bank lending, using interest rates to deter money supply growth (e.g.

the higher the rate of interest the less attractiveinvestments become; less money would be borrowedand thus 'created').

Expected effect inflation occurs because of ananticipation that inflation will occur within current wages bargaining and price adjustments. Forexample, employees negotiating an annual wagesettlement who anticipate an increase in inflationduring the year ahead would consequently demanda higher rate of wage increase to compensatefor this future inflation. In this respect, inflationbecomes a self-fulfilling prophesy.

Options for government to reduce the self

fulfilling influences include:

pursuing clear policies which indicate itsintention to contain/reduce rates of inflation,

not practising 'U-turn' economic policy.

MAP NEXT MNEMONIC

MAP NEXT MNEMONIC

Expectationseffect

inflation

Money-supplyinflation

Importedinflation

Costinflation

Source

of inflation

Demandinflation

Copyright Tony Surridge Online Limited, 2010










36

Sources of inflation

A principal objective of any central bank is to safeguard the value of the currency in terms of what it will purchase. Rising prices -inflation - reduces the value of money. Monetary policy is directed at achieving this objective and providing a framework for non-inflationary economic growth. As in most other developed countries, monetary policy operates in the UK mainly throughinfluencing the price of money - the interest rate, In May 1997 the Government gave the Bank of England independence to setmonetary policy by deciding the level of interest rates ('repo rates') to meet the Government's inflation target - currently 2% (August

2007).

Low inflation is not an end in itself. It is however an important factor in helping to encourage long-term stability in the economy.Price stability is a precondition for achieving a wider economic goal of sustainable growth and employment. High inflation can bedamaging to the functioning of the economy. Low inflation can help foster sustainable long-term economic growth.

Financial managers need to be aware of:- the probable level of future inflation, and- the effects on their organisation of likely government (central bank) policies to deal with rising inflation.

There are five types (or sources) of inflation, some of which overlap, which might lead the government (central bank) to pursuedeflationary policy:

M Money supply inflation. Money supply inflation results from an over expansion of the money supply. (A simplisticexplanation of the 'Monetarists' position on the relationship between money supply and the rate of inflation, is thatinflation is caused by money supply growth -'too much money chasing too few goods‘ .) Options for government (central bank) to reduce the rate of money supply growth include:- cutting the public sector borrowing requirement (PSBR),- funding the PSBR by borrowing from the non-bank private sector (which wouldpull money from other corporate

and private investments),- control or reduction of bank lending,- using interest rates to deter money supply growth (e.g. the higher the rate of interest the less attractive

investments become; less money would be borrowed and thus 'created').

E ‘Expectations effect’ inflation. Expected effect inflation occurs because of an anticipation that inflation will

occur within current wages bargaining and price adjustments. For example, employees negotiating an annual wagesettlement who anticipate an increase in inflation during the year ahead would consequently demand a higher rate ofwage increase to compensate for this future inflation. In this respect, inflation becomes a self-fulfilling prophesy.Options for government to reduce the self fulfilling influences include:- pursuing clear policies which indicate its intention to contain/reduce rates of inflation,- not practising 'U-turn' economic policy.

D Demand inflation. Demand inflation occurs when demand and purchasing power outstrips (exceeds) the rate of

output. Options for government to reduce demand include:- increasing taxation (corporate, VAT, direct taxes) - to cut consumer spending,- lowering government expenditure (and lower government borrowing) with the aim of using the multiplier effect to

spread out in reverse.- increasing interest rates (central bank policy, perhaps).

I Imported inflation. Imported inflation is a consequence of prices rising because of the weakening (softening)

value of the country's foreign exchange rate against other trading currencies. The result of this is that imports costmore. Options for government to counter-balance foreign exchange disadvantages include:

- appreciation or depreciation of the domestic currency rate (rare),- the central bank raising interest rates to counteract fall in currency value,- trying to achieve a balance of trade (imports and exports).

C Cost inflation. Costs rises because of a shortage of factors of supply. Money is such a factor, but there are others,

particularly labour. A shortage of labour tends to cause an increase in the level of wages.Options for government toincrease the factors of supply include:- de-regulating labour markets (e.g. reducing the power of trade unions to impose 'closed shops'),- encouraging greater productivity,- applying controls over wages and price rises (prices and incomes policy).- encourage immigrant labour.

‘MEDIC’, may have no word association with ‘inflation’ but high levels of inflation

are unhealthy for an economy..

MAP NEXT MNEMONIC

MAP NEXT MNEMONICCopyright Tony Surridge Online Limited, 2010







37

Government policy: Full employment

The Government aims to reduce the number of involuntary unemployed people to an acceptable level, orthe creation of more jobs. (It is possible to create more jobs without reducing unemployment, eg by more

school leavers entering the jobs market than new jobs being created.)

G Growth in private sector. Encouraging growth in the private sector.

E Encouraging training in job skills.

T Training grants to employers in selected regional areas.

S Spending money directly on jobs, e.g. employing more civil servants.

T Trade union ‘closed shops’ agreements disallowed or discouraged.

H Higher education and university places made available.

E Encouraging labour mobility.

M Minimum wage legislation. Careful balancing of minimum-wage legislation.

Memory jog: Government policy ‘GETS THEM’, (people) into work.

MAP







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