RCMA 4: INFLATION AND FINANCIAL RATIOS

Special Issues: Inflation and Financial Ratios

INFLATION

Inflation - The rate at which the general level of prices for goods and services rises, eroding purchasing power. Inflation has an impact on financial ratios in which inflation affects various financial ratios like the Price-Earnings Ratio, Debt-to-Equity Ratio, and others. Specific examples demonstrating adjustments in financial analysis during inflationary periods.

Subconcepts of Inflation:

Types of Inflation:

Demand-pull Inflation: Occurs when aggregate demand in an economy outpaces aggregate supply.
Cost-push Inflation: Arises from an increase in the cost of production, leading to decreased supply.
Built-in Inflation: Inflation that is triggered by past inflation expectations influencing wages and prices.

Effects of Inflation:

Purchasing Power: Inflation reduces the value of money, thereby decreasing the quantity of goods or services that can be purchased.
Interest Rates: Central banks may adjust interest rates to control inflation.
Income Redistribution: Inflation can benefit debtors (if unexpected) and harm creditors by reducing the real value of money over time.

Measurement of Inflation:

Consumer Price Index (CPI): Measures changes in the price level of a market basket of consumer goods and services purchased by households.
Wholesale Price Index (WPI): Measures and tracks the changes in prices of goods at the wholesale level.
Core Inflation: Excludes the prices of volatile items like food and energy to provide a clearer measure of long-term inflation trends.

Inflation, characterized by a widespread increase in prices across an economy, impacts various economic aspects, both positively and negatively, influenced by its rate, origins, and context. Below are the main effects of inflation:

1. Purchasing Power

Decrease in Purchasing Power: With rising inflation, the value of money diminishes, reducing the quantity of goods and services consumers can purchase with the same amount of money, potentially undermining consumer confidence and decreasing overall economic activity.

2. Income and Wealth Distribution

Redistribution of Income: Inflation can shift the flow of income from creditors to debtors. If inflation is expected, debtors can settle debts with less valuable money than when initially borrowed, while creditors end up with a diminished value in return.
Savings Impact: Inflation diminishes the real worth of savings unless interest rates exceed the inflation rate, discouraging savings and reducing investment levels.

3. Investment and Economic Growth

Investment Uncertainty: Elevated inflation introduces uncertainty regarding future costs and returns, deterring investment in new ventures or expansions, which negatively affects economic growth.
Increased Capital Costs: As inflation rises, it can lead to higher capital costs because lenders require increased interest rates to counteract the reduced value of future repayments.

4. Interest Rates and Monetary Policy

Central Bank Response: To manage inflation, central banks might increase interest rates to slow down an overheating economy and control inflation, elevating borrowing costs which may suppress spending and investment.
Real Interest Rates: When nominal interest rate hikes don't align with inflation expectations, real interest rates may drop below zero, encouraging short-term spending and investment but potentially leading to economic imbalances.

5. International Trade

Competitiveness: Domestic inflation affects a country’s competitiveness abroad. Higher local prices can render exports less attractive and imports more appealing.
Exchange Rate Fluctuations: Ongoing inflation disparities between countries can alter exchange rates. Higher inflation relative to trading partners can devalue a nation’s currency, impacting trade balances and economic stability.

6. Sectoral Effects

Varied Sectoral Impact: Inflation impacts sectors differently. Sectors dependent on raw materials might face harder times when inflation causes these materials to become pricier, whereas sectors that can easily transfer costs to consumers may experience less impact.

Inflation is a complex phenomenon with broad implications for the economy. Thus, managing inflation is essential for economic policy aimed at ensuring stability and maintaining confidence by keeping inflation within expected and manageable limits.

Inflation related terms:

Consumer Price Index (CPI): A measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care.
Producer Price Index (PPI): An index that measures the average changes in selling prices received by domestic producers for their output.
Hyperinflation: Extremely high and typically accelerating inflation, often exceeding 50% per month.
Deflation: A decrease in the general price level of goods and services, often caused by a reduction in the supply of money or credit.
Stagflation: A situation in which the inflation rate is high, the economic growth rate slows, and unemployment remains steadily high.
Inflation Targeting: A monetary policy strategy used by central banks for maintaining prices at a predetermined or targeted inflation rate.

Inflation Related Formulas:

Inflation Rate Calculation:

This formula calculates the percentage increase in the consumer price index over a year, which is a common measure of inflation.

Real Interest Rate:

This shows the lending rate of return adjusted for inflation, providing insight into the real gains from investments.

FINANCIAL RATIOS

Financial Ratios - Quantitative measures derived from financial statements used by analysts to gauge the financial health of a company. The categories of financial ratios are profitability, liquidity, efficiency, and solvency.

Subconcepts of Financial Ratios

Categories of Financial Ratios:

Liquidity Ratios: Measure the ability of a company to meet its short-term debt obligations. Examples include the Current Ratio and Quick Ratio.
Profitability Ratios: Assess the ability to generate earnings relative to revenue, assets, equity, and other factors. Examples include Return on Assets (ROA) and Gross Profit Margin.
Leverage Ratios: Indicate the level of debt incurred by a business entity against several other accounts in its balance sheet, income statement, or cash flow statement. Examples include Debt-to-Equity Ratio and Interest Coverage Ratio.
Efficiency Ratios: Reflect the company's use of its assets and management of its operations. Examples are Inventory Turnover and Asset Turnover.

Interpretation and Use:

Trend Analysis: Financial ratios are used to identify trends over time for one company or to compare two or more companies at one point in time.
Benchmarking: Comparing a company’s financial ratios against those of peers or industry averages to gauge performance and efficiency.

Impact of Inflation on Financial Ratios:

Distortions in Financial Statements: Inflation can distort the value of assets, liabilities, and equity on the balance sheet, impacting the accuracy of financial ratios.
Real vs. Nominal Values: Adjusting financial statements for inflation to get real values provides a clearer picture of a company's financial health and performance.

Financial ratios serve as essential tools in financial analysis, providing deep insights into a company's operational performance and financial health. These metrics, derived from financial statements, are invaluable to stakeholders such as investors, creditors, and managers, helping them make well-informed decisions. Here’s why they are critically important:

1. Performance Evaluation

Financial ratios facilitate the quantitative assessment of a company’s operational performance over time. Key ratios like Return on Equity (ROE), Return on Assets (ROA), and Gross Profit Margin are indicative of how efficiently a company operates, its profitability, and its ability to generate earnings from sales, assets, and equity.

2. Comparative Analysis

These ratios allow for comparative assessments both over different periods for the same company and between different companies or sectors. Such analyses aid stakeholders in understanding a company’s market position and competitiveness. For instance, comparing Price-Earnings (P/E) ratios can help identify potentially overvalued or undervalued companies within the same industry.

3. Liquidity Assessment

Liquidity ratios, including the Current Ratio and Quick Ratio, measure a company's ability to cover short-term liabilities without needing additional capital. This is crucial to ensure that the company can continue operations during tough economic times or when unexpected expenses occur.

4. Solvency and Risk Assessment

Ratios such as the Debt-to-Equity Ratio and Interest Coverage Ratio shed light on a company’s debt levels and its capability to service such debt. Elevated debt levels compared to equity might signify greater financial risk, possibly affecting the company's capacity to secure future financing or endure economic slumps.

5. Investment Decisions

Financial ratios are heavily utilized by investors to guide investment choices. Ratios like the P/E Ratio, Dividend Yield, and Earnings Per Share (EPS) directly relate to stock valuation. Investors use these ratios to predict future performance and determine the viability of including a stock in their investment portfolio.

6. Operational Efficiency

Efficiency ratios such as Asset Turnover and Inventory Turnover evaluate how effectively a company utilizes its assets to generate revenue and manage its inventory. These metrics help identify operational problems, like asset underutilization or high inventory levels, which can immobilize capital and escalate operational costs.

7. Strategic Planning and Control

Financial ratios are critical for managers engaged in strategic planning and operational control. Regular monitoring of these ratios helps managers spot trends, forecast future performance, and formulate strategic decisions aimed at enhancing financial outcomes or rectifying identified weaknesses.

8. Credit Analysis

For lenders and creditors, specific financial ratios are essential for assessing a company's creditworthiness. Ratios like the Debt-Service Coverage Ratio (DSCR) and Times Interest Earned Ratio are crucial indicators of a company’s ability to fulfill its debt obligations, playing a significant role in evaluating lending or investment risks.

In summary, financial ratios are fundamental to financial analysis, equipping stakeholders with crucial data for evaluating past and projected performance and making informed financial, operational, and strategic decisions.

Financial Ratio-Related Terms:

- Debt-to-Equity Ratio (D/E): This ratio reflects the extent to which shareholder equity and debt are used to finance a company's assets, showing the balance between the two.

- Price-Earnings Ratio (P/E): This valuation metric compares the current share price of a company to its earnings per share.

- Current Ratio: This liquidity measure evaluates whether a company can cover its short-term obligations with its short-term assets.

- Return on Equity (ROE): This performance indicator measures how effectively a company generates profit relative to the equity held by shareholders.

- Gross Profit Margin: This financial indicator shows what percentage of sales revenue remains after subtracting the cost of goods sold, reflecting the financial health of a company.

- Interest Coverage Ratio: This ratio measures a company's ability to meet its interest obligations on debt with its earnings before interest and taxes.

Financial Ratio Formulas:

Debt-to-Equity Ratio (D/E):

This ratio measures a company's financial leverage and is crucial for understanding how much of the company is financed by debt versus equity.

Price-Earnings Ratio (P/E):

It evaluates the market value of a stock relative to its earnings, indicating how much investors are willing to pay per dollar of earnings.

Current Ratio:

This liquidity ratio assesses a company's ability to pay off its short-term liabilities with its short-term assets.

Return on Equity (ROE):

ROE indicates how efficiently a company is using its equity to generate profits.

Gross Profit Margin:

This shows the percentage of revenue that exceeds the cost of goods sold, an indicator of production and pricing efficiency.

Interest Coverage Ratio:

This ratio determines how easily a company can pay interest on outstanding debt with its earnings before interest and taxes.

PRACTICE EXERCISES

1: What type of inflation is caused by a rise in prices due to an increase in the cost of production?

A) Demand-pull inflation
B) Cost-push inflation
C) Built-in inflation
D) Deflation

2: Which financial ratio is used to measure a company's ability to pay off its short-term liabilities with its short-term assets?

A) Debt-to-Equity Ratio
B) Price-Earnings Ratio
C) Current Ratio
D) Return on Equity

3: Which of the following is NOT a direct effect of inflation?

A) Decreased purchasing power
B) Increased interest rates
C) Reduced real income
D) Increased unemployment

4: What does the Price-Earnings (P/E) Ratio indicate about a company?

A) The company’s ability to generate profit from its shareholders' investments.
B) The amount of assets available to cover liabilities.
C) How much the market is willing to pay for each dollar of earnings.
D) The efficiency of the company’s inventory management.

5: If the Consumer Price Index (CPI) increases from 120 to 132 over a year, what is the rate of inflation for that year?

A) 10%
B) 12%
C) 15%
D) 20%

6. Question: If the Consumer Price Index (CPI) was 245 last year and it increased to 257 this year, what is the inflation rate?

7. Question: A company has total liabilities of $500,000 and shareholders' equity of $1,000,000. Calculate the Debt-to-Equity Ratio.

8. Question: A company's stock is trading at $50 per share and its earnings per share (EPS) is $5. Calculate the Price-Earnings (P/E) Ratio.

9. Question: A company has $200,000 in current assets and $100,000 in current liabilities. What is the Current Ratio?

10. Question: A company reported a net income of $150,000 last year. If the inflation rate was 3%, what is the net income adjusted for inflation for comparison with this year?

ANSWER KEY

MCQ:

B. Cost-push inflation
C. Current Ratio
D. Increased unemployment
C. How much the market is willing to pay for each dollar of earnings
A. 10%

Problems:

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References:

Investopedia. (n.d.). What are financial ratios? Definitions and examples. Retrieved May 4, 2024, from https://www.investopedia.com/terms/f/financial-ratios.asp

Corporate Finance Institute. (n.d.). Free finance courses. Retrieved May 4, 2024, from https://corporatefinanceinstitute.com/resources/courses/