Economic Environment and Accounting

Question 1

With regards to balance of payments, what does a receipts and payments refer to?

Answer 1

A receipt represents sterling flowing into the country, or any transaction that requires the exchange of foreign currency for sterling.

A payment represents sterling flowing out of the country, or any transaction that requires the conversion of sterling into some other currency

Question 2

How can central banks prevent or reduce deflation? What actions can they take?

Answer 2

Reduce interest rates - stimulates consumer demand / business investment.

Engage in a strategy or QE, increasing the money supply to stimulate growth.

Increase gov spending.

Reduce taxes.

Question 3

Explain why the Bank of England may not raise interest rates even if inflation increases significantly and exceeds their target.

Answer 3

• Deemed to be temporary/factors causing inflation will fall out of the annual calculation
• Future economic uncertainty e.g. BREXIT/to ensure economic stability.
• High levels of corporate and personal debt/risk to debtors.
• Exchange rate concerns and the effect on trade.
• Increasing interest rates may not impact on some types of inflation

Question 4

With regards to balance of payments, what are the two offsetting components?

Answer 4

1. current account, which deals with imports and exports of goods and services
2. capital and financial account, which deals with foreign investments in the UK and UK investment abroad, as well as loans.

Question 5

What is the current account divided into?

Answer 5

Trade in goods: The exports and imports of products ranging from commodities to manufactured products.

Trade in services: The exports and imports of services such as tourism, transport and banking.

Investment income: Comprises the earnings on investments held by Britons overseas and the earnings on investments held by foreigners in Britain.

Transfer payments: Items such as overseas aid and contributions to international organisations.

Question 6

State the three main components of the UK’s capital account.

Answer 6

• Foreign Investments/assets.
• Foreign Loans/borrowing.
• Foreign currency reserves.

Question 7

State the principal purpose of a capital account surplus within the UK’s balance of payments.

Answer 7

• To finance/fund;
• a current account;
• deficit.

Question 8

How is inflation perceived as both positive and negative?

Answer 8

Positive:
Increasing asset prices such as property.
Value of debt reduces.

Negative:
reduction in purchasing power for money held on deposit.

Question 9

If the current account is in deficit, what must happen?

Answer 9

the capital account must be in surplus. In other words, a deficit inflow of income is offset by a surplus inflow of capital. A country running a current account deficit (e.g. USA and UK) must be a net importer of capital.

Question 10

If the current account is in surplus, what must happen?

Answer 10

the capital account must be in deficit. In other words, a surplus inflow of income is offset by a deficit inflow of capital. Countries that run a current account surplus are net exporters of capital

Question 11

What are some potential causes of inflation?

Answer 11

Rising cost of raw materials.

Increasing cost of labour via wages.

Increased consumer demand in wider economy.

Lack of capacity in business.

Growth in the money supply.

Question 12

How can the BoE use interest rates to control inflation within the economy?

Answer 12

Increasing interest rate to make borrowing more expensive.

Increase rates to provide higher interest on savings and deposits.

Consumers have less disposable income and so spend less.

Less disposable income to invest.

Question 13

What is the effect of a budget deficit within the economy?

Answer 13

• Sustained deficits result in rising interest rates, which likewise act as a dampener on economic activity.
• Sustained deficits also cause a rise in total gross government debt so that interest payments on debt become a significant element of public spending. This became evident in the UK in 2022/23 as interest rates rose.
• Private sector investment is crowded out by the public sector’s demand for finance.
• Budget deficits, if sustained, reduce total national savings and hence, lower investment, which in turn will harm output, productivity and economic growth.
• Deficits have to be made good at some point, which usually means higher taxes or public spending cuts, or both, that slow economic activity

Question 14

What is monetary policy?

Answer 14

Monetary policy attempts to stabilise the economy by controlling interest rates and the supply of money.

Question 15

Explain M0 money supply

Answer 15

This includes:
– notes and coins in circulation; plus
– banks’ operational deposits with the Bank of England.

• M0 reflects changes in the economic cycle but does not cause them as it has little effect on total national output or inflation.
• M0 is also known as ‘narrow money’ and is an indicator of consumer spending and retail sales:

– Growth in M0 indicates that consumer spending is buoyant.
– A contraction in M0 suggests that consumers are behaving more cautiously.

Question 16

Explain M4 money supply

Answer 16

Comprises notes and coins in circulation, plus all instant access and time deposit accounts of UK residents with UK banks and building societies.

M4 is also known as ‘broad money’.

M4 includes deposits created by banks and building societies through their lending activities, as well as deposits lodged in accounts by people wanting to save.

An increase in the demand for loans will therefore be reflected in a faster growth in M4.

Question 17

What are the four phases of the economic cycle and explain them

Answer 17

Recovery, followed by expansion:
Real national output picks up from the trough reached at the low point of recession.

Boom:
Occurs when national output is rising strongly. Output and employment are both expanding . Gov tax revenues rise.

Slowdown :
Occurs when the rate of growth decelerates - but national output is still rising.

Recession:
growth is negative in at least two successive quarters.

Question 18

If the BoE prints more money and buys securities, which money supply will increase?

Answer 18

M4

Question 19

What is the effect of inflation on fixed interest securities?

Answer 19

Economy is booming, people are prepared to pay more for goods and services. This pushes up prices, generating inflation and higher interest rates. The yields from fixed-interest securities will need to be higher to compete with other investments, so their price will fall.

When inflation and interest rates are low and falling, the income from fixed-interest securities
becomes more attractive. In a recession and the early stages of a recovery, the prices of fixed- interest securities should increase due to falling interest rates.

Question 20

How is GDP Calculated?

Answer 20

GDP = C + I + G + (X – M)

where:

C = consumption: the expenditure of households on goods and services such as food and rent.
I = investment: the expenditure by businesses and individuals for capital investment.
G = government spending: the sum of government spending on goods and public sector jobs.
X = exports: the value of goods produced for export to other countries.
M = imports: the value of goods and services imported from other countries.

Question 21

How can the Bank of England create money or reduce the supply of money?

Answer 21

The Bank of England can create money by buying government securities; it can reduce the money supply by selling government securities via the repo market:

The bank can use its repo operations to influence short-term interest rates by:

Lending money in exchange for gilts and so inject money into the financial system: in simple terms, this should operate to lower rates by making money more readily available

Borrowing money in exchange for gilts and so withdrawing money from the financial system. This should operate to raise interest rates by reducing the supply of money. This process, in which the central bank is the borrower rather than the lender.

Question 22

State the main objectives of quantitative tightening (QT).

Answer 22

• Slow economy down/reduce consumer spending.
• Reduce liquidity/withdraw money from circulation.
• Raise interest rates/make monetary policy restrictive.
• Reduce inflation.

Question 23

what is cost-push inflation?

Answer 23

If firms face increased costs and inelastic demand for their output, the likelihood is that these rising costs will be passed on to the end consumer. Consumers will, in turn, demand higher wages from firms, causing a wage-price spiral to develop.

Question 23

Explain briefly tthe consequences of a central bank implementing QT.

Answer 23

• Increased supply of bonds causes prices to fall;
• and yields to rise.
• Borrowing becomes more expensive/less disposable income.
• Savings rates increase/become more attractive.
• Inflation comes down/reduces.
• Lenders unable to lend as much/less credit available.

Question 24

What is demand-pull inflation?

Answer 24

When the economy is operating beyond its full employment level of output, prices are pulled up as a result of an inflationary gap emerging. This excess demand can often stem from the optimism that accompanies rising asset prices, but has resulted, on innumerable occasions, from politically inspired tax cuts.

Question 25

Identify five main economic factors that may result in an increase in interest rates

Answer 25

• Business/economic cycle.
• Expansionary fiscal policy.
• Tightening monetary policy.
• QT/unwinding QE.
• Rising inflation.
• Currency weakness/economic imbalance.
• Market forces/credit spreads widening/UK downgraded.

Question 26

What is disinflation

Answer 26

Prices of goods and services are still rising, but there is a slowing of the rate at which they increase. Typically, this can occur during a recession, as sales drop and retailers are not able to pass higher prices on to customers.

Question 27

What is deflation?

Answer 27

Deflation is the opposite of inflation and occurs as prices decline over time and the inflation rate becomes negative. If the supply of goods rises faster than the supply of money, the purchasing power of money increases and the general price level of goods falls.

• If the prices of goods keep falling, manufacturers will reduce output as it is difficult for them to recover the cost of producing those goods. This will lead to a reduction in profits.
• Once deflation occurs, it is self-perpetuating, as reduced output and profits will lead to businesses reducing their workforce, creating unemployment.
• This will lead to further reductions in sales, so that production has to be further reduced.

Question 28

what is stagflation? and why is it a problem?

Answer 28

Stagflation is a combination of ‘stagnant growth’ and ‘inflation’, and is a situation that has not been seen in the UK since 1991.

The problem of stagflation cannot be resolved by simply raising interest rates (the usual route to controlling inflation) as the economy is weak and businesses would suffer further, leading to more job losses. In addition, if house prices are falling, rising interest rates would put further pressure on those already struggling.

Question 29

Effects of a rise in the exchange rate?

Answer 29

Exports become more expensive and so, fewer goods are demanded.

Imports become cheaper and so, demand increases.

Aggregate demand falls, leading to lower growth.

Inflation falls because of:
– the effect of cheaper prices for imported goods;
– lower aggregate demand; and
– less demand-pull inflation

Question 30

Effects of a fall in the exchange rate:

Answer 30

• More competitive exports, increasing demand for those goods.
• More expensive imports, reducing demand for those goods.
• Higher economic growth and rising aggregate demand.
• Potential for rising inflation.
• An improvement in the current account balance of payments.

Question 31

What economic factors could cause a country’s currency to fall in value?

Answer 31

Fall in interest rates compared to other countries.

Falling productivity or GDP growing faster than the amount of money in circulation.

Money supply increased at a faster rate than productivity.

Higher inflation compared to other countries.

Current account deficit or negative balance of payments (importing more than exporting).

UK capital accounts surplus.

Question 32

What happens if the real exchange rate rises or falls?

Answer 32

rises: domestic goods become more expensive relative to foreign goods, adversely affecting domestic production.

falls: domestic goods become relatively cheaper and demand for them increases.

Question 33

With regards to company accounts, what is “Goodwill”

Answer 33

Intangible assets to which a financial / economic value can be attached which belongs to the company. Examples include brand values, the value of a loyal customer base and reputation.

Question 34

What is operating and net profit?

What is profit margin and why is it useful?

Answer 34

Operating: Profit after operating and admin costs. It excludes the effects of investments, interest expenses and tax. Also referred to as EBIT (earning before interest and tax).

Net: Profit that is left to distribute to shareholders once interest and tax has been paid.

Profit margin: profit as a % of sales. You can work out operating or net profit margin. Identifies profitability from one year to the next (growth / fall in sales).

Question 35

Types of assets?

Answer 35

Non-current assets = long terms assets of the company with life longer than a year.

Current assets = short term assets which are turned into cash, usually with one year.

Question 36

What is turnover?

Answer 36

Sale the company has made. Represents income generated by a company from selling its services/products.

Question 37

What are the two main measures of profitability?

Answer 37

ROE = Return on Equity

Net profit / shareholder’s funds (total equity)

Measures the return on shareholder investment as a percentage. The ability to earn consistent above average ROE is fundamental. Evaluates profitability from shareholder’s point of view, relating to the profit available for distribution as a dividend.

Used effectively when comparing equities with other asset classes such as bonds and fixed interest.

ROCE = Return on Capital Employed

Operating profit / capital employed (total assets less current liabilities)

Measure how effectively a company has used its assets during a given accounting period. Capital employed is is equivalent to shareholders’ funds (capital and reserves) plus long-term creditors (long-term loans plus other liabilities and provisions for other liabilities).

Used effectively when making comparisons between companies.

Question 38

How can ROCE be broken down further?

Answer 38

ROCE = Profit margin x Asset Turnover

Profit margin = profit / sales

Asset turnover = sales / capital employed

Shows how much of return arises from good asset utilisation, how effectively assets are managed. If two companies compete, then profit margins will naturally converge, thus the only distinguishing factor is performance of asset turnover.

Higher the number the better as it means companies can generate more sales with fewer assets, indicating higher turnover ratio.

Indicates pricing strategy:

companies with low-profit margins tend to have high-asset turnover - Mcdonalds

Companies with high-profit margins tend to have low asset turnover - Rolls Royce

Question 39

What is profit volatility and how is it assessed?

Answer 39

How consistently can a company make profits year on year and sensitive is the company to changes such as interest rates?

Financial leverage: the ratio of debt to equity, commonly referred to as ‘gearing’. This measure indicates, among other things, the sensitivity of a company’s profits to changes in interest rates.

Operating leverage: the ratio of fixed costs to variable costs, sometimes known as ‘break-even analysis’. This measure indicates the sensitivity of operating profit to changes in sales volumes

Interest cover: How many times over could the interest bill be paid out of current profits?

Question 40

What is financial leverage?

Answer 40

The extent to which a business is using borrowed money.

Gearing = (long term loans + preference shares) / (total equity - preference shares).

Debt to equity ratios of more than 100% (that is, as much debt as equity) are generally
considered too high in the UK. However, it is therefore more appropriate to compare a company’s position against its immediate competitors.

Where a company has debt, it must pay interest before it can be dividends.

If revenues decline the company may find it harder to borrow or raise more money. If interest rates increase the cost of debt will increase and new debt will rise.

Question 41

What is the effect of gearing on profits?

Answer 41

High gearing exaggerates changes to ROE. When profits are high, high gearing boosts ROE, which is the main reason why companies gear. But if profits fall, ROE falls faster and further for a highly geared company than for a lower geared company. This is because the proportion of equity used in funding the company is lower.

If revenues decline, a highly geared company is less likely to be able to raise new loans to fund any corrective actions needed to maintain sales and profits. Where loans can be raised, above-average interest rates may have to be paid to reflect the additional risk.

A rise in interest charges also increases costs more for highly geared, more indebted companies. The exceptions are those companies that have structured their loans a competitive fixed rates, but this effect may only be short-term.

Question 42

What is operating leverage?

Answer 42

Considers the ratio of fixed costs to variable costs. Measures the sensitivity of operating profit to changes in sales volume.

Operating leverage = fixed costs / variable costs (costs of sales)

Higher operating leverage (high fixed costs compared to variable) indicates more volatility around the break-even point, with profits increasing/falling more quickly after this point.

Example:

A company which has fixed, expensive costs, such as Microsoft, will have the same costs no matter if it sells 1 laptop or 100m laptops. the costs to develop and market the product are the same for one laptop of 100m = high operating leverage.

Once they have hit their breakeven point then profits will skyrocket for every further laptop sold. However high operating leverage is consider high risk as changes in sales will reduce profit more so than low operating leverage.

Conversely, a supermarket will have costs related to the individual item sold, so if they sell 1 item of a 100m items, the proportion of costs per sale remains the same. Costs increase as sales revenue does.

Question 43

what is interest cover?

Answer 43

How many times over could the interest bill be paid out of current profits.

Interest cover = Profit before interest and tax / gross interest payable

High interest cover gives lenders confidence and can help improve the credit rating of a company.

Question 44

What is working capital / current ratio

Answer 44

Measure of the extent to which the claims of short-term creditors are covered by assets that are expected to be converted into cash within the next year.

Current ratio = current assets / current liabilities

Ratio less than 1 = current liabilities are greater than current assets, using creditors to finance ongoing capital requirements.

Healthy is considered 1.5 - 2, depending on industry, i.e. how quickly can a company realise cash from assets - think housebuilders, hard and long to sell houses.

Question 45

What is the liquidity ratio or acid test or quick ratio?

Answer 45

Similar to current ratio, but removes assets which may take a long time to sell, i.e. measures liquid assets within the business against liabilities.

Liquidity ratio = (current assets & cash equivalents - stock) / current liabilities

Measures how likely a company is to pay creditors.

As a generalisation, the liquidity ratio should be at least 1.0. However, this criterion cannot be applied to all types of business. Supermarkets, for example, often have a liquidity ratio of less than 1.0. They buy goods on credit, sell them for cash and have a quick turnover of stock. As their stock is a relatively liquid asset and is not dominated by any one category or brand of goods, the financial markets accept that they can run with lower liquidity ratios.

Question 46

Explain the implications and risks of having a high level of debt

Answer 46

Small increase in interest rates leads to disproportionate reduction in profits.

Risk of insolvency/default on debts.

Future dividend payments uncertain/could be cut.

Increases the volatility of share price/potential price fall.

Difficulty in securing additional borrowing.

Reduction in potential growth/expansion/less money for investment.

Gearing may also have a positive impact enhancing returns.

Question 47

In relation to cashflows, what would an investor focus on, the 4 areas?

Answer 47

Is the company cash flow positive at the operating level?

Where is the company spending its money?

How much cash is being provided from non-operating sources?

What changes to its financing position have occurred?

Question 48

What is the analysis of a company’s cashflow being positive or negative?

Answer 48

Positive:
This indicates that profitable trading levels are being maintained, generating positive cash flows into the business.

Negative:
Operating costs are higher than the revenue generated/company is making a loss from operating activities/each unit sold.
Would lead to liquidation in the long term/if persists.

Question 49

Explain what is meant by quality of earnings

Answer 49

Accurately represents trading performance of business.

Not manipulated by accounting policies/no one off items.

Strong free cashflow/cash generation.

Performance repeatable/consistent/dependable/sustainable.

Question 50

What is an exceptional item?

Answer 50

A charge incurred by a company that must be noted separately in its financial report in accordance with Generally Accepted Accounting Principles (GAAP). Despite the name, such items are considered to be ordinary business charges but they must be separated out for the sake of financial reporting clarity.

Concerns are:
if increasing each year
Open to manipulation/could hide ongoing problems

Question 51

Why would a company set a low dividend per share?

Answer 51

Increasing reserves/contingency/strengthen balance sheet.

Reinvesting earnings in business/fund takeovers.

Set at sustainable level.

Question 52

What is GDP and when is an economy in a recession?

Answer 52

Calculated by adding together the total value of all goods and services produced domestically during a calendar year.

After two successive quarters of declining GDP, it is said to be in a ‘technical recession’ (there is no universally agreed definition of a recession)

Question 53

What is fiscal policy?

Answer 53

Fiscal policy is the use of government spending and taxation to influence both the level of demand in the economy and the level of economic activity:

Question 54

What is a budget deficit and what are the problems caused by having one?

Answer 54

The imbalance between government spending and receipts results in either a budget deficit or surplus.

• Sustained deficits result in rising interest rates, which likewise act as a dampener on economic activity.
• Sustained deficits also cause a rise in total gross government debt so that interest payments on debt become a significant element of public spending. This became evident in the UK in 2022/23 as interest rates rose.
• Private sector investment is crowded out by the public sector’s demand for finance.
• Budget deficits, if sustained, reduce total national savings and hence, lower investment, which in turn will harm output, productivity and economic growth.
• Deficits have to be made good at some point, which usually means higher taxes or public spending cuts, or both, that slow economic activity.

Question 55

Financial systems perform four essential functions in a modern economy, what are these?

Answer 55

1. They provide a conduit through which savings are channelled into capital investment.
2. They provide a means by which savers’ desire for liquidity – ready access to their savings – can be matched with borrowers’ requirements for committed long-term funds.
3. They allow people and companies to insure against risks that they do not wish to take but that others are prepared to assume in return for a payment.
4. They allow investors to diversify risks across different investment products.

Question 56

What does the price elasticity of demand measure?

Answer 56

The price elasticity of demand measures the extent to which demand responds to a given change in prices.

• Consumers buy less of a product as its price increases, partly because they can spend their money on substitutes. For example, if the prices of restaurant meals rise, consumers will tend to eat at home more often.
• In contrast, demand is inelastic where a change in price has only a small impact on the demand for products. For example, the sharply rising gas prices in recent times have had only limited effect on domestic consumption as households have no real alternative for heating.

Question 57

Factors that effect demand?

Answer 57

• price;
• buyer’s income;
• demand for alternatives or substitutes;
• demand for other goods or services used at the same time;
• ease of purchasing; and
• whether the buyers like the product – their personal taste.

Question 58

Factors that effect supply?

Answer 58

• price;
• manufacture and distribution costs, e.g. materials, labour, transport or technology;
• supply of alternative products that could be made with the same resources;
• supply of products actually produced at the same time; and
• unexpected events that make supply easier or more difficult.

Question 59

Why do financial bubbles occur?

Answer 59

Financial bubbles happen when investors lose sight of fundamental values and buy shares or other assets simply because they expect prices will continue to rise. This is often known as the ‘greater fool theory,’ i.e. relying on a greater fool to purchase the shares/asset at a higher price.

Question 60

What is one theory for why bubbles occur?

Answer 60

A possible cause is that in an attempt to revive the economy in the early part of the decade, rates are cut too far and liquidity rushes into speculative investments. The mania accelerates towards the end of the decade before collapsing – requiring rates to be cut aggressively once more. So far, the 2020s look quite different, with post-pandemic global interest rates rising sharply