Balance of Payment

Balance of Payments and Multinational Corporations

Introduction

Balance of Payments – Over the last two decades, the world economy has been changed to an extent on which the nations are interconnected with each other in terms of commerce and financial relationship. This circumstance is popularly known as globalization (Vinals, 2004). This interconnection not only helps to exchange goods or service but also force to keep account of financial payment between two countries (Dabrowski, 2006). This record is known as balance of payment. Generally, a multinational corporation has a strong relationship with the balance of payment between two countries (Stein, 1984). The multinational corporation may be affected positively or negatively in the host or home country by the balance of payment (Wilamoski and Tinkler, 1999). The positive relation between MNCs and Balance of Payment creates many opportunities for the multinational corporation. A manager of multinational company must take necessary steps to grab those nice opportunities.

What is Balance of Payment?

Balance of payment is a process of keeping record of transaction of a country with the rest of the word. It includes not only payment for goods and services but also all others payment over the border (Chamberlin, 2009). According the Sloman John, Balance of payment is an account that contains all monetary transaction of a country with the other countries of the world (1998). The transactions contain exports, import, incoming payment and transfer of finance. The balance of payment is usually evaluated based on certain period such as year.  It is also calculated on a single currency, normally US dollar (Mcbride, 2007).

Sources of money are considered positive and deployed of funds is negative items. According to Investopedia, the balance of payment generally should be zero to be optimum (2013). However, it does not happen most of the time. The balance of payment is normally surplus or deficit for maximum country. A surplus balance of payment is said to be exist when the incoming payment is higher than total transfer.  On the other hand, a deficit balance of payment is said to be exist when the transfer payment is higher than the incoming payment.

What is Multinational Corporations or MNCs?

A multinational corporations or MNCs, also known as Multinational enterprise (MNE), is a company that operates is business or produce and sale product in more than one country (Daniels, Radebaugh and Sulivan, 2001). According to Van De Kuil, a multinational corporation follows the internationalized philosophy and operates its business both home and host country (2008).

He also added that to be a multinational corporation, a company must have the assets and facilities outside the border of national country. The host country, home country and the multinational company get benefits from a multinational trade (Kokko, 2006). The host country gets higher tax or vat, the home country get foreign currency and the multinational company get profit. Here is some example of well-known multinational company Honda, Toyota, Google, HSBC, Wal-Mart, Samsung and chevron etc.

Relevance of Balance of Payments to Multinational Corporation

There is a strong relationship between the balance of payment and Multinational Corporation. A multinational corporation helps both host and home country to increase their balance of payment. In the contrary, the balance of payment situation of a country impact the operation of a multinational corporation by changing the rules and regulation based on country specific needs (Ker and Yeates, 2013). Let us look the relevance of balance of payment to Multinational Corporation in terms of different situation.

Relevance Based on “Direct impact”

 A country in which a multinational company is located tends to be get higher balance of payment. It experiences capital inflow when a multinational company get started with a certain fee. It also gets funds or money from the portion of profit of that Multinational Company (Shoo, 2005). On the other hand, the multinational company helps to improve the balance of payment of home country. The home country gets funds when the MNC make profit and return the money to the home country.

Relevance Based on “Regulatory Relation”

Another positive or negative relation between balance of payment and the MNCs is regulatory relationship. The balance of payment represents the foreign reserve of a country. The trade policy of a country changes with the changes on balance of payment position. If a country has negative balance of payment, it tries to hold the money by encouraging more export than import (Hale, 2013). It also tries to get more tax or VAT from the normal sources. This tighten money policy affects the business flow of multinational companies. They have to give more tax to the government. The sales volume of MNCs may rise because the local producer is busy to export in other countries. The MNCs can be the market leader. It may not happen all time.

The rules and regulation may be strict for both domestic and multinational companies. On the other hand, if a country more reserve or balance of payment, it tries to deployed money. It encourages import than import or it invests money to another country as FDI or foreign direct investment. It may reduce the tax burden for MNCs (Bhusnurmath, 2011). By this way, the MNC can get maximum profit. The host country may be benefited from this policy by getting portion of profit when it will get back to it.

Relevance Based on “Measurement Challenge”

The MNC puts a measurement challenge of balance of payment for both home and host country. The goal of a Multinational company is to maximize the profit in after tax all over the world. To do this, they allocate resources, make mixing price system and make extra bill. These conducts is very difficult to measure for the regulatory bodies (Landefeld, Moulton, and Whichard, 2008). There are some good reasons behind this; the resources of production are not same in all countries and the price too. Therefore, it is very tough to evaluate the perfect amount of balance of payment. The mix price is also difficult to detect. Therefore, the proper amount of payment is in question in all countries due the inappropriate recording of MNCs transactions.

Relevance Based on “Foreign Exchange”

The balance of payment is a better indicator of country’s financial status. It helps to evaluate the foreign exchange rate of a country. This exchange rate has direct or indirect effect to the multinational corporation (Wang, 2005). When a currency of a country is strong, the import will cheaper and the export will less competitive. This situation puts pressure to the MNCs to adjust the situation. At that price of goods tends to be cheaper so that the multinational corporation must adjust their price level. Again, when the exchange rate of a country is weaker, the import will expensive and export will high competitive because of inflation. This situation makes higher price level within the country and the MNC have to adjust their price in a high level.

Relevance Based on “Asset Reserve”

The balance of payment also consists of asset such as gold reserve. The higher gold reserve means country has higher trade surplus and thus the higher money supply. This tends to create inflation within the country. Therefore, the MNCs can make higher profit by raising their price level. Conversely, when there is a trade deficit means low assets reserve. This makes the price lower because there is a low money supply. Therefore, the MNCs must adjust their prices level to cope up with host country’s policy.

Relevance Based on “Decision Making”

The balance of payment statistics is very important for all kinds of decision makers. The authority of a country looks carefully the flow of balance of payment. The balance of payment generally is a great indicator of future exchange rate of a country. This put pressure to the monetary authority to take necessary steps to control the money supply. Again, the balance of payment indicates the proper amount of assets reserve for a country. This makes concern for the fiscal authority. They should determine the trade policy, VAT, income taxes and the policy for the multinational corporation. Therefore, we can say, balance of payment accounts are closely related to the overall saving, investment and price policy of a country.

Relevance Based on “Business Policy”

The MNCs are also a good user of balance of payment statistics. They must assess the balance of payment both host and home country for their business policy. The policy of a MNC much depends on the balance of payments flow because change in balance of payment also changes the rules and regulations. When a multinational company try to start their business in another country, they must assess the domestic balance of payment. Because the domestic balance of payment, indicate the permission. If the host country has surplus balance of payment, the MNC can start their operation.

Conversely, if the balance of payment is in deficit position the MNC may not get the foreign investment permission. Again, the MNC must assess the host country’s balance of payment. If the host country has already huge surplus balance of payment, it may not give permission to a new MNC because it tries to invest their money not get money. Conversely, if the balance of payment is in deficit position in the host country, they may welcome new money flow to their country. Thus, the balance of payment position in host and home country affect the decision of business start up. The MNC should also asses the foreign exchange rate position in home and host country.

The weaker currency in home country means the multinational company have to pay more to start their business in another country. Conversely, if the exchange rate is weaker in host country, the Multinational Corporation can start their business cheaply in the host country. Balance of payments also influence the interest rate because of high bank reserve, the MNC also have to consider the interest rate in the host country. The higher the interest rate means the higher business cost for MNC in the host country.

Finance Essays Balance of Payment
Finance Essays

Changes in Balance of Payment and Management Actions

What is change in balance of payment?

Balance of Payments should be equal in all time. However, in reality, it does not happen. The balance of payment is continuously fluctuating all time. This is called disequilibrium of balance of payment. According to TR Jain, disequilibrium payment is a situation when the balance of payment fluctuates from zero (2008). Another author Cherunilam argues that a country’s balance of payment is disequilibrium when there is surplus or benefit (2010). There are three types of changes in balance of payment favourable, unfavourable and balance. Favourable balance of payment means surplus balance of payment. Unfavourable balance of payment means deficit balance of payment. Balance in BOP means equal incoming fund and outgoing funds.

Causes of Changes in Balance of Payments

There are various causes of change in balance of payment. From them, Raj Kumar, author of international economics pointed out three main reasons such as economic, political and natural (2008). He said that if a country is in developing position it must be in deficit balance of payment. The reasons behind economic cause are huge economic development in infrastructure, inflation or deflation, cyclical fluctuation and changes in foreign exchange rates. Again, the reasons behind political cause in balance of payment are political instability and international relations. The natural consequences such as earthquakes, hurricane and others are the reason for natural cause in balance of payment.

Result of Changes in Balance of Payment

The changes in balance of payment may affect positively or negatively to the economy. Here are some Results of changes in Balance of payment:

  • Positive effects of Changes in BOP increase the creditability of a country. Conversely, Negative changes in BOP lower the international creditability.
  • Positive changes decrease the foreign dependency in terms of financial help. Conversely, Deficit changes in BOP increase the foreign economic dependency.
  • Surplus changes increase the foreign exchange reserve. Conversely, Negative changes in BOP deplete the foreign exchange reserve.
  • Reserve of gold is increase in the case of surplus balance of payment. Conversely, the reserve of gold decreases and goes away in negative BOP situation.
  • Negative balance of payment hampers the economic development. Conversely, positive balance of payment improves the economic condition.
  • Surplus balance of payment increases the global market leadership for the home multinational company. Conversely, Deficit balance of payment hampers to get global market leadership position.

Opportunities for MNCs Revealed by Changes in Balance of Payments

The changes in balance of payment position affects positively and negatively for a country’s economy. As the MNCs are one of the important parts of economy, it also gets affected due to changes in balance of payment. Here are some opportunities for MNCs revealed by the changes in balance of Payments.

Business Growth: A multinational company can get business growth advantages in both home and host country. If the home country has surplus balance of payment, the authority approves MNC to start their business internationally. It means they do not mind in capital outflow from the nation as they have surplus funds to invest. On the other hand, a MNC can expand their business to a host country if they have negative balance of payment. They must try to grab money from the other national to increase their business infrastructure. For this reason, MNC is the best way to get finance.

Low start-up cost: A multinational company can start their operation cheaply in host country due to changes in balance of payment. If the host country has deficit balance of payment, they must encourage funds flow from MNC with low regulations and cost. Again, if the home country has high balance of payment, they allow MNC to start its business with lower fees.

Tax benefits: An MNC can also get tax benefits both home and host country due to fluctuation of balance of payment. The home country encourages FDI when it has surplus balance of payment. For this reason, the tax tends to be lower than deficit BOP to encourage foreign direct investment. Again, in the host country the MNC gets lower tax benefit due to deficit balance of payment (Robert, Dunn and Mutti, 2009). The MNC can also get the lower tax benefit, when the country tries to increase their export and reduce import.

Exchange rate benefits: The fluctuation of exchange rate is highly related to balance of payment. This exchange rate or balance of payment affects the operation cost positively or negatively to a multinational corporation. The MNC pay less if the home country has higher balance of payment or strong exchange rate. Here, they get exchange rate benefits due to weak currency in host country. This strong exchange rate also reduces the resources costs in the host country. Moreover, the MNC can get bill paying benefits due to change in balance of payment system.

Low cost of operation: A multinational corporation can experience low cost of operation due changes in balance of payment in both home and host country. It can get factors of production such as land, labour, machinery and others tools at low prices where the balance of payment is lower. Because, lower balance of payment indicates high rate of unemployment in the host country.

Higher Sales: A multinational corporation can increase their sales due to impact the balance of payment in the host countries. When a country experience lower balance of payment, it tries to increase the export and reduce import to get higher balance of payment. To do this, the country should ensure high production unit. The domestic producer may unable to cope up this policy. Therefore, the MNC get the opportunity to sales more during the recovery situation in balance of payment.

Higher Profit: A multinational corporation can make higher profit due to changes in balance of payment. As we discuss earlier MNC can sale higher volume in the host country in the recovery situation. By this, it can make higher profit because higher sales means higher profit (Deresky, 2009). On the other hand, the MNC can make higher profit if the currency of host country is devaluated. For example, European MNC operates its business in US. If the US dollar is weaker than Euro, the European countries will get higher value of money when they convert the money into their own currency.

Measures to exploit opportunities revolved by changes in Balance of Payments

As a MNC operates internationally, it must cope up with the changes on balance of payment in both home and host country. The manager of MNC should be careful to grab every opportunity provided by the BOP. The management measures have been given below:

Seek for growth: A manager of Multinational Corporation should always seek for business growth in home, host or any other country. To seek the business growth opportunity the MNC have to assess the balance of payment position. If the balance of payment is favourable, the manager should grab the opportunity for growth.

Alert all time: The manager should be alert all time to grab the best opportunity for business. As there are various obstacles for a multinational business, the manager have to overcome the obstacle by grabbing the best available opportunity.

Acquire new technology: New technology is very important for a business to get the competitive advantages. A company can implement a new technology to track the balance of payment related data to know the future trend of exchange rate, business cost and tax rate.

Hire business analyst: The manager can hire a business analyst to analyze the balance of payment data and recommend the best opportunity. The analyst also may responsible for making quick and instant decision regarding balance of payment trend.

Implementing short and long-term strategy: The manager can implement a short and long-term strategy for grabbing the opportunity of balance of payment. The short-term strategy may be for less than one year and the long-term strategy may be for above the one year. In addition, this strategy should include the yearly business strategy.

Conclusion

Due to high impact of globalization, every country must engage business internationally through Multinational Corporation. The multinational corporation contribute in the economy of related party’s as well whole world. This report describes that there is a strong relevance of balance of payment to Multinational Corporation. They are related to each other’s in terms of direct impact, regulatory relation, assets measurement, foreign exchange, business policy and decision-making.

This report also describes that the changes in balance of payment creates some opportunities for MNC such as business growth, low start up cost, exchange rate, higher sales and higher profit benefit. Moreover, this report suggests that a manager of a company should take some important measures such as implementing new technology, higher business professional and hiring business analyst to grab the best available opportunity revealed by changes in the balance of payments.

References

Akrani, G. 2010. Disequilibrium in the Balance of Payment – Meaning , Causes.

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Cherunilam, F. 2010. International business. New Delhi: PHI Learning Private Limited.

Dabrowski, M. 2006. Rethinking balance-of-payments constraints in a globalized world. [e-book] Available through: Munich Personal RePEc Archive

Daniels, J., Radebaugh, L. and Sulivan, D. 2011. International business. Boston: Pearson.

Deresky, H. 2011. International Management. Boston, Mass.: Pearson.

Eicher, T., Mutti, J., Turnovsky, M. and Dunn, R. 2009. International economics. London: Routledge.

Essay.uk.com. n.d.. Negative and positive impact of globalisation

Hale, G. 2013. Federal Reserve Bank San Francisco | Research, Economic Research, Europe, Balance of Payments, European Periphery

Investopedia.com. 2013. What Is The Balance Of Payments?

Investopedia.com. 2013. How The Federal Reserve Manages Money Supply

Jain, T. 2008. Macroeconomics and Elementary Statistics. V K Publications.

Kokko, A. 2006. The Home Country Effects of FDI in Developed Economies. [e-book] Stockholm School of Economics

Kumar, R. 2008. International economics. New Delhi: Excel Books.

Landefeld, J., Moulton, B. and Whichard, O. 2008. The Impact of Multi-National  Companies on Balance of Payments  and National Accounts

Mcbride, C. 2007. How to Calculate the Balance of Payments | eHow

Palgrave-journals.com. 2004. United Kingdom Balance of Payments: The Pink Book – Further information on UK balance of payments

Shoo, D. 2005. Economic Effects of Multinational Corporations | eHow

Sloman, J. 1998. Essentials of economics. London: Prentice Hall Europe.

Stein, L. 1984. Trade & structural change. London: Croom Helm.

The Economic Times. 2011. MNCs lower tax burden by swopping domicile – The Economic Times.

The Sydney Morning Herald. 2013. Multinationals cry foul at tax changes

Van De Kuil, A. 2008. Strategies of Multinational corporations in the emerging markets China and India. Mu¨nchen: GRIN Verlag GmbH.

Vinals, J. 2004. “European Central Bank Statistics and Their Use for Monetary and Economic Policy Making”, paper presented at Second ECB Conference on Statistics, European Central Bank, 22 and 23 April 2004. Germany: European Central Bank.

Wang, P. 2005. The economics of foreign exchange and global finance. New York, NY: Springer.

Wilamoski, P. and Tinkler, S. 1999. The trade balance effects of U.S. foreign direct investment in Mexico. Atlantic Economic Journal, 27 (1), pp. 24-37

meritnation.com. n.d.. What are the advantages & disadvantages of MNCs?

Balance of Payments Relevant Links

International Finance Management

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Asset Price Bubbles

Central Bank Response to Asset Price Bubbles

Recent research in the area of macroeconomics has been focused on trying to identify the causes of the 2007 – 2008 global financial crisis and determining best central bank monetary policies to prevent future crises. A debate that has for the last few decades been settled is now being revived; “lean” versus “clean” handling of asset Price bubbles.

The prevailing consensus of central bank monetary policy has followed the “Greenspan Doctrine” established in the 1970’s for dealing with asset price bubbles. Alan Greenspan, who was the chairman of the U.S. Federal Reserve from 1987 to 2006, believed that cleaning up after an asset bubble burst was less costly and damaging to the economy than allowing central banks to burst bubbles; attempting to “Lean Against The Wind (LATW) (Wadhwani, 2008)” on rising asset bubbles to prevent a bigger burst. This perspective was widely accepted by central banks around the world.

There are mainly four arguments against LATW monetary policy. First, bubbles are difficult to predict; the market would likely detect asset bubbles before regulators would and the market would be able to orderly deflate those bubbles through natural market processes. Secondly, there is evidence that raising interest rates (a central bank strategy for determent) doesn’t reduce the inflation of bubbles since investors are likely to take the risk on high interest rate assets in the midst of an asset bubble based on the expectation of high returns on those assets. Third, the Fed is incapable of isolating dangerous asset bubbles from normal rising asset prices; monetary policy could ham-handedly attempt to prevent asset bubbles but have the effect of harming normal asset prices. Lastly, proactively bursting asset bubbles could make the burst harsher than if the bubble were allowed to burst on its own.

Those cautions have kept the Greenspan Doctrine in place since the late 80’s, but in the aftermath of the 2007 – 2008 crisis, many economists are beginning to wonder if the “lean” strategy may actually be cleaner than the Greenspan Doctrine. Not to mention, the Greenspan Doctrine assumed that bubbles could not be as destructive as the most recent housing bubble. Could central banks develop monetary policy strategies that are more precise in detecting and deterring asset bubbles?

Combating Price Bubbles

Clearly, setting aside the lean versus clean debate, there are standard monetary principles that have not always been followed or enforced. Namely, regulators should demand more transparent disclosure, require more capital and liquidity, apply stricter monitoring of risk, stronger enforcement of compliance, and more accountability for regulators charged with overseeing the financial stability of markets. These policies need to be either reinstated and or reinforced to help stabilize the markets during asset bubbles or otherwise.

But for central banks to devise better strategies for combating bubble driven asset pricing, it is necessary to rethink the Greenspan Doctrine considering how ill-prepared the central banks were for dealing with the crisis in the financial markets. Or, perhaps both strategies have a time and place in setting monetary policy. Frederic Mishkin argues that there is a way to apply the LATW strategy to the financial markets if first central banks understand that there are two different types of bubble driven assets and each one requires a different monetary strategy.

Asset-pricing bubbles are divided into “credit bubbles” – like the housing bubble – and “irrational exuberance bubbles” – like the dot-com bubble (Mishkin, 2011).” He argues that because credit bubbles are so destructive to the economy and so hard to clean up that it would be appropriate for central banks to focus their monetary policies on predicting and deflating credit bubbles before they grow too large. Credit bubbles are linked to the financial markets so intricately that whenever there is a credit bubble like the one just experienced, its bursting usually leaves in its wake a deep recession, a financial crisis and a long period of slow growth and high unemployment.

Asset Price Bubbles
Asset Price Bubbles

Unlike normal recessions, there was no sharp recovery after the last three big asset bubbles. Because it is so hard to recover from credit bubbles, trying to head them off and prevent them is necessary. The LATW can be applied and should factor in to central bank policy because credit bubbles are much easier to identify. Each credit bubble shares certain symptoms that could alert regulators to the problem: lower lending standards, premiums on risk become abnormally low and credit is being extended at a much faster and higher rate (Mishkin, 2011).

The central bank targets these credit bubbles by slowly raising interest rates to discourage excessive risk taking in the credit markets. By inflating the interest rates on these assets, central banks can tamp down exuberance as well as spark growth in a slowing economy (The Financial Times LTD, 2014). This requires central banks to turn their focus more sharply and aggressively towards monitoring and reacting to irregularities in asset pricing more than the traditional singular focus on controlling inflation (Wadhwani, 2008) (Gambacorta & Signoretti, 2013). Lastly, this type of proactive monetary policy could have the effect of reducing moral hazard through proactive responses to booms as opposed to the reactionary approach to booms after the bust; this could discourage the reckless risk taking that typifies credit bubbles (The Financial Times LTD, 2014).

While economists are still debating the merits of the LATW strategy of curtailing asset price bubbles, it is without question that the traditional standards of monetary oversight have been too lax over recent decades and reinforcing those policies will go a long way to restoring healthy checks and balances to the world market. However, it has also become very clear that these boom and bust cycles threaten financial stability in such a way that central banks can no longer ignore fluctuations in credit markets. While focusing on controlling inflation is still a target for central bank monetary policy, central banks must now focus efforts on developing Bubble Policies (Rudebusch, 2005) that can prevent or deflate asset price bubbles before they can do real damage to the economy

References

Brittan, S., Meltzer, A. H., Wolf, M., Smaghi, L. B., Schlesinger, H., Mayer, M. Frankel, J. (2009, Fall). Should, or Can, Central Banks Target Asset Prices? A Symposium of Views

Gambacorta, L., & Signoretti, F. M. (2013, July). Should monetary policy lean against the wind? – an analysis based on a DSGE model with banking.

Mishkin, F. S. (2011). How Should Central Banks Respond to Asset Price Bubbles? The ‘Lean’ versus ‘Clean’ Debate After the GFC. Reserve Bank of Australia June Bulletin, 59-67.

Rudebusch, G. D. (2005, August 5). Monetary Policy and Asset Price Bubbles.

The Financial Times LTD. (2014, April 16). Definition of leaning against the wind. Retrieved from Financial Times Lexicon: http://lexicon.ft.com/term?term=leaning-against-the-wind

Wadhwani, S. (2008). Should Monetary Policy Respond to Asset Price Bubbles? Revisiting the Debate. National Institute Economic Review, 25 – 34.

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2007-2008 Financial Crisis Essay

The 2007-2008 Financial Crisis

2007-2008 Financial Crisis – According to Saylor Academy (2012), a financial crisis happens when many financial markets function inefficiently or stop functioning completely; when one or few of the financial markets stop functioning the crisis that result is nonsystematic Saylor Academy (2012). The 2007 financial crisis started with subprime mortgages and in 2008 it turned severe systematic after major financial institutions failed.

The 2007-2008 Financial Crisis was a combination of many things, including: Monetary policy easing, banks taking excessive risks, consumers borrowing more than they could afford, the eventual US Housing Market Crash, stocks and poor risk pricing, the federal budget deficit, excessive leveraging by banks, predator lending, poor underwriting practices and the Federal Budget Deficit. This paper explores how the 2007-2008 Financial Crisis financial happened, what markets were impacted and how it was dealt with.

Monetary policy easing – Deregulating policies that were placed in placed to repeat historic failures is like playing Jenga, eventually everything will fall. According to (Market Oracle Ltd, 2009), the first block of deregulation happened in 1980 with the Depository Institutions and Monetary Control Act of 1980 – this was the first thing the banking system was being let a bit loose after the regulations that were put into place after the Great Depression.

The act accomplished the following: required less reserved from the banks, it created a committee to get rid of federal interest rate caps, increased insurance of Federal deposits, allowed banks to get credit advances from the Federal Reserve Discount Window and finally, it overstepped over state laws that restricted lenders by putting a ceiling on the interest rates they could charge from mortgage loans.

The second piece of monetary easing happened when the government and their great wisdom or greed decided to pick apart key pieces of the Banking Act of 1933 (Glass-Steagall Act of 1933). The act was in place to prevent banks from gambling with people’s savings, it separated commercial banks from investment banks – this was very important because investment banks could not take huge risks with people’s money.

Gramm-Leach-Bliley Financial Services Modernization Act was the drop that spilled the cup or the final straw that broke the camel’s back. This law, removed the last protective barrier that Glass-Steagall Act provided and allowed banks to do whatever they wanted; for example, Travelers investment bank was able to buy Citibank…Remember the law wanted to keep investment banks from using people savings? Well, this last act allowed investment banks to play with other people’s money (Market Oracle Ltd, 2009). Monetary policy easing removed all roadblocks that annoyed banks, but kept people’s savings intact and save; additionally, it gave birth to Subprime lending which later would be a major player in the Housing Market crash.

Banks taking excessive risks: According to (The Economist, 2013) Senator Phil Gramm once was quoted as saying “I look at subprime lending and I see the American Dream in action”. Due to the economy doing so well and low inflation, banks and investors were willing to take more risks in order to get a piece of the action. Banks were being irresponsible with mortgage lending and lower standards with subprime lending, borrowers who should not have gotten loans were able to get into houses they could not afford.

In order for banks to lessen or mitigate the risks, they played the numbers games, they gathered a many high-risk loan and put them together in groups (pooling), depending on the probability of defaults – in theory, this would decrease the risk because what were the probabilities that all borrowers in that pool could default on their loans? (The Economist, 2013)

Consumers borrowing more than they could afford – This comes back to subprime mortgages and just the timing of what was happening with the economy and the housing market. According to (John V. Duca, 2013) – traditionally, borrowers have to have good credit, good income and good debt to income ration in order to be the proud owners of a house with a white picket fence – those borrowers who did to meet the requirements above, would historically not qualify for any loans to buy a house. The ability of more people qualifying for mortgages they could not afford, lead to an increase in the housing market because the economy was experiencing more first-time home buyers.

The increase in demand created an increase in housing prices and it required more money to be borrowed by the people who were already stretched thin on the amount of money they were borrowing (John V. Duca, 2013). Up to this point, banks and consumers were lending and borrowing money banking on best case scenario and not planning for the worst. Added to the situation was the fact that the government had mandated Fannie Mae and Freddie Mac to increase home ownership, so both Fannie Mae and Freddie Mac had purchased lots of subprime mortgages (John V. Duca, 2013).

Secured Lending - 2007-2008 Financial Crisis
Secured Lending – 2007-2008 Financial Crisis

US Housing Market Crash – In the famous quote from Isaac Newton “What goes up must come down”.  Once housing market reached its plateau, mortgage financing and home selling became less attractive and that is when they began to drop in price, lenders and investors started losing money. The first casualty of subprime mortgages happened in April 2007, New Century Financial Corps filed for bankruptcy – after that, all the pooling that was done by experts to mitigate default risk was downgraded to high risk and many small subprime lenders went out of business.  Lenders stopped issuing loans, specially the high interest rate ones (subprime) – this resulted in less people getting loans after that and as a result, less houses being purchased by consumers.

Low demand for houses led to a drop-in price, the famous law of supply and demand had kicked in. Prices dropped so much that borrowers who were trying to sell them could not send them at the price they owed in their loans. Remember that government told Fannie Mae and Freddie Mac to increase home ownership? Well, as a result, Fannie Mae and Freddie Mac suffer major losses an all subprime mortgages they had purchased and insured (John V. Duca, 2013). The housing market was flooded by banks selling their foreclosed/repossessed homes, people trying to sell their houses because they get foreclosed, people doing short-sales and in addition the market was getting the normal number of houses being sold the usual sellers (new construction, people moving, etc.).

US House Prices - 2007-2008 Financial Crisis
US House Prices – 2007-2008 Financial Crisis

Stocks and poor risk pricing – Prior to the economic crisis, investors were unable to get the exact value of risk they would be bearing when taking up stocks or financial assets from the traders. Risk pricing or the cost of risk is implied in the rate of interest charged and the investors, with poor risk profile of certain assets in the market, would not know the value of the risk assumed when buying stocks or the value of risk exchanged when selling stocks (Amadeo, 2010; Williams, 2010). The market participants were thus inaccurate in their risk analysis due to the complex financial system and innovations among other factors such as ignorance and deceit from the traders themselves.

JP Morgan is quoted as selling and quoting the risk price of CDOs at a price way lower than the market price due to lacking accuracy or information as is contrasted to stable prices in a perfect market, where market information is publicly available, as per the Basel accords. In a similar risk pricing error and crisis, the AIG had to be taken over by the American government, settling about 180 billion US dollars from the tax payers’ money because AIG had taken premium guarantees to pay several CDS obligations to many lenders of small and global parties, whose risk profile was then uncertain to the lender and insurer and plunged the institution into near bankruptcy (Amadeo, 2010).

There was then no clear model of ascertaining the level of risk assumed by a guarantor or a borrower given the dynamic and complex financial innovations of the time and the slowly growing financial academia, practice and experience within a span of two years, that is, between 2007 and 2008 (Jickling, 2009).

The Role of The Federal Reserve in the 2007-2008 Financial Crisis

The Federal Reserve and liquidity – The Federal Reserve is the lender of last result to banks and thus, is the only last savior in a financial crisis. However, the reserve faced inadequate cash to lend to banks with the rapid mortgage and loan processing witnessed alongside booming borrowing and house financing by banks and financial institutions. Commercial banks couldn’t afford adequate liquidity to finance their obligations and the large sizes of mortgages they were buying.

In the same time, the price of commodities and especially minerals such as oil and copper were growing at an unsustainable rate, with most of the minerals being imported from outside. The rise would give the impression to traders that it was an opportunity to invest in the appreciating metals and thus, there was a general cash outflow from the US in exchange for metals and gems, which saw increased trading lead to a decline in the prices thereof and a general loss of cash from the American economy to oil producing and mining countries such as the middle east nations. The cash inflow into the US was less than the cash outflow and commercial  banks would earn less than they were paying as cost of leveraging. This Federal Reserve with less inject into the economy to facilitate liquidity among the commercial banks (Jickling, 2009).

Excessive leveraging by banks – Before the 2007-2008 financial crisis struck the market, banks and other institutions in the mortgage and finance sector had used massive leveraging, that is, using credits and other derivatives to acquire assets. Leveraging shifts the risk of lending to the leveraging institution, thus removes the risk adverseness of a financial institution. They trade with appetite for risky investments which they perceive are most productive. The state of affairs with the highly leveraged financial institutions, therefore, led to risky deals which ultimately led to high rates of defaulting. Also, a major contributor to the 2007-2008 financial crisis.

The high level of leveraging, also, exposed the banks to massive risk impact should a financial downturn result and when it did with the bursting housing prices balloon, the financial institutions came crumbling down, leading to a global and all-sector financial crisis with little identity as to which institutions were in bankruptcy (Amadeo, 2010). This was as a result of a complex system of financial derivatives and contracts that were difficult to determine given the limited financial information then available (Jickling, 2009).

Predator lending – Another factor that contributed greatly and grossly to the financial crisis of the time was the deceitful predatory lending by financial institutions. The institutions would entice borrowers or mortgage buyers with appealing interest rates and have them commit to the mortgages even when such a commitment had hidden charges or adjustments (The Economist, 2010). A common practice involved the use of very low interest rates to hook up people after financing. Upon the completion of the mortgage, the client would realize later that the mortgage was an adjustable one with rates rising gradually to almost double the value they borrowed.

Many would end up unable to pay back the commitments and have their mortgages seized or have to deal with a negative amortization mortgage (McLean & Nocera, 2010).  In one case, the California attorney sued Countrywide Financial for fraudulently enticing borrowers in to a bait-and-switch conman mortgage with expensive mortgage payments (The Economist, 2010). With the falling housing prices, the home owners with outstanding mortgages were demotivated to pay their dues against the devalued prices of their mortgages, leading to massive defaulting and a financial crisis in the industry (Jickling, 2009).

Poor underwriting practices – Another factor that led to the ultimate onset and peaking of the financial crisis was the poor underwriting practices by intermediaries, banks and even insurers. Regulations require that a loaning process should follow the loaning institutions documentation guidelines and the underwriting process ought to be understood in depth to avoid unforeseen difficulties or illegalities. However, the pre-crisis period was characterized by rapid underwriting processes with little or no attention to the lender’s procedures and rules of engagements.

Loans and mortgages would be processed with little or no official documentation completed as per the issuers rules of engagement, which would lead to borrowers being subjected to terms they didn’t sign for or they were unaware of, high defaulting rate by loan holders and selling of loans without full disclosure as to the terms attached to such loans (Greenberg & Hansen, 2009; Amadeo, 2010). At the end, the victims would be realized as unable to honor their commitment due to the inflated loans, some of which would never be recovered.

In this saga, about 1600 mortgages bought by the mortgage firm Citi from mortgage dealers were found to be defective and unenforceable while the mortgages had been passed on from the dealers to the banker. The poor and fraudulent underwriting process therefore contributed immensely to the financial crisis in which banks couldn’t provide financing as they had too many commitments to honor, alongside the housing crisis (Jickling, 2009).

2007-2008 Financial Crisis, in conclusion, this paper asserts the academic and scholarly authority that the largest and longest financial crisis witnessed post the great depression era was as a result of structural factors such as the easing on monetary policies, excess risk assumed by banks, excessive borrowing of cheap but risky loans by consumers, the fall of the US Housing Market, poor risk profile on stocks, the federal budget deficit, over leveraging by banks, predatory lending, poor underwriting and the Federal Budget Deficit. These factors made many banks and institutions to collapse.

References

Amadeo, K. (2010). “2008 Financial Crisis: The Causes and Costs of the Worst Financial Crisis Ever Since the Great Depression.” The Balance.

Greenberg, R., & Hansen, C. (2009). “If you had a pulse, we gave you a loan.” NBC news.

Jickling, M. (2009). Causes of the 2007-2008 Financial Crisis.

McLean, B., & Nocera, J. (2010). All the devils are here: unmasking the men who bankrupted the world. Penguin UK.

The Economist (2010). “Predatory lending: let’s not pretend we don’t understand how it worked.”

Williams, M.T (2010). Uncontrolled risk: the lessons of Lehman Brothers and how systemic risk can still bring down the world financial system. McGraw-Hill.

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Costing Methods Financial Essay

Costing Methods

Costing Methods in Financial Management – The globalization resulted in excessive heights of competition which compelled businesses to the concepts of products and prices. The differentiation strategy works well when the companies charge the lowest prices possible for their products. Business organizations can practice the differentiation in their products by working the quality of their products and implementing some of the marketing approaches like after sale services. With that in mind, the business must conduct market research to ascertain the specific market cost of the products and services then they aligned their products upon the established prices.

Therefore, the standard costing methods remain outdated at this point, and business firms installed more strategic costing procedures. Some of these strategic costs applied by contemporary businesses consist of target costing, life cycle costing, and the Kaizen costing. This report seeks to describe and discuss target costing, life cycle costing, and kaizen costing with their examples and make conclusion and recommendations about the application of three costing methods.

Introduction to Costing Methods

The contemporary customer is a vocal consumer who has the market knowledge thereby posing a stiff competition in the market. The increased competition compels companies to embrace marketing strategies which may make them meet the level of competition trend. As a result, to remain relevant companies must redesign their processes to maximize product quality at reduced costs. Company businesses must work with price reduction as a way to remaining gain the market share in a competitive environment. Therefore, for the realization of the above strategies a company cost detection mark it as the better option.

Therefore, cost methods used by the firm act as significant strategic tools for opportunities identifications that guarantee cost reduction and product quality improvements.  The report describes and discusses target costing, life cycle costing, and kaizen costing as the modern cost management techniques which the company can use to sustain a competitive market environment.

Target Costing

The target costing is a modern cost management technique that has ide coverage usage by most managers. According to Cooper, target costing relates to Functional Cost Analysis as well as Value engineering to align the products and services to match the market dynamics (Cooper 2017). The onset of cost management according to this cost method is at the development stage where the product attributes that match the next generation get incorporated with the intention of generating the required return on investment.

The whole process entails market segmentation to identify the most reliable segment to target and customize the products and services to meet the prevailing conditions. Also, the company must study the convenience of the rival firms in the same segment to deliver the same quality at a cheaper cost. The company proceeds to the next by filtering its activity which is relevant for the delivery of the already established product attributes.

With that in mind, the identified relevant activities are subject to costing to gauge their total costs against the anticipated returns. In the event of any variation, functional costing and value engineering get into play for cost reduction strategies to get employed without compromising the required product quality. The latter process gets continued in line with the market pricing spirit until the best cost is established then the company proceeds to invest in the production of the product required (Talebnia et al. 2017).

Furthermore, functional Cost Analysis together with the Value Engineering techniques help the inter-processes teams to creatively identify the best ways to install the alternative cost reduction product designs without charging the recommendable market features of the product (Talebnia et al. 2017). This is important when analyzing costing methods in the management of finace.

Also, for the company to achieve the maximum value engineering techniques, the company must go through two significant steps by performing some of the radical design changes at the development stage so long as the product is capable of delivering the required service. Second, the use of different design teams may get considered for cost reduction purposes (Talebnia et al. 2017).

According to hart, target costing offers the following advantages to any committed firm (Cooper 2017). First, helps the management with the required knowledge to the development of products and services that are market-oriented through the firm’s strategic objectives, they develop products are following the tastes and preferences of the customer regarding functionality and the delivery method.

Second, it forms an essential element of product development teams, while giving products that are flexible to dynamic costs and life cycle changes and services that are relevant in their application context.

Third, the target costing supports activity-based costing through well-presented costing data during the specific developmental stages. Finally, target costing provides market-driven product features by ascertaining the use of simple, relevant, and user-friendly products. The development teams use simple language to prevent time wastage during costs evaluation (Cooper 2017). 

Life Cycle Costing

The method of life cycle costing considers not only the initial cost of a company asset but also the costs involved over the useful life cycle of the same assets for a rational investment decision (Moreau & Weidema 2015). The life cycle technique confirms the significance of valuing the asset by considering the total ownership costs to provide a viable management decision making. The information about the whole life cycle of an asset can offer some insights such as; future required resources, investment evaluation, and supplier appraisal, resources accountability, improved system design, and asset economic life assessment.

The complexity of the asset in the question determines the kind of life costing approach to get applied, and the annual costing can ask directly approach as opposed to complex computerized processes of future costing. The life cycle costing involved the analysis of the entire asset life span cycle by considering the initial acquisition costs, operating costs, loss of failures, repair cost, preventive costs, and maintenance costs. Other expenses include interest rates, depreciation, present value, and discount rates.

According to Nasik, the life cycle analysis is possible in a spreadsheet with the fair, necessary cost values because it only entails adding up of the respective costs and other rates like discount and interest (Daylan & Ciliz 2016). The costs involved by finding the summation of all the expenses are deterministic, on the other hand, some values are probabilistic like costs concerning the asset reliability and maintainability (Daylan & Ciliz 2016).

The project manager has the responsibility of assessing the present asset condition, the budgeted value for the purchase of the asset, historical background to define the best alternative asset the company may consider worth the investment with the assurance of service delivery beyond the expected levels (Moreau & Weidema 2015).

Therefore, the making it possible for a rational decision concerning capital and expenditures, prioritize every company projects regarding total costs of ownership, and build management confidence when doing their report to major company stakeholders. Life cycle cost analysis also boosts management morale since the analysis assists in project validation calculation, risk reduction strategies, and consistent ways of project evaluation.

The asset life span starts immediately during creation planning to the time of disposal (Daylan & Ciliz 2016). For example, the asset passes through some stages such the concept definition, development of the design features, features specifications and documentation, manufacturing, the awarded warranty duration, and utilization stages. The other steps during the operation include maintenance and finally disposal.

Most importantly, is the strategic and periodic asset life span cycle which always commenced at the strategic planning, the asset formulation, operations level, asset in house maintenance, possible rehabilitation, and finally disposal. The life cycle of the asset is subject to necessary maintainability, technological developments, and the dynamic nature of the operational requirements are the few factors that may influence the life span of an asset (Moreau & Weidema 2015).

Costing Methods Financial Management
Costing Methods Financial Management

Kaizen Costing

The kaizen has its roots from the Japan where the knowledge of continuous improvement originated. According to Hert, the target costing planning process is compatible with the kaizen process in the production stage while firms which concentrate more on the shorter life cycle products usually use the target charging planning instead of combining the two charging methods (Kaplan & Atkinson 2015).

On the other hand, most of the companies with a complex life cycle practice kaizen during their operations at different stages of target costing to get products which are relevant to all generations. Kaizen holds every business organization player to get responsible and embrace never ending the quest for quality improvement through constant job processes evaluation.

All that this method need is just embracing the organization culture whereby all company processes get interconnected in a way that promotes learning from each other on the cost reduction strategies and quality improvement. As a result, kaizen is more aligned with knowledge sharing among the team members with the sole objective of enhancements. The kaizen costing holds the mighty aim of showing the management direction on how to apply the kaizen costing to ascertain a culture of continuous improvement across the organization (Mena et al. 2018). 

In the field of management accounting, kaizen assists firms to gain a competitive edge as it helps the management to do an appraisal to its strategic plans, activities, and long-term operations goals (Mena et al. 2018). With that in mind, the activities such as increasing company improvements, the permanent cost reduction along the production line, and ever diligent in the product design and development stages help the active management to reduce wastes and costs during production. Therefore, the output from the company processes meets the required quality to guarantee customer satisfaction at affordable prices in the market to make the company competitive.

Kaizen differs with the target costing in that the target costing involves product development stages while kaizen comes in during the manufacturing stage to eliminate wastes and reduce costs along the manufacturing lines. Furthermore, the kaizen uses the value analysis method in the form of value engineering to ascertain cost reduction at each process level. Notably, kaizen stresses the improvement in quality and cost delivery through the controlling the product market cost, timely delivery, and distribution.

According to Mark adults, the kaizen profits by getting the difference between corporate management projected profits and lower control expected profits (Kaplan & Atkinson 2015). For a company to achieve the benefits through kaizen costing it must install kaizen costing teams in every department to assist in planning, monitoring, and an evaluation of the processes.

Second, the target charging team must work hand in hand with the kaizen team for compatibility of refined product attributes with the set manufacturing kaizen standards and any variations in kaizen costing must get reported in time to the relevant authority for expert action. Third, the culture of continuous improvement gets supported by active channels of communication across the entire company.

The kaizen principles must get formal communications for kaizen costing information dissemination. Finally, the management ought to establish an evaluation method to gauge the kaizen success on a yearly basis and make the necessary adjustments (Mena et al. 2018).   

Costing Methods Conclusion

The three costing methods are very vital for any business organization to remain competitive in the contemporary market. They help in aligning the products and services offered with the requirement of the dynamic and volatile competitive current markets consisting of a knowledgeable consumer. The knowledge of target costing assist the design and development teams to come up with designs that are generational oriented after thorough market analysis.

The market segmentation helps the team to understand profoundly different needs of a different category of consumers. Also, life cycle costing is an important in management accounting because the methods help the organization concerned with asset acquisition the required knowledge for charging the asset ownership costs, supplier evaluation, and the general company projects evaluation skills.

Moreover, the life cycle helps the procurement and costs expert to acquire the relevant production machines at fair prices. Finally, kaizen costing is an equally more important approach that ascertains reduction of wastes and unnecessary cost along the production lines and, therefore, verifies quality products at affordable market prices. The combined knowledge of the three methods of costing makes a company to gain a competitive advantage in the global markets and assure sustainability.

For the organizations to apply the three costing methods successfully, they need to integrate the accounting knowledge with the strategic management approach thinking for effective internal control systems. Also, the company must work on its both inbound and outbound logistics, production policies and procedures, distribution channels, and marketing strategies like after sales services to offer it a better market advantage over rival firms. Therefore, the successful application of cost management strategies needs an effective and efficient supply chain management.

References

Cooper, R. (2017). Target costing methods and value engineering. Routledge.

Daylan, B., & Ciliz, N. (2016). Life cycle assessment and environmental life cycle costing analysis of lignocellulosic bioethanol as an alternative transportation fuel. Renewable Energy89, 578-587.

Kaplan, R. S., & Atkinson, A. A. (2015). Advanced management accounting and Costing Methods. PHI Learning.

Mena, C., Van Hoek, R., & Christopher, M. (2018). Leading procurement strategy: driving value through the supply chain. Kogan Page Publishers.

Moreau, V., & Weidema, B. P. (2015). The computational structure of environmental life cycle costing. The International Journal of Life Cycle Assessment20(10), 1359-1363.

Talebnia, G., Baghiyan, F., Baghiyan, Z., & Abadi, F. M. N. (2017). Target Costing, the Linkages Between Target Costing and Value Engineering and Expected Profit and Kaizen. International Journal of Engineering1(1), 11-15.

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Strategic Finance Management

Strategic finance management refers to the procedures, systems, and practices established by an institution to aid in reaching its goals, such as expansion, stakeholder’s wealth maximization, and corporate social responsibility. The executives develop insights from business activities, its capabilities, stakeholder expectations, as well as the available opportunities. Hence, the strategies have to be based on a well-formulated game-plan, which has a clear vision (Deloitte, 2019).

An appropriate strategic finance management scenario defines an elaborate picture of the organization’s target, lays down the courses of action to lead the entity there, brings work satisfaction and morale, as well as brings together finance officials through fast communication, and timely decision making (Deloitte, 2019).

Ratio Computation and Analysis for Redding and Neaves Companies – Using Strategic Finance Management Techniques

1. Profitability Ratios

This refers to financial computations that investors and business advisers apply while determining an institution’s revenue (Clear Tax, 2018). To get the profit realized, the metrics asses the difference between the receipt and payments made within a particular financial period, such as a year. For the two competing manufacturers, returns on investment and returns on capital employed are used.

a. Return on Investment

It is a ratio used to compute the gains of an investor concerning the amount of their investment. A high ratio, the more the benefits to be earned by the investor (Schmidt, 2019). With this ratio, investors can eliminate the projects promising low profits and focus on those that have a likelihood of raising higher returns.

Return on Investment Redding Co. = Revenue after Tax  × 100

Capital Employed 

ROI = 49 × 100 = 40.49%

121

ROI Neaves Co.

= 379 × 100 = 65.34%

580

Conclusion: Neaves has a higher ROI, hence is earning more revenue compared to Redding by 24.84%. Thus, Neaves is more appealing to an investor.

b. Return on Capital Employed

It is a ratio that is used in determining a company’s profitability due to its efficiency in capital utilization. A company with a higher ROCE means that it had a more economical use of capital that realized maximum gains (Daniel, 2018).            

ROCE = Earnings before Interest and Tax × 100

Capital Employed

Redding: =      80   × 100 = 66.11%.

121      

Neaves ROCE = 503 × 100 = 104.79%

480

Conclusion: both organizations have a significant amount of returns on the capital they have put to use. However, with Neaves having a higher return, investors can prefer it as their investment of choice because it will utilize their funds better.

2. Efficiency Ratios Strategic Finance Management

They are financial metrics that inform on a company’s ability to utilize its assets while keeping an eye on its liabilities in both the short and long terms (Peavler, 2019). It is the efficiency ratios that ensure an organization is not experiencing over investment or under investments. Fixed assets turnover and inventory turnover are the ratios to be used in this analysis.

a. Fixed Assets Turnover

It looks into how a form utilizes the available fixed assets like plants and equipment to increase sales. A firm that has a low number of fixed assets turnover in under utilizing its assets and should work towards optimizing the usage of fixed assets (Peavler, 2019). 

Fixed Assets Turnover = (Sales ÷ Fixed Assets)

Redding Co.

FAT = (195 ÷ 255) = 0.764

Neaves Co.

FAT = (1050 ÷ 1026) = 1.033

Conclusion: Neaves Company has a higher fixed assets turnover, meaning that it utilizes its fixed assets in making sales, better compared to Redding Company.

b. Inventory Turnover

Also known as stock turnover, inventor turnover is a financial metric that is used in determining the number of times that a business has ordered a new batch of inventory after selling a previous batch (Nicasio, 2019). It is computed on pre-determined periods such as semiannually, annually, monthly, or weekly.  

Inventory Turnover = Cost of Sales.

Average Stock 

Redding Co. = 78 = 5.2 Times

15

Neaves Co. = 273 = 8.03 Times  

34

Conclusion: Neaves Co. has a higher inventory turnover ratio than Redding Co. it implies that Neaves has more sales; hence, more promising returns or revenue.

Strategic-Finance-Management
Strategic-Finance-Management

3. Liquidity Ratios

They are ratios used in measuring the ability of an organization to settle its short-term liabilities when they are due without necessarily having to raise capital from lenders (Kenton, and Hayes, 2019). The quick ratio and Current ratio are used in this analysis and commonly found in strategic finance management.

a. Quick Ratio

It is a financial ratio used in determining the ability of an entity to meet its current liabilities using its liquid assets only. In this case, the stock is eliminated from the liquid assets category because it is time-consuming to convert it into cash (Eliodor 2014, P. 5). A company that is at optimal performance should have a quick ratio of 1:1, which shows its ability to pay for the liabilities due using its liquid assets. 

Quick ratio = Current Assets – Stock

   Current Liabilities  

Redding Co. = 65 – 15 = 1.67

  30

Neaves Co. = 198 – 34 = 1.07

153

Conclusion: Since the optimal quick ratio should be 1:1, and both have a quick ratio of more than 1, they can readily service their obligations when due. However, Redding Co has a higher quick ratio and is, therefore, better positioned to convert its liquid assets faster compared to Neaves Co.

c. Current Ratio

It is a liquidity ratio, which is used in measuring an entity’s ability to pay for its short-term liabilities that is the debts due within a year. It informs the investors about how well a company realizes optimal benefits from its current assets so that it can meet its current debts and other payables (Kenton, 2019).  The optimal current ratio should be 2:1 that is two current assets for one current liability

Current Ratio = Current Assets

Current Liabilities

Redding Co.

Current Ratio = 65 = 2.167

30

Neaves Co.

Current Ratio= 198 = 1.294

153

Comparison: Redding Company has a higher current ratio of 2.17:1, while Neave’s Company’s current ratio is 1.29:1. It implies that Redding can quickly pay for its current liabilities while Neaves is going to experience challenges paying for the obligations because it has not met the optimal current ratio.

4. Gearing Ratios.

It is a business assessment ratio that is concerned with the business’s capital structure. The ratio determines the amount and impacts of financing contributed by the stakeholders compared to external funding, such as the use of debt (Bragg, 2019). If a company has a high gearing ratio, it implies that the company has used more of debt capital and less of equity capital. Besides, low gearing means that the company has employed more equity and less of debt in its capital. A highly leveraged/geared company uses debt capital to meet daily obligations, which poses a threat of bankruptcy to the organization (Bragg, 2019). In this comparison, the equity ratio and debt ratio will be used to assess the gearing of the two companies.

a. Equity Ratio/ Net worth to total assets ratio

It is a financial arithmetic that indicates the relative amount of equity that is used in paying for a company’s assets. It informs shareholders about their funds compared to the institution’s total assets, thereby showing the businesses’ solvency position in the future (Ready ratios, 2013).  

Equity ratio = Equity ÷ Total Assets

Redding Co.

Equity ratio = 121 ÷ 320 = 0.378 or 37.8 %.

Neaves Co.

Equity ratio = 480 ÷ 1214 = 0.395 or 39.5 %

Comparison: both companies have an equity ratio of less than 51%. It means that their equity has funded a low amount of their assets, while a significant amount is funded using borrowed funds. The two companies are leveraged and are going to pay a significant amount of interest on the borrowed funds.

b. Debt Ratio

It is a financial leverage arithmetic that is used to measure the amount of a company’s assets that have been purchased using debt capital. If a company has a debt ratio of more than 1, it implies that it has a higher number of liabilities compared to its assets. Conversely, a ratio that is less than 1 indicates that the company has a high proportion of its assets purchased using equity (Investors answers, 2019).

Debt Ratio = Debt

Total Assets

Redding Co.

Debt ratio = 199 = 0.62 or 62%

320

Neaves Co.

Debt ratio = 634 = 0.52 or 52%

1214

Comparison: Redding Co. has a higher debt ratio, meaning that a significant proportion of its assets are acquired using debt capital other than equity. Therefore, Redding Company is more leveraged compared to Neaves Company.

5. Ratios by Investors to Determine Performance

They are financial arithmetic ratios that are used in determining the amount of returns an investor expects if they obtain a company’s stock at the current market prices. The ratio help in determining whether the shares are under priced or overpriced (Peavler, 2019). The ratios to be used are the interest coverage ratio and preference dividend coverage ratio. 

a. Interest Coverage Ratio

It is used in determining the ease of a business in servicing the interest of its borrowed funds from the realized revenue (Ready Ratios, 2013). The higher the ratio, the better the financial stability of an institution. If a company has a ratio of less than 1.0, it is facing challenges in making ales to raise revenue.

Interest Coverage Ratio = Earnings Before Interest and Tax 

Interest Expense

Redding Co.

ICR = 80 ÷ 19 = 4.21

Neaves Co.

ICR = 503 ÷ 29 = 17.34

Comparison: Both companies have an ICR of more than 1. Therefore, they can pay their interest expenses quickly from the revenue realized. Neaves Company is better positioned to pay for interest expenses because it has a higher ICR compared to Redding Co.

b. Preference Dividends Coverage Ratio

It is a financial ratio used in determining the organization’s ability to for its preference dividends.  A company that has issued preference dividends determines its ability to pay the dividends on such shares using this ratio.

Preference dividends coverage ratio = Profits After Tax.

Preference Dividends

Redding Co.

= 49 ÷ 0 = 0

Neaves Co.

379 ÷ 100 = 3.79

Comparison: Redding Company has not issued any preference shares; hence, it doesn’t pay any preference dividends. Neaves Co. has issued preference shares and has a preference dividends coverage ratio of 3.79. The latter company can, therefore, pay for the preference easily when they are due.

References – Strategic Finance Management Essential Reading

Bragg, S. (2019) Gearing ratio, Accounting Tools

Clear tax, (2018) Profitability Ratio Formula with Examples

Daniel, E. (2018) Return on Capital Employed

Deloitte (2019) Finance Strategy solutions

Eliodor, T. (2014)  Financial Statement Analysis, Journal of Knowledge Management, Economics, and IT.

Investing Answers (2019). Debt Ratio

Kenton, W. (2019) Current ratio Analysis – Strategic Finance Management

Kenton, W. (2019)  Strategic Financial Management

Nicasio, F. (2019) Inventory Turnover Definition and How to get it Right

Peavler, R. (2019). Asset Management ratios in Financial Analysis

Ready Radios, (2013) The definition and application of equity ratio – Strategic Finance Management

Schmidt, M. (2019) Returns on Investment Metric for measuring profitability

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