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Investment - Foreign Exchange Rate Systems
International trade requires a system for transferring currencies across nations because every country does not utilize the same form of money. To pay for items from another country, money from one country must be changed into the currency of another country.
International trade needs payments between countries. These payments involve an exchange of currencies and are affected by international exchange rates and foreign exchange rate systems.
The rate at which a unit of one currency can be exchanged for a unit of another currency is referred to as the foreign exchange rate or exchange rate. An exchange rate is expressed as the number of units of one currency it takes to convert into the other currency.
International commerce payments may be done in the country’s own currency or in a foreign currency. Assume a supermarket chain located in France imports dairy products from the United Kingdom and has to pay the UK producers in British pounds. The exchange rate between the pound and the euro is commonly given in euros per pound (EUR/GBP).
An exchange rate of EUR1.20/GBP1 means that it takes 1 euro and 20 cents to acquire 1 pound. If the French grocery chain has to make a payment of GBP100,000 to the UK producers, it will need to exchange EUR120,000 to obtain GBP100,000 (£100,000 × €1.20/£1).
The exchange rates between world currencies, such as the US dollar (USD), euro (EUR), British pound (GBP), and Japanese yen (JPY), are like the pricing of goods and services. Like most commodities and services, exchange rates move frequently depending on supply and demand. If a lot of people desire to acquire a certain currency, such as the euro, demand for the euro will increase and the price of the euro will rise, or appreciate, relative to other currencies; consequently, it will take more of another currency to buy a euro.
Alternatively, if the euro falls out of popularity, demand for the euro would diminish and the price of the euro will fall, or depreciate, relative to other currencies.
There are three primary types of exchange rate systems:
Fixed rate
Floating rate
Managed floating rate
At the Bretton Woods conference in 1944, the major nations of the Western world agreed on an exchange rate system in which the value of the US dollar was defined as USD35 per ounce of gold. That is, a dollar was equivalent to one thirty-fifth of an ounce of gold. All other currencies were defined with relation to, or ‘pegged’ to, the US dollar.
Such a system of exchange rates, which does not allow for volatility, is known as a fixed exchange rate system.
The advantage of a fixed exchange rate system is that it removes currency risk (or foreign exchange risk), which is the risk connected with the fluctuation of exchange rates.
In a fixed-rate environment, importers and exporters know with certainty the amount that they will pay or get for the items and services they trade.
A downside of a fixed-rate regime is that, as the competitiveness of countries varies over time, an economy that becomes uncompetitive would see its current account balance worsen because its currency gets overvalued. Its exports are too expensive from the buyer’s standpoint, while its imports are too cheap from the seller’s perspective. Under a fixed exchange rate system, the only answer to this dilemma is for the government to legally depreciate its currency.
Devaluation is the decision made by a country’s central bank to decrease the value of the domestic currency relative to other currencies, an action that many governments are reluctant to perform.
To overcome the problems of a fixed exchange rate system, the Bretton Woods agreement was abandoned in 1973, and currency values were left to fluctuate up and down, or float, with the market forces of supply and demand. Since 1973, the major currencies have existed under a floating exchange rate regime. In a fully floating exchange rate system, a country’s central bank does not intervene and allows the market determine the value of its currency. Under this structure, the exchange rate between the domestic currency and foreign currencies is exclusively driven by the supply of and demand for each currency.
In a controlled floating exchange rate regime, a central bank intervenes to stabilise its country’s currency. To strengthen the domestic currency, it buys domestic currency using foreign currency reserves, or it buys foreign currency using domestic currency to weaken the domestic currency.
In the wake of the European sovereign debt crisis in 2012, many investors switched their euros to Swiss francs, perceiving the Swiss franc as a safer currency than the euro. The rise of the Swiss currency started weakening the competitiveness of Swiss exporters and led the Swiss National Bank, Switzerland’s Central Bank, to interfere.
To drive the price of the Swiss franc down, the Swiss National Bank sold its own currency and bought foreign currencies, such as the euro; in other words, the Swiss National Bank did the reverse of what investors were doing. In the process, it accumulated foreign cash reserves.
This example indicates that central banks do not usually aim for a perfectly fixed exchange rate, but typically endeavor to maintain the value of their country’s currency within a particular range. Central banks tend to intervene infrequently, therefore generally, such a system runs as a floating exchange rate system.
International trade requires a system for transferring currencies across nations because every country does not utilize the same form of money. To pay for items from another country, money from one country must be changed into the currency of another country.
International trade needs payments between countries. These payments involve an exchange of currencies and are affected by international exchange rates and foreign exchange rate systems.
The rate at which a unit of one currency can be exchanged for a unit of another currency is referred to as the foreign exchange rate or exchange rate. An exchange rate is expressed as the number of units of one currency it takes to convert into the other currency.
International commerce payments may be done in the country’s own currency or in a foreign currency. Assume a supermarket chain located in France imports dairy products from the United Kingdom and has to pay the UK producers in British pounds. The exchange rate between the pound and the euro is commonly given in euros per pound (EUR/GBP).
An exchange rate of EUR1.20/GBP1 means that it takes 1 euro and 20 cents to acquire 1 pound. If the French grocery chain has to make a payment of GBP100,000 to the UK producers, it will need to exchange EUR120,000 to obtain GBP100,000 (£100,000 × €1.20/£1).
The exchange rates between world currencies, such as the US dollar (USD), euro (EUR), British pound (GBP), and Japanese yen (JPY), are like the pricing of goods and services. Like most commodities and services, exchange rates move frequently depending on supply and demand. If a lot of people desire to acquire a certain currency, such as the euro, demand for the euro will increase and the price of the euro will rise, or appreciate, relative to other currencies; consequently, it will take more of another currency to buy a euro.
Alternatively, if the euro falls out of popularity, demand for the euro would diminish and the price of the euro will fall, or depreciate, relative to other currencies.
There are three primary types of exchange rate systems:
Fixed rate
Floating rate
Managed floating rate
At the Bretton Woods conference in 1944, the major nations of the Western world agreed on an exchange rate system in which the value of the US dollar was defined as USD35 per ounce of gold. That is, a dollar was equivalent to one thirty-fifth of an ounce of gold. All other currencies were defined with relation to, or ‘pegged’ to, the US dollar.
Such a system of exchange rates, which does not allow for volatility, is known as a fixed exchange rate system.
The advantage of a fixed exchange rate system is that it removes currency risk (or foreign exchange risk), which is the risk connected with the fluctuation of exchange rates.
In a fixed-rate environment, importers and exporters know with certainty the amount that they will pay or get for the items and services they trade.
A downside of a fixed-rate regime is that, as the competitiveness of countries varies over time, an economy that becomes uncompetitive would see its current account balance worsen because its currency gets overvalued. Its exports are too expensive from the buyer’s standpoint, while its imports are too cheap from the seller’s perspective. Under a fixed exchange rate system, the only answer to this dilemma is for the government to legally depreciate its currency.
Devaluation is the decision made by a country’s central bank to decrease the value of the domestic currency relative to other currencies, an action that many governments are reluctant to perform.
To overcome the problems of a fixed exchange rate system, the Bretton Woods agreement was abandoned in 1973, and currency values were left to fluctuate up and down, or float, with the market forces of supply and demand. Since 1973, the major currencies have existed under a floating exchange rate regime. In a fully floating exchange rate system, a country’s central bank does not intervene and allows the market determine the value of its currency. Under this structure, the exchange rate between the domestic currency and foreign currencies is exclusively driven by the supply of and demand for each currency.
In a controlled floating exchange rate regime, a central bank intervenes to stabilise its country’s currency. To strengthen the domestic currency, it buys domestic currency using foreign currency reserves, or it buys foreign currency using domestic currency to weaken the domestic currency.
In the wake of the European sovereign debt crisis in 2012, many investors switched their euros to Swiss francs, perceiving the Swiss franc as a safer currency than the euro. The rise of the Swiss currency started weakening the competitiveness of Swiss exporters and led the Swiss National Bank, Switzerland’s Central Bank, to interfere.
To drive the price of the Swiss franc down, the Swiss National Bank sold its own currency and bought foreign currencies, such as the euro; in other words, the Swiss National Bank did the reverse of what investors were doing. In the process, it accumulated foreign cash reserves.
This example indicates that central banks do not usually aim for a perfectly fixed exchange rate, but typically endeavor to maintain the value of their country’s currency within a particular range. Central banks tend to intervene infrequently, therefore generally, such a system runs as a floating exchange rate system.
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Investment - Value of Currencies
There are numerous elements that influence the value of a currency. The relative worth of a currency relies on the economic activity and outlook of a country. This section analyzes factors that determine the value of a currency and describes how to measure the relative value of currencies.
Major Factors That Affect the Value of a Currency
The key elements that determine the value of a currency include the country’s (1) balance of payments, (2) inflation, (3) interest rates, (4) government debt, and (5) the political and economic environment.
Balance of Payments
A current account deficit tends to lead to a devaluation of the home currency.
Level of Inflation
High inflation tends to lead to a devaluation of the indigenous currency.
Level of Interest Rates
High interest rates tend to lead to an appreciation of the home currency.
Level of Government Debt
High government debt tends to lead to a depreciation of the domestic currency
Political and Economic Environment
Political instability and bad economic prospects tend to lead to a depreciation of the domestic currency.
Balance of Payments
As noted, the current account balance has an impact on the value of a currency. In a floating exchange rate system, the exchange rate should adjust to remedy an unsustainable current account deficit or surplus.
If a country has a big current account deficit, the domestic currency should devalue relative to foreign currencies. The relative price of that country’s exports in international markets should reduce, making exports more competitive.
At the same time, the relative price of imports in the country should rise, making imports more expensive. Exporting more and importing less should in principle lower the current account deficit and could even transform it into a surplus. In contrast, if a country has a high current account surplus, the native currency should gain relative to foreign currencies. The home currency’s appreciation, or getting stronger compared to the foreign currency, should have a negative influence on exports and a positive effect on imports, diminishing the current account surplus.
A floating exchange rate system tends to be self-adjusting. But the self-adjusting method does not always operate in practice since factors besides international commerce influence exchange rates. In addition, the natural correction that should lead to a reduction of the current account deficit or surplus may not occur if the country belongs to a single currency zone, such as the European Union (EU). France, Belgium, and Italy run huge current account deficits, although the euro is used by other EU members that might have current account surpluses. It is difficult, if not impossible, for natural corrections to take place if the countries in question utilize the same currency but confront extremely different economic situations.
Level of Inflation
Inflation erodes the purchasing power of a country’s currency, so when prices climb, a unit of domestic currency buys less international products and services.
The following example illustrates the effect of inflation on the purchasing power of a country’s currency.
Example: Effect of Inflation on a Country’s Currency
Consider the pricing of similar loaves of bread in Ireland and in the United Kingdom in January and in June.
In January, the loaf of bread costs EUR1.20 in Ireland and GBP1.00 in the United Kingdom, which implies an exchange rate of EUR1.20/GBP1. If inflation in the United Kingdom raises the price of the bread to GBP1.10 in June, but the price remains EUR1.20 in Ireland, then the purchasing power of the pound is lower in June than it was in January. The exchange rate has increased from EUR1.20/GBP1 to EUR1.20/GBP1.10, or EUR1.09/GBP1. Because a pound now buys fewer euros, it has depreciated relative to the euro.
A country with a consistently high level of inflation will see the value of its currency diminish relative to the currency of a country that has a consistently low level of inflation.
Level of Interest Rates
Higher interest rates, unless they are driven by inflation, normally enhance capital flows into a country since they make investments in that country more attractive, all other circumstances being equal. Increased investments in the country create a demand for the country’s currency. Thus, higher interest rates push the value of the currency higher.
Increasing interest rates is a technique for central banks to control inflation. When a central bank boosts interest rates, it may entice more foreign investors to buy that currency, making the currency gain. The strengthening currency makes imports less expensive and helps lower inflation.
Some countries that have balanced economic development and higher relative interest rates may see increasing interest in their currency. This increase occurs because many investors regard rising interest rates as a way of earning a higher yield, so they buy the currency to partake in that yield. But high interest rates can also decrease capital inflows if investors believe they lead to rising inflation and currency devaluation.
Level of Government Debt
If it looks that a government is functioning with too much debt and may be unable to fulfill a promised payment of interest or principal, investors may decide that they no longer wish to retain the bonds issued by that country.
If investors sell the government bonds they own and take their money out of the country, it will trigger a depreciation of the country’s currency.
" " Political and Economic Environment
Capital tends to flow to countries with political stability and excellent economic performance. Countries with political instability or poor economic prospects, such as low growth and high unemployment, are likely to see the value of their currencies drop.
As an economy grows, capital flows will also often increase. Government policies towards international investors will also effect capital flows.
Foreign direct investments (FDIs)
Capital flows normally increase when a country becomes more open to outside investors and liberalises foreign direct investments (FDIs), the investments made by foreign investors and companies.
Reserve currency
A reserve currency is a currency that is held in considerable amounts by governments and financial organizations as part of their foreign exchange reserves.
A reserve currency tends to be what globally traded items are priced in, including commodities, such as oil and gold. Because the US dollar is a reserve currency, the demand for US financial assets and for US dollars is stronger than it would be based on the country’s macroeconomic outlook alone.
Relative Strength of Currencies
The idea of purchasing power parity has long been used to explain relative currency valuations.
Purchasing power parity is an economic theory based on the premise that a basket of commodities in two different countries should cost the same, after taking into account the exchange rate between the two countries’ currencies.
Purchasing power parity is the premise underpinning the Economist’s Big Mac index. On a regular basis, the Economist records the price of McDonald’s Big Mac hamburgers in various nations across the world, and then it estimates what the exchange rates should be to make the price of Big Macs the same in all the countries.
This exchange rate relies on buying power parity and assumes that an identical product, the Big Mac, should have the same price everywhere on Earth. The Economist evaluates the purchasing power parity exchange rates compared to the US dollar and compares them with the actual exchange rates to assess if currencies are under- or overvalued relative to the US dollar.
In June 2022, a Big Mac cost USD5.15 in the United States and ZAR39.90 in South Africa, which implies a purchasing power parity exchange rate of ZAR7.75/USD1 (ZAR39.90/USD5.15). Suppose the real exchange rate was ZAR17.04/USD1. This means, based on purchasing power parity, the South African rand is undervalued relative to the US dollar since it takes more South African rand than buying power parity implies to acquire a US dollar.
Put another way, if a Big Mac cost ZAR39.90 in South Africa and the real currency rate was ZAR17.04/USD1, the cost of a Big Mac in the United States should be USD2.34. But the actual cost is USD5.15, which suggests that the South African rand was devalued by more than 50%. In other words, changing ZAR39.90 to US dollars would only provide USD2.34, which is not enough to buy a Big Mac in the United States.
The purchasing power parity exchange rates created using Big Macs are only roughly indicative of actual exchange rates because they are based on just one product. In truth, purchasing power parity exchange rates should reflect a representative basket of products, but the Big Mac index serves as a readily accessible proxy.
Although buying power parity provides a mechanism to explain comparable currency valuations, it has drawbacks. Two of these constraints are the difficulty of establishing a basket of items for comparison between countries and the impediments to international trade.
These factors help explain why data suggests that purchasing power parity does not persist very well in the short to medium term. But in the long term, aberrations of actual exchange rates from purchasing power parity rates gradually fix themselves. In other words, buying power parity tends to apply only in the long term.
There are numerous elements that influence the value of a currency. The relative worth of a currency relies on the economic activity and outlook of a country. This section analyzes factors that determine the value of a currency and describes how to measure the relative value of currencies.
Major Factors That Affect the Value of a Currency
The key elements that determine the value of a currency include the country’s (1) balance of payments, (2) inflation, (3) interest rates, (4) government debt, and (5) the political and economic environment.
Balance of Payments
A current account deficit tends to lead to a devaluation of the home currency.
Level of Inflation
High inflation tends to lead to a devaluation of the indigenous currency.
Level of Interest Rates
High interest rates tend to lead to an appreciation of the home currency.
Level of Government Debt
High government debt tends to lead to a depreciation of the domestic currency
Political and Economic Environment
Political instability and bad economic prospects tend to lead to a depreciation of the domestic currency.
Balance of Payments
As noted, the current account balance has an impact on the value of a currency. In a floating exchange rate system, the exchange rate should adjust to remedy an unsustainable current account deficit or surplus.
If a country has a big current account deficit, the domestic currency should devalue relative to foreign currencies. The relative price of that country’s exports in international markets should reduce, making exports more competitive.
At the same time, the relative price of imports in the country should rise, making imports more expensive. Exporting more and importing less should in principle lower the current account deficit and could even transform it into a surplus. In contrast, if a country has a high current account surplus, the native currency should gain relative to foreign currencies. The home currency’s appreciation, or getting stronger compared to the foreign currency, should have a negative influence on exports and a positive effect on imports, diminishing the current account surplus.
A floating exchange rate system tends to be self-adjusting. But the self-adjusting method does not always operate in practice since factors besides international commerce influence exchange rates. In addition, the natural correction that should lead to a reduction of the current account deficit or surplus may not occur if the country belongs to a single currency zone, such as the European Union (EU). France, Belgium, and Italy run huge current account deficits, although the euro is used by other EU members that might have current account surpluses. It is difficult, if not impossible, for natural corrections to take place if the countries in question utilize the same currency but confront extremely different economic situations.
Level of Inflation
Inflation erodes the purchasing power of a country’s currency, so when prices climb, a unit of domestic currency buys less international products and services.
The following example illustrates the effect of inflation on the purchasing power of a country’s currency.
Example: Effect of Inflation on a Country’s Currency
Consider the pricing of similar loaves of bread in Ireland and in the United Kingdom in January and in June.
In January, the loaf of bread costs EUR1.20 in Ireland and GBP1.00 in the United Kingdom, which implies an exchange rate of EUR1.20/GBP1. If inflation in the United Kingdom raises the price of the bread to GBP1.10 in June, but the price remains EUR1.20 in Ireland, then the purchasing power of the pound is lower in June than it was in January. The exchange rate has increased from EUR1.20/GBP1 to EUR1.20/GBP1.10, or EUR1.09/GBP1. Because a pound now buys fewer euros, it has depreciated relative to the euro.
A country with a consistently high level of inflation will see the value of its currency diminish relative to the currency of a country that has a consistently low level of inflation.
Level of Interest Rates
Higher interest rates, unless they are driven by inflation, normally enhance capital flows into a country since they make investments in that country more attractive, all other circumstances being equal. Increased investments in the country create a demand for the country’s currency. Thus, higher interest rates push the value of the currency higher.
Increasing interest rates is a technique for central banks to control inflation. When a central bank boosts interest rates, it may entice more foreign investors to buy that currency, making the currency gain. The strengthening currency makes imports less expensive and helps lower inflation.
Some countries that have balanced economic development and higher relative interest rates may see increasing interest in their currency. This increase occurs because many investors regard rising interest rates as a way of earning a higher yield, so they buy the currency to partake in that yield. But high interest rates can also decrease capital inflows if investors believe they lead to rising inflation and currency devaluation.
Level of Government Debt
If it looks that a government is functioning with too much debt and may be unable to fulfill a promised payment of interest or principal, investors may decide that they no longer wish to retain the bonds issued by that country.
If investors sell the government bonds they own and take their money out of the country, it will trigger a depreciation of the country’s currency.
" " Political and Economic Environment
Capital tends to flow to countries with political stability and excellent economic performance. Countries with political instability or poor economic prospects, such as low growth and high unemployment, are likely to see the value of their currencies drop.
As an economy grows, capital flows will also often increase. Government policies towards international investors will also effect capital flows.
Foreign direct investments (FDIs)
Capital flows normally increase when a country becomes more open to outside investors and liberalises foreign direct investments (FDIs), the investments made by foreign investors and companies.
Reserve currency
A reserve currency is a currency that is held in considerable amounts by governments and financial organizations as part of their foreign exchange reserves.
A reserve currency tends to be what globally traded items are priced in, including commodities, such as oil and gold. Because the US dollar is a reserve currency, the demand for US financial assets and for US dollars is stronger than it would be based on the country’s macroeconomic outlook alone.
Relative Strength of Currencies
The idea of purchasing power parity has long been used to explain relative currency valuations.
Purchasing power parity is an economic theory based on the premise that a basket of commodities in two different countries should cost the same, after taking into account the exchange rate between the two countries’ currencies.
Purchasing power parity is the premise underpinning the Economist’s Big Mac index. On a regular basis, the Economist records the price of McDonald’s Big Mac hamburgers in various nations across the world, and then it estimates what the exchange rates should be to make the price of Big Macs the same in all the countries.
This exchange rate relies on buying power parity and assumes that an identical product, the Big Mac, should have the same price everywhere on Earth. The Economist evaluates the purchasing power parity exchange rates compared to the US dollar and compares them with the actual exchange rates to assess if currencies are under- or overvalued relative to the US dollar.
In June 2022, a Big Mac cost USD5.15 in the United States and ZAR39.90 in South Africa, which implies a purchasing power parity exchange rate of ZAR7.75/USD1 (ZAR39.90/USD5.15). Suppose the real exchange rate was ZAR17.04/USD1. This means, based on purchasing power parity, the South African rand is undervalued relative to the US dollar since it takes more South African rand than buying power parity implies to acquire a US dollar.
Put another way, if a Big Mac cost ZAR39.90 in South Africa and the real currency rate was ZAR17.04/USD1, the cost of a Big Mac in the United States should be USD2.34. But the actual cost is USD5.15, which suggests that the South African rand was devalued by more than 50%. In other words, changing ZAR39.90 to US dollars would only provide USD2.34, which is not enough to buy a Big Mac in the United States.
The purchasing power parity exchange rates created using Big Macs are only roughly indicative of actual exchange rates because they are based on just one product. In truth, purchasing power parity exchange rates should reflect a representative basket of products, but the Big Mac index serves as a readily accessible proxy.
Although buying power parity provides a mechanism to explain comparable currency valuations, it has drawbacks. Two of these constraints are the difficulty of establishing a basket of items for comparison between countries and the impediments to international trade.
These factors help explain why data suggests that purchasing power parity does not persist very well in the short to medium term. But in the long term, aberrations of actual exchange rates from purchasing power parity rates gradually fix themselves. In other words, buying power parity tends to apply only in the long term.
- Published on
Investment - The Foreign Exchange Market
The foreign exchange market is where currencies are traded. It is incredibly active and liquid, with an average of USD6.6 trillion moved globally every day. It is not situated in one area but is a highly integrated decentralized electronic network that connects buyers and vendors.
Foreign Exchange Rate Quotes
If you have ever converted currency, maybe at the airport, you are already aware that a bank or currency dealer always displays two conversion rates for a certain currency.
Bid Exchange Rate
The bid exchange rate, or bid rate, is the exchange rate at which the bank or currency dealer will buy the foreign currency.
Offer Exchange Rate
The offer exchange rate, or offer rate, also termed the ask exchange rate (or ask rate), is the exchange rate at which the bank or dealer will sell the foreign currency.
The difference between the bid and offer (ask) rates is known as the bid–offer spread, or bid–ask spread. The bid–offer spread is how the bank or currency dealer makes money, profiting by buying a unit of currency for less than they sell it.
The bid–offer spread will fluctuate from bank to bank, from currency to currency, and according to market conditions. The more a currency is traded, which implies better liquidity, the tighter the bid–offer spread.
Spot and Forward Markets
Foreign exchange transactions may take place in the spot market or in the future market.
Spot market
The spot market is where currencies are traded now and delivered instantly. An example of a spot market transaction would be an individual trading currency at an airport, like in the case above. The exchange rate for the transaction is termed the spot exchange rate, or spot rate.
Forward market
In contrast, the forward market is where currencies are traded at agreed on exchange rates today but are delivered at some future period, such as in one month or in two months. The exchange rate for the transaction is termed the forward exchange rate, or forward rate.
In many circumstances, investors or organizations desire to lock in an exchange rate today for a currency transaction that will occur at a later date. The objective for doing so is to eliminate currency rate risk between now and the transaction date.
Let us return to the example of the French grocery chain buying dairy products from the United Kingdom for GBP100,000. If the French supermarket needs to make the payment now and convert euros into pounds quickly, the transaction will occur in the spot market at the spot rate.
In the commercial world, however, many suppliers grant credit to their clients, allowing payment for today’s transactions at some point in the future.
Assume that the French grocery company has two months to pay its UK dairy producers. By waiting until the end of the two months to trade, the French grocery chain confronts uncertainty regarding the exchange rate that will exist at that time. In other words, the French supermarket chain is exposed to currency risk because of potential adverse movements in the EUR/GBP exchange rate.
Alternatively, the French retail chain can enter the forward market and can lock in the currency rate at which it will pay the invoice in two months. By doing so, it eliminates the currency risk, no matter how much the euro changes compared to the pound in the next two months.
For example, if the prevailing two-month forward rate for delivery in two months is EUR1.21/GBP1, the French grocery chain can lock in that exchange rate and know with certainty that it will require EUR121,000 to acquire the GBP100,000 necessary to pay its UK dairy farmers.
Gaining assurance enables organizations to assure that they can meet future cash expenditures, such as operating expenses and interest payments. Could it be the fact that the French retail company could have secured a more favourable exchange rate by waiting two months? Sure, but it could have also received a less favourable one. Locking in currency rates in the forward market assures the predictability of cash flows and profitability.
The foreign exchange market is where currencies are traded. It is incredibly active and liquid, with an average of USD6.6 trillion moved globally every day. It is not situated in one area but is a highly integrated decentralized electronic network that connects buyers and vendors.
Foreign Exchange Rate Quotes
If you have ever converted currency, maybe at the airport, you are already aware that a bank or currency dealer always displays two conversion rates for a certain currency.
Bid Exchange Rate
The bid exchange rate, or bid rate, is the exchange rate at which the bank or currency dealer will buy the foreign currency.
Offer Exchange Rate
The offer exchange rate, or offer rate, also termed the ask exchange rate (or ask rate), is the exchange rate at which the bank or dealer will sell the foreign currency.
The difference between the bid and offer (ask) rates is known as the bid–offer spread, or bid–ask spread. The bid–offer spread is how the bank or currency dealer makes money, profiting by buying a unit of currency for less than they sell it.
The bid–offer spread will fluctuate from bank to bank, from currency to currency, and according to market conditions. The more a currency is traded, which implies better liquidity, the tighter the bid–offer spread.
Spot and Forward Markets
Foreign exchange transactions may take place in the spot market or in the future market.
Spot market
The spot market is where currencies are traded now and delivered instantly. An example of a spot market transaction would be an individual trading currency at an airport, like in the case above. The exchange rate for the transaction is termed the spot exchange rate, or spot rate.
Forward market
In contrast, the forward market is where currencies are traded at agreed on exchange rates today but are delivered at some future period, such as in one month or in two months. The exchange rate for the transaction is termed the forward exchange rate, or forward rate.
In many circumstances, investors or organizations desire to lock in an exchange rate today for a currency transaction that will occur at a later date. The objective for doing so is to eliminate currency rate risk between now and the transaction date.
Let us return to the example of the French grocery chain buying dairy products from the United Kingdom for GBP100,000. If the French supermarket needs to make the payment now and convert euros into pounds quickly, the transaction will occur in the spot market at the spot rate.
In the commercial world, however, many suppliers grant credit to their clients, allowing payment for today’s transactions at some point in the future.
Assume that the French grocery company has two months to pay its UK dairy producers. By waiting until the end of the two months to trade, the French grocery chain confronts uncertainty regarding the exchange rate that will exist at that time. In other words, the French supermarket chain is exposed to currency risk because of potential adverse movements in the EUR/GBP exchange rate.
Alternatively, the French retail chain can enter the forward market and can lock in the currency rate at which it will pay the invoice in two months. By doing so, it eliminates the currency risk, no matter how much the euro changes compared to the pound in the next two months.
For example, if the prevailing two-month forward rate for delivery in two months is EUR1.21/GBP1, the French grocery chain can lock in that exchange rate and know with certainty that it will require EUR121,000 to acquire the GBP100,000 necessary to pay its UK dairy farmers.
Gaining assurance enables organizations to assure that they can meet future cash expenditures, such as operating expenses and interest payments. Could it be the fact that the French retail company could have secured a more favourable exchange rate by waiting two months? Sure, but it could have also received a less favourable one. Locking in currency rates in the forward market assures the predictability of cash flows and profitability.
- Published on
Investment - Roles in Financial Reporting
Financial statements describe how lucrative a firm is and how efficiently it manages its resources and commitments, and they are read and used by a wide variety of people.
The financial performance of a corporation important to many different people.
Company managers utilize financial performance to analyze the effectiveness of their strategies relative to historical and expected performance and comparing to competitors' performance
Employees care because the financial success of the company effect their job security and salary.
The company's financial performance important to investors since it influences the return of investment.
Tax authorities may be fascinated with the company 's financial performance so that they can tax the earnings.
Investment analyst examine the financial performance of the firm and provide recommendation to the customer whether to buy or sell securities such as bond and share issued by the company.
One way to analyze a firm is to look at its historical performance, which is shown in a company’s financial statements.
The financial accounts demonstrate, among other things, how effective a company has been at generating earnings (profits) to repay their obligations or reward shareholders.
Accountants collect this information and convey it to investors, management, and employees through three key financial statements:
Balance sheet
Income statement
Statement of cash flows
Key Characteristics of Financial Statements
Financial statements: Show the monetary value of the economic resources under a company’s control and how those resources have been employed to create value over time.
Are historical and forward-looking at the same time; they represent previous performance, and they provide signals about future performance.
Include notes that summarize the selected accounting methods, accounting practices, and other information crucial to analyzing a company’s results. These notes are a crucial component of a shareholder’s judgment.
Describe how profitable a company is and how efficiently it handles its resources and commitments.
The value of a company’s debt and equity securities depends on its predicted success and its capacity to repay its debt and to produce returns for shareholders to compensate for the risks they assume when investing in the firm.
Financial statements provide hints to future success by recounting the tale of past performance. They are read and utilized by a wide range of individuals for a vast variety of purposes; sooner or later, it will help you to know how to make sense of them.
Roles of Standard Setters, Auditors, and Regulators in Financial Reporting
Standards for financial reporting are often set at the national or worldwide level by accounting standard-setting groups. Standard setters, regulators, and auditors all have roles in assuring the uniformity of the financial information disclosed by corporations.
STANDARD SETTERS
Detailing one set of ‘rules’ for financial reporting are the International Financial Reporting Standards (IFRS), produced by the International Accounting Standards Board (IASB).
Most nations require or allow corporations to produce financial reports using IFRS. Publicly traded corporations situated in the United States, however, must report following generally accepted accounting principles (US GAAP). US-based corporations report using GAAP and non-US-based companies may report using IFRS.
There is a push to have accounting standards converge and to create a single set, or at least a compatible set, of high-quality financial reporting standards worldwide. In nations that have not implemented IFRS, attempts to converge with or transition to IFRS are going place.
When standards provide some option, the accounting system that a corporation adopts influences the reported earnings.
A corporation may utilize aggressive accounting practices that enhance reported earnings, or it may use conservative accounting methods that decrease stated profitability.
A corporation may recognise more or less revenue, and so display higher or lower profitability, depending on how the company interprets the accounting standards.
Despite guidelines that lead corporations to generate generally similar financial statements, there is still flexibility in their selection and interpretation.
The choice of appropriate alternative accounting methods are provided in the notes, which accompany the statements and explain parts of them, including the accounting judgments underlying them. The notes are an aid to interpreting the financial statements.
REGULATORS
Regulators assist financial reporting standards by recognising them and by enforcing rules that complement them.
Companies that issue securities traded in public markets are typically required to file reports that comply with standards specified by their country’s regulatory bodies, such as the Securities and Exchange Commission (SEC) in the United States, the Prudential Regulation Authority (PRA) in the United Kingdom, and the Financial Services Commission in South Korea. These reports comprise the financial statements and material that documents company operations.
AUDITORS
Before they can be released, the financial accounts must first be verified by independent accountants called auditors. An auditor offers an opinion on the correctness and presentation of a firm’s financial statements, which indicates to the reader how trustworthy the statements are in reflecting the financial performance of the organization.
Opinions can range from an unqualified or clean opinion, meaning that the financial statements are prepared in accordance with the applicable accounting standards, to an adverse opinion, which indicates that the financial statements do not comply with the accounting standards and, therefore, do not provide a fair representation of the company’s performance.
Note that a clean audit report does not suggest a financially sound organization. It just confirms that the financial statements were generated and presented accurately. In other words, an audit opinion is not a verdict on the company’s performance, but on how well it has accounted for its performance.
Financial statements describe how lucrative a firm is and how efficiently it manages its resources and commitments, and they are read and used by a wide variety of people.
The financial performance of a corporation important to many different people.
Company managers utilize financial performance to analyze the effectiveness of their strategies relative to historical and expected performance and comparing to competitors' performance
Employees care because the financial success of the company effect their job security and salary.
The company's financial performance important to investors since it influences the return of investment.
Tax authorities may be fascinated with the company 's financial performance so that they can tax the earnings.
Investment analyst examine the financial performance of the firm and provide recommendation to the customer whether to buy or sell securities such as bond and share issued by the company.
One way to analyze a firm is to look at its historical performance, which is shown in a company’s financial statements.
The financial accounts demonstrate, among other things, how effective a company has been at generating earnings (profits) to repay their obligations or reward shareholders.
Accountants collect this information and convey it to investors, management, and employees through three key financial statements:
Balance sheet
Income statement
Statement of cash flows
Key Characteristics of Financial Statements
Financial statements: Show the monetary value of the economic resources under a company’s control and how those resources have been employed to create value over time.
Are historical and forward-looking at the same time; they represent previous performance, and they provide signals about future performance.
Include notes that summarize the selected accounting methods, accounting practices, and other information crucial to analyzing a company’s results. These notes are a crucial component of a shareholder’s judgment.
Describe how profitable a company is and how efficiently it handles its resources and commitments.
The value of a company’s debt and equity securities depends on its predicted success and its capacity to repay its debt and to produce returns for shareholders to compensate for the risks they assume when investing in the firm.
Financial statements provide hints to future success by recounting the tale of past performance. They are read and utilized by a wide range of individuals for a vast variety of purposes; sooner or later, it will help you to know how to make sense of them.
Roles of Standard Setters, Auditors, and Regulators in Financial Reporting
Standards for financial reporting are often set at the national or worldwide level by accounting standard-setting groups. Standard setters, regulators, and auditors all have roles in assuring the uniformity of the financial information disclosed by corporations.
STANDARD SETTERS
Detailing one set of ‘rules’ for financial reporting are the International Financial Reporting Standards (IFRS), produced by the International Accounting Standards Board (IASB).
Most nations require or allow corporations to produce financial reports using IFRS. Publicly traded corporations situated in the United States, however, must report following generally accepted accounting principles (US GAAP). US-based corporations report using GAAP and non-US-based companies may report using IFRS.
There is a push to have accounting standards converge and to create a single set, or at least a compatible set, of high-quality financial reporting standards worldwide. In nations that have not implemented IFRS, attempts to converge with or transition to IFRS are going place.
When standards provide some option, the accounting system that a corporation adopts influences the reported earnings.
A corporation may utilize aggressive accounting practices that enhance reported earnings, or it may use conservative accounting methods that decrease stated profitability.
A corporation may recognise more or less revenue, and so display higher or lower profitability, depending on how the company interprets the accounting standards.
Despite guidelines that lead corporations to generate generally similar financial statements, there is still flexibility in their selection and interpretation.
The choice of appropriate alternative accounting methods are provided in the notes, which accompany the statements and explain parts of them, including the accounting judgments underlying them. The notes are an aid to interpreting the financial statements.
REGULATORS
Regulators assist financial reporting standards by recognising them and by enforcing rules that complement them.
Companies that issue securities traded in public markets are typically required to file reports that comply with standards specified by their country’s regulatory bodies, such as the Securities and Exchange Commission (SEC) in the United States, the Prudential Regulation Authority (PRA) in the United Kingdom, and the Financial Services Commission in South Korea. These reports comprise the financial statements and material that documents company operations.
AUDITORS
Before they can be released, the financial accounts must first be verified by independent accountants called auditors. An auditor offers an opinion on the correctness and presentation of a firm’s financial statements, which indicates to the reader how trustworthy the statements are in reflecting the financial performance of the organization.
Opinions can range from an unqualified or clean opinion, meaning that the financial statements are prepared in accordance with the applicable accounting standards, to an adverse opinion, which indicates that the financial statements do not comply with the accounting standards and, therefore, do not provide a fair representation of the company’s performance.
Note that a clean audit report does not suggest a financially sound organization. It just confirms that the financial statements were generated and presented accurately. In other words, an audit opinion is not a verdict on the company’s performance, but on how well it has accounted for its performance.
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Investment - Balance Sheet
The balance sheet reflects the company’s financial condition at a given time, such as the conclusion of the fiscal year or the end of the quarter.
Balance sheet often referred to as statement of financial position or statement of financial condition displays what the company owns, its assets and how the assets are financed at a specific point in time. The finance include what it owes others, the debt or liabilities, and shareholders' investment on equity.
Income statement often referred to as profit and loss account, the statement of profit or loss, profit or loss statement, or statements of operation, identifies the profit or loss generated by the company over the time covered by the financial statements
Cash flow statement is a statement of cash flows which displays the soruces of cash received and the uses of cash expended over the period covered by financial statements.
Notes to the financial statements give information relevant to understanding and assessing the financial statements.
Other reports may also be requested. In the United Kingdom, firms are required to produce a report from the directors as well as a report from the auditors. The directors’ report comprises information regarding the following:
The directors of the firm
The directors’ remuneration
Review of the business’s performance throughout the reporting year
Statement on the company’s compliance with corporate governance norms of conduct
In the United States, a 10-K report must be filed annually with the SEC. The 10-K report includes the following:
Financial statements
Management’s appraisal of financial conditions
Discussion of operating results
Quantitative and qualitative disclosures on the risks that the company faces
The Balance Sheet
The balance sheet reflects the company’s financial condition at a given time, such as the conclusion of the fiscal year or the end of the quarter. Essentially, it displays the following:
The resources the corporation controls (assets)
Its commitments to lenders and other creditors (liabilities or debt)
Owner-supplied capital (shareholders’ equity or owners’ equity)
The fundamental relationship underlying the balance sheet is known as the accounting equation:
Total assets = Total liabilities + Total shareholders’ equity
Another way of looking at the balance sheet is that total assets indicate the resources available to the organization for creating profit. Total liabilities plus shareholders’ equity demonstrate how such resources are financed, either by borrowing from creditors (liabilities) or by equity capital contributed by shareholders.
The value of the assets on one side of the balance sheet must equal the sum of the value of the debt and equity capital on the other side of the balance sheet, which is given to buy the assets. In other words, the balance sheet must balance.
The valuations of many assets are stated at their historical cost, which is the actual cost of acquiring the asset minus any cost expensed to date, which is also referred to as book value. An alternative to reporting an asset’s value at its book value is to declare its fair value, which indicates the amount it could be sold for in a transaction between willing and unconnected parties, called an arm’s length transaction. Fair value accounting is often used to only a few assets, such as some financial instruments. Most corporations choose to list assets, where allowed, at historical cost.
Let’s adjust the accounting equation to calculate shareholders’ equity:
Total shareholders’ equity = Total assets – Total liabilities
Total shareholders’ equity reflects the residual value of the company’s shares. Note that this is not the same as the market value of the firm’s equity, which is what the company’s shares are worth or what the market feels the company is worth. Differences arise in part because the balance sheet shows the book value of most assets and not their fair market value.
Although it is usual practice to use parenthesis or minus signs to indicate subtraction, some organizations will presume that the reader knows which numbers are generally subtracted from others and will not use minus signs or parentheses.
Assets
Balance sheets traditionally classify assets as current and non-current, and assets are presented in order of their liquidity, which is the ease with which an asset can be changed into cash at fair market value. Being the most liquid asset, cash is placed first.
The distinction between current and non-current assets is the period of time over which they are expected to be transformed into cash, used up, or sold.
Current assets comprise cash, inventories, which are unsold units of production on hand that are also referred to as stocks in various parts of the world, and accounts receivable, which is the money due to the company by customers who purchase on credit.
Current assets are projected to be transformed into cash, used up, or sold within the current operating term. A company’s operating period is the average amount of time spent between acquiring inventory and collecting the cash from sales to customers, which is normally one year, but can vary.
Non-current assets are often referred to as fixed assets or long-term assets. They include tangible assets, such as land, buildings, machinery, and equipment, and intangible assets, such as patents.
These assets are projected to create money for the organization over a period of years. A company’s tangible assets are frequently bundled together on the balance sheet as property, plant, and equipment (PP&E). Non-current assets may also include financial assets, such as shares or bonds issued by another company.
Asset Depreciation
When a corporation purchases a long-term (non-current) asset, it does not report that purchase as an expense on the income statement in the current operating period. Instead, the purchase amount is capitalized and recorded as an asset on the balance sheet. The corporation then allocates the cost of that asset throughout the asset’s expected useful life, often a span of years. This process is termed depreciation.
The amount of cost allotted each year is referred to as depreciation expense and is presented on the income statement as an expense.
The purchase amount represents the gross worth of the item and remains the same throughout the asset’s life.
The net book value of the long-term asset, however, decreases each year by the amount of the depreciation charge.
An asset’s net book value is computed as the gross value of the asset minus cumulative depreciation, where accumulated depreciation is the sum of the reported depreciation charges for the particular asset.
Details concerning the original costs, depreciation expenses, and accumulated depreciation of property, plant, and equipment can normally be found in the notes to the financial statements.
Other Non-Current Assets
Other non-current assets are long-term financial investments, intangible assets, such as patents, and goodwill. Similar to the depreciation of tangible assets, intangible assets are expensed during their useful lives through amortisation.
Goodwill is recognised and reported if a firm buys another company and paid more than the fair value of the net assets (assets minus liabilities) of the company it purchased. This value difference is created by other items not mentioned on the balance sheet, such as a devoted client base or skilled personnel.
Liabilities
Similar to assets, debt is separated on the balance sheet into current or short-term liabilities and long-term debt.
CURRENT LIABILITIES
Current liabilities must be repaid in the next year and include operating debt, such as accounts payable, which is credit granted by suppliers, short-term borrowing (such as loans from banks), and the amount of long-term debt that is due within the reporting year.
Unpaid operating expenses, such as money due to workers, are commonly shown combined as accumulated liabilities.
LONG-TERM DEBT
Long-term debt is money obtained from banks or other lenders that is to be returned over periods longer than one year.
Equity
Shareholders are the residual owners of the firm; they possess the residual worth of the company once its liabilities are satisfied. The quantity of the company’s equity is indicated on the balance sheet in two parts:
Amount received from selling stocks in the company to common shareholders, which is called common stock in the sample balance statement for ABC Company.
Retained profits (retained income), which reflects the company’s undistributed income, as opposed to dividends that represent distributed income. Retained earnings are an indirect contribution of capital by shareholders who allow the company to retain profits and constitute a link between the company’s income statement and the balance sheet.
When a firm produces profit and does not pay the proceeds to shareholders as dividends, the profit adds value to the company’s equity. After all, the firm exists to produce a profit; when it does, that makes the company more valuable.
Likewise, if the company has a net loss, that diminishes the value of its retained earnings and consequently its equity; the corporation becomes less valuable because it has lost, rather than earned, value.
The balance sheet reflects the company’s financial condition at a given time, such as the conclusion of the fiscal year or the end of the quarter.
Balance sheet often referred to as statement of financial position or statement of financial condition displays what the company owns, its assets and how the assets are financed at a specific point in time. The finance include what it owes others, the debt or liabilities, and shareholders' investment on equity.
Income statement often referred to as profit and loss account, the statement of profit or loss, profit or loss statement, or statements of operation, identifies the profit or loss generated by the company over the time covered by the financial statements
Cash flow statement is a statement of cash flows which displays the soruces of cash received and the uses of cash expended over the period covered by financial statements.
Notes to the financial statements give information relevant to understanding and assessing the financial statements.
Other reports may also be requested. In the United Kingdom, firms are required to produce a report from the directors as well as a report from the auditors. The directors’ report comprises information regarding the following:
The directors of the firm
The directors’ remuneration
Review of the business’s performance throughout the reporting year
Statement on the company’s compliance with corporate governance norms of conduct
In the United States, a 10-K report must be filed annually with the SEC. The 10-K report includes the following:
Financial statements
Management’s appraisal of financial conditions
Discussion of operating results
Quantitative and qualitative disclosures on the risks that the company faces
The Balance Sheet
The balance sheet reflects the company’s financial condition at a given time, such as the conclusion of the fiscal year or the end of the quarter. Essentially, it displays the following:
The resources the corporation controls (assets)
Its commitments to lenders and other creditors (liabilities or debt)
Owner-supplied capital (shareholders’ equity or owners’ equity)
The fundamental relationship underlying the balance sheet is known as the accounting equation:
Total assets = Total liabilities + Total shareholders’ equity
Another way of looking at the balance sheet is that total assets indicate the resources available to the organization for creating profit. Total liabilities plus shareholders’ equity demonstrate how such resources are financed, either by borrowing from creditors (liabilities) or by equity capital contributed by shareholders.
The value of the assets on one side of the balance sheet must equal the sum of the value of the debt and equity capital on the other side of the balance sheet, which is given to buy the assets. In other words, the balance sheet must balance.
The valuations of many assets are stated at their historical cost, which is the actual cost of acquiring the asset minus any cost expensed to date, which is also referred to as book value. An alternative to reporting an asset’s value at its book value is to declare its fair value, which indicates the amount it could be sold for in a transaction between willing and unconnected parties, called an arm’s length transaction. Fair value accounting is often used to only a few assets, such as some financial instruments. Most corporations choose to list assets, where allowed, at historical cost.
Let’s adjust the accounting equation to calculate shareholders’ equity:
Total shareholders’ equity = Total assets – Total liabilities
Total shareholders’ equity reflects the residual value of the company’s shares. Note that this is not the same as the market value of the firm’s equity, which is what the company’s shares are worth or what the market feels the company is worth. Differences arise in part because the balance sheet shows the book value of most assets and not their fair market value.
Although it is usual practice to use parenthesis or minus signs to indicate subtraction, some organizations will presume that the reader knows which numbers are generally subtracted from others and will not use minus signs or parentheses.
Assets
Balance sheets traditionally classify assets as current and non-current, and assets are presented in order of their liquidity, which is the ease with which an asset can be changed into cash at fair market value. Being the most liquid asset, cash is placed first.
The distinction between current and non-current assets is the period of time over which they are expected to be transformed into cash, used up, or sold.
Current assets comprise cash, inventories, which are unsold units of production on hand that are also referred to as stocks in various parts of the world, and accounts receivable, which is the money due to the company by customers who purchase on credit.
Current assets are projected to be transformed into cash, used up, or sold within the current operating term. A company’s operating period is the average amount of time spent between acquiring inventory and collecting the cash from sales to customers, which is normally one year, but can vary.
Non-current assets are often referred to as fixed assets or long-term assets. They include tangible assets, such as land, buildings, machinery, and equipment, and intangible assets, such as patents.
These assets are projected to create money for the organization over a period of years. A company’s tangible assets are frequently bundled together on the balance sheet as property, plant, and equipment (PP&E). Non-current assets may also include financial assets, such as shares or bonds issued by another company.
Asset Depreciation
When a corporation purchases a long-term (non-current) asset, it does not report that purchase as an expense on the income statement in the current operating period. Instead, the purchase amount is capitalized and recorded as an asset on the balance sheet. The corporation then allocates the cost of that asset throughout the asset’s expected useful life, often a span of years. This process is termed depreciation.
The amount of cost allotted each year is referred to as depreciation expense and is presented on the income statement as an expense.
The purchase amount represents the gross worth of the item and remains the same throughout the asset’s life.
The net book value of the long-term asset, however, decreases each year by the amount of the depreciation charge.
An asset’s net book value is computed as the gross value of the asset minus cumulative depreciation, where accumulated depreciation is the sum of the reported depreciation charges for the particular asset.
Details concerning the original costs, depreciation expenses, and accumulated depreciation of property, plant, and equipment can normally be found in the notes to the financial statements.
Other Non-Current Assets
Other non-current assets are long-term financial investments, intangible assets, such as patents, and goodwill. Similar to the depreciation of tangible assets, intangible assets are expensed during their useful lives through amortisation.
Goodwill is recognised and reported if a firm buys another company and paid more than the fair value of the net assets (assets minus liabilities) of the company it purchased. This value difference is created by other items not mentioned on the balance sheet, such as a devoted client base or skilled personnel.
Liabilities
Similar to assets, debt is separated on the balance sheet into current or short-term liabilities and long-term debt.
CURRENT LIABILITIES
Current liabilities must be repaid in the next year and include operating debt, such as accounts payable, which is credit granted by suppliers, short-term borrowing (such as loans from banks), and the amount of long-term debt that is due within the reporting year.
Unpaid operating expenses, such as money due to workers, are commonly shown combined as accumulated liabilities.
LONG-TERM DEBT
Long-term debt is money obtained from banks or other lenders that is to be returned over periods longer than one year.
Equity
Shareholders are the residual owners of the firm; they possess the residual worth of the company once its liabilities are satisfied. The quantity of the company’s equity is indicated on the balance sheet in two parts:
Amount received from selling stocks in the company to common shareholders, which is called common stock in the sample balance statement for ABC Company.
Retained profits (retained income), which reflects the company’s undistributed income, as opposed to dividends that represent distributed income. Retained earnings are an indirect contribution of capital by shareholders who allow the company to retain profits and constitute a link between the company’s income statement and the balance sheet.
When a firm produces profit and does not pay the proceeds to shareholders as dividends, the profit adds value to the company’s equity. After all, the firm exists to produce a profit; when it does, that makes the company more valuable.
Likewise, if the company has a net loss, that diminishes the value of its retained earnings and consequently its equity; the corporation becomes less valuable because it has lost, rather than earned, value.
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Investment - Income Statement
The income statement identifies the profit or loss created by a company for a certain time period, such as a year. Generating profit over time is vital for a firm to continue in business. In practice, the income statement may be referred to as the P&L (short for profit and loss).
In its most basic form, the income statement can be expressed by the following equation:
Profit (loss) = Revenues – Expenses
Expenses are the cost of firm resources — cash, inventories, equipment, and so on — that are utilized to earn sales. Expenses can be classified into categories that reflect their role:
Operating expenses comprise the cost of sales or cost of products sold; selling, general, and administrative expenses (SGA); and depreciation expenses
Financing charges, which include interest expenses
Income taxes
Gross Profit, Operating Profit, and Net Profit
Analysts refer to three metrics of profit: gross profit, operating profit, and net profit.
Gross Profit
Gross profit, which accounts for the cost of creating or acquiring the company’s products or services, is measured as:
Gross profit = Revenues – Cost of sales
Of course, cost of sales is not the only cost borne by a corporation in its efforts to sell products or services
Operating Profit
Other operating expenses include marketing expenses, which are the costs of promoting the products or services to customers; administrative expenses, which are the costs of running the company that are not directly related to production or sales, such as executive salaries and utility costs; and depreciation expenses, which are the annual non-cash expenses allocated to long-term assets, such as equipment.
Subtracting these additional costs from gross profit generates operating profit or operating income:
Operating profit = Gross profit – Other operating expenditures
Operating profit is typically referred to as earnings before interest and taxes, or EBIT.1 Operating income is the income (profits) earned by the company before factoring finance costs (interest) and taxes.
Another measure of income widely used by analysts is earnings before interest, taxes, depreciation, and amortisation (EBITDA), which is operational profit before depreciation and amortisation expenditures are deducted:
EBITDA = EBIT (or operational income) + Depreciation + Amortisation
The depreciation and amortisation values are not cash flows, and they are decided by the choice of accounting system rather than by operating actions. EBITDA is a measure of the company’s operating performance and its management’s ability to produce revenues and control expenses that are relevant to its operations. EBITDA may be a better measure than EBIT of management’s capacity to manage the revenues and expenses within its control. But EBITDA does not appear on a company’s income statement.
Net Profit
If the corporation has borrowed money to finance its activities, it will have to pay interest. Deducting interest expense from operational income determines a company’s earnings before taxes, or profit before tax:
Earnings before taxes = EBIT (or operating profit) – Interest expense
The income taxes owing by the corporation on its earnings are then deducted to arrive at net income or net profit or profit after tax:
Net income = EBIT (or operating income) – Interest expense – Tax expense
= Earnings before taxes – Tax expense
Net income indicates the income that the company has available to retain and reinvest in the company (retained earnings) or to distribute to owners in the form of dividends (disbursements of profit).
Note in the sample income statement that the net income of USD76 million minus the dividends paid of USD43 million equals USD33 million, which is the same amount as the change in retained earnings from 20X1 to 20X2 as shown on the balance sheet from Lesson 2 ($148 million – $115 million = $33 million).
The company’s owners (shareholders) are interested to know how much income the company has created per share, which is called earnings per share (EPS). It is approximated as net income divided by the number of shares outstanding. Investors are also interested in the amount of dividends the company pays for each share outstanding, or dividend per share.
The income statement identifies the profit or loss created by a company for a certain time period, such as a year. Generating profit over time is vital for a firm to continue in business. In practice, the income statement may be referred to as the P&L (short for profit and loss).
In its most basic form, the income statement can be expressed by the following equation:
Profit (loss) = Revenues – Expenses
Expenses are the cost of firm resources — cash, inventories, equipment, and so on — that are utilized to earn sales. Expenses can be classified into categories that reflect their role:
Operating expenses comprise the cost of sales or cost of products sold; selling, general, and administrative expenses (SGA); and depreciation expenses
Financing charges, which include interest expenses
Income taxes
Gross Profit, Operating Profit, and Net Profit
Analysts refer to three metrics of profit: gross profit, operating profit, and net profit.
Gross Profit
Gross profit, which accounts for the cost of creating or acquiring the company’s products or services, is measured as:
Gross profit = Revenues – Cost of sales
Of course, cost of sales is not the only cost borne by a corporation in its efforts to sell products or services
Operating Profit
Other operating expenses include marketing expenses, which are the costs of promoting the products or services to customers; administrative expenses, which are the costs of running the company that are not directly related to production or sales, such as executive salaries and utility costs; and depreciation expenses, which are the annual non-cash expenses allocated to long-term assets, such as equipment.
Subtracting these additional costs from gross profit generates operating profit or operating income:
Operating profit = Gross profit – Other operating expenditures
Operating profit is typically referred to as earnings before interest and taxes, or EBIT.1 Operating income is the income (profits) earned by the company before factoring finance costs (interest) and taxes.
Another measure of income widely used by analysts is earnings before interest, taxes, depreciation, and amortisation (EBITDA), which is operational profit before depreciation and amortisation expenditures are deducted:
EBITDA = EBIT (or operational income) + Depreciation + Amortisation
The depreciation and amortisation values are not cash flows, and they are decided by the choice of accounting system rather than by operating actions. EBITDA is a measure of the company’s operating performance and its management’s ability to produce revenues and control expenses that are relevant to its operations. EBITDA may be a better measure than EBIT of management’s capacity to manage the revenues and expenses within its control. But EBITDA does not appear on a company’s income statement.
Net Profit
If the corporation has borrowed money to finance its activities, it will have to pay interest. Deducting interest expense from operational income determines a company’s earnings before taxes, or profit before tax:
Earnings before taxes = EBIT (or operating profit) – Interest expense
The income taxes owing by the corporation on its earnings are then deducted to arrive at net income or net profit or profit after tax:
Net income = EBIT (or operating income) – Interest expense – Tax expense
= Earnings before taxes – Tax expense
Net income indicates the income that the company has available to retain and reinvest in the company (retained earnings) or to distribute to owners in the form of dividends (disbursements of profit).
Note in the sample income statement that the net income of USD76 million minus the dividends paid of USD43 million equals USD33 million, which is the same amount as the change in retained earnings from 20X1 to 20X2 as shown on the balance sheet from Lesson 2 ($148 million – $115 million = $33 million).
The company’s owners (shareholders) are interested to know how much income the company has created per share, which is called earnings per share (EPS). It is approximated as net income divided by the number of shares outstanding. Investors are also interested in the amount of dividends the company pays for each share outstanding, or dividend per share.
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Investment - Cash Flow
The statement of cash flows, or cash flow statement, details the sources and uses of cash during a period and explains the change in the cash balance recorded on the balance sheet.
There are cash inflows and outflows in a given reporting period that are not shown in a company’s income statement, such as purchases of new inventory, the repayment of debt, and purchases or sales of property, plant, and equipment. In fact, many of the year-over-year changes indicated on a company’s balance sheet reflect cash inflows or outflows that are not reflected on the income statement.
The statement of cash flows serves to reconcile disparities in a firm’s reported profit (net income) and the amount of net cash flow generated by the company during the reporting period.
The statement’s cash flows split into three categories:
Operating activities
Investment activities
Financing activities
Cash flows from operating activities (CFO)
Cash flows connected to the company’s primary business operations, including changes in net working capital
Cash inflows received for sales of products or services
Cash outflows paid for operating expenses
Inventory purchases and sales
Cash inflows or outflows from changes in accounts receivable and accounts payable
Borrowing or repayment of supplier debt
Cash flows from investment activities (CFI)
Cash flows related to purchases or sales of long-term assets
Purchase or sale of property, plant, and equipment
Cash outflow for an acquisition
Cash flows from financing activities (CFF)
Cash flows pertaining to the company’s debt and equity securities
Borrowing new long-term debt (issue new bonds)
Issuance of new equity securities
Repayments of long-term debt
Repurchases of shares
Payment of dividends
The statement of cash flows, or cash flow statement, details the sources and uses of cash during a period and explains the change in the cash balance recorded on the balance sheet.
There are cash inflows and outflows in a given reporting period that are not shown in a company’s income statement, such as purchases of new inventory, the repayment of debt, and purchases or sales of property, plant, and equipment. In fact, many of the year-over-year changes indicated on a company’s balance sheet reflect cash inflows or outflows that are not reflected on the income statement.
The statement of cash flows serves to reconcile disparities in a firm’s reported profit (net income) and the amount of net cash flow generated by the company during the reporting period.
The statement’s cash flows split into three categories:
Operating activities
Investment activities
Financing activities
Cash flows from operating activities (CFO)
Cash flows connected to the company’s primary business operations, including changes in net working capital
Cash inflows received for sales of products or services
Cash outflows paid for operating expenses
Inventory purchases and sales
Cash inflows or outflows from changes in accounts receivable and accounts payable
Borrowing or repayment of supplier debt
Cash flows from investment activities (CFI)
Cash flows related to purchases or sales of long-term assets
Purchase or sale of property, plant, and equipment
Cash outflow for an acquisition
Cash flows from financing activities (CFF)
Cash flows pertaining to the company’s debt and equity securities
Borrowing new long-term debt (issue new bonds)
Issuance of new equity securities
Repayments of long-term debt
Repurchases of shares
Payment of dividends
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Investment - Links Between Financial Statements
Although the balance sheet, income statement, and cash flow statement give different sorts of financial information, they are not fully independent.
The income statement displays a company’s profit, but profit is not the same as net cash flow, which is how much cash the company made during the period. The statement of cash flows reconciles the difference between reported net income and the amount of net cash flow generated by the company during the period.
What explains this sharp difference? One reason is that many cash transactions that are recorded on the balance sheet, such as changes in inventory, sales or repurchases of new stock, and the issuance or repayment of debt, do not appear on the income statement.
Another explanation for the disparity is due to accrual accounting.
Accounting standards normally mandate that revenue and expenses be recorded when they are incurred, even if the cash is not collected from the sale or paid for the charge. These transactions lead to revenues and expenses shown on the income statement without cash being exchanged, and that leads to disparities between net income and net cash flow.
Analysts and investors rely on the statement of cash flows to better comprehend the difference between reported net income and net cash flow.
A corporation must eventually make profits to offer returns to shareholders, but it must generate cash to keep itself operating. Suppliers, staff, costs, and debts must be paid for the company to remain running. The income statement demonstrates how good a firm is at earning profit, but it is also crucial to assess how good the company is at generating cash.
A corporation can be profitable but have negative cash flows; for example, it may be delayed at collecting payment from its customers. Or a corporation may operate at a loss but have positive cash flows, which could be the situation for a company with large depreciation and amortisation charges.
A corporation can function at a loss as long as the owners allow it, providing the company can create cash flows to maintain its survival. But a corporation cannot live long with negative cash flows, no matter how profitable it is. Negative cash flows may shut off access to resources, such as material and manpower, and they can cause a company to go bankrupt.
Although the balance sheet, income statement, and cash flow statement give different sorts of financial information, they are not fully independent.
The income statement displays a company’s profit, but profit is not the same as net cash flow, which is how much cash the company made during the period. The statement of cash flows reconciles the difference between reported net income and the amount of net cash flow generated by the company during the period.
What explains this sharp difference? One reason is that many cash transactions that are recorded on the balance sheet, such as changes in inventory, sales or repurchases of new stock, and the issuance or repayment of debt, do not appear on the income statement.
Another explanation for the disparity is due to accrual accounting.
Accounting standards normally mandate that revenue and expenses be recorded when they are incurred, even if the cash is not collected from the sale or paid for the charge. These transactions lead to revenues and expenses shown on the income statement without cash being exchanged, and that leads to disparities between net income and net cash flow.
Analysts and investors rely on the statement of cash flows to better comprehend the difference between reported net income and net cash flow.
A corporation must eventually make profits to offer returns to shareholders, but it must generate cash to keep itself operating. Suppliers, staff, costs, and debts must be paid for the company to remain running. The income statement demonstrates how good a firm is at earning profit, but it is also crucial to assess how good the company is at generating cash.
A corporation can be profitable but have negative cash flows; for example, it may be delayed at collecting payment from its customers. Or a corporation may operate at a loss but have positive cash flows, which could be the situation for a company with large depreciation and amortisation charges.
A corporation can function at a loss as long as the owners allow it, providing the company can create cash flows to maintain its survival. But a corporation cannot live long with negative cash flows, no matter how profitable it is. Negative cash flows may shut off access to resources, such as material and manpower, and they can cause a company to go bankrupt.
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Investment - Financial Statements Analysis
Financial statement analysis is the use of information provided by financial statements, as well as information from other sources, to find key links. These relationships may not be evident by reading the financial accounts alone.
The use of ratios allows analysts to standardise financial information and offers a context for making meaningful comparisons between years (time series) and between firms (cross-sectional). Specifically, ratios let investors evaluate companies of different sizes as well as help assess the performance of one company at different points in time.
They also enable managers of the company or outside creditors and investors answer crucial questions relevant to predicting a company’s likely future performance, such as the following:
How liquid is the company?
Is the corporation earning enough returns from its assets?
Does the corporation have too much debt?
Is the corporation delivering sufficient return for its shareholders?
How Liquid Is the Company?
In accounting, liquidity refers to a company’s capacity to fulfill its existing commitments in the short term, often within the next year. Two ratios typically used to assess liquidity are the current ratio and the quick ratio.
CURRENT RATIO
The current ratio assesses the current assets available to meet current liabilities:
If the current ratio is larger than 1, current assets are more than current liabilities and the company appears to be able to cover its debts in the short term.
But not every current asset is easily or rapidly convertible into cash, hence a current ratio of 2 is usually employed as a minimum desired requirement.
Current ratio = Current assets/Current liabilities
QUICK RATIO
Some consider the quick ratio to be a stronger predictor of liquidity than the current ratio since it excludes inventories, which are significantly less liquid than other current assets. A fast ratio of 1 or above is frequently seen as desirable.
Quick ratio = (Current assets – Inventories)/Current liabilities
It is crucial to note that a high current or quick ratio is not necessarily indicative of a problem-free organization. It may signal that the company is hoarding too much cash and not investing in other long-term assets necessary to create greater earnings.
For both ratios, a larger ratio suggests a higher level of liquidity; there is a greater availability of short-term resources to cover short-term obligations.
For example, a company’s balance sheet might give investors information about the company’s capacity to fulfill its outstanding commitments in the short term, commonly known as its liquidity. Investment managers utilize information on a company’s balance sheet to compute the current and quick ratios to measure liquidity. Let’s follow along to see how this is done.
As is the case for most ratios, comparing them with industry norms in the form of average ratios for the industry, ratios for comparable companies, or prior ratios provides a broader context for evaluating the ratios.
Is the Company Generating Enough Returns from Its Assets?
A widely used statistic for analyzing a company’s profitability is the net profit margin, which measures the percentage of revenues that is profit, in other words the percentage of revenues remaining for the shareholders after all expenses have been accounted for.
Net profit margin = Net income/Revenues
Generally, the bigger the net profit margin the better.
Return on Assets
Another ratio used to analyze profitability is return on assets (ROA).
Return on assets = ROA = Net income/Total assets
Return on assets specifies how much return, as measured by net income, is created per monetary unit invested in total assets. Generally, the bigger the return on assets the better.
Some analysts utilize operational income rather than net income when assessing return on assets.
Recall that operating income is the money derived by a company’s assets, excluding how those assets are financed. When calculated using operating income, a better name for the ratio is operational return on assets or basic earning power.
The basic earning power ratio compares the profit earned from operations with the assets utilized to create that income.
Basic earning power = Operating income/Total assets
Whatever ratio is chosen to quantify profitability per unit of assets, it should be utilized consistently when making comparisons.
A Deeper Dive into Return on Assets
To study how the company earns more money from its assets than comparable companies, return on assets can be divided into two components:
ROA = Net income/Total assets = Net income/Revenues x Revenues/Total assets
Similarly, the basic earning power ratio can be divided into two components:
Basic earning power = Operating income/Total assets = Operating income/Revenues × Revenues/Total assets
OPERATING INCOME
The first component of these two enlarged equations is a measure of profitability: It is net profit margin in the return on assets ratio and a ratio called operational profit margin in the basic earning power ratio. Net profit margin and operating profit margin reflect how good the company is at turning revenues into net income or operating income.
In other words, they reflect how successful the organization is at limiting the costs of creating its sales.
Financial statement analysis is the use of information provided by financial statements, as well as information from other sources, to find key links. These relationships may not be evident by reading the financial accounts alone.
The use of ratios allows analysts to standardise financial information and offers a context for making meaningful comparisons between years (time series) and between firms (cross-sectional). Specifically, ratios let investors evaluate companies of different sizes as well as help assess the performance of one company at different points in time.
They also enable managers of the company or outside creditors and investors answer crucial questions relevant to predicting a company’s likely future performance, such as the following:
How liquid is the company?
Is the corporation earning enough returns from its assets?
Does the corporation have too much debt?
Is the corporation delivering sufficient return for its shareholders?
How Liquid Is the Company?
In accounting, liquidity refers to a company’s capacity to fulfill its existing commitments in the short term, often within the next year. Two ratios typically used to assess liquidity are the current ratio and the quick ratio.
CURRENT RATIO
The current ratio assesses the current assets available to meet current liabilities:
If the current ratio is larger than 1, current assets are more than current liabilities and the company appears to be able to cover its debts in the short term.
But not every current asset is easily or rapidly convertible into cash, hence a current ratio of 2 is usually employed as a minimum desired requirement.
Current ratio = Current assets/Current liabilities
QUICK RATIO
Some consider the quick ratio to be a stronger predictor of liquidity than the current ratio since it excludes inventories, which are significantly less liquid than other current assets. A fast ratio of 1 or above is frequently seen as desirable.
Quick ratio = (Current assets – Inventories)/Current liabilities
It is crucial to note that a high current or quick ratio is not necessarily indicative of a problem-free organization. It may signal that the company is hoarding too much cash and not investing in other long-term assets necessary to create greater earnings.
For both ratios, a larger ratio suggests a higher level of liquidity; there is a greater availability of short-term resources to cover short-term obligations.
For example, a company’s balance sheet might give investors information about the company’s capacity to fulfill its outstanding commitments in the short term, commonly known as its liquidity. Investment managers utilize information on a company’s balance sheet to compute the current and quick ratios to measure liquidity. Let’s follow along to see how this is done.
As is the case for most ratios, comparing them with industry norms in the form of average ratios for the industry, ratios for comparable companies, or prior ratios provides a broader context for evaluating the ratios.
Is the Company Generating Enough Returns from Its Assets?
A widely used statistic for analyzing a company’s profitability is the net profit margin, which measures the percentage of revenues that is profit, in other words the percentage of revenues remaining for the shareholders after all expenses have been accounted for.
Net profit margin = Net income/Revenues
Generally, the bigger the net profit margin the better.
Return on Assets
Another ratio used to analyze profitability is return on assets (ROA).
Return on assets = ROA = Net income/Total assets
Return on assets specifies how much return, as measured by net income, is created per monetary unit invested in total assets. Generally, the bigger the return on assets the better.
Some analysts utilize operational income rather than net income when assessing return on assets.
Recall that operating income is the money derived by a company’s assets, excluding how those assets are financed. When calculated using operating income, a better name for the ratio is operational return on assets or basic earning power.
The basic earning power ratio compares the profit earned from operations with the assets utilized to create that income.
Basic earning power = Operating income/Total assets
Whatever ratio is chosen to quantify profitability per unit of assets, it should be utilized consistently when making comparisons.
A Deeper Dive into Return on Assets
To study how the company earns more money from its assets than comparable companies, return on assets can be divided into two components:
ROA = Net income/Total assets = Net income/Revenues x Revenues/Total assets
Similarly, the basic earning power ratio can be divided into two components:
Basic earning power = Operating income/Total assets = Operating income/Revenues × Revenues/Total assets
OPERATING INCOME
The first component of these two enlarged equations is a measure of profitability: It is net profit margin in the return on assets ratio and a ratio called operational profit margin in the basic earning power ratio. Net profit margin and operating profit margin reflect how good the company is at turning revenues into net income or operating income.
In other words, they reflect how successful the organization is at limiting the costs of creating its sales.
ASSET TURNOVER
The second component is a measure of asset utilization called as total asset turnover. This ratio is expressed as a multiple and represents the volume of revenues being generated by the assets used in the firm, or how successfully the company uses its assets to generate revenues. An growing ratio may imply increased performance, although care should be exercised in interpreting this data.
An increasing ratio may also suggest static revenues and declining assets related to depreciation; in other words, sales are not expanding, and the company is not reinvesting to maintain its plant and machinery up to date. It is always necessary to examine the cause of changes in a ratio.
The second component is a measure of asset utilization called as total asset turnover. This ratio is expressed as a multiple and represents the volume of revenues being generated by the assets used in the firm, or how successfully the company uses its assets to generate revenues. An growing ratio may imply increased performance, although care should be exercised in interpreting this data.
An increasing ratio may also suggest static revenues and declining assets related to depreciation; in other words, sales are not expanding, and the company is not reinvesting to maintain its plant and machinery up to date. It is always necessary to examine the cause of changes in a ratio.
Does the Company Have Too Much Debt?
To analyze financial leverage, which is the extent to which debt is used in the financing of the business, experts use the debt-to-equity ratio. This ratio reflects how much debt the company has relative to equity.
Debt-to-equity ratio = Debt/Equity
Typically, the debt examined is solely interest-bearing debt, which includes the following:
Short-term borrowing
Portion of long-term debt due within the reporting period
Long-term debt
It does not contain accounts payable and accrued expenses that do not necessitate an interest payment.
Another popular ratio used for analyzing the amount of debt employed by the corporation is the financial leverage ratio, or equity multiplier ratio.
Financial leverage = Equity multiplier = Total assets/Equity
This equity multiplier estimates the amount of total assets supported by one monetary unit of equity. The bigger the equity multiplier, the more debt is being used by the corporation to finance its assets.
A corporation with a low equity multiplier is one largely financed by equity.
Holding a higher amount of debt is riskier because a firm is obligated to service its debt by paying interest, whereas it does not have a similar duty to serve its equity by paying dividends.
For a company with relatively large debt, it may not be in a position to satisfy its interest payments or to respond as fast as its competitors to new opportunities.
In certain nations, the usage of debt finance is referred to as gearing rather than leverage. Highly leveraged or geared corporations are generally referred to as being less solvent. Thus, leverage and solvency are notions that are inversely related.
A company that employs little debt financing is generally considered to be more solvent than a company that uses a high amount of debt financing.
Is the Company Providing Sufficient Returns to Its Shareholders?
It is crucial to examine whether the return made by the company is sufficient from the standpoint of the shareholders. Is the return high enough for investors to still want to purchase the share? One ratio typically employed to answer this question is the return on equity (ROE).
Return on equity = ROE = Net income/Equity
A company’s ROE reveals how much return, as measured by net income, is made per monetary unit of stock.
This statistic can be compared with the company’s ROE over time, with the ROE for other companies, and with the appropriate industry average ROE.
ROE can also be broken into three components: net profit margin, asset turnover, and financial leverage:
ROE = Net income/Equity = Net income/Revenues × Revenues/Total assets × Total assets/Equity
or
ROE = Net profit margin × Asset turnover × Financial leverage
The product of the first two components produces the company’s return on assets. Another element potentially affecting the return on equity is the amount of leverage or debt the company has.
A corporation with more debt will have a higher return on equity as long as the debt returns more than it costs by supporting a return on assets that is greater than the after-tax cost of debt.
Thus, the third component of the ROE decomposition is the financial leverage ratio, the equity multiplier.
To analyze financial leverage, which is the extent to which debt is used in the financing of the business, experts use the debt-to-equity ratio. This ratio reflects how much debt the company has relative to equity.
Debt-to-equity ratio = Debt/Equity
Typically, the debt examined is solely interest-bearing debt, which includes the following:
Short-term borrowing
Portion of long-term debt due within the reporting period
Long-term debt
It does not contain accounts payable and accrued expenses that do not necessitate an interest payment.
Another popular ratio used for analyzing the amount of debt employed by the corporation is the financial leverage ratio, or equity multiplier ratio.
Financial leverage = Equity multiplier = Total assets/Equity
This equity multiplier estimates the amount of total assets supported by one monetary unit of equity. The bigger the equity multiplier, the more debt is being used by the corporation to finance its assets.
A corporation with a low equity multiplier is one largely financed by equity.
Holding a higher amount of debt is riskier because a firm is obligated to service its debt by paying interest, whereas it does not have a similar duty to serve its equity by paying dividends.
For a company with relatively large debt, it may not be in a position to satisfy its interest payments or to respond as fast as its competitors to new opportunities.
In certain nations, the usage of debt finance is referred to as gearing rather than leverage. Highly leveraged or geared corporations are generally referred to as being less solvent. Thus, leverage and solvency are notions that are inversely related.
A company that employs little debt financing is generally considered to be more solvent than a company that uses a high amount of debt financing.
Is the Company Providing Sufficient Returns to Its Shareholders?
It is crucial to examine whether the return made by the company is sufficient from the standpoint of the shareholders. Is the return high enough for investors to still want to purchase the share? One ratio typically employed to answer this question is the return on equity (ROE).
Return on equity = ROE = Net income/Equity
A company’s ROE reveals how much return, as measured by net income, is made per monetary unit of stock.
This statistic can be compared with the company’s ROE over time, with the ROE for other companies, and with the appropriate industry average ROE.
ROE can also be broken into three components: net profit margin, asset turnover, and financial leverage:
ROE = Net income/Equity = Net income/Revenues × Revenues/Total assets × Total assets/Equity
or
ROE = Net profit margin × Asset turnover × Financial leverage
The product of the first two components produces the company’s return on assets. Another element potentially affecting the return on equity is the amount of leverage or debt the company has.
A corporation with more debt will have a higher return on equity as long as the debt returns more than it costs by supporting a return on assets that is greater than the after-tax cost of debt.
Thus, the third component of the ROE decomposition is the financial leverage ratio, the equity multiplier.
When any of these component ratios improve, all else being equal, the return on equity increases. Although it makes obvious sense that a firm’s performance increases when generating more profit from revenues and more revenues from its assets, a corporation can also boost its return on equity by supplementing its equity with borrowing, or in other words, employing leverage.
But borrowing may not be a viable idea if the company would struggle to satisfy its financial obligations. An increase in return on equity due to borrowing comes with increased risk.
Decomposing ROE into the three components, net profit margin, total asset turnover, and financial leverage, is valuable because it allows analysts to better understand why the company’s return on equity is changing and to analyze the origins of that change.
Market Valuations
So far, we have measured performance using financial statements. Another way is to evaluate performance in terms of creating or destroying value for the company’s shareholders.
Two ratios, both dependent on a company’s share price, are often used to judge management’s success.
PRICE-TO-EARNINGS
The first ratio compares a company’s share price with its earnings per share.
A price-to-earnings ratio, or P/E multiple, informs us how much investors are ready to pay for every dollar of earnings per share. For example, a firm with a P/E of 15 suggests that investors are willing to pay 15.00 for every 1.00 of earnings per share.
If the price-to-earnings ratio is higher for one company than it is for another in the same industry, it may signal that investors think that the company with the higher price-to-earnings ratio has more growth potential. Alternatively, the firm with the lower price-to-earnings ratio may be undervalued by the market.
Price-to-earnings ratio = Market price per share/Earnings per share
PRICE-TO-BOOK
The second ratio based on the share price is the price-to-book ratio (P/B). It compares the company’s share price with the company’s book value per share.
The book value of stock generally represents historical costs and measures the amount shareholders have invested in the company across its lifetime. Therefore, a P/B ratio larger than 1 suggests that investors feel the company is worth more in the long run than the money shareholders have put in it.
In other words, the company’s management has created value for shareholders since their original investment. A ratio less than 1 is often an indicator that the company’s managers have destroyed value. But in actuality, listed businesses could trade at a price-to-book ratio of less than 1 for many other reasons, ranging from ephemeral undervaluation, negative industry sentiment, or a substantially inflated book value.
Price-to-book ratio = Market price per share/Book value per share
Where Book value per share = Equity recorded on the balance sheet/Number of shares outstanding
But borrowing may not be a viable idea if the company would struggle to satisfy its financial obligations. An increase in return on equity due to borrowing comes with increased risk.
Decomposing ROE into the three components, net profit margin, total asset turnover, and financial leverage, is valuable because it allows analysts to better understand why the company’s return on equity is changing and to analyze the origins of that change.
Market Valuations
So far, we have measured performance using financial statements. Another way is to evaluate performance in terms of creating or destroying value for the company’s shareholders.
Two ratios, both dependent on a company’s share price, are often used to judge management’s success.
PRICE-TO-EARNINGS
The first ratio compares a company’s share price with its earnings per share.
A price-to-earnings ratio, or P/E multiple, informs us how much investors are ready to pay for every dollar of earnings per share. For example, a firm with a P/E of 15 suggests that investors are willing to pay 15.00 for every 1.00 of earnings per share.
If the price-to-earnings ratio is higher for one company than it is for another in the same industry, it may signal that investors think that the company with the higher price-to-earnings ratio has more growth potential. Alternatively, the firm with the lower price-to-earnings ratio may be undervalued by the market.
Price-to-earnings ratio = Market price per share/Earnings per share
PRICE-TO-BOOK
The second ratio based on the share price is the price-to-book ratio (P/B). It compares the company’s share price with the company’s book value per share.
The book value of stock generally represents historical costs and measures the amount shareholders have invested in the company across its lifetime. Therefore, a P/B ratio larger than 1 suggests that investors feel the company is worth more in the long run than the money shareholders have put in it.
In other words, the company’s management has created value for shareholders since their original investment. A ratio less than 1 is often an indicator that the company’s managers have destroyed value. But in actuality, listed businesses could trade at a price-to-book ratio of less than 1 for many other reasons, ranging from ephemeral undervaluation, negative industry sentiment, or a substantially inflated book value.
Price-to-book ratio = Market price per share/Book value per share
Where Book value per share = Equity recorded on the balance sheet/Number of shares outstanding
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Investment - Types and Characteristics of Investors
Introduction to Investor Types
Investors are not a homogeneous group; both individual and institutional investors have diverse features. Clients differ in terms of their financial resources, objectives, personalities, financial expertise, and so on. These variances affect their financial demands, what services they require, and what assets are appropriate for them. Consider the following example:
Elderly customers with significant resources may be highly concerned with estate planning.
Elderly consumers with little resources may be more anxious about outliving their assets.
Thus, a gap in investment returns may have major ramifications for people concerned about outliving their assets but have less impact on those with significant resources.
Investors can own securities, such as shares and bonds, directly, or they can invest in professionally managed funds to acquire market exposure. Investors may choose securities or funds themselves or contact an investment professional to aid in the decision. Investment experts attempt to provide appropriate investment services to fulfill clients’ demands.
The most basic distinction among investors is that between individual and institutional investors.
INDIVIDUAL INVESTORS
Individual investors trade (buy or sell) securities or permit others to trade stocks for their personal accounts.
INSTITUTIONAL INVESTORS
Institutional investors are organisations that hold and manage portfolios of assets for themselves or others.
The traits that distinguish individual investors are frequently distinct from those that define institutional investors.
Individual Investors
Individual investors are often differentiated based on their resources. The word ‘retail investor’ can be used to refer to all individual investors, although it is typical to use the term to refer to individual investors with little resources to invest. Many investing businesses create a distinction between their regular clients, more affluent clients with higher amounts to invest, and high- and ultra-high-net-worth investors, who have the biggest amounts of investable assets.
The services supplied by investment businesses and the investments available will often vary by the amount of money the client has to invest. Some specialist funds may need minimum quantities of investment (e.g., USD1 million), and some portfolio management services may have minimum costs, rendering them uneconomical for lesser account sizes.
An investment firm that focuses on retail investors has to satisfy the needs of a large number of relatively modest accounts. Doing so often implies consolidating the retail investors’ assets into a smaller number of funds and establishing automated systems for the administration of client fund holdings.
An investment firm or division within an investment firm specializing on high-net-worth investors may have fewer clients, but greater average account balances, than one that concentrates on regular investors. Investor assets may still be placed in funds, however some high-net-worth investors will prefer their own segregated accounts (known as separately managed accounts). Wealthy clients may have higher expectations of client service than retail consumers, and usually the services that are delivered to them are more individualized.
Individual investors vary in their level of investment knowledge and competence. Some individual investors have very limited investment knowledge and competence, and others are more knowledgeable, maybe as a result of their schooling or work experience.
Because individual investors are typically viewed of as less knowledgeable and less experienced than institutional investors, regulators in many countries try to safeguard them by setting restrictions on the assets that can be sold to them.
For example, as of 2022 in the United States, the Securities and Exchange Commission (SEC) restricts investing in some alternative investments to accredited individuals. An individual qualifies as an accredited investor if they have earned income of USD200,000 or more in each of the prior two years and has a reasonable expectation to earn at least USD200,000 in the current year, or has (alone or together with a spouse) a net worth (excluding his or her primary residence) greater than USD1 million.
This restriction is based on the assumption that wealthier investors are anticipated to have a higher level of investing expertise — or access to professional investment counsel — and possess a greater ability to forgo investment liquidity.
Additional variables of the personal situations of individual investors, such as age and family obligations, may also differ and affect their investing demands and decision making. The planned holding term (time or investment horizon) for investments, risk tolerance, and other conditions also affect investors’ needs.
Retail Investors
The investing sector delivers primarily standardised services to retail investors because they make the least money per investor for investment firms. Many retail investing services are supplied online or by customer service personnel working at call centres.
High-Net-Worth Investors
Wealthier investors often receive more personal attention from financial experts. Their investment problems sometimes involve tax and estate planning complications that demand greater resources and professional knowledge. They either pay directly for these services on a fee-for-service basis or indirectly through commissions and other transaction charges.
Ultra-High-Net-Worth Investors and Family Offices
Very affluent individuals generally employ professionals who help them manage their money, future estates, and legal concerns. These specialists generally operate in a family office, which is a private corporation that administers the financial affairs of one or more members of a family or of numerous families.
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Many family offices serve the heirs of huge family fortunes that have been acquired over generations. In addition to investing services, family offices may provide personal services to the family members, such as bookkeeping, tax planning, managing household personnel, making travel arrangements, and coordinating social events.
Wealthy families generally have huge real estate holdings and large financial portfolios. The investment professionals who work in family offices often handle these investments using the same strategies and processes that institutional investors use. They pay especially close attention to personal and estate tax issues that may considerably affect the family’s wealth and their capacity to transfer money on to future generations or charity institutions.
Institutional Investors
Institutional investors are organisations that hold and manage portfolios of assets for themselves or others. There are numerous different sorts of institutional investors with differing investment criteria and limits. Institutional investors may invest to promote their mission, or they may invest for others to address the others’ needs. Institutional investors that invest to achieve their missions include the following:
Pension plans
Endowment funds and foundations
Trusts
Governments and sovereign wealth funds
Non-financial companies
Institutional investors that invest to provide financial services to their clients include investment companies, banks, and insurance companies. Some institutional investors handle their investments internally and employ investment specialists whose duty is to select the investments.
Other institutional investors outsource the investing of the portfolio to one or more external investment firms. The choice between internal and external management will frequently be influenced by the size of the institutional investor, with larger institutional investors better able to afford the resources required for internal management.
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Some institutional investors will choose a mixed model, managing some assets domestically in which they have competence and outsourcing more specialist investments — for example, alternative investments — to external managers. Those institutional investors that choose to outsource investment management still have significant decisions to make in terms of which managers to choose. They may use internal expertise to make manager selection decisions, or they may employ a consultant.
Pension Plans
Pension plans hold investment portfolios — that is, pension funds — for the benefit of future and existing retired members, who are called beneficiaries.
A firm or other body may set up a pension plan to provide benefits to its employees. The companies and governments that sponsor these plans are termed pension sponsors or plan sponsors. Money from employer and/or employee contributions is placed away to give income to plan members when they retire. The payments must be invested until the employee retires and receives the retirement benefits.
Pension plans differ by whether they are arranged as defined benefit or defined contribution schemes.
Defined Benefit Pension Plans
Defined benefit pension schemes promise a defined annual sum to their retired participants. The set amount normally fluctuates by member based on such factors as years of service and annual income while working.
Typically, employees do not have the right to collect benefits until they have worked for the company or government for a term set by the pension plan. An employee’s rights are vested (covered by law or contract) once they have worked for that duration.
Defined benefit pension funds, particularly those of government-sponsored schemes, are among the largest institutional investors. Pension funds may invest in equities securities, debt securities, and alternative assets because they often have relatively lengthy time horizons.
As employees retire, new employees are added to the plan. If new employees are not being added to the plan, the temporal horizon of the plan will diminish over time.
In a defined benefit pension plan, the sponsoring employer promises its members (or employees) a defined amount of benefit. For example, it is extremely typical for the company to promise a yearly pension that is a specified proportion of the employee’s final pre-retirement income.
The pension may be adjusted for inflation over time. The employer will pay contributions to the pension fund to honor the promise. Employees may also be asked to donate.
In a defined benefit plan, the employer bears the risk – in this example, that the investments made by the pension fund fail to perform as predicted. If the investments fail to perform as planned, the employer may be obliged to make further contributions to the fund.
But it is likely that pension sponsors will be unable to make the necessary contributions and that beneficiaries would not receive the benefits expected. Defined benefit plans are becoming less widespread around the globe and are being replaced by defined contribution plans.
Euro Pension Fund is the fund for a defined benefit pension plan located in Frankfurt, Germany. The plan sponsor remits money to the fund based on projections of pension benefit commitments compared with pension plan assets. Working members of the plan also pay a portion of their wages to the fund.
It has an asset management team that devises the fund’s strategy and implements it.
Defined Contribution Pension Plans
In a defined contribution pension plan, the pension sponsor normally contributes an agreed-on amount — the defined contribution — to an account set up for each employee.
Employees also often contribute to their own retirement plan accounts, primarily through employee payroll deductions.
The contributions are subsequently invested, generally in funds that the employee chooses from a list of approved funds inside the plan.
The plan gives enough options of funds to allow employees to establish a broadly diversified portfolio. The sponsor often limits the selections to a group of mutual funds sponsored by recognized investment managers. The pension plan sponsor should also guarantee that the costs levied on the funds are appropriate. At retirement, the money that has accumulated in the account is available to the employee.
In defined contribution plans, the member (or employee) takes the risk that the pension account’s investments fail to perform as predicted. This contrasts with defined benefit plans, in which the employer takes the risk.
In defined contribution plans, the employer has no commitment to make further payments if the investments perform poorly. If the retirement fund is less than projected, the employee may have to make do with less retirement income or, maybe, defer retirement.
Because saving enough and choosing the correct investments are very important, defined contribution plan sponsors are increasingly providing financial assistance to their beneficiaries or arranging for financial consultants to help guide members.
In the past, most pension plans were defined benefit pension plans. Because these plans promise defined benefits to their beneficiaries, they are expensive responsibilities for the sponsor (company) and many sponsors no longer offer them. This development explains why defined contribution pension plans are progressively replacing defined benefit plans in most countries.
Endowment Funds and Foundations
Endowment funds and foundations are also big institutional investors in many nations. Endowment funds are long-term funds of nonprofit institutions, such as universities, hospitals, and museums.
These institutions use their endowment monies to provide some services to their students, patients, and supporters. Foundations are grant-making institutions funded by gifts and by the investment income that they earn. Most foundations do not directly provide services. Instead, they fund entities that provide services in such areas as the arts or charities. Foundations often own endowment funds, which invest the foundation’s money.
Endowment funds and foundations often have a charity or philanthropic aim and accept endowments from contributors interested in supporting their activities. In many countries, gifts to these institutions are tax deductible for the donors.
That is, gifts diminish the income on which the donors have to pay taxes. Investment income and capital gains that these organisations get from investing these funds may also be tax-exempt.
Endowment funds are normally meant to remain in perpetuity and, as such, are viewed as very long-term investors. But they are also often mandated to spend annually on the benevolent or philanthropic objective for their existence, therefore money needs to be pulled from their funds.
Many endowment funds and foundations adopt spending criteria; for example, they may set expenditure goals of a percentage range of their assets. Often, their issue resides in combining long-term growth with shorter-term income or cash flow requirements.
Each endowment fund or foundation has its own special circumstances. Some are able to raise money on an ongoing basis, but others are limited from raising more money. Some endowment funds and foundations are mandated to spend a fixed part of the portfolio each year, whilst others have more flexibility to adjust spending.
These discrepancies have significance for how the institutional investor’s assets are invested. An endowment client that is barred from fundraising has to meet its financial needs from income or the sale of assets, whereas an endowment client that has no restriction on fundraising may also raise money to satisfy its financial needs.
Most institutions with endowment funds use professional investment managers to manage the funds. Some manage portions of their money domestically, in some cases through an investment management company that they control.
Governments and Sovereign Wealth Funds
Governments receive money from collecting taxes or selling bonds. When they do not have to spend this money immediately, they frequently invest it.
Some governments have accumulated significant surpluses from selling natural resources that they control or from financing the trade of goods and services. They create sovereign wealth funds to invest these surpluses for the benefit of present and future generations of their citizens.
Sovereign wealth funds often invest in long-term securities and assets. They also may purchase companies. Sovereign wealth funds either manage their investments in-house or engage investment managers to manage their money.
Non-Financial Companies
Analysts typically identify companies as either financial companies or non-financial companies.
Financial Companies
Financial companies include investment companies, banks and other lenders, and insurance organizations. These companies provide financial services to its clientele.
Non-Financial Companies
Non-financial enterprises produce items and non-financial services for their consumers.
These companies invest money that they do not presently require to run their businesses.
The money invested by non-financial companies may be invested short-term, mid-term, or long-term. The corporate treasurer usually controls the short-term investment assets. These assets often comprise cash that the company will need shortly to pay salaries and accounts payable and financial vehicles that are safe and liquid, like demand deposits (checking accounts), money market funds, and short-term debt securities issued by governments or other companies.
Long-term investments are normally managed under the leadership of the chief financial officer or the chief investment officer, if the company has one. firms often invest long term to finance future research, investments, and acquisitions of firms and goods. Companies may invest long term directly, or they may hire investment managers to invest on their behalf.
Some corporations invest directly in the shares and bonds of their suppliers and in the shares of possible merger partners to strengthen their relationships with them. Practitioners term these investments ‘strategic investments’. These types of investments are widespread in Asian countries, such as Japan and South Korea, and in European countries, such as France, Germany, and Italy.
Investment Companies
Investment businesses include mutual funds, hedge funds, and private equity funds. These firms operate exclusively to hold investments on behalf of its owners, partners, or unitholders (units refer to shares and bonds for equity and debt securities, respectively). These companies are called pooled investment vehicles because investors in these organizations pool their money for common management.
Investment companies are handled by experienced investment managers that work for investment management organizations. These management businesses often structure and market the investment companies that they manage and so function as the investment sponsors.
Mutual funds pool the assets of many investors into a single investment vehicle, which is professionally managed and benefits from economies of scale. There are thousands of mutual funds administered by investment management businesses.
Mutual funds are often classed by their investment(s). Investments eligible for inclusion may be strictly or broadly defined and based on categories of assets, geographic area, and so on.
For example, mutual funds may specify that they invest in Chinese equities identified as having growth potential, global equities, long-term investment-grade European corporate bonds, or commodities. The investment management business receives a fee for managing the fund. Although a mutual fund can be viewed as an institutional investor, the phrase ‘mutual fund’ also refers to the investment vehicle, shares of which an individual or institutional investor might hold in a portfolio.
Hedge funds and private equity funds can similarly be considered institutional investors that manage private investment pools and as investment vehicles. They are distinguished by their use of tactics outside the limits of most standard mutual funds (discussed in Course 2, Types and Functioning of Markets).
Insurance Companies
Insurance companies form another key group of institutional investor.
Insurance Companies collect premium from persons and companies they cover. Premium are required by insurance firms to offer insurance coverage for the policyholders.
Some of the premiums are deposited into a reserve fund form which insurance coverage can be paid. The premiums in the reverse funds are invested in broad portfolios of securities and assets that attempt to ensure that adequate money are always available to meet all claims.
Regulations typically impose rules to restrict the types of investments insurance firms can keep.
Insurance firms profit from the income they gain form float which is the amount money they have available to use after receiving premium and before paying claims.
There are two primary sorts of insurance businesses.
PROPERTY AND CASUALTY
Property and casualty insurance firms safeguard their insured from the financial loss caused by such catastrophes as accidents and theft.
Property and casualty insurers have short-term views and generally unpredictable payouts; therefore, they favor shorter-term assets that are more cautious and liquid.
LIFE
Life insurance firms give payments to the policyholder’s beneficiaries in the event the policyholder dies while the insurance coverage is in force.
Life insurers have longer-term time horizons and more predictable payouts and, thus, have more leeway to engage in riskier assets. They frequently invest their reserve funds, which often are extremely big, in stocks, commodities, real estate, and other real assets.
Some insurance firms give both forms of insurance.
nsurance businesses aim to match their investments to their responsibilities. For example, if they intend to make fixed annuity payments in the far future, they may invest in long-term fixed-income securities to match the interest rate risk of their assets to the interest rate risk of their liabilities.
This approach of matching investment assets to liabilities, called asset/liability matching, decreases the risk that the company would fail to fulfill its claims.
Most large insurance companies manage their investments in-house. They also may contract with investment managers to oversee specialty investments in industries, asset classes, or geographical regions where they lack expertise or access.
Investors — both individual and institutional — differ in their financial resources, circumstances, objectives, views, financial skills, and so on. These distinctions determine what services the client requires and what types of investments are appropriate for the client. Therefore, it is crucial to record information about the client and the client’s needs.
Introduction to Investor Types
Investors are not a homogeneous group; both individual and institutional investors have diverse features. Clients differ in terms of their financial resources, objectives, personalities, financial expertise, and so on. These variances affect their financial demands, what services they require, and what assets are appropriate for them. Consider the following example:
Elderly customers with significant resources may be highly concerned with estate planning.
Elderly consumers with little resources may be more anxious about outliving their assets.
Thus, a gap in investment returns may have major ramifications for people concerned about outliving their assets but have less impact on those with significant resources.
Investors can own securities, such as shares and bonds, directly, or they can invest in professionally managed funds to acquire market exposure. Investors may choose securities or funds themselves or contact an investment professional to aid in the decision. Investment experts attempt to provide appropriate investment services to fulfill clients’ demands.
The most basic distinction among investors is that between individual and institutional investors.
INDIVIDUAL INVESTORS
Individual investors trade (buy or sell) securities or permit others to trade stocks for their personal accounts.
INSTITUTIONAL INVESTORS
Institutional investors are organisations that hold and manage portfolios of assets for themselves or others.
The traits that distinguish individual investors are frequently distinct from those that define institutional investors.
Individual Investors
Individual investors are often differentiated based on their resources. The word ‘retail investor’ can be used to refer to all individual investors, although it is typical to use the term to refer to individual investors with little resources to invest. Many investing businesses create a distinction between their regular clients, more affluent clients with higher amounts to invest, and high- and ultra-high-net-worth investors, who have the biggest amounts of investable assets.
The services supplied by investment businesses and the investments available will often vary by the amount of money the client has to invest. Some specialist funds may need minimum quantities of investment (e.g., USD1 million), and some portfolio management services may have minimum costs, rendering them uneconomical for lesser account sizes.
An investment firm that focuses on retail investors has to satisfy the needs of a large number of relatively modest accounts. Doing so often implies consolidating the retail investors’ assets into a smaller number of funds and establishing automated systems for the administration of client fund holdings.
An investment firm or division within an investment firm specializing on high-net-worth investors may have fewer clients, but greater average account balances, than one that concentrates on regular investors. Investor assets may still be placed in funds, however some high-net-worth investors will prefer their own segregated accounts (known as separately managed accounts). Wealthy clients may have higher expectations of client service than retail consumers, and usually the services that are delivered to them are more individualized.
Individual investors vary in their level of investment knowledge and competence. Some individual investors have very limited investment knowledge and competence, and others are more knowledgeable, maybe as a result of their schooling or work experience.
Because individual investors are typically viewed of as less knowledgeable and less experienced than institutional investors, regulators in many countries try to safeguard them by setting restrictions on the assets that can be sold to them.
For example, as of 2022 in the United States, the Securities and Exchange Commission (SEC) restricts investing in some alternative investments to accredited individuals. An individual qualifies as an accredited investor if they have earned income of USD200,000 or more in each of the prior two years and has a reasonable expectation to earn at least USD200,000 in the current year, or has (alone or together with a spouse) a net worth (excluding his or her primary residence) greater than USD1 million.
This restriction is based on the assumption that wealthier investors are anticipated to have a higher level of investing expertise — or access to professional investment counsel — and possess a greater ability to forgo investment liquidity.
Additional variables of the personal situations of individual investors, such as age and family obligations, may also differ and affect their investing demands and decision making. The planned holding term (time or investment horizon) for investments, risk tolerance, and other conditions also affect investors’ needs.
Retail Investors
The investing sector delivers primarily standardised services to retail investors because they make the least money per investor for investment firms. Many retail investing services are supplied online or by customer service personnel working at call centres.
High-Net-Worth Investors
Wealthier investors often receive more personal attention from financial experts. Their investment problems sometimes involve tax and estate planning complications that demand greater resources and professional knowledge. They either pay directly for these services on a fee-for-service basis or indirectly through commissions and other transaction charges.
Ultra-High-Net-Worth Investors and Family Offices
Very affluent individuals generally employ professionals who help them manage their money, future estates, and legal concerns. These specialists generally operate in a family office, which is a private corporation that administers the financial affairs of one or more members of a family or of numerous families.
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Many family offices serve the heirs of huge family fortunes that have been acquired over generations. In addition to investing services, family offices may provide personal services to the family members, such as bookkeeping, tax planning, managing household personnel, making travel arrangements, and coordinating social events.
Wealthy families generally have huge real estate holdings and large financial portfolios. The investment professionals who work in family offices often handle these investments using the same strategies and processes that institutional investors use. They pay especially close attention to personal and estate tax issues that may considerably affect the family’s wealth and their capacity to transfer money on to future generations or charity institutions.
Institutional Investors
Institutional investors are organisations that hold and manage portfolios of assets for themselves or others. There are numerous different sorts of institutional investors with differing investment criteria and limits. Institutional investors may invest to promote their mission, or they may invest for others to address the others’ needs. Institutional investors that invest to achieve their missions include the following:
Pension plans
Endowment funds and foundations
Trusts
Governments and sovereign wealth funds
Non-financial companies
Institutional investors that invest to provide financial services to their clients include investment companies, banks, and insurance companies. Some institutional investors handle their investments internally and employ investment specialists whose duty is to select the investments.
Other institutional investors outsource the investing of the portfolio to one or more external investment firms. The choice between internal and external management will frequently be influenced by the size of the institutional investor, with larger institutional investors better able to afford the resources required for internal management.
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Some institutional investors will choose a mixed model, managing some assets domestically in which they have competence and outsourcing more specialist investments — for example, alternative investments — to external managers. Those institutional investors that choose to outsource investment management still have significant decisions to make in terms of which managers to choose. They may use internal expertise to make manager selection decisions, or they may employ a consultant.
Pension Plans
Pension plans hold investment portfolios — that is, pension funds — for the benefit of future and existing retired members, who are called beneficiaries.
A firm or other body may set up a pension plan to provide benefits to its employees. The companies and governments that sponsor these plans are termed pension sponsors or plan sponsors. Money from employer and/or employee contributions is placed away to give income to plan members when they retire. The payments must be invested until the employee retires and receives the retirement benefits.
Pension plans differ by whether they are arranged as defined benefit or defined contribution schemes.
Defined Benefit Pension Plans
Defined benefit pension schemes promise a defined annual sum to their retired participants. The set amount normally fluctuates by member based on such factors as years of service and annual income while working.
Typically, employees do not have the right to collect benefits until they have worked for the company or government for a term set by the pension plan. An employee’s rights are vested (covered by law or contract) once they have worked for that duration.
Defined benefit pension funds, particularly those of government-sponsored schemes, are among the largest institutional investors. Pension funds may invest in equities securities, debt securities, and alternative assets because they often have relatively lengthy time horizons.
As employees retire, new employees are added to the plan. If new employees are not being added to the plan, the temporal horizon of the plan will diminish over time.
In a defined benefit pension plan, the sponsoring employer promises its members (or employees) a defined amount of benefit. For example, it is extremely typical for the company to promise a yearly pension that is a specified proportion of the employee’s final pre-retirement income.
The pension may be adjusted for inflation over time. The employer will pay contributions to the pension fund to honor the promise. Employees may also be asked to donate.
In a defined benefit plan, the employer bears the risk – in this example, that the investments made by the pension fund fail to perform as predicted. If the investments fail to perform as planned, the employer may be obliged to make further contributions to the fund.
But it is likely that pension sponsors will be unable to make the necessary contributions and that beneficiaries would not receive the benefits expected. Defined benefit plans are becoming less widespread around the globe and are being replaced by defined contribution plans.
Euro Pension Fund is the fund for a defined benefit pension plan located in Frankfurt, Germany. The plan sponsor remits money to the fund based on projections of pension benefit commitments compared with pension plan assets. Working members of the plan also pay a portion of their wages to the fund.
It has an asset management team that devises the fund’s strategy and implements it.
Defined Contribution Pension Plans
In a defined contribution pension plan, the pension sponsor normally contributes an agreed-on amount — the defined contribution — to an account set up for each employee.
Employees also often contribute to their own retirement plan accounts, primarily through employee payroll deductions.
The contributions are subsequently invested, generally in funds that the employee chooses from a list of approved funds inside the plan.
The plan gives enough options of funds to allow employees to establish a broadly diversified portfolio. The sponsor often limits the selections to a group of mutual funds sponsored by recognized investment managers. The pension plan sponsor should also guarantee that the costs levied on the funds are appropriate. At retirement, the money that has accumulated in the account is available to the employee.
In defined contribution plans, the member (or employee) takes the risk that the pension account’s investments fail to perform as predicted. This contrasts with defined benefit plans, in which the employer takes the risk.
In defined contribution plans, the employer has no commitment to make further payments if the investments perform poorly. If the retirement fund is less than projected, the employee may have to make do with less retirement income or, maybe, defer retirement.
Because saving enough and choosing the correct investments are very important, defined contribution plan sponsors are increasingly providing financial assistance to their beneficiaries or arranging for financial consultants to help guide members.
In the past, most pension plans were defined benefit pension plans. Because these plans promise defined benefits to their beneficiaries, they are expensive responsibilities for the sponsor (company) and many sponsors no longer offer them. This development explains why defined contribution pension plans are progressively replacing defined benefit plans in most countries.
Endowment Funds and Foundations
Endowment funds and foundations are also big institutional investors in many nations. Endowment funds are long-term funds of nonprofit institutions, such as universities, hospitals, and museums.
These institutions use their endowment monies to provide some services to their students, patients, and supporters. Foundations are grant-making institutions funded by gifts and by the investment income that they earn. Most foundations do not directly provide services. Instead, they fund entities that provide services in such areas as the arts or charities. Foundations often own endowment funds, which invest the foundation’s money.
Endowment funds and foundations often have a charity or philanthropic aim and accept endowments from contributors interested in supporting their activities. In many countries, gifts to these institutions are tax deductible for the donors.
That is, gifts diminish the income on which the donors have to pay taxes. Investment income and capital gains that these organisations get from investing these funds may also be tax-exempt.
Endowment funds are normally meant to remain in perpetuity and, as such, are viewed as very long-term investors. But they are also often mandated to spend annually on the benevolent or philanthropic objective for their existence, therefore money needs to be pulled from their funds.
Many endowment funds and foundations adopt spending criteria; for example, they may set expenditure goals of a percentage range of their assets. Often, their issue resides in combining long-term growth with shorter-term income or cash flow requirements.
Each endowment fund or foundation has its own special circumstances. Some are able to raise money on an ongoing basis, but others are limited from raising more money. Some endowment funds and foundations are mandated to spend a fixed part of the portfolio each year, whilst others have more flexibility to adjust spending.
These discrepancies have significance for how the institutional investor’s assets are invested. An endowment client that is barred from fundraising has to meet its financial needs from income or the sale of assets, whereas an endowment client that has no restriction on fundraising may also raise money to satisfy its financial needs.
Most institutions with endowment funds use professional investment managers to manage the funds. Some manage portions of their money domestically, in some cases through an investment management company that they control.
Governments and Sovereign Wealth Funds
Governments receive money from collecting taxes or selling bonds. When they do not have to spend this money immediately, they frequently invest it.
Some governments have accumulated significant surpluses from selling natural resources that they control or from financing the trade of goods and services. They create sovereign wealth funds to invest these surpluses for the benefit of present and future generations of their citizens.
Sovereign wealth funds often invest in long-term securities and assets. They also may purchase companies. Sovereign wealth funds either manage their investments in-house or engage investment managers to manage their money.
Non-Financial Companies
Analysts typically identify companies as either financial companies or non-financial companies.
Financial Companies
Financial companies include investment companies, banks and other lenders, and insurance organizations. These companies provide financial services to its clientele.
Non-Financial Companies
Non-financial enterprises produce items and non-financial services for their consumers.
These companies invest money that they do not presently require to run their businesses.
The money invested by non-financial companies may be invested short-term, mid-term, or long-term. The corporate treasurer usually controls the short-term investment assets. These assets often comprise cash that the company will need shortly to pay salaries and accounts payable and financial vehicles that are safe and liquid, like demand deposits (checking accounts), money market funds, and short-term debt securities issued by governments or other companies.
Long-term investments are normally managed under the leadership of the chief financial officer or the chief investment officer, if the company has one. firms often invest long term to finance future research, investments, and acquisitions of firms and goods. Companies may invest long term directly, or they may hire investment managers to invest on their behalf.
Some corporations invest directly in the shares and bonds of their suppliers and in the shares of possible merger partners to strengthen their relationships with them. Practitioners term these investments ‘strategic investments’. These types of investments are widespread in Asian countries, such as Japan and South Korea, and in European countries, such as France, Germany, and Italy.
Investment Companies
Investment businesses include mutual funds, hedge funds, and private equity funds. These firms operate exclusively to hold investments on behalf of its owners, partners, or unitholders (units refer to shares and bonds for equity and debt securities, respectively). These companies are called pooled investment vehicles because investors in these organizations pool their money for common management.
Investment companies are handled by experienced investment managers that work for investment management organizations. These management businesses often structure and market the investment companies that they manage and so function as the investment sponsors.
Mutual funds pool the assets of many investors into a single investment vehicle, which is professionally managed and benefits from economies of scale. There are thousands of mutual funds administered by investment management businesses.
Mutual funds are often classed by their investment(s). Investments eligible for inclusion may be strictly or broadly defined and based on categories of assets, geographic area, and so on.
For example, mutual funds may specify that they invest in Chinese equities identified as having growth potential, global equities, long-term investment-grade European corporate bonds, or commodities. The investment management business receives a fee for managing the fund. Although a mutual fund can be viewed as an institutional investor, the phrase ‘mutual fund’ also refers to the investment vehicle, shares of which an individual or institutional investor might hold in a portfolio.
Hedge funds and private equity funds can similarly be considered institutional investors that manage private investment pools and as investment vehicles. They are distinguished by their use of tactics outside the limits of most standard mutual funds (discussed in Course 2, Types and Functioning of Markets).
Insurance Companies
Insurance companies form another key group of institutional investor.
Insurance Companies collect premium from persons and companies they cover. Premium are required by insurance firms to offer insurance coverage for the policyholders.
Some of the premiums are deposited into a reserve fund form which insurance coverage can be paid. The premiums in the reverse funds are invested in broad portfolios of securities and assets that attempt to ensure that adequate money are always available to meet all claims.
Regulations typically impose rules to restrict the types of investments insurance firms can keep.
Insurance firms profit from the income they gain form float which is the amount money they have available to use after receiving premium and before paying claims.
There are two primary sorts of insurance businesses.
PROPERTY AND CASUALTY
Property and casualty insurance firms safeguard their insured from the financial loss caused by such catastrophes as accidents and theft.
Property and casualty insurers have short-term views and generally unpredictable payouts; therefore, they favor shorter-term assets that are more cautious and liquid.
LIFE
Life insurance firms give payments to the policyholder’s beneficiaries in the event the policyholder dies while the insurance coverage is in force.
Life insurers have longer-term time horizons and more predictable payouts and, thus, have more leeway to engage in riskier assets. They frequently invest their reserve funds, which often are extremely big, in stocks, commodities, real estate, and other real assets.
Some insurance firms give both forms of insurance.
nsurance businesses aim to match their investments to their responsibilities. For example, if they intend to make fixed annuity payments in the far future, they may invest in long-term fixed-income securities to match the interest rate risk of their assets to the interest rate risk of their liabilities.
This approach of matching investment assets to liabilities, called asset/liability matching, decreases the risk that the company would fail to fulfill its claims.
Most large insurance companies manage their investments in-house. They also may contract with investment managers to oversee specialty investments in industries, asset classes, or geographical regions where they lack expertise or access.
Investors — both individual and institutional — differ in their financial resources, circumstances, objectives, views, financial skills, and so on. These distinctions determine what services the client requires and what types of investments are appropriate for the client. Therefore, it is crucial to record information about the client and the client’s needs.