One morning, you turn on the financial news channel to discover that the S&P 500 has surpassed the 2800 level. Stock reports continue to be favorable, and you recognize that going overweight in equities will allow you to make more money. Then the mental process comes to an abrupt halt.
You start to wonder whether the market will continue to rise or if it is losing steam. The Producer Price Index (PPI), the Consumer Price Index (CPI), jobless claims reports, the unemployment rate, and other main inflation gauges the Producer Price Index (PPI), the Consumer Price Index (CPI), the unemployment rate, and so on all raise inflation concerns on a daily basis. You’re worried that if you invest at the top of the market, you’ll overpay for the stocks in question, resulting in lower predicted returns.
This is when knowing how to analyze financial statements comes in handy. In the end, the share price is driven by the return a company receives on its stock, and inflation decreases equity returns.
Investors who don’t grasp accounting and finance are like blurry-visioned hunters: they’re playing a fast-paced game that they’ll eventually lose.
Financial statements for reporting purposes incorporate accrual accounting, management estimates, and managerial judgment to provide crucial information. However, when used to financial analysis, they have two major flaws:
- Accounting book values rarely match market values because accountants rely on the historical cost assumption.
- Accounting income differs from economic income since accountants do not account for unrealized gains and losses or imputed costs.
Simply explained, inflation is a rise in an economy’s overall price level. In the macroeconomic realm, inflation reduces the supply of loanable money while increasing demand, leading interest rates to rise. As a result, interest rates reflect anticipated inflation, and the stock market moves in the opposite direction of interest rates.
Inflation impacts a company’s income statement in three ways from a microeconomic standpoint.
First, historical cost depreciation overstates reported earnings and income taxes due by understating the genuine drop in the value of assets. Second, the cost-flow technique for inventory valuation has a variety of effects on the reported net income. During periods of high inflation, first in, first out (FIFO) valuation overstates reported earnings and taxes. Last in, first out (LIFO) valuation, on the other hand, while matching current costs to revenues, understates inventories and so overstates return on assets (ROA). When inventory are valued at their original cost, LIFO accounting causes balance sheet irregularities. Because it undervalues the investment base on which the return is achieved, this results in an upward skew in the return on equity (ROE), which is defined as net income accessible to common shareholders divided by average common shareholders’ equity. Despite this flaw, LIFO is preferred over FIFO when calculating economic earnings.
The influence of stated interest expense on firm earnings is the third distortion. The historical interest expenditure is inflated due to inflation, as the value of debt reduces due to inflation, resulting in understated reported earnings and, as a result, a reduction in taxes owed.
The efficiency with which a company uses its owners’ cash is measured by its return on investment (ROI). For regulating the ROE, management has three levers:
The company’s pricing strategy and ability to control operating costs are reflected in the net profit margin ratio, or net income/sales. High profit margins are associated with low asset turnover, and vice versa. The asset turnover ratio, also known as sales/assets, is a metric that assesses capital intensity, with a low asset turnover indicating a capital-intensive business and a high asset turnover indicating the inverse. Asset turnover is influenced by the type of a company’s products and its competitive strategy. ROA is a metric that determines how well a company allocates and manages its resources.
Companies with a large percentage of fixed costs are more susceptible to sales decline. Businesses with predictable and consistent operating cash flows can take on more financial leverage securely than those confronting market volatility. Companies having a low return on investment (ROA) tend to use more debt financing, and vice versa.
- Temporal analysis: Because ROE is limited to a single year’s results, it typically fails to capture the full impact of long-term decisions.
- Due to a probable divergence between the market value of stock and its book value, a high ROE may not be synonymous with a good return on investment to shareholders.
- Risk aversion: ROE focuses solely on the return and ignores the risk involved in achieving such returns.
Determine the industry distribution of the firm’s revenues and where each major industry segment is in the industry’s life cycle is a vital initial step in company analysis. Second, investors must grasp that earnings per share (EPS) is return on investment (ROI) multiplied by book value per share. As a result, a rise in the return on stockholders’ equity, an increase in stockholders’ equity per share, or both might result in increased net income per share.
Investors must assess what kind of future growth rate the company can sustain over the next five to ten years after piecing together all of the financial data. The highest rate at which a company’s sales can expand without diminishing its financial resources is known as its sustainable growth rate. It’s nothing more than the company’s equity growth rate. To put it another way, growth rate is retention rate multiplied by return on investment.
Mature and declining businesses frequently invest significant resources in new goods or businesses that are still growing. Inflation affects a company’s sustainable development rate if managers, creditors, and investors make decisions based on previous cost financial statements. Adjusting for inflation has a relatively minor impact on the rate of sustainable growth.
On the balance sheet, historical cost accounting tends to understate long-term assets and exaggerate long-term liabilities. In addition, when measured on historical cost financial statements, inflation raises the amount of external funding necessary and the company’s debt-to-equity ratio. Inflation distorts reported earnings, overstating true economic earnings. As a result, the price-to-earnings (P/E) ratio declines.
As a result, the P/E ratio represents the market’s belief in a company’s growth prospects. When growth potential outnumber total value estimates, the company’s P/E ratio rises. The P/E ratio, in general, provides little insight into a company’s present financial performance.
When inflation is predicted to be low, the earnings yield on stocks, or EPS/price, should be higher than the yields to maturity on bonds. When inflation is projected to be high, the opposite should be true. The combination of a bright future, a high stock price, and a low earnings yield is a winning combination.
Investors should concentrate on the ROE since it is influenced by EPS, which defines the sustainable growth rate and is reflected in the equity security’s price via the P/E ratio.
“Financial statements are like beautiful perfume: to be sniffed but not swallowed,” said Abraham Brilloff.
That’s something to bear in mind the next time you’re thinking about overweighting stocks.
What effect will inflation have on the computation of key profitability ratios?
- Inflation occurs when a currency’s purchasing power diminishes over time, resulting in increased prices.
- Companies tend to pass on growing production costs to their customers, making stocks an effective inflation hedge in general.
- Inflation estimates also influence investor expectations, with more inflation leading to higher expected returns.
- P/E ratios tend to fall when inflation is high because earnings in the denominator tend to rise faster than the stock price.
What impact does inflation have on the balance sheet?
As a company acquires additional assets and responsibilities, the value of its balance sheet fluctuates. Inflation affects balance sheet values as well, as rising inflation leads to higher tangible asset valuations. Cash and cash equivalents retain their worth, but their purchasing power (the amount of money they can buy) decreases when inflation rises. Inflation tends to push wages, the cost of suppliers, and inventories up, inflating incurred expenses in the “Liabilities” column. Other liabilities may or may not vary in value; debts with fluctuating interest rates typically grow in value when inflation rises, but debts with set rates do not.
What are some of the flaws in ratio analysis?
The human element of a company is not measured by ratio analysis. Only other businesses of the same size and type can be compared using ratio analysis. It may be tough to compare your company to others since they may not be willing to give information.
Inflation distorts reported income in what ways?
Financial statements are a crucial indicator of your company’s financial health. With that in mind, you should be aware that they may not always provide an accurate picture of your company’s current state or how it compares to competitors. On paper, a variety of things can distort reality.
The following are the most common reasons of income and performance picture distortions in financial statements:
If the impact of these elements is not taken into account, a false picture of the business’s state may emerge.
Inflation’s influence on financial statements
Inflation may wreak havoc on the reported earnings of companies with large inventories. Consider the following illustration:
Last year, Patrick’s PC Shop made $100,000 in sales. Its cost of goods sold was $75,000, resulting in a $25,000 profit.
Assume Patrick’s PC Shop sells the same number of units this year as last year, but that its prices have increased by 5% due to inflation. Assume that its cost of goods increased by 5%, but that half of its sales will come from “old” inventory purchased at last year’s price.
So, for the current year, Patrick’s PC Shop has $105,000 in sales and $76,875 in cost of goods sold ($75,000 + 5%). Even if Patrick’s level of business activity remained unchanged, gross profits increased by $1,875at least some of which will show up in net income.
In the case above, Patrick’s PC Shop’s greater profits are not due to improved performance. They’re nothing more than “inflation profits.”
When the expenses of fixed assets are attributed to income through depreciation, inflation distorts reported income. The depreciation charge does not reflect the higher expenses of replacing fixed assets.
Inflation has an impact on how a company is valued by investors and potential buyers who do not place a high value on inflation earnings. A company that fails to account for this element in its financial planning may have its value drop despite steady or mildly increasing profits.
Considering accounting procedures
When financial statements and ratio analysis of the items in the statements diverge from accounting processes used to arrive at the figures in the income statement and balance sheet, there will be some dissonance between the facts and the real world.
Although accountants follow generally accepted accounting principles (GAAP), there is opportunity for diversity in how GAAP is applied by different organizations and accountants.
Within a certain business, consistency is necessary. Different policies in different businesses, on the other hand, can alter reported outcomes and skew the picture of where your company stands in relation to others.
- The time it takes for sales to appear on an income statement varies by company. A more aggressive approach may expedite revenue items by reporting them as soon as possible, but a more prudent approach may cause revenues to be postponed.
- Depreciation charges for financial reporting purposes on essentially equivalent assets might vary from company to company, based on depreciation procedures and useful lifetimes.
- Accounting policies for inventory may differ. In a period of rising prices, a company that uses first-in, first-out (FIFO) accounting will make more money than a company that uses last-in, first-out (LIFO) accounting.
- When it comes to expensing, policies may differ. A company may charge an item to income as a cost right away, whereas another company may capitalize the identical thing and report a bigger profit.
- The cost of goods sold and the gross profit reported will be affected by different approaches of treating the cost of developing a product.
- Depending on your accounting practices, extraordinary or nonrecurring charges may or may not be recognized in operating income.
Take the results with a grain of salt when comparing your financial statements to industry standards or those of another company for all of these reasons.
What effect does inflation have on working capital?
Inflation is a scenario in which the general price level of goods and services continues to rise. The amount of working capital required to sustain a typical level of production and sales grows in this situation. Inflation raises the cost of raw materials, raises the pay rate, and raises all other expenses, necessitating the use of more working capital. As a result, as the rate of inflation rises, a company’s working capital requirements rise as well.
What is the impact of inflation on financial performance?
Inflationary rates are linked to greater inflation and stock return variability. 2. Inflationary pressures mean less long-term financial activity. Intermediaries will lend less and allocate money less effectively in high-inflation nations, and equity markets will be smaller and less liquid.
What impact does inflation have on businesses?
Inflation decreases money’s buying power by requiring more money to purchase the same products. People will be worse off if income does not increase at the same rate as inflation. This results in lower consumer spending and decreased sales for businesses.
What effect does inflation have on depreciation?
Because inflation is defined as a decrease in the value of money, if inflation rises, the currency in that economy will depreciate in relation to other currencies.