Your Business Matters!

Sunday, February 9, 2014

Can You Answer These 10 Questions about Interest Rates?

1) Why did interest rates change over the past year?

2) What is Interest rate elasticity?

3) How would an increase in government spending affect the rate of interest?

4) What happens to interest rates during a recession?

5) How are expected interest rates linked to an expectation of economic growth and inflation?

6) What is the link between the nominal rate of interest and real rate of interest?

7) When stock values experience a drop and investors sell, interest rates usually decline. How does the selling of stocks lead to lower interest rates?

8) How would expectations of higher global oil prices affect supply and demand for loan-able funds and interest rates in the United States? Will the change apply to the interest rates of other countries in the same way?

9) Why might we expect interest rate movements of established countries to have a higher correlation in recent years compared to historical measures?

10) How does government borrowing and the national deficit level affect interest rates?

Write down your responses here or there and I'll go find the answers. By the way, if you have any questions of your own or want to add a question to the list please do. There are no wrong answers, only right ones!

BONUS Questions!

A) What is Interest Rate Risk? and B) Who is at risk?

Answers!

1) The Fed began to wind down Quantitative Easing which is a reduction in the amount of Treasuries they purchase and amount of cash going into the economy. This is like taking your foot off of the gas when driving a car. It does not include braking to slow down which is akin to raising interest rates. Although the economy will perceive rising rates when QE winds down. Look at the housing market for example. Rates are scheduled to increase in 2015, of course there is no guarantee in future Fed actions.

2) Interest elasticity of demand represents the change in the quantity of loan-able funds demanded in response to a change in interest rates.

3) The governments demand for money would create a demand for loan-able funds which would have a tendency to push interest rates up.

4) During a recession companies tend to reduce spending and borrowing. The result is a reduction in demand for loans and a drop in interest rates.

5) Interest rates in the future should increase if economic growth and inflation are expected to rise; decrease if economic growth and inflation are expected to decline.

6) Nominal interest rate is the quoted rate while the real rate equal the nominal rate minus the rate of inflation or nominal rate = real rate + inflation. We are not including any other risk premiums here.

7) When stocks go through a sell-off the money typically goes into money market accounts creating an abundance of loan-able funds and thus lowering interest rates.

8) Expectations of higher oil prices creates concern for higher inflation. Since higher inflation can increase interest rates, it will cause an expectation of higher interest rates in the U.S. Firms and government agencies may borrow more funds before prices increase and before interest rates increase. Consumers may use their savings to buy products before the prices increase. Therefore, the demand for loan-able funds should increase, the supply of loan-able funds should decrease, and interest rates should increase.

The impact of higher global oil prices in other countries is not necessarily the same. If the country produces its own oil, it can set the oil prices in its respective country. If it can prevent high oil prices in its country, then the prices of products (gasoline) and services (transportation) may not be affected. Therefore, interest rates may not be affected.

9) Interest rates among countries are expected to have a higher correlation in recent years because financial markets are more geographically integrated. More international financial flows will occur to capitalize on higher interest rates in foreign countries, which affects the supply and demand conditions in each market. As funds leave a country with low interest rates, this places upward pressure on that country’s interest rates. The international flow of funds causes this type of reaction. Also known as carry trade.

10) When the government has a high borrowing deficit, the national interest payments on the loans are higher which reduces the amount of funds available for lending, driving up the rate of interest. When the deficit is low, there are more funds available and interest rates should be lower.

BONUS Answers!

A) Interest rate risk is a time based risk that occurs when rates fluctuate. Since rates will change more often over a long period of time relative to a shorter period, there is a premium added to account for the risk. This is one of the reasons the 10-year treasury has a higher return than a 6-month treasury. Homeowners at one time had to pay a penalty if they paid off their mortgage early.

B) Any person or organization that invests in the long-term faces the chance that interest rates will change. Insurance companies, pensions, and many investors who purchase bonds encounter similar patterns of risk.

You might also like Meet the New Economy, and The Fed and Monetary Policy - Where do we go from here?

Monday, October 7, 2013

Cash flow Statements: Operating, Investing, and Financing - Revenue or Other Comprehensive Income?

Locating the source of profits.

By Nicholas Morris

October 7, 2013

In line with our goal to locate opportunities for short-term investments for your business, we've discussed low short-term rates will remain for some time. With the economy struggling, business owners should identify with other companies that are market leaders. It’s not enough to know a company is profitable. We need to identify the source of the profit. One credible source of information is the statement of cash flows. Here we can see what is driving income. Browsing financial statements is fine, but take it a step further and read the Notes or Management's Discussion and Analysis when you want answers. Find and identify the path of revenue.

All financial statements are not created equal. Investors want and need a systematic way to take accounting information and turn it into a digestible story of events that clearly illustrate a company’s performance. One underlying theme is to validate earnings. If we can locate the company’s Statement of Cash Flows we get a closer look into the source of income. Check to see if earnings reported is substantiated by revenue generated for the period, hence operating income. If the revenue is not generated by sales or service, did the boost come from a one-time sale of company assets? Did the company sell off land, equipment, or maybe a division? Management has some flexibility with the reporting process. The key is to identify underlying trends and know how to locate the source. If you’re not familiar with the SEC website, you can search the Next-Generation EDGAR system to check on your favorite company using their stock symbol. Look for a blue Interactive Data button

in the top box near the bottom and click. The left hand column is expandable and will contain multiple categories for further investigation.

Have you seen my accrued revenue?

Most large companies will opt for accrual-based accounting. With accrual-based accounting, company sales and incoming revenue do not always coincide in timing or amount.

Unlike cash-basis accounting, accrual-based revenue is recognized when realized or realizable (cash is collected or expected to be collected) and earned (goods or services have been delivered or provided).

In accordance, under the matching principle, expenses are recognized in the same period as the matching revenues. However, accrual-based accounting requires the use of judgment and discretion by management when estimating how much revenue will be noncollectable. How much will product returns cost the company? How much will the company have to refund to their customers? What will the product’s warranty costs amount to? Also included in the list of options is: depreciation allowances, inventory, deferred taxes, and intangible assets like goodwill, write downs, gains and losses.

Quality of Earnings

The cash flow statement reports cash as operating, investing, or financing; and discloses explanations in the Notes to Financial Statements. When looking for performance issues, it is important to understand how operating cash flow relates to the company’s operating earnings. Did the company have a higher earnings number due to an increase in sales? Earning quality refers to the company’s use of depreciation methods, doubtful accounts, and unearned revenue. The degree can vary from conservative which decreases current earnings, to a more liberal use which might inflate earnings which should create some skepticism from investors. Sooner or later unearned revenue will become earned or will be written off, thus eliminated. These methods are self-correcting because the accounts have to balance.

Apple Inc.’s Statement of Cash flows is a great example of a company with a lot of cash and a lot of options. Their operating cash flow comes from sales and service. Cash flows from investments comes from and goes to business acquisitions, the purchase of property, plant, and equipment, and intangibles. Cash flows from financing come from and go to the sale of stock and the distribution of dividends. Borrowing money to buy back company stock is common when cash levels remain high and stock prices are at a discount.

The cash flow statement begins with net income from the income statement. Adjustments are made to eliminate non-cash revenues and expenses from operating activities, (i.e. depreciation is a reduction in asset value from use and not an expense). The next two categories include balance sheet items from investing activities (the purchase or sale of property, plant, and equipment) and financing activities (long-term borrowing, dividends) are totaled. These three activities are then added together to produce the years total cash and cash equivalents balance.

With EDGAR, we can identify and investigate the transactions by entry by looking to the Notes. The structure is layered for drilling down to the information you need. For example, under investing activity, Apple acquired intangible assets for $1,107 mil. The breakdown consists of amortizing the assets by class and duration. The categories are fairly self explanatory.

This Weeks Formula is Accrual to assets ratio.

Accrual to assets ratio =

Change in Working Capital - Change in Cash - Change in Depreciation
Change in Total Assets

Next time: How to determine earnings quality.

Your Business Matters!

The Fed and Monetary Policy - Where do we go from here?

YES! Your Business Matters

The Fed and Monetary Policy -

Where do we go from here?

If you feel you’re a victim of the economy and want to take control of your fortunes, you might want to know how changes in the Feds policy can and will affect your business. You need to read up because this is a big step, or turning point, in the economic recovery process. Not only for residents of the U.S. but many parts of the world are affected by the Feds actions.

It has been a long, slow process - 5 years and counting (capital ($), leverage($$), debt($$$)) to bring the global economy back to near normal - historically speaking. There have been many changes in government policies, laws, and financial market regulations. If the Fed, QE, and Monetary Policy are not your specialty, a recap on economic basics should shed some light on recent Fed policy events.

1) How does The Fed's Monetary Policy impact our economy?

The Fed’s monetary policy can affect the supply of loanable funds available in financial markets and therefore may affect interest rates. It may also affect inflation and the demand for loanable funds by encouraging inflationary expectations.

*This is important if you’re looking to expand your business, especially if interest rates are about to increase. It is vital to keep your cost of capital, debt & equity, less than your return on equity. When you make capital expenditures you can calculate your economic value added by taking your net profit after tax (NOPAT) minus your (cost of capital times the increase in balance sheet asset investments for the year).

EVA = NOPAT - (Cost of capital x Capital expenditures)

2) What are the trade-offs of Monetary Policy?

A stimulative monetary policy can increase economic growth and reduce unemployment, but may increase inflation. A loose monetary policy can be used to stimulate the economy, especially if inflation is not a concern.

*This was termed Quantitative Easing (QE) when the Fed buys and increases the money supply. There were 3 series of QE sessions since the recovery began.

A restrictive monetary policy can keep inflationary pressure low but may cause low economic growth and higher unemployment. A tight monetary policy may result in higher interest rates, reduced borrowing, and reduced spending to an excessive degree.

*Inflation correlates to an increase in prices and a reduction in the value of the dollar.

What does inflation mean to you?

If you are interested in learning more about the Federal Reserve, the FDIC, or any of the Federal Departments, there are a host of links. Feel free to contact me on G+ with your questions. In your best interest!