THE FRAMEWORK OF FINANCIAL MANAGEMENT

WEEK 4

SUPPLY-SIDE POLICIES
 Supply-side economics holds that increasing the supply of goods translates to economic growth for a
country. In supply-side fiscal policy, practitioners often focus on cutting taxes, lowering borrowing
rates, and deregulating industries to foster increased production.

GOVERNMENT AND AGGREGATE SUPPLY

 The stagflation of the 1970s led to the realization that all economic problems could not be solved by
focusing solely on aggregate demand.
 Aggregate demand is a measurement of the total amount of demand for all finished goods and
services produced in an economy. Aggregate demand is expressed as the total amount of money
exchanged for those goods and services at a specific price level and point in time.

SUPPLY SIDE POLICIES

 Supply-side economists focus their attention on government policies such as high taxation that
impede the expansion of aggregate supply.
 Tax policies can improve the unemployment/inflation trade-off
 A reduction in taxes on capital gains (profit from investment spending) and/or corporate income will
increase business profit expectations and increase investment.
 This increase in investment means greater capital stock which leads to increased productivity and an
outward shift of both the SRAS and the LRAS

ADVANTAGES OF SUPPLY SIDE POLICIES

 A reduction in taxes on personal income leads to higher levels of savings
 More savings leads to lower interest rates = more investment = more capital stock = SRAS and
LRAS shift out.
 A reduction in taxes on personal income creates an incentive to work and to work harder.
 An increase in labor force participation = SRAS and LRAS shift out.
 An increase in productivity shifts SRAS and LRAS outward
 Supply-side policies can help reduce inflationary pressure in the long term because of efficiency and
productivity gains in the product and labour markets. They can also help create real jobs and
sustainable growth through their positive effect on labour productivity and competitiveness.

WEAKNESSES OF SUPPLY SIDE POLICIES

 Unpopular: Supply-side economics can be unpopular because cutting taxes from the rich does not
directly benefit middle or lower-class citizens.
 Time-consuming: The results of supply-side economics are slow and deferred because of the many
involved components, such as job growth.
 The main criticism against supply side economics is that merely cutting taxes alone would not do the
trick and other measures like controlling the money supply and lowering interest rates are the
necessary conditions for economic growth.

POLICIES TO IMPROVE SUPPLY-SIDE POLICIES

 The supply-side of an economy can also be improved by the actions of firms acting in their own self-
interest. For example, increasing staff training or using the latest technology will increase
productivity and benefits firms in terms of efficiency and gaining a competitive advantage.

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  Supply-side policy recommendations typically include deregulation of heavily regulated industries,
promotion of greater competition through lowering protectionist barriers to international trade, and
measures to repeal special subsidies and tax loopholes targeting particular industries in favor of
lower and more ...
 The government can boost demand by cutting tax and increasing government spending. Lower
income tax will increase disposable income and encourage consumer spending. Higher government
spending will create jobs and provide an economic stimulus.

POLICIES TOWARDS MONOPOLIES AND OLIGOPOLIES

 Types of Market Structure
 perfect competition
 monopoly
 oligopoly
 monopolistic competition

THE MEANING OF MONOPOLY

 A monopolist is a firm that is the only producer of a good that has no close substitutes. An industry
controlled by a monopolist is known as a monopoly.
 The ability of a monopolist to raise its price above the competitive level by reducing output is known
as market power.

POLICIES TOWARD PRIVATIZATION AND DEREGULATION

 Privatization (also privatization in British English) can mean several different things, most
commonly referring to moving something from the public sector into the private sector. It is also
sometimes used as a synonym for deregulation when a heavily regulated private company or industry
becomes less regulated.
 deregulation, removal or reduction of laws or other demands of governmental control. Deregulation
often takes the form of eliminating a regulation entirely or altering an existing regulation to reduce
its impact.

WHAT IS PRIVATIZATION POLICY

 Privatization describes the process by which a piece of property or business goes from being owned
by the government to being privately owned. It generally helps governments save money and
increase efficiency, where private companies can move goods quicker and more efficiently.

ENVIRONMENTAL (“GREEN”) POLICIES

 A Green Policy is your company's statement about the commitment to sustainability and
environmental management that your business is prepared to make. Having a formal green policy
shows your employees and customers that managing environmental issues is a high priority for your
company.

IMPLICATIONS FOR THE MANAGEMENT OF BUSINESS OF ENVIRONMENTAL GREEN

POLICIES
 Environmental regulations raise production costs and lower productivity by requiring firms to install
pollution control equipment and change production processes. Regulatory costs can influence firms'
decisions about locating new plants and shifting production among existing plants.

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  An environmentally aware business considers more than just profits — it considers its impact on
society and the environment. Such a business is sustainable because it contributes to the health of the
structure within which it operates, thereby helping construct an environment in which the business
can thrive.
 Benefits of Becoming a Sustainable Business
 Improved brand image and competitive advantage. ...
 Increase productivity and reduce costs. ...
 Increase business ability to comply with regulation. ...
 Attract employees and investors. ...
 Reduce waste. ...
 Make shareholders happy.
 It is said that environmental regulation is too expensive, reduces economic growth, hurts
international competitiveness, and causes widespread layoffs and plant closures. Sometimes, it is
said, it even forces businesses to flee to more accommodating countries.
 Environmental law works to protect land, air, water, and soil. Negligence of these laws results in
various punishments like fines, community service, and in some extreme cases, jail time.

THE “EFFICIENT MARKETS” HYPOTHESIS

 The efficient market hypothesis states that when new information comes into the market, it is
immediately reflected in stock prices and thus neither technical nor fundamental analysis can
generate excess returns.

RELEVANCE TO DECISION MAKING AND TO FINANCIAL MANAGEMENT PRACTICE OF

“EFFICIENT MARKETS” HYPOTHESIS

 According to the efficient market hypothesis, stock prices reflect all available information. This
makes it impossible for investors to outperform average market returns. The hypothesis is important
because it shapes investment decisions in the stock market.

BASIC INTERPRETATION AND USE OF FINANCIAL STATEMENTS

 Definition of Accounting Ratio:
 It may be defined as the relationship or proportion that one amount bears to another, the first number
being the numerator and the latter the denominator.
 Another explanation of the ratio may be the relation of the latter to the earlier amount and computed
by dividing the amount for the latter date or period by the amount of the earlier date or period.

BASIC INTERPRETATION AND USE OF FINANCIAL STATEMENTS

(i) Pure ratio: e.g., a ratio between Debt and the Equity, say, 1: 1;
(ii) Ratio which refers to ratios ascertained with reference to time period—e.g., working Capital Turnover
Ratio 3 times a year;
(iii) Percentage: e.g.—Net Profit of 20% on sales.

IMPORTANCE OF RATIO ANALYSIS:

 The interrelationship that exists among the different items in the Financial Statement are revealed by
accounting ratios. Thus, they are equally useful to the internal management, prospective investors,
creditors and outsiders etc.
 Analysis and Scrutiny of the Past Result:

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  Preparation of Budgets:
 Time Dimension by Trend Analysis:
 Measurement of Degree of Efficiency:
 Inter-Firm Comparison:
 Testing Short-term Liquidity:
 Communication:
 Testing Long-Term Solvency Position:

Current ratio = current asset/current liability

2003=100,000/50,000 = 2
current ratio 2003 2:1
2004 =200,000/150,000 = 1.33:1

 It will be observed from the above statement that although, in both the years, the absolute difference
between Current Assets and Current Liabilities, i.e., Working Capital (Net) of X Co. Ltd. is equal,
i.e., Rs. 50,000, its current ratio, i.e., relation between Current Assets and Current Liabilities, is
different. Current ratio had been 1.33: 1 in the year 2004 as against 2: 1 in the year 2003.
 Thus, despite an identical amount of Working Capital (Net) in both the years, its short-term financial
position so far as it can be read from the current ratio, had been much better in 2003 than in 2004.
This is because, in the year 2003, two rupees of Current Assets were available against each rupee of
Current Liability, whereas, in the year 2004, only one rupee and thirty-three paise of Current Assets
were available against one rupee of Current Liability. Thus, it becomes obvious that ratio
communicates a better information about the financial strength of a firm than can be conveyed by the
absolute figures.
 The aforesaid example also indicates how ratio analysis can serve as a better tool for measurement of
the financial health of an enterprise than is possible by the analysis of absolute figures.

RETURN ON EQUITY

 Return on equity (ROE) is the measure of a company's net income divided by its shareholders'
equity. ROE is a gauge of a corporation's profitability and how efficiently it generates those profits.
The higher the ROE, the better a company is at converting its equity financing into profits.
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  What is a good return on equity? In most cases, the higher your return on equity, the better. Investors
want to see a high ROE because it indicates that the business is using funds effectively. Generally, a
return on equity of 15-20% is considered good.

DUPONT’S EFFICIENCY AND LEVERAGE RATIOS

 DuPont analysis is a useful technique used to decompose the different drivers of return on equity. An
investor can use analysis tools like this to compare the operational efficiency of two similar firms.
Managers can use DuPont analysis to identify strengths or weaknesses that should be addressed.
 Leverage ratios determine the amount of debt the business has taken on the assets or equity of the
business. A high ratio indicates that the company has taken on a larger debt than its capacity and will
not be able to service the obligations with the ongoing cash flows.

DUPONT ANALYSIS
 The DuPont analysis is a formula used to track a company's financial performance. It was developed
in 1914 by F. Donaldson Brown, who worked for the DuPont Corporation. His formula incorporates
earnings, investment, and working capital together into a single figure that he called return on
investment (ROI). It became a standard measure for all DuPont departments and was adopted by
other companies.
 A DuPont analysis is used to evaluate the component parts of a company's ROE. This allows an
investor to determine what financial activities contribute the most to the changes in ROE. An
investor can use tools like this to compare the operational efficiency of two similar firms. Managers
can use DuPont analysis to identify strengths or weaknesses that should be addressed

There are three major financial metrics that drive ROE:

 operating efficiency, which is represented by net profit margin or net income divided by total sales or
revenue
 asset use efficiency, which is measured by the asset turnover ratio
 financial leverage—a metric that is measured by the equity multiplier, which is equal to average
assets divided by average equity

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  A normal asset turnover ratio will vary from one industry group to another. For example, a discount
retailer or grocery store will generate a lot of revenue from its assets with a small margin, which will
make the asset turnover ratio very large. On the other hand, a utility company owns very expensive
fixed assets relative to its revenue, which will result in an asset turnover ratio that is much lower than
that of a retail firm.
 The ratio can be helpful when comparing two companies that are very similar. Because average
assets include components like inventory, changes in this ratio can signal that sales are slowing down
or speeding up earlier than they would show up in other financial measures. If a company's asset
turnover rises, its ROE improves.

 Most companies should use debt with equity to fund operations and growth. Not using any leverage
could put the company at a disadvantage compared with its peers. However, using too much debt in
order to increase the financial leverage ratio—and therefore increase ROE—can create
disproportionate risks.

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