Economic and Industry

Analysis

• ACC4345/ACC3350: Financial Statement Analysis

Learning Outcomes
• Describe the meaning of the GDP and its relation to business operations

• Explain the meaning of monetary policy and monetary policy instruments.

• Describe the meaning of fiscal policy and its key components.

• Discuss the impact of monetary and fiscal policy on key economic variables

• Explain the relation between inflation, interest rates and stock prices of firms.

• Explain how key economic variables affect the exchange rate.

• Explain how exchange rate changes affect returns earned on a foreign investment.

• Calculate the local currency return, foreign currency return, and currency return.

Department of Accounting
Learning Outcomes
• Explain the meaning of the yield curve and different types of yield curves.

• Describe leading, coincident and lagging economic indicators.

• Explain the relation between economic cycle and industry sectors.

• Describe cyclical and structural influences on the economy and industries.

• Explain the forces driving industry competition.

• Describe the industry life-cycle and characteristics of its stages.

• Differentiate between growth, cyclical and defensive industries.

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Gross Domestic Product (GDP)
• Domestic Economic Activity
• Assess economic prospects through gross domestic product (GDP)

• Analyze GDP components

• Private consumption

• Government consumption

• Investment expenditure

• Net exports

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Department of Accounting

• Domestic Economic Policies

• Monetary Policy
• Controlling the money supply to
influence economic activity
Monetary • Affect the economy through
Policy interest rates
• Monetary policy instruments
• Open market operations
• Discount rate
• Reserve requirements
Department of Accounting

• Open market operations

• Central Bank buying or selling
government securities in the open
Open market
• Central Bank Buying (expansionary)
Market => pay for bonds, increase money
supply, decrease interest rates
Operations • Central Bank selling (contractionary)
=> receive funds for bonds, decrease
money supply, increase interest rates
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• Reserve Requirements
• % of deposits banks must hold as
deposits with the Central Bank
Reserve • Lower RR (expansionary)
=> increase money supply, decrease
Requirements interest rates
• Higher RR (contractionary)
=> decrease money supply, increase
interest rates
Department of Accounting

• Discount rate

Discount • Rate the Central Bank charges

on short-term loans to banks
• Decrease DR (expansionary)
Rate/Polic => increase money supply,
decrease interest rates

y Rate • Increase DR (contractionary)

=> decrease money supply,
increase interest rates
 • Fiscal Policy
• Government spending and taxation
• Indicated by the budget deficit / surplus
• Slowly implemented; affects the economy directly
• Increased government spending
Fiscal Policy • stimulate the economy / increase employment
• upward pressure on interest rates (crowding-out)
• Tax cuts
• Increase consumer spending
• stimulate economy / increase employment
• upward pressure on inflation and interest rates

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 • Inflation
• Assess the inflation expectations
• Core Inflation and headline inflation
• Higher expected inflation

Inflation • causes nominal interest rates to rise

• may reduce demand for exports
• may make imports cheaper
• increases operating costs and business
uncertainty
• affects stock prices negatively

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 SFDR and SFLR 4.5% and
5.5% for almost two years

SFDR and SFLR Changed to 14.5% and

15.5% respectively in 2022

Changed to 11% and 12%

in July 2023

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Interest Rates

• Analyze the movements of the interest rates

• Higher interest rates
• increases cost of funds
• reduces borrowing and investment leading to a economic slowdown
and lower corporate profits
• leads to higher required returns and lower stock prices
• makes bonds more attractive compared to stocks

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Exchange Rates
• Appreciation of local currency against foreign currency
• Imports become less expensive and import demand can increase
• Exports become more expensive for foreigners
• Profits and returns earned abroad decline in local currency terms
• Depreciation of local currency against foreign currency
• Imports become more expensive for locals
• Exports become cheaper for foreigners
• Profits and returns earned abroad increase in local currency terms

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Factors Affecting Exchange Rates

• Inflation
• The currency of the country with higher inflation tends to depreciate.
• The currency of the country with lower inflation tends to appreciate.
• Real interest rates
• An increase in real interest rates will lead to appreciation of that country’s
currency. This is because higher interest rates (expected returns) attract more
financial flows into debt securities.
• A decrease in real interest rates will lead to a depreciation of that country’s
currency.

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Factors Affecting Exchange Rates

• Economic growth
• Higher growth will attract more financial flows due to higher expected
returns and lead to appreciation of that country’s currency.
• Higher growth can also lead to more imports than exports resulting in a
deterioration of the current account. This will lead to depreciation of the
currency.
• The cumulative effect depends on the relative sizes of financial flows vs
current account balance.

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Local and Foreign Currency Returns
• Local currency and foreign currency returns

R L = (1 + R F )(1 + e) − 1
St − St −1
e=
St −1
RL = Return in terms of local currency
RF = Return in terms of foreign currency
e = percent change in the value of foreign currency
St = the spot exchange rate at time t
St-1 = the spot exchange rate at time t-1
Spot rates are expressed as the local currency per unit of
foreign currency (direct method)

Department of Accounting
Local and Foreign Currency Returns
• Example: A Sri Lankan buys shares in the Indian stock market. The
spot rate at the time of the investment is SLR 2.50 per Indian
rupee. During a one-year period the investment earns a return of
20% in Indian rupee terms. The spot rate after one year is SLR
2.35 per Indian rupee. What is the rate of return to the Sri Lankan
investor in local currency terms?

2.35 − 2.50
e= = −6%
2.50

R L = (1.20)(0.94) − 1 = 12.80%

Foreign currency depreciation leads to lower returns in terms of

local currency.

Department of Accounting
Local and Foreign Currency Returns
• Local currency and foreign currency returns
• Example: A Sri Lankan buys shares in the NYSE. The spot rate at
the time of the investment is SLR 203 per dollar. During a one-
year period the investment earns a return of 10% in dollars terms.
The spot rate after one year is SLR 365 per dollar. What is the rate
of return to the Sri Lankan investor in local currency terms?

Foreign currency appreciation leads to higher returns in terms of

local currency.

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Demand Shocks

• Demand shocks
• Events that affect the demand for goods and services in the economy
• Tax rate cut
• Increases in government spending
• Increases in export demand
• Output, interest rates and inflation move in the same direction.
• + shocks will increase them
• - shocks will decrease them

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Supply Shocks

• Supply shocks
• Events that influence the production capacity or production costs
• Commodity price changes (such as oil)
• Supply disruptions (natural disasters, weather)
• Educational level of economic participants
• Output moves in the opposite direction to interest rates and inflation
movements.
• + shocks will increase output, lower interest rates and inflation
• - shocks will decrease output, increase interest rates and inflation

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Economic Indicators: Inflation

• Inflation Indicators
• Changes in consumer price index (CPI)
• Money-supply growth (M2)
• Change in commodity prices
• Increase in Treasury bill yields without changes in money market
conditions and real economic growth

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Economic Indicators: Yield Curve

• The yield curve is the relation between yield and time to maturity of
Treasury securities.
• The change in the shape of the yield curve may predict future economic
conditions.
• Main types of yield curve
• Normal
• Rising (upward sloping)
• Declining (down sloping)

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Economic Indicators: Normal Yield Curve

• Normal economic growth

• No significant changes in expected future inflation
• No significant changes in available capital
• Maturity Risk Premium is always positive. Long-term investors demand a higher yield for
higher price risk associated with long-term securities. The result is a rising yield curve.
Notation:
r* = real risk-free rate
IP = inflation premium
MRP = maturity risk premium

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Economic Indicators
Normal Yield Curve
6

Yield %
3

0
1 5 10 20 30
Years to Maturity

r* IP MRP

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Economic Indicators: Steep Yield Curve

• Observed before an economic expansion (after a slowdown or a recession)

• Economic growth is expected to accelerate
• Depressed short-term rates
• Expectations of rising inflation
• Expected higher demand for capital as the economy grows
• The spread between the long-term and short-term rates gets wider
• Long-term investors demand higher yields for the greater risks
• Central Bank policy bias:
• Contractionary / Monetary Tightening ( raise the target Federal Funds Rate to contain inflation)

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Economic Indicators
8 Steep Yield Curve
7

Yield %
4

0
1 5 10 20 30
Years to Maturity

r* IP MRP

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Economic Indicators: Inverted Yield Curve

• Observed before an economic slowdown or a recession

• Economic growth is expected to decline
• Higher short-term rates
• Expectations of declining inflation
• Expected lower demand for capital as the economy grows
• Long-term investors settle for lower yields because they expect yields to decline further in the
future.
• Central Bank policy bias:
• Expansionary / Monetary Easing (lower the target Federal Funds Rate to lower interest rates in
order to stimulate the economy)

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Economic Indicators
7 Inverted Yield Curve
6

Yield %
4

0
1 5 10 20 30
Years to Maturity

r* IP MRP

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Cyclical Economic Indicators

• Business Cycle: Alternating waves of economic expansion and

contraction
• Leading economic indicators tend to rise and fall in advance of the
economy
• Coincident economic indicators tend to change concurrent with
economic conditions
• Lagging economic indicators tend to lag the economic conditions

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Business Cycle Peak

Peak

Trough

Trough
Time

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Business Cycle Indicators

• Leading Indicators
• Index of stock prices
• Real money supply: M2 adjusted for inflation
• Interest Rate Spread : Long-term interest rate less short-term rate
• Index of consumer expectations
• Index of new private housing starts
• Manufacturers’ new orders

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Business Cycle Indicators

• Coincident Indicators
• Manufacturing and trade sales
• Industrial production
• Personal income

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Business Cycle Indicators

• Lagging Indicators
• Inventories to sales ratio, manufacturing and trade
• Average prime rate
• Commercial and industrial loans
• Consumer installment credit to personal income ratio

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Behavior of Economic Variables during the Business Cycle

Variable Expansion Contraction

Growth ▲ ▼
Interest Rates ▲ ▼
Inflation ▲ ▼
Investment demand ▲ ▼
Consumption demand ▲ ▼
Profits ▲ ▼
Stock prices ▲ ▼
Bond prices ▼ ▲

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Industry Analysis

• Objectives of industry analysis:

• Understand and predict the industry prospects under different
economic and business conditions.
• Select industries for investment purposes consistent with the risk-return
objectives.

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 The Relation between the Economy and Industry
• Economic trends affect industry performance
• Economic trends:
• Cyclical changes
• Ups and down of the business cycle
• Different industries experience unique results
depending on the point within the business cycle
• Rotation strategy: switching across industries
• Capitalization rotation strategy: switching across large,
mid and small-cap stocks

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The Relation between the Economy and
Industry

• Structural changes
• Societal changes
• Demographics: population growth, age distribution, geographical distribution of
people, ethnic mix, income distribution
• Lifestyles
• Social values
• Technology
• Politics and Regulation
• Need to anticipate structural changes and analyze the likely impact on various
industries

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Analysis of Industry Competitive Structure

• Porter’s competitive forces are factors that determine a firm’s competitive environment
• Rivalry among existing competitors
• Both price-based and non-price-based competition
• Threat of new entrants
• Are there barriers to entry?
• Threat of substitute products
• Bargaining power of buyers
• Volume discounts, quality demands
• Bargaining power of suppliers
• Can suppliers increase prices or reduce quality?

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Analysis of Industry Life Cycle
Auto
Some Food Cigarette
Retail
Biotech

Sales
Interactive
Cable

Pioneering Rapid Mature Maturity Decline

Development Growth Growth

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 Characteristics of Stages of Industry
Life Cycle
Stage Growth New ROI Business Profit Dividends
Investments Risk Margins

Pioneering Slow High R&D Negative / High Negative / Zero / Low

Development (new product) Low Small

Rapid Faster (Product High/ Moderate High Moderate High Initiate

Growth penetration, little dividends
competition)

Mature Above Normal Low Above-normal Low Normal / Moderate

Growth (More competition) Stable

Maturity Slow / Normal Low Normal / Low Low / Stable High / Stable
(market saturation, stable Stable
competition)

Decline Less than normal / Decline Low/ High Low / Low /

declining (product Decline Negative Cuts
obsolescence,
consolidation,
bankruptcy)

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Industry’s Business Cycle Sensitivity

• Growth Industries
• Industries with expected earnings growth significantly above the
average industry
• Growth may occur regardless of the economic conditions
• Examples
• Biotechnology
• Cellular phone

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Industry’s Business Cycle Sensitivity

• Cyclical Industries
• Industries that have above-average sensitivity to economic conditions
• Outperform others during expansion and underperform during
contractions
• Examples
• Capital goods (machinery, equipment, steel, construction)
• Durable goods (autos, refrigerators, washing machines)

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Industry’s Business Cycle Sensitivity

• Defensive Industries
• Industries that have lower sensitivity to economic conditions
• Outperform others during recessions and underperform during expansions
• Examples
• Food producers, processors and distributors
• Public utilities (electricity, telephone, natural gas)
• Pharmaceutical firms
• Tobacco and alcohol
• Medical services

Department of Accounting