Question Tag: Inflation

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  • 9 Marks

AFM – Nov 2017 – L3 – Q1a – Role and Responsibility towards Stakeholders

Explains two reasons why interest rates rise in periods of inflation and discuss the implications of high or fluctuating interest rates on business financing and asset-holding decisions.

Under conditions of inflation, it is common for interest rates to rise possibly at a rate different from those applicable to goods and services.

Required:
i) Explain TWO possible reasons for this phenomenon.

(3 marks)

ii)

Discuss the implications of high or fluctuating interest rates for:

  • Business financing; and (3 marks)
  • Assets-holding decisions. (3 marks)

(Give examples of the types of actions that a company might take)

i)

  • Because of Government monetary policy. Interest rates may be increased to reduce the flow of money in the economy.
  • Because of Government exchange control policy. If inflation is making it more difficult to export and encouraging an increase in imports, the government may intervene by raising domestic interest rates. This would encourage a flow of foreign investment into the domestic market and improve the exchange rate.
  • Because of a reduced propensity to save, at a time when inflation is eroding the value of any funds not consumed immediately. This could lead banks and other financial institutions to raise their interest rates to attract more deposits.

ii)

Implications on Business Financing:

  • High or fluctuating interest rates make it difficult to obtain funds. Companies will be reluctant to raise fixed-interest borrowing if they fear that interest rates will fall. Overdraft finance will also be expensive but preferable as the interest rate is not fixed.
  • They may cause liquidity problems, making business operations difficult throughout the economy. Debtors may delay payments, and creditors will increase pressure for quick settlements.
  • It complicates planning and budgeting, as cash flow becomes uncertain and interest charges vary with fluctuations in interest rates, reducing available liquid funds.

Implications on Asset-Holding Decisions:

  • Liquidity problems will force companies to scrutinize their current assets. This could involve reducing buffer stocks, tightening credit terms, and realizing investments.
  • The difficulty in securing long-term finance could prevent replacing fixed assets or necessitate selling fixed assets to generate liquid funds.
  • 3 Marks

CR – May 2018 – L3 – Q4b – Presentation of financial statements

Explain three problems that arise when using ratios to compare the performance of two companies.

Fordland Ltd and Fiatland Ltd are two companies in the garment industry. The following are financial ratios computed by the Research Department of ICAG as part of analyzing companies’ performance industry by industry.

Required:
Explain THREE problems that are inherent when ratios are used to compare the performance of two companies, even in the same industry.

Three problems that arise when using ratios to compare the performance of two companies:

  1. Different Accounting Policies and Practices:
    Even within the same industry, companies may apply different accounting policies (e.g., depreciation methods, inventory valuation techniques like FIFO vs LIFO). These variations can significantly affect financial ratios and make comparison less meaningful. For instance, one company may capitalize certain expenses while another may expense them, distorting profit margins and other ratios.
  2. Impact of Inflation:
    Inflation can distort financial statements and ratios, especially for companies with significant non-current assets. Companies operating in economies with different inflation rates may show inflated profits or asset values due to historical cost accounting, making it difficult to compare ratios like return on assets or return on equity accurately.
  3. Seasonal Factors:
    Seasonal fluctuations can lead to temporary changes in financial ratios. For example, companies with significant sales or production cycles may have varying levels of inventory or receivables at different times of the year. This can distort liquidity and efficiency ratios, making it challenging to compare companies that are in different stages of their operating cycle.

(3 points for 3 marks)

  • 5 Marks

BMIS – Dec 2023 – L1 – Q2b – The external environment

Outlines five effects that inflation can have on an economy.

The global economic challenges have largely been fueled by demand-pull inflation or cost-push inflation. Many governments have initiated measures to mitigate the associated effects.

Required:

Outline FIVE (5) effects inflation have on an economy.

Effects of Inflation on an Economy:

  1. Reduction in Consumer Purchasing Power:
    Inflation decreases the purchasing power of consumers as the value of money declines, leading to higher prices for goods and services.
    (1 mark)
  2. Reduction in Investor Confidence:
    High inflation can reduce investor confidence in the economy, leading to lower levels of investment and economic growth.
    (1 mark)
  3. Economic Growth Slows Down:
    Persistent inflation can slow down economic growth as rising costs reduce consumption and investment.
    (1 mark)
  4. Uncertainty in Business and Financial Planning:
    Inflation creates uncertainty for businesses and individuals in planning their finances, as the real value of income and expenses becomes unpredictable.
    (1 mark)
  5. Rise in Unemployment Levels:
    As businesses struggle with rising costs, they may reduce their workforce, leading to higher unemployment levels.
    (1 mark)

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