Financial Development And Economic Growth Essay

Question:

Discuss about the Financial Development and Economic Growth.

Answer:

Introduction:

The current report is based on the critical analysis of the different tradition and modern methods involved in the determining the financial and operating position of an organization. Several financial analysis tools has been proposed and examined by the researchers from the last decades. Most notably and widely acknowledged is the vertical and horizontal method of analysis the financial position of the organization. Following the vertical and horizontal mode of analysis the financial position of an organization there is also another tool of analysing the financial position of the organizations is the ratio analysis (Grant 2016). Ratio analysis is regarded as the core of the financial analysis because of its ability of covering large range of financial aspects of the company by addressing the rotating financial and operating activities of the organization.

The current report will be critically analysing the financial position of the Wolseley and Rexam by employing the financial analysis tools of vertical horizontal and ratio analysis to measure the operating performance of the organization. On the other hand, other methods such as Capital asset pricing model, dividend growth model and effective market hypothesis will be performed as well. The analysis will cover the description of the models and will address the limitations surrounding the model. Finally, a comprehensive conclusion will be presented stating the best available tool of analysing the financial performance of organizations.

The most commonly used methods of analysis is the horizontal analysis. These are the statements, which shows the profitability and the financial position of the organization for a different period under the comparative form in order to give an idea regarding the financial position of two or more periods. It is generally applicable to two most important financial statements particularly the balance sheet and the statement of profit and loss in a comparative method (Wahlen, Baginski and Bradshaw 2014). The financial data will be comparative under the circumstances when the identical principles of accounting is used in preparing the statements. If this is not the situation, changes in the use of the methods of accounting principles must be mentioned in the footnotes.

As derived from the financial computation a somewhat tumultuous trends is found by having an in depth analysis for the Wolseley with the falling trend in the sales as the company suffered a falling trend of sales in the financial year of 2012 and 2013. However, in the following years of 2015 and 2016 the sales revenue increased for the Wolseley. On the other hand Rexam reported a blend in their trend of sales as reported by the company during the financial year. The revenue reported by the company experienced a rising trend of 1.89% during the year 2011-12 however in the following years of 2012-13 since the revenue declined by 8.56% which further declined in the subsequent years of 2014-15 by 2.82%. The trend represented a declining terms of the revenue derivation, which slightly aided in the year of 2015 with a slight increase of 2.43 for Rexam. Therefore, horizontal analysis is beneficial for the readers since it provides them with the benefits of examining and comparing the position of the organization over the years.

However, horizontal analysis suffers from criticism since it suffers from the shortcoming that the aggregate of the information that is stated in the financial statements may be changed over the period (Weygandt, Kimmel and Kieso 2015). This is because of the ongoing changes in the accounts might shift amid different accounts and therefore it causes variances at the time of comparing the balance of the accounts from one period to another period of accounting.

Vertical analysis:

There are certain statements that reflects the association of different items on the financial statement with common items by stating each item as the percentage of the common item. Vertical analysis can be defined as the proportional analysis of the financial statements where each line of items of the financial statements is recorded as the percentage of the other item (Carmona 2014). Typically, this represents that the each line of the item in the income statement is the percentage of gross sale while every line of item of on the balance sheet is stated as the percentage of the total sales (Vogel 2014). Considering the horizontal analysis performed for the companies it can be stated that Rexam reported a profit from the business operations of 8.88% and 5.58% respectively for the financial year of 2011-2012 respectively. A declining trend in the profit was noticed in the subsequent year of 2013 with Rexam reporting a profit of 2.38%. On the other hand the profit reported by the Wolseley for the year 2013-14 stood 2.25% and 4.11% respectively. However in the following year of 2015 and 2016 the profit attributed to the shareholder stood 1.60% and 4.57% respectively.

While considering the other side of analysis Vertical analysis is entitled to the certain limitations. According to Edmonds et al. (2013), criticizes the technique since it does not addresses the significant changes in the degree of inflationary effect. Therefore, the results of the inputs can be misleading because the information is largely reliant on the historical cost. Additionally the analysis does not considers the qualitative aspects at the time of evaluating the performance such as quality of the work, relation with stakeholders etc. Additionally, it is restricted to liquidity aspects of the analysis and ignores the current ratio and debt ratio, which holds the entitlement of computing the liquidity and solvency.

Traditional Ratio analysis:

Ratio analysis is considered as the most widely used and appreciated method of comparing in respect of the financial and operating performance. In the words of Valickova, Havranek and Horvath (2015), have stated their opinion that ratio analysis determining the efficiencies of the organization in respect of the financial and operating performance. The ratio analysis helps the managers to identify the degree of efficiency in respect of deriving profits from the assets employed. As represented in table below;

Year

2012

2013

2014

2015

2016

Wolseley Fixed asset turnover %

4.86

4.59

4.31

5.21

4.94

Rexam fixed asset turnover %

0.94

1.08

1.21

1.17

1.11

As evident from the above stated ratio trend it provides the reader with the in depth vision of the fixed asset turnover for both Wolseley and Rexam. An assertion can be bought forward in this context by stating that Wolseley has reported a higher return on assets that its counterpart Rexam with the trend over the period of five year has reflected a rising trend while Rexam reported a somewhat tumultuous return. Rexam has experienced an unstable trend of return on asset deployed by the company a notable trend of decline has been witnessed during 2012-13 while it regained in the following year of 2015 to 1.21 however in the later years the return again take a downward dive. Therefore, it can be stated that the ratio analysis is considered an effective tool when there is a situation of comparing the financial performance of two companies.


Additionally, ratio analysis is considered as the effective means of identifying the shortcoming in the performance of the companies operations in spite of the fact the overall performance of the company is better (Edmonds et al. 2016). The statistics gained that is gained by the management from the ratio analysis helps in formulation of plans by analysing the past performance and develop an effective plan to overcome the weakness in foreseeable time.

2012

2013

2014

2015

2016

Current Ratio of Wolseley

1.69

1.51

1.49

1.38

1.46

Current Ratio of Rexam

1.56

1.17

1.11

1.13

0.98

By noticing the trend above, it provides the reader with the analysis of the liquidity position of both Wolseley and Rexam in terms of the current ratio reported by the company. considering into the scenario of the Wolseley the company posted a strong liquidity position as it reported a better current ratio over the period of five years (Mayes 2014). Rexam, on the other side reported a declining trend of current ratio with overall span of slight increase in 2014. Thereby, it can be concluded by stating the recognition of liquidity by the management of Wolseley and Rexam with sufficient strategies must be aligned to overcome the shortcomings.

The capital asset pricing model is based on the specific assumptions where some of which is common to CAPM and MPT. The model has been widely appreciated for its capability of calculating the risk efficiently. According to Barberis et al. (2015), considers CAPM as the tool of systematic risk for the investors to diversify their portfolio for eliminating the haphazard risk. Additionally, it was also reinforced in comparing the perspective since CAPM considers the company comparing itself throughout the market. The investors under the CAPM model aims at maximising the utility of their wealth. The main difference between them is that individual prefer taking into the considerations the account of utility concept.

Whereas as some have preference for large amount of risk that will have increasing marginal utility or wealth. Others will have less preference for their risk in the incremental wealth will be considered to be less attractive if it is attached with more risk (Habibi et al. 2016). The technique of CAPM is considered as the better technique for the investors to use the tool for investment appraisal because it provides appropriate link with the required rate of return and systematic risk. The contemporary procedure of CAPM overcomes the shortcomings of the other traditional methods by addressing risk by facilitating comparison of the performance that is ignored by the traditional methods.

Investors have identical anticipations of Risk and return therefore without such consensus standards the estimates related to mean variance might result in different forecast with the result that the critical portfolio of each will be not be similar from that of the others (Golez 2014). Given that the investors does not have identical anticipations there will be no homogeneity in their conception and solitary efficient frontier would be applicable to all. The assumptions of the CAPM represents that the market equilibrium and the anticipated rate of return is equivalent to the required rate of return for the given degree of risk. CAPM offers a liner association amid the required rate of return and it is associated to the market risk or Beta that cannot be avoided.

The model of CAPM is not considered to be realistic since it assumes that all the investors are averse to risk and with higher risk the return is higher. In spite of getting widespread support, the model of CAPM suffers from certain limitations and shortcomings (Bodie, Kane and Marcus 2014). At first CAPM is largely based on the assumptions that have bought forward the questions based on the actuality of the model since the prevalence of the perfect market is absence from the pricing of the model. In addition to this, borrowing from the investors is not performed at the risk free rate and this represents that the actual security market line will be steeper. Finally, in terms of the competition with the CAPM, investment appraisal provides bigger perception on the investments returns whereas the model of CAPM restricts the span to short and singular period.

Dividend Growth Model:

The Gordon’s dividend growth model is considered as one of the most popular model in finance to make use value in order to evaluate the fundamental values of the stocks. The dividend discount model assumes that the value is a direct function of the cash flow anticipated in the future (Asimakopoulos et al. 2016). Under the circumstances of the common stock, the relevant cash flows is the dividends that is paid along with the value of the stock when it is sold. The price or the value of the share is that is derived from the future stream of dividends is considered to be the intrinsic value of the stock. By assuming that the dividends are paid out at the end of every year, the investors can estimate the fair price of the stock to hold for the period of three years.

According to Belo et al. (2015), the advantage of dividend growth model lies in its consistency since dividend generally stays for a longer period as compared to the other components like earnings. Hamid et al. (2017), also supports the model for their wide range of coverage that considers the minority shareholders. An important consideration in this regard can be bought forward that dividend growth model is the efficient model in respect to other traditional analysis since it enables the companies to compare companies of different industries and market conditions that is primarily limitations to the ratio analysis.

The dividend growth model offers a wide mean of developing the explicit returns together for the individual stocks and the aggregate market (Jordan 2014). The model essentially contributes in the appraisal of the relative attractiveness of the individual stocks together with the evaluation of the attractiveness of the stock market in the entire asset allocation settings. In addition to this, the dividend growth model provides the usefulness in understanding the factors of risk such as variation in interest rate with changing inflation rate create an impact on the stocks.

In spite of the success of the model, dividend growth model possesses certain limitations as well. In the words of Lundholm and Sloan (2013), the mode is reliant heavily on the inputs since a small change in the required rate of return or a continuous growth might result in huge change in the terminal value along with the value of the stock. The model has been additionally criticized for assuming that the growth rate is constant that makes the dividend of the company appear liner whereas the empirical evidences represents that the dividend growth is found to be seldom liner which ultimate makes the validity of the model under query. The model does not assume non-dividend factors such as brand loyalty, retention of customers and ownership of the intangible assets which increases the value of the company. The model assumes that the stock price of the company is hypersensitive to the dividend growth rate selected and the growth rate cannot go past the cost of equity and this generally does not happen.

Effective market hypothesis:

The effective market hypothesis is regarded as the proposition where present prices of stock clearly reflects the information that is available regarding the value of the organization with no other means of earning excess amount of profit (Frahm 2014). The effective market hypothesis is concerned with the most fundamental and exciting issues in finance by addressing the reasons behind the change in the price and methods involved in changes in price in security market. The effective market hypothesis holds important implications for the investors along with the managers that the traditional method of analysis.

Several investors make an attempt to recognize the securities, which is undervalued, and are anticipated to increase the value in upcoming time and especially those that would increase more than others would (Weygandt, Kimmel and Kieso 2015). Several investors along with investment managers considers that they can select securities, which would outperform in market. They make use of the several types of valuation and forecasting techniques to assist them in their investment decision.

Most arguably, none of the economics theory or financial theory have produced more passionate discussion surrounding its challenges and proponent. As stated by Narayan et al. (2015), there is no proposition in the economics that possess more solid empirical evidence supporting the efficient market hypothesis. An important consideration to denote that effective market hypothesis suggest that profiting by predicting the price movements is cumbersome and unlikely prospect. The main engine behind the price changes is the influx of the new evidence. A market is considered to be efficient if the price adjust quickly and on average without being bias to the new information (Jovanovic, Andreadakis and Schinckus 2016). Consequently, the present price of the securities reflects all the available information during any given period. Because of this, there is hardly any reason to believe that the prices are very high or low. The price of the securities adjust before an investor has the time to adjust to the trade and profit the new section of information.

One of the prime reason for the prevalence of the effective market hypothesis is the high degree of competition amid the investors to profit from the new information. The ability of identifying the over and under priced stocks is considered to be very valuable as it enables the investors to purchase some stocks in less than the true value and selling those stocks to others at a higher value (Baltes, Dragoe and Ardelean 2015). In natural terms as more number of investors compete against each other with the effort of taking advantage of over and undervalued securities with the probability of being able to identify the exploit such miss-priced securities becomes relatively small. An important considerations under the Effective market hypothesis is that at any situation of time prices of the securities provides an all known information that is available to the investors. There is hardly any means of deceiving investors and because of this all the investments under the efficient market is priced fairly. In other words, investors get just what they pay for.

Conclusion:

On succeeding review of the literature a conclusion can be drawn by stating that tradition tool of financial analysis namely, vertical horizontal and ratio analysis possess certain kinds of limitations, which makes these analysis almost insufficient to use. On the other hand, the capital asset pricing model has responded to the criticism by providing a appropriate computation of the risk involved in investment.

As it is understood that systematic risk has been ignored by other methods of analysis CAPM is regarded as one of the better tool of diversifying the risk involved in portfolio. An important consideration can be draw in this context is that even though the model has been subject to some criticism in the recent years because of the multifaceted business environment the model of CAPM yet remains one of the useful mode of analysis until something better is presented to diversify the risk for the investors involved in investment.

Reference List:

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Baltes, N., Dragoe, A.G.M. and Ardelean, D.I., 2015. Study regarding the assets evaluation on the financial market through the CAPM model. Studia Universitatis Vasile Goldis Arad, Seria Stiinte Economice, 24(3), pp.78-87.

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