Preface
To protect privacy, I am not divulging much of my details. However, the purpose of this blog is to impart knowledge to those readers who have a shared interest in finance-related matters and to elicit responses from the participants. A thorough understanding of the balance sheet and profit/loss statements may help bankers, shareholders, investors, and the general public to make sound decisions in their area of operation. After the advent of technology as a game-changer, we have been experiencing a massive shift from traditional methods of investment and banking to decentralized methods of finance. Since IOT(internet of all things) has started to link all the bank accounts together, we are able to seamlessly transfer funds from the bank account of one bank to a different bank account instantaneously. That throws up new challenges to the investors and the public as money can be lost or gained instantaneously. Though the choice of investment lies only with the investor, the plethora of information in the different media has created confusion of sorts even in the minds of the most informed investors. If this blog is able to clear some of that confusion, then I will consider that the purpose of this blog has been achieved.
Understanding Why Politics matter:
The Rise and Fall of Nations are often due to the state of their economy. At one point in time, an American president quoted," It's the economy, stupid"; It underlines the importance of management of an economy in national politics. Often Governments are made or destroyed depending on how they manage the economy.
Before we proceed further, we need to understand how money management and the management of the economy influence the movement of markets.
For this, Let's travel in time to post first World War I Germany. As many of you may be aware, Germany faced a problem of hyperinflation. The German Mark became worthless as a medium of exchange and immensely contributed to the political instability of Post War Germany. Now comes the moot point. The strength of a country's currency vis-a-vis indicates the strength of its economy. Any adverse movement indicates stress in a country's economy and must be studied in detail.
Now, Let's explore all the crucial concepts one by one.
What is Money?
Money is how goods and services are valued in a particular country. It is the principal medium of trade in a country.
What is "Economy"?
"Economy" defines how efficiently a country manages its resources.
Advanced economies manage their economies better than developing economies. "Economical" means how a country creates maximum value with the minimum input.
A detour now to a famous line from the "Rime of Ancient Mariner" by Samuel Coleridge. The mariner confounded by the static ship cries the following lines, "Water! water! everywhere. Not a drop to drink." Similarly, Money loses its value if there are no goods to buy. If the economic infrastructure of a country collapses, the monetary value of its currency will also collapse. Both are inextricably linked. Hence, an investor should observe the general trend of its industries before taking a decision.
Understanding Opportunity cost:
Let's suppose that a Dentist from Texas who works in a hospital earns $60000 per year as a salary from that hospital. On a fine day, he decides to start his clinic to cater to patients in that area. As this is capital intensive, he buys equipment worth $100000 for the new clinic. Now, our dentist is all set to use his new clinic. However, he earns only $30000 for the next three years. That does not deter our dentist; he continues to put his heart and soul into his field of work. After the initial three years, he earns a name in the society; hence his return increases to $300000 per year.
Now, Let's calculate the cost it took the dentist to reach the return of $300000 per year.
a) If the dentist had continued working in the hospital in Texas, he would have earned $60000*4=$240000
b) The cost of opening the clinic is $100000.
c) Income earned for the three years is $30000*3=$90000
d) Income earned in the fourth year is $300000
So, in short, the income from the clinic at the end of four years equals is $300000+$90000-$100000= $290000.
If he had worked in the hospital, he would have earned $240000 only. Hence, the difference is $290000-$240000=$50000.
The dentist would have lost $50000 if he had not opened the clinic. The opportunity gained him an amount of $50000. That is known as the opportunity cost. It is also the cost incurred had he not exercised the option of the switch.
Similarly, an investor should look into the nuances of the opportunity cost offered at different points in time.
Understanding comparative advantage:
Since we have dealt with opportunity cost, let's learn about comparative advantage.
Have you ever wondered why countries trade with each other?
Have you ever been curious about how some countries create superior final products despite their limited resources?
It is due to a concept called comparative advantage.
Let's suppose that country A produces 100 tonnes of Wheat and 200 tonnes of rice in a year. Similarly, another country, say B produces 200 tonnes of Wheat and 100 tonnes of rice in a year. Let's assume that the sale generates revenue of $150 million to each of these countries. We can infer that Country A produces rice better than Country B whereas Country B produces Wheat better than Country A. To put it in terms of a mathematical equation,
For Country A,
100Wheat+ 200Rice= $150 Million.
For Country B,
200Wheat+100 Rice=$150 Million
In economic terms, we can say that Country A has a comparative Advantage over country B in producing rice. Similarly, Country B has a comparative Advantage as far as Wheat production is concerned.
Shall we say that each of those countries produces the goods at the minimum opportunity cost for creating the Advantage?
Now, a question for the readers?
How will both the countries benefit each other?
No prizes for guessing!!
Country A should produce more rice and trade with Country B for Wheat. The reverse is true for country B.
Though this is a far-fetched topic as far as investment is concerned, it is better to know it on the go.
Understanding Competitive Advantage and profitability:
Let's learn what firms should do to stay competitive in the market.
Have you ever been curious why only a handful of companies have survived in the market whereas others have perished?
What is the USP of these companies for their longevity?
Let's learn with an example:
Let's assume that Company A specializes in the manufacture of electric bulbs. They have been the market leaders for the last 20 years in their field. However, their sales have been falling in recent times. The Company is not able to find out the reasons. The manufacturing capacity is still state of the art; the volume of bulbs manufactured by the Company is still the same. The competitive edge is somewhere missing. The accountant had found this out from the "profit/sales" ratio. This ratio which is known as "profitability" is declining every year.
It then hires a consultant to examine the problems and suggest solutions.
The consultant finds out that the advent of energy-efficient electrical bulbs has changed the buying habits of the general customers.
Even-though, the Company still holds the advantage in the manufacture of old-generation electrical bulbs, the newer types of electrical bulbs lead to savings in terms of lower electricity bills. Due to this reason, the Company has been recording lesser sales than usual.
In economic terms, we may say that the Company has a comparative advantage in the manufacture of old-generation electrical bulbs. However, the competitive advantage is with other companies as far as energy-efficient bulbs are concerned.
There are many ways how a Company achieves a competitive advantage. One of them is the advent of new technology. It differentiates the products manufactured by a Company from the rest.
In this scenario, the Company should either cut the costs of its product or should adapt to the new technology.
We have also seen the importance of profitability in our analysis.
In the same way, a clear analysis of profitability is necessary for an investor.
Understanding Absolute Advantage:
In light of the concepts of competitive advantage and comparative advantage we have discussed so far, the reader can conceive of absolute advantage.
A company or firm that manufactures goods with the lowest opportunity cost and with a definitive competitive advantage means that it has gained an absolute advantage over its competitors. In simple terms, the company is the most efficient of all the other companies.
For a real-world example, Let's take the case of OPEC countries. It is not beneficial for them to import oil from other countries. The cost is higher and, the quality is poorer than what is locally produced. However, it makes sense to export oil to other countries due to the demand and profit. The countries that have achieved absolute advantage can only export.
Understanding Economies of Scale:
Have you ever been curious about why a larger company has a chance of being more successful than smaller ones?
We can understand it better from the following illustration.
Let's assume that chocolate factory "A" can produce 1000 chocolates.
Similarly, chocolate factory "B" can produce 10000 chocolates. The companies procure cocoa at the rate of $5 per barrel. Factories will break even only if chocolate sells at $2 per piece. That is known as a break-even point. At a break-even point, the profit earned is zero.
Let's assume that factory A sells its chocolates at $10 per piece and factory B sells its chocolates at $8 per piece. Profit earned by factory A is $8000 whereas profit earned by factory B is $60000. However, there is a problem with the above assumption. Consumers will prefer to buy the chocolates of the second factory as it is cheaper other things remaining same. Due to this reason, the smaller factory will not be able to earn the estimated $8000 and is forced to bring down the prices. The big factory has achieved a substantially large size and position to dictate the price in the market. Such a large size is called economy of scale.
Understanding "Price war" and product differentiation:
Let's assume that two large companies with economies of scale produce the same goods.
Since they are locked in competition, one can expect them to reduce their profit margin to capture the market. Hence, both try to sell the goods at the lowest possible price. That's called a price war. Since there is no possibility of price reduction as it leads to loss of customers, the companies try to innovate to reduce the input costs. Adoption of new technologies can lead to such a result. Also, the companies will try to sell better products to meet the competition. Therefore, the customers are benefited from the competition directly.
Comments
Post a Comment