EP.2 – Principles of Economics and Finance

The “Principles of Economics and Finance” chapter is an essential foundation for investors, providing a deep dive into economic and finance theories as they apply to the investment landscape. In the chapter, the chapter explains how supply and demand directly affect market prices and overall dynamics, as well as how macroeconomic indicators such as inflation, GDP, unemployment rates, and consumer confidence influence market behavior. By describing the roles of key players, such as investors, brokers, and regulatory agencies, the author sets the stage for a thorough discussion of how financial markets function and structure and introduces a fundamental concept of the time value of money—vital for understanding the profitability of investment through the mechanisms of compounding interest and discounting cash flows. Readers will also learn about the essentials of financial statements, such as balance sheets, income statements, and cash flow statements, which are crucial to conducting a fundamental analysis that determines the financial health of entities and whether they are profitable investments. In this chapter, financial models are presented as a means of exploiting market trends using economic theories, enabling investors to navigate and optimize their investment strategies in a complex financial and economic environment.

1. Basic Economics

• Supply and Demand: The price of a good or service is determined by the availability (supply) and the desire (demand) of buyers to purchase it. Prices tend to rise when demand exceeds supply and fall when supply exceeds demand.

Example
In the commodity markets, the price of oil can fluctuate significantly based on supply issues (such as geopolitical tensions in oil-rich regions) and demand shifts (such as increased consumption in developing economies or changes due to the adoption of alternative energy). To effectively predict price movements, traders need to monitor these supply and demand indicators.

• Inflation: Inflation is defined as the rate by which prices are rising, which erodes purchasing power. It is a critical economic indicator that affects money’s value, interest rates, and investment returns.

Example
The real returns of fixed-income investments are directly impacted by inflation, so bond investors need to understand it. The price of existing bonds will inversely be affected by the increase in yields on new bonds if inflation rises to compensate for the decreased purchasing power of future interest payments.

• Economic Indicators GDP Growth: It is an indicator of economic health and growth that GDP growth is positive for equity markets. An increase in GDP indicates a thriving economy, which is generally good for equity markets.

Example
A rising GDP is often linked to increased corporate earnings as businesses experience more demand, which can lead to a rise in stock prices. Investors may increase their holdings in sectors that benefit most from economic expansion, such as consumer products.

2. Financial Markets

• Market Participants: There are many buyers, sellers, and intermediaries involved in the trading of financial assets. Each has a different motive, resources, and behavior, which all contribute to market dynamics.

Example
An important aspect of predicting market movements is understanding the role institutional investors (like pension funds and insurance companies) play versus retail investors. It is common for institutional investors to make large trades based on extensive research and long-term objectives, which impacts market prices and creates opportunities for retail investors.

• Mga Uri ng Instrumentong Pananalapi (Financial Instruments): A variety of instruments are available, ranging from stocks and bonds to derivatives and foreign exchange. Each instrument has its characteristics, risk profiles, and strategies that are suited to certain market conditions.

Example
It is possible for traders to hedge against downside risk in a stock portfolio by purchasing put options, and to speculate on future movements of an asset’s price with derivatives, such as options and futures.

Investing in long-term financial success requires a comprehensive understanding of both basic economics and financial markets. An investor must take advantage of this holistic understanding to achieve long-term financial objectives. A sound financial plan should be tailored to the individual’s needs and risk tolerance. A combination of traditional and alternative investments should be considered to provide a diversified portfolio. Professional financial advice should be sought to ensure a successful outcome. The investor should also ensure that investments are managed properly and regularly reviewed. Regular saving and investing should also be encouraged. Finally, the investor should be aware of potential risks and take necessary steps to mitigate them.

3. Reading Financial Statements

Both corporate finance and investment analysis require financial statements. A company’s financial statements act as formal records of its financial activities and position, allowing stakeholders to determine its profitability, liquidity, and solvency. In order to determine a company’s intrinsic value and predict its future earnings potential, these statements are indispensable for investors conducting fundamental analysis. These documents serve as benchmarks and comparison tools for analysts, while managers refer to them when making strategic decisions to enhance operational efficiency. Among the three components of financial statements, the balance sheet, income statement, and cash flow statement all provide unique information: 

• Balance Sheet: The financial statement provides investors with a snapshot of the company’s financial situation at a particular point in time. It lists assets, liabilities, and shareholders’ equity, so they can see what the company owns and owes, as well as how much they invested.

Example
If a company has $100,000 in assets and $60,000 in liabilities, its shareholders’ equity would be $40,000. This simple equation shows not only the company’s capital structure but also its financial stability and leverage.

• Income Statement: Also known as the profit and loss statement, it shows the company’s revenues, expenses, and profits over a specific period. It helps investors evaluate a company’s operational efficiency and profitability.

Example
Consider the case of a company with annual revenues of $500k and total expenses of $300k, including the cost of goods sold, operating expenses, and taxes. In the income statement, the company will show a net profit of $200,000, which indicates how much it has earned after subtracting all its expenses.

• Cash Flow Statement: The cash flow statement breaks down the cash inflows and outflows into three categories: operating activities, investing activities, and financing activities. Investors use this statement to assess a company’s financial health and cash flow. It is also used by financial analysts when making investment decisions. It is essential for understanding a company’s long-term solvency and liquidity.

Example
A company can show negative cash flow from investing activities, due to heavy investments in equipment and property, but positive cash flow from operating activities and financing activities, which indicates healthy operational income and new funds raised.

Stakeholders can evaluate a company’s financial health comprehensively by examining these three financial statements. Investors and managers can make informed decisions regarding investment opportunities, creditworthiness, and business strategy, respectively, by assessing how assets are managed, revenue is controlled, and cash flows through the organization. In addition to financial professionals, anyone involved in business management or investments needs this kind of financial literacy.

Integration of Economics and Finance Principles

Economic and financial principles provide the foundation for understanding how economies work, how financial markets operate, and how companies make decisions. Taking advantage of these principles can help individuals make better decisions about investments, savings, and financial strategies, both personally and professionally. The business can also plan for future growth, navigate market dynamics, and manage its resources more effectively.