Financial Analysis in an Inflationary Environment

Abstract

This paper has attempted to show that more than the officially recognized inflation-adjustments are necessary before even the simplest financing ratios can meaningfully be compared over time. If these adjustments are made, the decline in profits and retained earnings after 1965 is far less than commonly measured and so is the increased reliance on external funds after 1968. Specifically it was argued that inflation-adjusted profits, retained earnings, and the gross flow of internal funds should include any reduction in real indebtedness. Adding this amount to the sum of retained earnings (including the IVA and CCA) and replacement-cost depreciation yields the correct measure of gross internal funds for purposes of financial analysis whether or not inflation premiums are fully reflected in interest rates. Correspondingly, that part of the increase in debt that merely goes to maintain the real value of past debt should be excluded from the external sources of funds if the relative importance of debt-financing is to be determined for periods with different inflation rates. While we certainly recognize that a rise in inflation rates and risk premiums can and probably does reduce the market value of the firm below the replacement cost of its assets in spite of the reduction in its real net indebtedness, such an outcome provides no justification for measuring the flow of internal funds incorrectly in the first place or for confusing nominal with real changes in net indebtedness. We are also aware that inflation in effect shortens the effective maturity or duration of the debt. As more frequent recourse to the credit market is required just to maintain real indebtedness or to finance the inflation premium in the interest rates paid by nonfinancial corporations, risks premiums may rise. Hence our point is not that a rise in the rate of inflation does not depress investment, but only that some of the most commonly cited reasons why it may do so may not apply at all... [ABSTRACT FROM AUTHOR]