Big Data in Accounting

The use of big data in accounting can open up massive possibilities for growth by providing valuable insights to assist leaders in decision-making regarding finances, compliance, and risk management.

Uses:

Audit

Auditing is the core of the accounting industry. It helps analyze a company’s financial assets and performance. However, in this age, traditional accounting procedures are time-consuming and don’t provide valuable insights. Big data and data analytics are transforming the audit process from being sample-based to data-based, providing information about all key areas of the business. It helps leaders understand their business better by providing detailed information. Big data helps track expenditure accurately in real-time and is, thus, highly helpful with periodic auditing. Combining the power of big data, analytics, and other tools such as RPA can not only automate the auditing process but also help reduce errors usually encountered in the manual process. Thus, they provide greater accuracy and compliance than conventional methods.

Risk management

The insights provided by big data help to identify financial risks and rectify them easily. Having a huge set of data beforehand empowers accountants to carry out predictive analytics, and thus they can predict future risks more accurately. They can warn clients and advise them to take the necessary steps required to avert any major financial issue. Big data analytics can also help to identify potential frauds. It, however, may need the support of AI, blockchain, and computer vision technology to continuously monitor an enterprise’s assets and expenditure details to determine any irregularities.

Business decisions

Since big data helps businesses take complete control of their financial operations, business leaders can make better growth-oriented decisions. With the real-time availability of data, leaders can make better short-term, and, as well as, long-term financial plans. Thus, big data works as a trusted advisor for accountants, helping them provide better services to their clients.

Big data brings enormous benefits to the accounting sector. Still, it needs a coherent partnership of other technologies such as artificial intelligence, RPA, and computer vision to be leveraged to its maximum potential. Therefore, accounting firms investing in big data in accounting practices should also look to incorporate the other technologies mentioned to maximize the benefits of big data.

How Can the Use of Big Data and Related Technologies Improve Accounting Practices?

One of the most straightforward, impactful technologies in accounting and finance sector applications is robotic process automation (RPA). With RPA, advanced AI software can automate many repetitive tasks, like data entry, as well as more complex tasks involved in auditing and other accounting practices.

This streamlines and exponentially increases the efficiency of mundane accounting processes. RPA also helps reduce errors common to manual data entry, improving process speed and accuracy as well as the resulting quality and timeliness of insight gained from analysis. Plus, with the ability to detect outliers in vast datasets, RPA and big data analytics help accountants move past the limits of narrow audit sampling.

The speed and scope of AI-driven RPA and big data analysis enable accounting insight delivery in near real-time, on demand. This availability means decision-makers get the information they need when they need it. Plus, accountants are freed up to do more impactful work. The accountant’s role becomes more of a strategic advisor than a number cruncher, helping translate big data analyses into strategy formulation insight for clients and businesses.

An Institute of Management Accountants (IMA) survey found that 70% of respondents who have implemented big data into practices use it to inform strategy formulation. Improving business decision-making and strategy is the real benefit of data analysis. Deploying big data capabilities to analyze large amounts of complex finance and accounting data can maximize the perspective and insight gained for strategy formulation.

Components of economic analysis

Economic analysis involves assessing or examining topics or issues from an economist’s perspective. Economic analysis is the study of economic systems. It may also be a study of a production process or an industry. The analysis aims to determine how effectively the economy or something within it is operating. For example, an economic analysis of a company focuses mainly on how much profit it is making.

Economists say that economic analysis is a systematic approach to find out what the optimum use of scarce resources is.

Template.net, which supplies ready-made analysis templates, says that economic analysis involves comparing at least two alternatives in achieving, for example, a certain goal under specific constraints and assumptions.

Economic analyses factor in the opportunity costs that people or companies employ. They measure, in monetary terms, what the benefits of a project are to the economy or community.

Features

A typical analysis includes details of the proposal or project, estimated risks, projected costs and expected impediments. Thus, the details section for the economic analysis of a restaurant business lists the type of food it will serve and the estimated demographic. The estimated risks might include the low demand during the summer if the restaurant targets college students. The projected costs section details the kitchen equipment, food costs and wages. Expected impediments include paying higher prices for ingredients during the off-season, such as fresh peaches in January.

The analysis typically includes several economic scenarios. Because organizations perform differently during recessions and strong growth, anticipating the financial outcome for both is prudent.

Function

The purpose of an economic analysis is multifaceted: In some cases, financial institutions read the analysis to determine if they should finance a project. Directors also read the analysis to assess if the undertaking is advantageous to the company. Sometimes, the analysis provides a clear picture of the economic well-being of the company or industry. The company uses the findings to make better decisions or avoid potential problems.

Significance

A well-written analysis saves money in the long run. If, for instance, the report anticipates a sharp increase in the price of steel, an automotive company can plan for the expected increase and buy the commodity in advance. Or, a report could prevent a new business owner from starting an unsuccessful venture: An owner may realize that a luxury dog clothing store will go out of business during a recession in two years without enough savings.

Considerations

Do not attempt to write a formal economic analysis for your own business. Business owners should seek a fresh perspective from a seasoned professional in the industry. Hire a consultant to draft the analysis and use the report to assess the viability and long-term success of your business.

Warning

Even the most thorough analysis can be rendered irrelevant by unseen economic forces. For instance, the economic analysis conducted by businesses in New Orleans a month before Hurricane Katrina hit was no longer useful in light of the catastrophe. Natural disasters, terrorist attacks and a key vendor’s bankruptcy are just a few examples of unpredictable forces that derail the most detailed, well-planned economic analysis.

Characteristics of an industry analysis

Industry analysis is a type of investment research that begins by focusing on the status of an industry or an industrial sector. A form of fundamental analysis involving the process of making investment decisions based on the different stages an industry is at during a given point in time. The type of position taken will depend on firm specific characteristics, as well as where the industry is at in its life cycle.

Industry Life Cycle Analysis

Many industrial economists believe that the development of almost every industry may be analyzed in terms of following stages:

  • Pioneering stage: New technologies like personal computers or wireless communication portray the initial stages of an industry. At this stage, it is very difficult to anticipate which firms will succeed; some firms will be a total success while some might fail completely. Hence, the risk involved in selecting any specific firm in the industry is quite high at this stage. However, at this stage, since the new product has not yet flooded its market, there will be a rapid growth in sales and earnings at industry level. Like, for example, in 1980’s, personal computers were a part of very few houses, while on the other hand, products like fans or even refrigerators were part of almost every household. So naturally, the growth rate of products like refrigerators will be much less.
  • Rapid growth stage: Once the product has proved itself in the market, several leaders in the industry start surfacing. The start-up stage survivors become more stable and market share can be easily envisaged. Thus, the performance of the industry in general will be more minutely tracked by the performance of the firms that have survived. As the product breaks through the market place and is used commonly, the growth rate of the industry is still faster than the rest of economy.
  • Maturity and stabilization stage: The product has attained the full aptitude to be consumed at this stage by the users. So, any growth from this point just tracks the growth of the economy in general. At this stage, as the product gets more and more standardized, it compels the producers to compete heavily on price basis. As a result, the profit margins are lowered and add to the pressure on profits. Most often, firms at this stage are referred to as cash cows as their cash flows are quite consistent but offer very little opportunity for growth of profit. Instead of reinvesting the cash flows in the company, they are best milked from.
  1. Decline stage: In this stage following features are identified.
  • Costs become counter-optimal
  • Sales volume decline or stabilize
  • Prices, profitability diminish
  • Profit becomes more a challenge of production/distribution efficiency than increased sales.

Characteristics of An Industry Analysis

In an industry analysis, the following key characteristics should be considered by the analyst. These are explained as below:

  • Post sales and Earnings performance: The historical performance of sales and earnings should be given due consideration, to know how the industry have reacted in the past. With the knowledge and understanding of the reasons of the past behaviour, the investor can assess the relative magnitude of performance in future. The cost structure of an industry is also an important factor to look into. The higher the cost component, the higher the sales volume necessary to achieve the firm’s break-even point, and vice-versa.
  • Nature of Competition: The top firms in the industry must be analyzed. The demand of particular product, its profitability and price of concerned company scrip’s also determine the nature of competition. The investor should analyze the scrip and should compare it with other companies. If too many firms are present in the industry, this will lead to a decline in price of the product.
  • Raw Material and Inputs: We need to have a look on industries which are dependent on raw material. An industry which has limited supply of raw material will have a less growth. Labor in also an input and problems with labor will also lead to growth difficulties.
  • Attitude of Government towards Industry: The government policy with regard to granting of clearance, installed capacity and reservation of the products for small industry etc. are also factors to be considered for industry analysis.
  • Management: An industry with many problems may be well managed, if the promoters and the management are efficient. The management has to be assessed in terms of their capabilities, popularity, honesty and integrity. A good management also ensures that the future expansion plans are put on sound basis.
  • Labor Conditions and Other Industrial Problems: The industries which depend on labor, the possibility of strike looms as an important factor to be reckoned with. Certain industries with problems of marketing like high storage costs, high transport costs etc leads to poor growth potential and investors have to careful in investing in such companies.
  • Nature of Product Line: The position of industry in the different stages of the life cycle is to be noted. And the importance attached by planning commission on these industries assessment is to be studied.
  • Capacity Installed and Utilized: If the demand is rising as expected and market is good for the products, the utilization of capacity will be higher, leading to bright prospects and higher profitability. If the quality of the product is poor, competition is high and there are other constraints to the availability of inputs and there are labor problems, then the capacity utilization will be low and profitability will be poor.
  • Industry Share Price Relative to Industry Earnings: While making investment the current price of securities in the industry, their risk and returns they promise is considered. If the price is very high relative to future earnings growth, the investment in these securities is not wise. Conversely, if future prospects are dim but prices are low relative to fairly level future patterns of earnings, the stocks in this industry might be an attractive investment.
  • Research and Development: The proper research and development activities help in increasing economy of an industry and so while investing in an industry, the expenditure should also be considered.
  • Pollution Standards: These are very high and restricted in the industrial sector. These differ from industry to industry, for example, in leather, chemical and pharmaceutical industries the industrial effluents are more.

Economic Analysis: International & Domestic economic scenario

Economic analysis involves assessing or examining topics or issues from an economist’s perspective. Economic analysis is the study of economic systems. It may also be a study of a production process or an industry. The analysis aims to determine how effectively the economy or something within it is operating. For example, an economic analysis of a company focuses mainly on how much profit it is making.

Economists say that economic analysis is a systematic approach to find out what the optimum use of scarce resources is.

An economic analysis isn’t limited to medium or large-sized businesses, it’s valuable for small companies as well. In fact, small businesses probably need to perform economic analysis more often than businesses that have enough built-in capital and resources to sustain an economic downturn. There are several types of economic evaluation methods business owners can use to gain a comprehensive view of how their companies will fare in the future.

Cost-Benefit Analysis

One of the most effective types of economic evaluation is the cost-benefit analysis, also referred to as a benefit-cost analysis. This is a technique used to determine whether a project or activity is feasible by weighing the monetary cost of doing the project or activity versus the benefits. A cost-benefit analysis will always compare the cost of the effort against the benefits that result from that effort. Because it deals solely in monetary terms, a cost-benefit analysis is one of the most bottom-line types of economic evaluation. It can provide valuable insight in comparing and contrasting work projects, help determine whether an investment opportunity is ideal, and help assess the consequences of implementing changes to your business. However, there is a drawback to this analysis as it is difficult to place a monetary value on some activities such as the benefits of increased public safety versus the cost to increase law enforcement presence in major cities. After performing the cost-benefit analysis, a small business owner can make an educated business decision.

Cost-Effective Analysis

In a cost-effective analysis, you weigh the effectiveness of a project against its price. Unlike with cost-benefit analysis, however, a low cost doesn’t mean high effectiveness, and the reverse is also true. For example, let’s say you’ve determined that installing an automated system that can handle customer orders 24-hours a day, seven days a week, is the cheapest way to boost your incoming orders. After research, however, you determine that many calls that come into the automated system are not complete, because callers hang up when they hear the automated voice on the system. Your market research also indicates that your customers want to speak to a live representative. A cost-effective analysis would tell you that the cheaper route of installing an automated system is not effective in processing more orders. Depending on the type of business you own, you may find that saving money doesn’t result in creating a desirable effect on your business.

Cost-Minimization Analysis

As the term suggests, cost-minimization analysis focuses on finding the cheapest cost to complete a project. This is one of the economic evaluation methods that business owners use when cost savings are at a premium and outweigh all other considerations. It is also used when there are two or more ways to accomplish the same task. Cost-minimization analysis is most often used in healthcare. For example, drug manufacturers may compare two drugs that have been shown to produce the same effect in patients, or a pharmaceutical company may implement cost-minimization analysis, to determine which of two medications that treat the same illness will cost the least amount of money to produce. In many instances, the generic equivalent of a name-brand drug is the least expensive drug to manufacture, especially if it produces the same therapeutic effect in patients.

Key components of an industry

  1. Competitors:

The intensity of competition from existing competitors will depend on several factors including:

  1. The number of competitors
  2. Their relative size
  3. Whether their product offering and strategies are similar
  4. The existence of high fixed costs
  5. The commitment of competitors and
  6. The size and nature of exist barriers

  1. Potential competitors:

Potential competitors who might have an interest in entering an industry. Whether potential competitors, identified or not, actually do enter, however, depends in large part upon the size and nature of barriers to entry. Thus, an analysis of barriers to entry is important in projecting the likely competitive intensity and profitability levels in the future.

Entry barriers include:

  1. Capital investment required.
  2. Industries like mining, refinery or automobiles require huge investments and larger gestation periods that increase the risk.

 

3. Economies of scale:

If scale economies exist in production, advertising, distribution, or other areas, it becomes necessary to obtain a large volume quickly. Such an effort not only increases the investment but it also increase the risk of retaliation from existing competitors. Reliance Fresh opted this strategy for reducing the price of fruits and vegetables in its retail outlets.

  1. Distribution channels:

Gaining distribution in some industries can be extremely difficult and costly. Even large established firms that sell products with substantial marketing budgets have trouble obtaining space on the supermarket shelf Competition between Pepsi and Coke limit the customers’ choice on cola as most of the retail outlets have a policy of eliminating one cola product (either Coke or Pepsi brands) from their shelves.

  1. Product differentiation:

Established firms may have high levels of customer loyalty caused and maintained by protected product features, a brand name and image, advertising, and customer service. Industries in which product differentiation barriers are particularly high include soft drinks, beer, cosmetics, over-the-counter drugs, and banking.

Unfortunately Transport Department of Govt. of India banned this advertisement by citing the reason such as youth tend to follow the ad, violate traffic rules and risk their life.

  1. Substitute products:

Substitute products are represented by those sets of competitors that are identified as competing with less intensity than the primary competitors.

  1. Customer power:

When customers have relatively more power than sellers do, they can force prices down or demand more services, thereby affecting profitability. A customer’s power will be greater when its purchase size is a large proportion of the seller’s business, when alternative suppliers are available, and when the customer can integrate backward and make all or part of the product.

  1. Supplier power:

When the supplier industry is concentrated and sells to a variety of customers in diverse industries, it will have relative power that can be used to influence prices. Power will also tend to be enhanced when the costs of customers to switch suppliers is high.

Trend analysis

Trend analysis is a technique used in technical analysis that attempts to predict future stock price movements based on recently observed trend data. Trend analysis uses historical data, such as price movements and trade volume, to forecast the long-term direction of market sentiment.

Trend analysis tries to predict a trend, such as a bull market run, and ride that trend until data suggests a trend reversal, such as a bull-to-bear market. Trend analysis is helpful because moving with trends, and not against them, will lead to profit for an investor. It is based on the idea that what has happened in the past gives traders an idea of what will happen in the future. There are three main types of trends: short-, intermediate- and long-term.

A trend is a general direction the market is taking during a specified period of time. Trends can be both upward and downward, relating to bullish and bearish markets, respectively. While there is no specified minimum amount of time required for a direction to be considered a trend, the longer the direction is maintained, the more notable the trend.

Trend analysis is the process of looking at current trends in order to predict future ones and is considered a form of comparative analysis. This can include attempting to determine whether a current market trend, such as gains in a particular market sector, is likely to continue, as well as whether a trend in one market area could result in a trend in another. Though a trend analysis may involve a large amount of data, there is no guarantee that the results will be correct.

In order to begin analyzing applicable data, it is necessary to first determine which market segment will be analyzed. For instance, you could focus on a particular industry, such as the automotive or pharmaceuticals sector, as well as a particular type of investment, such as the bond market.

Once the sector has been selected, it is possible to examine its general performance. This can include how the sector was affected by internal and external forces. For example, changes in a similar industry or the creation of a new governmental regulation would qualify as forces impacting the market. Analysts then take this data and attempt to predict the direction the market will take moving forward.

Critics of trend analysis, and technical trading in general, argue that markets are efficient, and already price in all available information. That means that history does not necessarily need to repeat itself and that the past does not predict the future. Adherents of fundamental analysis, for example, analyze the financial condition of companies using financial statements and economic models to predict future prices. For these types of investors, day-to-day stock movements follow a random walk that cannot be interpreted as patterns or trends.

Types of Trend

Uptrend

An uptrend or bull market is when financial markets and assets as with the broader economy-level move upward and keep increasing prices of the stock or the assets or even the size of the economy over the period. It is a booming time where jobs get created, the economy moves into a positive market, sentiments in the markets are favorable, and the investment cycle has started.

Downtrend

Companies shut down their operation or shrank the production due to a slump in sales. A downtrend or bear market is when financial markets and asset prices as with the broader economy-level move downward, and prices of the stock or the assets or even the size of the economy keep decreasing over time. Jobs are lost, asset prices start declining, sentiment in the market is not favorable for further investment, and investors run for the haven of the investment.

Sideways / horizontal Trend

A sideways/horizontal trend means asset prices or share prices as with the broader economy level are not moving in any direction; they are moving sideways, up for some time, then down for some time. The direction of the trend cannot be decided. It is the trend where investors are worried about their investment, and the government is trying to push the economy in an uptrend. Generally, the sideways or horizontal trend is considered risky because when sentiments will be turned against cannot be predicted; hence investors try to keep away in such a situation.

Uses:

Use in Technical Analysis

An investor can create his trend line from the historical stock prices, and he can use this information to predict the future movement of the stock price. The trend can be associated with the given information. Cause and effect relationships must be studied before concluding the trend analysis.

Use in Accounting

Sales and cost information of the organization’s profit and loss statement can be arranged on a horizontal line for multiple periods and examine trends and data inconsistencies. For instance, take the example of a sudden spike in the expenses in a particular quarter followed by a sharp decline in the next period, which is an indicator of expenses booked twice in the first quarter. Thus, the trend analysis in accounting is essential for examining the financial statements for inaccuracies to see whether certain heads should be adjusted before the conclusion is drawn from the financial statements.

Importance of Trend Analysis

  • The trend is the best friend of the traders is a well-known quote in the market. Trend analysis tries to find a trend like a bull market run and profit from that trend unless and until data shows a trend reversal can happen, such as a bull to bear market. It is most helpful for the traders because moving with trends and not going against them will make a profit for an investor.
  • Trends can be both growing and decreasing, relating to bearish and bullish market
  • A trend is nothing but the general direction the market is heading during a specific period. There are no criteria to decide how much time is required to determine the trend; generally, the longer the direction, the more is reliably considered. Based on the experience and some empirical analysis, some indicators are designed, and standard time is kept for such indicators like 14 days moving average, 50 days moving average, and 200 days moving average.
  • While no specified minimum amount of time is required for a direction to be considered a trend, the longer the direction is maintained, the more notable the trend.

Measuring returns; ROI, Absolute returns, Annualized return

ROI

Return on investment (ROI) is a financial ratio used to calculate the benefit an investor will receive in relation to their investment cost. It is most commonly measured as net income divided by the original capital cost of the investment. The higher the ratio, the greater the benefit earned.

ROI Formula

There are several versions of the ROI formula. The two most commonly used are shown below:

ROI = Net Income / Cost of Investment

or

ROI = Investment Gain / Investment Base

Benefits of the ROI Formula

There are many benefits to using the return on investment ratio that every analyst should be aware of.

Simple and Easy to Calculate

The return on investment metric is frequently used because it’s so easy to calculate. Only two figures are required the benefit and the cost. Because a “return” can mean different things to different people, the ROI formula is easy to use, as there is not a strict definition of “return”.

Universally Understood

Return on investment is a universally understood concept so it’s almost guaranteed that if you use the metric in conversation, then people will know what you’re talking about.

Limitations of the ROI Formula

While the ratio is often very useful, there are also some limitations to the ROI formula that are important to know.  Below are two key points that are worthy of note.

The ROI Formula Disregards the Factor of Time

A higher ROI number does not always mean a better investment option. For example, two investments have the same ROI of 50%. However, the first investment is completed in three years, while the second investment needs five years to produce the same yield. The same ROI for both investments blurred the bigger picture, but when the factor of time was added, the investor easily sees the better option.

The investor needs to compare two instruments under the same time period and same circumstances.

The ROI Formula is Susceptible to Manipulation

An ROI calculation will differ between two people depending on what ROI formula is used in the calculation. A marketing manager can use the property calculation explained in the example section without accounting for additional costs such as maintenance costs, property taxes, sales fees, stamp duties, and legal costs.

Absolute returns

The absolute return or simply return is a measure of the gain or loss on an investment portfolio expressed as a percentage of invested capital. The adjective “absolute” is used to stress the distinction with the relative return measures often used by long-only stock funds that are not allowed to take part in short selling.

The hedge fund business is defined by absolute returns. Unlike traditional asset managers, who try to track and outperform a benchmark (a reference index such as the Dow Jones and S&P 500), hedge fund managers employ different strategies in order to produce a positive return regardless of the direction and the fluctuations of capital markets. This is one reason why hedge funds are referred to as alternative investment vehicles.

Absolute return managers tend to be characterised by their use of short selling, leverage and high turnover in their portfolios.

The formula for absolute return is:

Absolute returns = 100* (Selling Price – Cost Price)/ (Cost Price)

Advantages

It offers multiple advantages. A few of the noteworthy are enumerated below:

  • First, it is straightforward to calculate and understand for all users.
  • Second, it is unaffected by period and benchmark comparison and provides returns generated in actual terms.
  • Third, it helps in reducing overall volatility as it doesn’t consider intermittent changes.

Disadvantages

  • It isn’t easy to compare across other asset classes.
  • It is a fault measure when comparing different time frames.
  • It doesn’t compare against any benchmark, which results in determining the relative performance. Also, absolute return lacks adjusting returns for inflation, leading to negative returns despite absolute returns showing a positive value.
  • These measures don’t allow investors to assess the efficacy of the Fund manager and whether they can generate positive alpha. Also, this measure completely avoids assessing risk-adjusted returns.
  • It is not comparable, which makes it an adequate measure of performance.
  • It can lead to the selection of those investments where risk is higher as it doesn’t consider risk measures such as Standard Deviation and other performance ratios such as Sharpe Ratio, Treynor Ratio, etc.

Annualized return

The annual return is the return on an investment generated over a year and calculated as a percentage of the initial amount of investment. If the return is positive (negative), it is considered a gain (loss) on the initial investment. The rate of return will vary depending on the level of risk involved.

Annual Return Formula

The return earned over any 12-month period for an investment is given by the following formula:

Annual Return = [(Final value of Investment – Initial value of Investment) / Initial value of Investment] * 100

Advantages:

  • It is very easy to calculate and simple to understand like payback period. It considers the total profits or savings over the entire period of economic life of the project.
  • This method recognizes the concept of net earnings i.e. earnings after tax and depreciation. This is a vital factor in the appraisal of a investment proposal.
  • This method facilitates the comparison of new product project with that of cost reducing project or other projects of competitive nature.
  • This method gives a clear picture of the profitability of a project.
  • This method alone considers the accounting concept of profit for calculating rate of return. Moreover, the accounting profit can be readily calculated from the accounting records.
  • This method satisfies the interest of the owners since they are much interested in return on investment.
  • This method is useful to measure current performance of the firm.

Disadvantages:

  • The results are different if one calculates ROI and others calculate ARR. It creates problem in making decisions.
  • This method ignores time factor. The primary weakness of the average return method of selecting alternative uses of funds is that the time value of funds is ignored.
  • A fair rate of return cannot be determined on the basis of ARR. It is the discretion of the management.
  • This method does not consider the external factors which are also affecting the profitability of the project.
  • It does not take into the consideration of cash inflows which are more important than the accounting profits.
  • It ignores the period in which the profits are earned as a 20% rate of return in 10 years may be considered to be better than 18% rate of return for 6 years. This is not proper because longer the term of the project, greater is the risk involved.
  • This method cannot be applied in a situation when investment in a project to be made in parts.
  • This method does not consider the life period of the various investments. But average earnings are calculated by taking life period of the investment. As a result, average investment or initial investment may remain the same whether investment has a life period of 4 years or 6 years.
  • It is not useful to evaluate the projects where investment is made in two or more instalments at different times.

Systematic and Unsystematic Risk

Systematic risk

Systematic risk is caused by the changes in government policy, the act of nature such as natural disaster, changes in the nation’s economy, international economic components, etc. The risk may result in the fall of the value of investments over a period. It is divided into three categories that are explained as under:

  • Interest risk: Risk caused by the fluctuation in the rate or interest from time to time and affects interest-bearing securities like bonds and debentures.
  • Inflation risk: Alternatively known as purchasing power risk as it adversely affects the purchasing power of an individual. Such risk arises due to a rise in the cost of production, the rise in wages, etc.
  • Market risk: The risk influences the prices of a share, i.e. the prices will rise or fall consistently over a period along with other shares of the market.

Unsystematic risk

Unsystematic risk is the risk that is unique to a specific company or industry. It’s also known as nonsystematic risk, specific risk, diversifiable risk, or residual risk. In the context of an investment portfolio, unsystematic risk can be reduced through diversification while systematic risk is the risk that’s inherent in the market.

The risk can be avoided by the organization if necessary actions are taken in this regard. It has been divided into two category business risk and financial risk, explained as under:

  • Business risk: Risk inherent to the securities, is the company may or may not perform well. The risk when a company performs below average is known as a business risk. There are some factors that cause business risks like changes in government policies, the rise in competition, change in consumer taste and preferences, development of substitute products, technological changes, etc.
  • Financial risk: Alternatively known as leveraged risk. When there is a change in the capital structure of the company, it amounts to a financial risk. The debt–equity ratio is the expression of such risk.

Systematic Risk

Unsystematic Risk
Meaning Risk/Threat associated  with the market or the segment as a whole Hazard associated with specific security, firm, or industry
Controllability Cannot be controlled Controllable
Hedging Allocation of the assets Diversification of the Portfolio
Responsible Factors External Internal
Avoidance Cannot be avoided It can be avoided or resolved at a quicker pace.
Types Interest Risk and Market Risk Financial and Business risk
Impact A large number of securities in the market Restricted to the specific company or industry
Protection Asset allocation Portfolio diversification

Extended Internal Rate of Return (XIRR)

The extended internal rate of return or the more commonly used, XIRR, is the rate which calculates the returns on the total investment made with increments, paid throughout the period under consideration.

XIRR is an annualized form of return. Annualized return indicates what investment would return over a time period if the annual return is compounded.

XIRR comes to an investor’s aid when investments are made into mutual funds at randomly spaced intervals. Moreover, redemptions are also processed at irregular time intervals. The time periods will differ for each cash flow. Each particular investment will offer a different rate of return at a given date of measurement.

XIRR= Weighted average CAGR of all instalments

IV= Investment Value (IV)

FV= Final Value (FV)

N= Investment intervals (n)

We understand it can be complicated to manually calculate XIRR for any investment. What’s more important is understanding its significance and need, especially when you are investing in mutual funds via SIP.

Therefore, XIRR can be used to calculate an investor’s mutual fund returns when investments and redemptions are spread over a period of time.

For example, Mr. A decided to invest Rs 50,000 in a thematic fund with the pharma sector as the theme on the news of the coronavirus pandemic. Mr. A redeems the invested amount on the news of economic recovery to look for better returns. Mr. A invests that Rs 50,000 in the consumer durables sector on the news of vaccine efficacy. On the release of auto sales data, Mr. A invested another Rs 50,000 in the auto sector with a short-term view to reap benefits of festive sales rally. Now, the investment and redemption time periods for each investment will be unevenly spaced. XIRR can be used to calculate the overall return on the invested corpus.

An investor may choose different options such as SIP, SWP, and lumpsum for different mutual funds. XIRR can be applied to such investment strategies.

XIRR, IRR, and CAGR can be quite confusing at times. CAGR and XIRR are both used to calculate returns on investment. XIRR can be referred to as an aggregate of multiple CAGRs. When there are multiple investments made in a fund, XIRR can be used to calculate the overall return.

There is a fine line of difference between CAGR and XIRR. CAGR is used to assess the performance of a mutual fund on a standalone basis. XIRR is computed to assess the performance of your investment in the mutual fund.

Let’s assume that one invests Rs 2000 per month for a year in a fund, which increases to Rs 48,000 in 4 years. How to calculate the overall return on this investment made over 12 months? If using CAGR, you will have to measure the CAGR for 48 months on the first installment, for 47 months on the second installment, for 46 months on the third installment, and so on. Instead of doing that, one can use the XIRR function of excel that takes into account all these CAGRs to give the overall CAGR.

XIRR and IRR functions of excel differ on the basis that the IRR function assumes that each period between a series of cash flows is of the same length. Rate of return on monthly, quarterly, or annual cash flows is generally measured using IRR. XIRR on the other hand offers to assign dates to the cash flows and doesn’t require each cash flow to be made after the same interval.

To summarise, if cash flows are made at regular intervals, IRR is preferred and if cash flows are not made at regular intervals then XIRR is preferred to measure the overall return.

Difference between Savings and Investment

Savings

Saving is setting aside some money for future expenses or needs. It is the first and foremost step towards leading a financially disciplined life. The savings fund comes as a boon during rainy days. A savings account or bank fixed deposits are some of the popular savings options in India. It is similar to holding cash. Our parents and grandparents have strongly believed in saving money for their children’s future to give them a comfortable life. That’s what kept them going and never touched their savings until and unless it was extremely necessary. While now most of us love to spend the money we earn and follow the ‘YOLO’ trend. Yes, You Only Live Once (YOLO). However, living without any financial hiccups should be the goal.

Objectives of Saving

  • A rainy day fund for emergencies
  • A down payment for a car or a home
  • Putting money aside for a trip, new appliances, or a car
  • Short-term educational expenses
  • Utilizing alternatives for Tax-Free Savings Accounts

The pros and cons of saving

There are plenty of reasons you should save your hard-earned money. For one, it’s usually your safest bet, and it’s the best way to avoid losing any cash along the way. It’s also easy to do, and you can access the funds quickly when you need them.

All in all, saving comes with these benefits:

  • Savings accounts tell you upfront how much interest you’ll earn on your balance.
  • The Federal Deposit Insurance Corporation guarantees bank accounts up to Rs. 5,00,000, so while the returns are lower, you’re not going to lose any money when using a savings account.
  • Bank products are generally very liquid, meaning you can get your money as soon as you need it, though you may incur a penalty if you want to access a CD before its maturity date.
  • There are minimal fees. Maintenance fees or Regulation D violation fees (when more than six transactions are made out of a savings account in a month) are the only way a savings account at an FDIC-insured bank can lose value.
  • Saving is generally straightforward and easy to do. There usually isn’t any upfront cost or learning curve.

Despite its perks, saving does have some drawbacks, including:

  • Returns are low, meaning you could earn more by investing (but there’s no guarantee you will.)
  • Because returns are low, you may lose purchasing power over time, as inflation eats away at your money.

Investing

Investing money is the process of using your money to buy assets that value over time and provide high returns in exchange for taking on more risk. Investments are typically volatile and illiquid. You earn returns by selling your assets for a profit or realising your capital gains.

Objectives of Investment

  • Paying for your children’s higher education
  • Building wealth for the future
  • Saving for retirement

The pros and cons of investing

Saving is definitely safer than investing, though it will likely not result in the most wealth accumulated over the long run.

Here are just a few of the benefits that investing your cash comes with:

  • Investing products such as stocks can have much higher returns than savings accounts and CDs. Over time, the Standard & Poor’s 500 stock index (S&P 500), has returned about 10 percent annually, though the return can fluctuate greatly in any given year.
  • Investing products are generally very liquid. Stocks, bonds and ETFs can easily be converted into cash on almost any weekday.
  • If you own a broadly diversified collection of stocks, then you’re likely to easily beat inflation over long periods of time and increase your purchasing power. Currently, the target inflation rate that the Federal Reserve uses is 2 percent, but it’s been much higher over the past year. If your return is below the inflation rate, you’re losing purchasing power over time.

While there’s the potential for higher returns, investing has quite a few drawbacks, including:

  • Returns are not guaranteed, and there’s a good chance you will lose money at least in the short term as the value of your assets fluctuates.
  • Depending on when you sell and the health of the overall economy, you may not get back what you initially invested.
  • You’ll want to let your money stay in an investment account for at least five years, so that you can hopefully ride out any short-term downdrafts. In general, you’ll want to hold your investments as long as possible and that means not accessing them.
  • Because investing can be complex, you’ll probably need some expert help doing it unless you have the time and skillset to teach yourself how.
  • Fees can be higher in brokerage accounts. You may have to pay to trade a stock or fund, though many brokers offer free trades these days. And you may need to pay an expert to manage your money.

Savings Investment
Meaning Savings represents that part of the person’s income which is not used for consumption. Investment refers to the process of investing funds in capital assets, with a view to generate returns.
Returns No or less Comparatively high
Liquidity Highly liquid Less liquid
Risk Low or negligible Very high
Purpose Savings are made to fulfill short term or urgent requirements. Investment is made to provide returns and help in capital formation.
Long term asset. Suitable for goals such as a child’s education, marriage, buying a house, etc. Short term asset. Suitable for short term goals such as buying furniture, home appliances, or meeting emergency requirements.
Products Stocks, Bonds, Mutual Funds, Gold, Real Estate, etc. Savings account, Certificate of deposits, money market instruments, etc.
Protection against Inflation Good protection against inflation. Only a little.
Account Type Brokerage Bank

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