p>To take into consideration the size of the firm, profits are calculated
as a percentage of several different aspects of the business, including
the firm’s level of sales, employment, and stockholders’ equity. Various
individuals will use one of these different methods to evaluate a
company’s performance, depending on what they want to know about how the
firm operates. For example, an efficiency expert might examine the firm’s
profits as a percentage of employment to determine how much profit is
generated by the average worker in that firm. On the other hand,
potential investors and a company’s chief executive would be more
interested in profit as a percentage of stockholder equity, which allows
them to gauge what kind of return to expect on their investments. A sales
executive in the same firm might be more interested in learning about the
company’s profit as a percentage of sales in order to compare its
performance to the performances of competing firms in the same industry.Using these different accounting methods often results in different
profit percent figures for the same company. For example, suppose a firm
earned a yearly profit of $1 million, with sales of $20 million. That
represents a 5-percent rate of profit as a return on sales. But if
stockholders’ equity in the corporation is $10 million, profits as a
percent of stockholders’ equity will be 10 percent. Return on Sales Year after year, U.S. manufacturing firms average profits of about 5
percent of sales. Many business owners with profits at this level or
lower like to say that they earn only about what people can earn on the
interest from their savings accounts. That sounds low, especially
considering that the federal government insures many savings accounts, so
that most people with deposits at a bank run no risk of losing their
savings if the bank goes out of business. And in fact, given the risks
inherent in almost all businesses, few stockholders would be satisfied
with a return on their investment that was this low. Although it is true that on average, U.S. manufacturing firms only make
about a 5-percent return on sales, that figure has little to do with the
risks these businesses take. To see why, consider a specific example. Most grocery stores earn a return on sales of only 1 to 2 percent, while
some other kinds of firms typically earn more than the 5-percent average
profit on sales. But selling more or less does not really increase what
the owners of a grocery store (or most other businesses) are risking.
Each time a grocery store sells $100 worth of canned spinach, it keeps
about one or two dollars as profit, and uses the rest of the money to put
more cans of spinach on the shelves for consumers to buy. At the end of
the year, the grocery store may have sold thousands of dollars worth of
canned spinach, but it never really risked those thousands of dollars. At
any given time, it only risked what it spent for the cans that were at
the store. When some cans were sold, the store bought new cans to put on
the shelves, and it turned over its inventory of canned spinach many
times during the year. But the total value of these sales at the end of the year says little or
nothing about the actual level of risk that the grocery store owners
accepted at any point during the year. And in fact, the grocery industry
is a relatively low-risk business, because people buy food in good times
and bad. Providing goods or services where production or consumer demand
is more variable—such as exploring for oil and uranium, or making movies
and high fashion clothing—is far riskier. Return on Equity What stockholders risk—the amount they stand to lose if a business incurs
losses and shuts down—is the money they have invested in the business,
their equity. These are the funds stockholders provide for the firm
whenever it offers a new issue of stock, or when the firm keeps some of
the profits it earns to use in the business as retained earnings, rather
than paying those profits out to stockholders as dividends. Profits as a return on stockholders’ equity for U.S. corporations usually
average from 12 to 16 percent, for larger and smaller corporations alike.
That is more than people can earn on savings accounts, or on long-term
government and corporate bonds. That is not surprising, however, because
stockholders usually accept more risk by investing in companies than
people do when they put money in savings accounts or buy bonds. The
higher average yield for corporate profits is required to make up for the
fact that there are likely to be some years when returns are lower, or
perhaps even some when a company loses money. At least part of any firm’s profits are required for it to continue to do
business. Business owners could put their funds into savings accounts and
earn a guaranteed level of return, or put them in government bonds that
carry hardly any risk of default. If a business does not earn a rate of
return in a particular market at least as high as a savings account or
government bonds, its owners will decide to get out of that market and
use the resources elsewhere—unless they expect higher levels of profits
in the future. Over time, high profits in some businesses or industries are a signal to
other producers to put more resources into those markets. Low profits, or
losses, are a signal to move resources out of a market into something
that provides a better return for the level of risk involved. That is a
key part of how markets work and respond to changing demand and supply
conditions. Markets worked exactly that way in the U.S. economy when
people left the blacksmith business to start making automobiles at the
beginning of the 20th century. They worked the same way at the end of the
century, when many companies stopped making typewriters and started
making computers and printers. CAPITAL, SAVINGS, AND INVESTMENT In the United States and in other market economies, financial firms and
markets channel savings into capital investments. Financial markets, and
the economy as a whole, work much better when the value of the dollar is
stable, experiencing neither rapid inflation nor deflation. In the United
States, the Federal Reserve System functions as the central banking
institution. It has the primary responsibility to keep the right amount
of money circulating in the economy. Investments are one of the most important ways that economies are able to
grow over time. Investments allow businesses to purchase factories,
machines, and other capital goods, which in turn increase the production
of goods and services and thus the standard of living of those who live
in the economy. That is especially true when capital goods incorporate
recently developed technologies that allow new goods and services to be
produced, or existing goods and services to be produced more efficiently
with fewer resources. Investing in capital goods has a cost, however. For investment to take
place, some resources that could have been used to produce goods and
services for consumption today must be used, instead, to make the capital
goods. People must save and reduce their current consumption to allow
this investment to take place. In the U.S. economy, these are usually not
the same people or organizations that use those funds to buy capital
goods. Banks and other financial institutions in the economy play a key
role by providing incentives for some people to save, and then lend those
funds to firms and other people who are investing in capital goods. Interest rates are the price someone pays to borrow money. Savings
institutions pay interest to people who deposit funds with the
institution, and borrowers pay interest on their loans. Like any other
price in a market economy, supply and demand determine the interest rate.
The demand for money depends on how much money people and organizations
want to have to meet their everyday expenses, how much they want to save
to protect themselves against times when their income may fall or their
expenses may rise, and how much they want to borrow to invest. The supply
of money is largely controlled by a nation’s central bank—which in the
United States is the Federal Reserve System. The Federal Reserve
increases or decreases the money supply to try to keep the right amount
of money in the economy. Too much money leads to inflation. Too little
results in high interest rates that make it more expensive to invest and
may lead to a slowdown in the national economy, with rising levels of
unemployment. Providing Funds for Investments in Capital To take advantage of specialization and economies of scale, firms must
build large production facilities that can cost hundreds of millions of
dollars. The firms that build these plants raise some funds with new
issues of stock, as described above. But firms also borrow huge sums of
money every year to undertake these capital investments. When they do
that, they compete with government agencies that are borrowing money to
finance construction projects and other public spending programs, and
with households that are borrowing money to finance the purchase of
housing, automobiles, and other goods and services. Savings play an important role in the lending process. For any of this
borrowing to take place, banks and other lenders must have funds to lend
out. They obtain these funds from people or organizations that are
willing to deposit money in accounts at the bank, including savings
accounts. If everyone spent all of the income they earned each year,
there would be no funds available for banks to lend out. Among the three major sectors of the U.S. economy—households, businesses,
and government—only households are net savers. In other words, households
save more money than they borrow. Conversely, businesses and government
are net borrowers. A few businesses may save more than they invest in
business ventures. However, overall, businesses in the United States,
like businesses in virtually all countries, invest far more than they
save. Many companies borrow funds to finance their investments. And while
some local and state governments occasionally run budget surpluses,
overall the government sector is also a large net borrower in the U.S.
economy. The government borrows money by issuing various forms of bonds.
Like corporate bonds, government bonds are contractual obligations to
repay what is borrowed, plus some specified rate of interest, at a
specified time. Matching Borrowers and Lenders in Financial Markets Households save money for several reasons: to provide a cushion against
bad times, as when wage earners or others in the household become sick,
injured, or disabled; to pay for large expenditures such as houses, cars,
and vacations; to set aside money for retirement; or to invest. Banks and
other financial institutions compete for households’ savings deposits by
paying interest to the savers. Then banks lend those funds out to
borrowers at a higher rate of interest than they pay to savers. The
difference between the interest rates charged to borrowers and paid to
savers is the main way that banks earn profits. Of course banks must also be careful to lend the money to people and
firms that are creditworthy—meaning they will be able to repay the loans.
The creditworthiness of the borrower is one reason why some kinds of
loans have higher rates of interest than others do. Short-term loans made
to people or businesses with a long history of stable income and
employment, and who have assets that can be pledged as collateral that
will become the bank’s property if a loan is not repaid, will receive the
lowest interest rates. For example, well-established firms such as AT&T
often pay what is called the bank’s prime rate—the lowest available rate
for business loans—when they borrow money. New, start-up companies pay
higher rates because there is a greater risk they will default on the
loan or even go out of business. Other kinds of loans also have greater risks of default, so banks and
other lenders charge different rates of interest. Mortgage loans are
backed by the collateral of the property the loan was used to purchase.
If someone does not pay his or her mortgage, the bank has the right to
sell the property that was pledged as collateral and to collect the
proceeds as payment for what it is owed. That means the bank’s risks are
lower, so interest rates on these loans are typically lower, too. The
money that is loaned to people who do not pay off the balances on their
credit cards every month represents a greater risk to banks, because no
collateral is provided. Because the bank does not hold any title to the
consumer’s property for these loans, it charges a higher interest rate
than it charges on mortgages. The higher rate allows the bank to collect
enough money overall so that it can cover its losses when some of these
riskier loans are not repaid. If a bank makes too many loans that are not repaid, it will go out of
business. The effects of bank failures on depositors and the overall
economy can be very severe, especially if many banks fail at the same
time and the deposits are not insured. In the United States, the most
famous example of this kind of financial disaster occurred during the
Great Depression of the 1930s, when a large number of banks failed. Many
other businesses also closed and many people lost both their jobs and
savings. Bank failures are fairly rare events in the U.S. economy. Banks do not
want to lose money or go out of business, and they try to avoid making
loans to individuals and businesses who will be unable to repay them. In
addition, a number of safeguards protect U.S. financial institutions and
their customers against failures. The Federal Deposit Insurance
Corporation (FDIC) insures most bank and savings and loan deposits up to
$100,000. Government examiners conduct regular inspections of banks and
other financial institutions to try to ensure that these firms are
operating safely and responsibly. U.S. Household Savings Rate A broader issue for the U.S. economy at the end of the 20th century is
the low household savings rate in this country, compared to that of many
other industrialized nations. People who live in the United States save
less of their annual income than people who live in many other
industrialized market economies, including Japan, Germany, and Italy. There is considerable debate about why the U.S. savings rate is low, and
several factors are often discussed. U.S. citizens may simply choose to
enjoy more of their income in the form of current consumption than people
in nations where living standards have historically been lower. But other
considerations may also be important. There are significant differences
among nations in how savings, dividends, investment income, housing
expenditures, and retirement programs are taxed and financed. These
differences may lead to different decisions about saving. For example, many other nations do not tax interest on savings accounts
as much as they do other forms of income, and some countries do not tax
at least part of the income people earn on savings accounts at all. In
the United States, such favorable tax treatment does not apply to regular
savings accounts. The government does offer more limited advantages on
special retirement accounts, but such accounts have many restrictions on
how much people can deposit or withdraw before retirement without facing
tax penalties. In addition, U.S. consumers can deduct from their taxes the interest they
pay on mortgages for the homes they live in. That encourages people to
spend more on housing than they otherwise would. As a result, some funds
that would otherwise be saved are, instead, put into housing. Another factor that has a direct effect on the U.S. savings rate is the
Social Security system, the government program that provides some
retirement income to most older people. The money that workers pay into
the Social Security system does not go into individual savings accounts
for those workers. Instead, it is used to make Social Security payments
to current retirees. No savings are created under this system unless it
happens that the total amount being paid into the system is greater than
the current payments to retirees. Even when that has happened in the
past, the federal government often used the surplus to pay for some of
its other expenditures. Individuals are also likely to save less for
their own retirement because they expect to receive Social Security
benefits when they retire. The low U.S. savings rate has two significant consequences. First, with
fewer dollars available as savings to banks and other financial
institutions, interest rates are higher for both savers and borrowers
than they would otherwise be. That makes it more costly to finance
investment in factories, equipment, and other goods, which slows growth
in national output and income levels. Second, the higher U.S. interest
rates attract funds from savers and investors in other nations. As we
will see below, such foreign investments can have several effects on the
U.S. economy.
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