Strong profits may cushion the downturn

The economic clouds are darkening for the <?xml:namespace prefix = st1 ns = "urn:schemas-microsoft-com:office:smarttags" />UK and Gordon Brown has been busy touring the media studios warning of a difficult year in 2008, downgrading expectations so that, if the worst doesn’t materialize, he can at least take some of the credit! <?xml:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" />

But one bright spot worthy of note is the continued high profitability of UK businesses. New data released by the Office of National Statistics finds that

“The overall profitability of UK private non-financial corporations in the third quarter of 2007 was 16.0 per cent, which was higher than the revised estimate of 15.6 per cent recorded in the previous quarter. The annual net rate of return for private non-financial corporations in 2006 was 14.5 per cent. Manufacturing companies’ net rate of return was estimated at 9.7 per cent in the third quarter. This is higher than the average of 7.8 per cent for 2006.”

The good news seems to be that profits as a share of UK GDP are currently at their highest level since 1999. Businesses in many sectors have enjoyed the fruits of sustained economic growth to rebuild profitability and improve their balance sheets. This will provide a welcome cushion once the economic downturn really starts to bite. 2008 may prove to be a year when profits are hit from several different angles:

The delayed effects of the credit crunch - driving corporate borrowing costs The slowdown and possible recession in the housing sector - hitting sales and profit margins for construction firms and many others whose fortunes are tied to the property market A slowdown in household spending - witness the flood of profits warnings from retailers Rising wage inflation will impact on labour costs. Many firms will not be able to pass in full on these extra expenses (and higher energy bills) to their customers The data is for non-financial firms - and this excludes the hit on profits taken by companies embroiled in the financial turmoil of recent months. Set against the fall-out from the credit crunch and slowdown, company profits may benefit from a sustained fall in the value of sterling against the euro and a weakening of the pound-dollar exchange rate. A lower pound raises the profitability of exporting to other countries. In a commentary on the profits figures, economist Roger Bootle casts doubt on the ability of UK businesses to maintain high profits in the months to come:

“The recent pick-up in households’ inflation expectations might mean that consumers will be willing to accept bigger price rises, allowing firms to protect profits by raising margins. But as demand slows, I would not be surprised to see most firms using price-discounting as a way to try to increase their market share. Some firms will also focus on cost-cutting to maintain profits growth. But with pay growth already fairly subdued and utility price hikes seemingly just around the corner, there is a limit to how far costs can be squeezed.”

AS Economics

Explain what is meant by the term ‘profit margin’ Outline two factors that might cause business profits to fall in 2008 Discuss the possible effects of a decline in business profits for the economy as a whole A2 Economics

Using a cost and revenue diagram, show how a rise in variable costs can affect the profitability of a business in an imperfectly competitive market What is meant by price discounting? When might price discounting lead to an increase in total revenue? Explain how a fall in the value of the currency can affect business profitability