A dictionary of financial terms
World Finance presents a compendium of financial terms. Please, use the menu on the right side to find a term.
A document that must be published by public corporations, disclosing in full to shareholders and regulators the company’s operational and financial activities over the previous year. Annual reports must go unqualified by external auditors. In recent years, sustainability reports, as well as corporate governance reports, have become more popular.
All publicly listed companies publish an annual report on a specified date each year. Unilever, for example, published their 2012 report on 8 March 2013. It begins with a mission statement, some examples of its brands, before a lengthy chairman’s statement. This is followed by the CEO’s review, operational highlights, company strategy, and detailed financial accounts.
An officially appointed person or team who is responsible for determining the accuracy of business records. Auditors can be independent, affiliated to the company they are audition, or even public officials. The main role of the auditor is to ensure companies are maintaining accurate and verifiable records and statements.
An audit committee works in cooperation with a company’s CFO and controller and comprises a select few individuals whose responsibility it is to ensure auditors remain independent of management. All publicly traded US companies are required to support an audit committee in order to remain listed.
The requirements of an audit committee often vary in accordance with the governing body. For example, in the US the Sarbanes-Oxley Act demands that all members be independent and that companies disclose whether or not the committee contains a financial expert.
A balance sheet, otherwise termed a financial statement, lists a company’s assets, liabilities and shareholders’ equity at any given point in time. The constituents of the balance sheet are used to determine the net value of a business by combining shareholders’ equity and liabilities.
Royal Dutch Shell releases a quarterly balance sheet containing the company’s assets, liabilities and equity. Each of the three sections is divided into more specific categories (for example, non-current and current liabilities) and compiled yearly into a consolidated balance sheet.
A legal petition filed by an individual or business that is unable to repay outstanding debts. The process sees all of the debtor’s assets evaluated and employed to repay a portion of the outstanding debts, after which time the debtor is relieved of all previous obligations. Bankruptcy offers businesses a fresh start by forgiving unaffordable debts, while allowing creditors to regain some degree of repayment.
A recent example of a business going bankrupt would be British camera retailer Jessops, which announced in January 2013 that it was entering administration due to being unable to pay its debts. 187 stores were closed, 1,370 jobs were lost, and a company that had been on many UK high streets since 1935 ceased to trade.
The last line of a financial statement that reflects the net profit or loss of a company. The figure factors in total revenues, minus total expenses to give net earnings or overall profit. A business that is said to be raising its net earnings or decreasing its expenses is said to be "improving its bottom line."
Illegally paying a party in return for a financial or legal favour. Bribes are often given to public officials in a bid to escape legal convictions, or as incentive to overlook inhibiting legislation. Committing bribery is typically punishable with serious punitive action from regulatory officials.
In 2007, the US Justice Department settled charges against Lucent Technologies after the telecoms company decided not to report millions of dollars worth of travel expenses used by Chinese foreign officials working for state-controlled telecom companies. After admitting to their crimes, Lucent were fined $2.5m.
Cannibalisation is a term used to describe the negative impact of a new product on an existing product’s sales. Cannibalisation often occurs in a situation wherein a new product targets a similar market to that of an existing product, and can cause a product’s lifespan to end prematurely.
Apple used cannibalisation effectively when they released the iPad in 2010. Although its introduction curbed sales of the Macintosh computer, the product expanded the market for consumer computing hardware, creating greater opportunities for Apple.
This represents the price of an asset, including the cost it would take to acquire that asset. It also means that an expenditure is recorded as an asset, instead of as an expense, appearing on the balance sheet instead of the income statement.
Companies capitalise assets as a way of showing it to be a long-term asset, rather than as an expense. If a company were to buy a factory, it would spread the cost of it over a long period of time, as it would be used for more than just a single accounting period.
Cash flow statement
A quarterly financial report providing aggregate date on all cash inflows a company receives from ongoing operations and investments, as well as cash outflows. All publicly traded companies are required to file a cash flow statement, as traditional income statements do not necessarily reflect changes in a firm’s cash arrangements.
An example of a cash flow statement would show three sections, beginning with cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. Operating activities include production, sales and payments. Investing activities cover the purchase or sale of an asset, as well as loans. Financing activities include cash coming from investors and dividend payouts.
Compliance is an organisation or individual’s ability to accord with a given specification, policy, standard or law set by a specific governing body. Compliance has recently emerged as a far greater concern for businesses, given the recent proliferation of regulatory standards.
A compliance audit entails the verification of a given company’s adherence to mandatory guidelines concerning regulatory, finance, IT, manufacturing and HR matters. The procedure is principally undertaken by an external body but may be conducted internally on certain occasions.
The UK Environment Agency asks that companies use their own metre readings as primary evidence and perform other comprehensive energy checks to prove they comply with the organisation’s Energy Efficiency Scheme.
A financial controller who oversees reporting procedures and financial methodologies for a corporation or governing body. Before publishing, accountants tend to pass on a company’s financial statements to the comptroller, who ensures a report’s accuracy and adherence to corporate and regulatory standards.
The role a business plays in its community, in both an economic and social sense. Particularly important nowadays, it takes a prominent role in company reports, and increasingly firms are eager to promote themselves as having strong ties to their communities.
Many companies claim to be good corporate citizens, but one leading example would be computing giant IBM, which dedicates much of its resources towards environmental, community, educational and health causes around the world. It has won a number of awards for ensuring its Integrated Supply Chain (ISC) makes high-quality, energy efficient products.
A debt obligation that comes attached with coupons representative of semi-annual interest payments. Coupon bonds are also sometimes referred to as bearer bonds. When acquiring a coupon bond, the issuer retains no record of the buyer’s identity, and their name is not printed on the certificate.
A person or entity that extends credit to another person or entity, usually in the form of lending or advancing money. A ‘real’ creditor- bank or financial company- will have legal contracts allowing it to collect any of the debtor’s assets if he or she fails to pay back a loan.
Day of grant
The day on which a key employee is granted a stock option. This issuance usually takes place under a contractual stock plan, and grants the employee the right to purchase a capped number of company shares at a predetermined price. Contracted employees must typically wait an extended period of time before they are granted permission to use any predetermined stock options.
The proportion of debt a company has relative to its assets. Calculated by a simple formula, a debt ratio above 1 means a company has more debt than assets. If the ratio is less than one, the company has more assets. The measure is useful to determine how leveraged a company is and its level of risk, when applied with other measures of financial soundness.
This refers to an individual, government or business that owes a debt to another entity. A debt, issued by a financial institution e.g. a bank, is called a loan and the debtor is referred to as a borrower. If a debt is issued in the form of securities e.g. bonds, then the debtor is referred to as an issuer.
A person takes on a debt – for example, a mortgage to purchase a house. That individual is known as the debtor and the bank that issued the mortgage is the creditor.
Defined benefit pensions
Defined benefit pensions are employer-sponsored retirement plans determined by salary history and duration of employment. Investment risk is entirely at the company’s discretion, though in the event of a funding shortfall employees are permitted to draw on the company’s earnings to supplement the difference.
example‘Final salary’ formula:
A defined-contribution plan entails a specific percentage of an employee’s salary being put aside by an employer, and although the employee contribution is fixed the resulting sum is not. The withdrawal of these funds comes with certain restrictions, which if impeded will result in a financial penalty.
The company enters into an employment contract with a select number of employees, who are each required to contribute one average monthly salary; the company then pays the participants’ average annual salary into a trust which is managed on the employee’s behalf. Contributions are not subject to any future changes to salary or inflation.
Depreciation is a term used to measure the loss of a tangible asset’s value over time and is often cited when referencing any deductions brought about by unfavourable market conditions. If an asset is anticipated to lose its value after ten years then it will be depreciated after ten years.
exampleStraight-line depreciation method:
Financial instruments whose value is ‘derived’ from the value of an underlying asset, such as a commodity, index, or interest rate. A derivative is simply a contract between two entities. Futures contracts are a common form of derivative and are instruments used to hedge risk, but can be used for speculative purposes.
Forward contracts Future contracts Options contracts Interest rate swaps Currency swaps
Directors are charged with running specific departments and reporting to the shareholders that appoint them. Elected at annual meetings, directors serve fixed terms before being nominated for re-election. Directly involved in the running of the business, they are also liable for those actions.
Company directors do not have to own any part of the business, and they are not restricted to the number of other companies they can be directors of. For example, in 2013 Australian investment banker Carolyn Hewson sits on the boards of four leading Australian listed companies with a combined market capitalisation of nearly A$209bn.
The act of making public or releasing all information by a company that may affect investment decisions, in the interest of fairness. Companies must meet disclosure standards in order to be listed in major stock exchanges. Brokerage firms, analysts and other financial institutions must also meet disclosure standards to avoid disputes over conflict of interest.
The interest rate used to determine a firm’s present value of future cash flows. This rate is set by taking into consideration the time value of funds and the risk of a company’s forecast for future cash flows. A discount rate also describes that interest rate a depository institution is charged to borrow short-term funds from a government’s central reserve bank, although this method of borrowing is relatively rare.
exampleYou want to calculate the present value of $5,000, due in one year’s time, when the discount rate is 10 percent:
Discounted cash flow rate of return
The rate of return an investor is projected to see on a company’s discounted cash flow. This is determined by using future cash flow estimates and discounting them down to a present value. Discounted cash flows are used to evaluate an investment’s potential. If the resulting figure is higher than an investment’s current cost, the rate of return should be higher.
Is a technique for managing a portfolio’s risk through investment in a variety of different assets. It is important to note that diversification yields the best results when investments are not correlated. For example mixing between domestic securities and foreign ones pose a lower risk as the two are not as closely linked.
An investor has $2m. He invests $1m in company ABC and $1m in company XYZ. Company ABC’s stock falls from $5 to $2.50, while company XYZs stock rises from $6 to $7.50. In this example the portfolio falls from $2m to $1.75m, which is a loss. However, had all the money been placed on company ABC he would have lost $1m.
Otherwise referred to as Dividend Per Share (DPS), dividends are a portion of the company’s earnings allocated to shareholders and decided upon by the board. The sum is typically paid out on a quarterly basis and is drawn from the company’s reserves.
Dividends can take the form of cash, stock or property. Stable companies usually offer dividends to investors because of their largely unchanging share price. Alternatively, rapidly expanding companies pay few dividends and instead reinvest their profits to sustain a high growth rate.
A measure used to determine how well a company uses its assets and liabilities internally. Efficiency ratios can calculate a number of measures from turnover of receivables to the quantity and usage of equity. These ratios are useful when compared to the same figures in similar companies in order to identify what businesses are better run, and target management improvements.
A technical evaluation of energy consumption in a business to monitor usage patterns. Energy audits usually aim at identifying where energy consumption savings can be made and efficiency increased. Energy audits can be carried out internally, or by an unaffiliated auditor.
A stake in a public business that, in finance terms, counts as ownership of an asset once all debts are considered. Stocks are referred to as equity, and are traded on the stock market. It is the most junior class of asset.
Equity is the remaining interests in the assets of a business, once liabilities have been deducted. Examples of equity include ordinary share capital, preference share capital, retained earnings and revaluation surpluses.
Equity Yield Ratio
Used to determine the percentage an investor earns on their shares through dividends. It allows a stock to be evaluated in relation to bonds. The Bond Equity Earnings Yield Ratio (BEER) helps investors see the correlation between earnings yields and bond yields.
The formula for working out what sort of dividend a share will yield is as follows:
Equity Yield Ratio = Dividend per Share/Earnings per share
For example, if Apple earned $2 per share in 2013 when it paid $1 per share as dividends, then its EQY would be 50 percent.
The last day (in America) or the only day (in Europe) when a specific option may be exercised- that is the final or only day when a holder can implement his or her right over an option to buy or sell an underlying security.
Exercise period (options)
The exercise period is determined by the option style and defines what circumstances the holder of an option can exercise it. European-style options can only be exercised on the expiration date. American-style options can be exercised at any point up to the expiration date and Bermudan-style options only on specified dates.
Fair value is the approximate value of a company’s assets and liabilities and is most often used to formulate a financial statement in the event of an acquisition. Fair value encompasses a range of objective and subjective factors in allocating a market price to what ultimately remains an indeterminate asset.
Fair value encompasses a range of factors: projected growth rates, profit margins, risk characteristics, supply and demand, and cost of capital. Each factor is analysed to formulate a fair market price for goods and services.
First in, first out. A valuation method used by corporations and asset managers that ensures all assets are used or disposed of in the order they were acquired. The FIFO method is often utilised for tax minimisation purposes, as it assumes all assets remaining in inventory match recently acquired assets.
At the beginning of the month a stationary store buys 20 notebooks costing $1 each. Later, the store buys 30 folders costing $5 each. At the end of the month the store has sold 20 items in total making $100 in revenue. Under FIFO the first item added to an inventory is the first recorded as sold.
A budget calculated to reflect different rates of production, sales, revenue based on different levels of output. Flexible budgets often reallocate funds along the year as different expectations are met or missed. A flexible budget will change according to what production or sales are actually achieved.
Footnotes are additional bits of information in financial statements, kept separate from the main bulk of information. This is usually done so that they don’t confuse the key information, but included to ensure full disclosure of information. They also provide context for the financial statements.
Examples of footnotes within a financial statement can include accounting policies, investments, liabilities, fixed assets, nonmonetary transactions, risks and uncertainties, goodwill and intangibles, and pensions. They are designed to offer a full, detailed account of the business’s financial picture.
A wrongful deception made with the intent to obtain personal or financial gain. In the corporate world, this amounts to the reporting of any fraudulent figures or misrepresentations, such as claiming on a false tax deduction, which may give the perpetrating company an unfair economic advantage over its competitors.
A variety of remuneration add-ons that are provided by employers, but not considered a part of a salary and therefore not generally subject to taxation. They commonly include health insurance, life coverage, education reimbursement, childcare and meal plans, among other things. Can be used by employers to make an overall remuneration package more attractive to prospective employees.
General accepted accounting principles are the standard guidelines for financial accounting in a certain jurisdiction, and set out how financial statements should be presented. While each country has its own guidelines, there have been moves recently to create a standardised set by the International Financial Reporting Standards Board.
Examples of international GAAP include the assumption that the business is separate from the personal affairs of its owner, that the business is a continuing concern; the accounts are fair and reasonable, they are written objectively, they cover a specific time period, and they are consistent with previous accounts.
This is the ratio between a business’s long-term debts with its equity capital. It explains how a company is financing its operations through debt. A company with a high level of gearing would be considered speculative, as it has more debt than shareholder equity.
Companies that look to gear their businesses often take out a loan that allows them to pay for an expansion of their operations. For example, if a company were to take out a loan to pay for a new factory. The level of gearing – or leverage – would be calculated through a ratio such as a debt-to-equity ratio.
Gross Profit Margin
Acts as a measurement of a company’s financial well-being, in relation to its competitors and is determined by calculating the difference between revenue and the cost of goods sold (production costs). A company with a good profit margin means it will be able to pay its operating costs and reinvest profits to help the company grow.
A company makes $50,000 in sales, while the cost of the goods sold equals $30,000. $50,000 minus $30,000 equals a gross profit of $20,000. Divide that number by $50,000 (total sales) to give a gross profit margin of 0.4 (40 percent). Meaning 40 cents from each dollar made can be used to cover basic operating costs and profit.
Rate at which any given variable has or is expected to grow over a specific period of time. Different industries consider different benchmark rates for growth. The most common growth rate measures the percentage increase in value of a variable – a country’s economy or company’s earnings- has increased over one year.
The halo effect is a marketing term used to describe a positive consumer bias towards a certain product based upon past experiences of the maker or manufacturer. The phenomenon is principally driven by brand equity and is vital in building a lasting customer base.
Apple built a positive customer association with the critically acclaimed iPod, which then bolstered sales of related Apple products such as the Macintosh computer and the iPad.
An investment made to offset the risk of price fluctuations in an underlying asset. A common strategy is to purchase futures contracts. If an investor is long a particular stock and wants to hedge against unexpected price movements, they could take a short position in the futures market, limit risk.
In August, the spot price for oil is $6.50 per barrel. An oil producer fears the price will fall. Currently, oil futures in September trade at $7 per barrel; she wants to lock in this selling price. She takes a short position in the futures market. By mid-August oil prices have declined $6 per barrel, but by hedging in the futures market, she is unaffected by the price.
When a company targets another with the intention of acquiring it, without the agreement of management of that company. Hostile takeovers usually occur when the buying company goes straight to the shareholders of its target with a tender offer, because the management of the target company does not want to be sold.
While there have been plenty of examples of hostile takeovers across many industries, one of the leading instances was when French pharmaceutical giant Sanofi-Sythelabo made a hostile takeover bid for rival Aventis in 2004. The bid, worth €47.8bn, was initially rejected by the Aventis board, before pressure led them to accepting a raised bid of €54.5bn.
Impairment represents the reduction in an assets’ value, usually due to it missing its estimated gain or loss. This can be caused by fluctuations in the market value of the asset, or an adverse business environment. An impaired asset is usually worth less on the market than how it is listen on the balance sheet.
If a company has an asset that it estimates to be worth $50,000, but if by the time of the accounts are released the market value of that asset has fallen to $40,000, then it will be shown has having an impairment cost of the difference (ie. $10,000).
Usually refers to auditor independence, and the need for auditors to have an objective approach to the audit process. Auditors must be independent from parties that may have financial interests in the business or company being audited. The concept of independence means the auditor carries out his or her duties freely and in an objective and unbiased way.
An integrated audit is a necessary process for publicly listed companies requiring that an external body assess a company’s financial statements and their internal capacity for legitimate financial reporting. The practice is intended to measure a company’s compliance with PCAOB auditing standards.
Interest is a fee paid on borrowed assets. The interest rate is the amount charged, expressed as a percentage of the original borrowed assets, by a lender, over time. Interest rates are usually noted on an annual basis. It can be thought of as compensation paid by the borrower to the lender for access to the principal.
Interest tax shield
An interest tax shield is the lesser extent of tax liabilities resulting from the tax-deductibility of interest payments on a company’s taxable income. Tax shields are often used as a means of maintaining cash flow and, as such, are effective in growing a business’s valuation.
Drawing on tax deductions such as mortgage interest, medical expenses, charitable donations, amortisation and depreciation reduces taxable income and delays tax on those factors.
International Accounting Standards Board
Founded in 2001 the IASB is an independent accounting standards body that is dedicated to developing and promoting a standardised set of accounting rules across the world. More than 100 countries currently require businesses to adhere to IASB standards. Based in London, it has 15 members on its board.
The IASB issues International Financial Reporting Standards that are adopted by jurisdictions around the world. The three basic accounting models allowed by IFRS include current cost accounting, financial capital maintenance in nominal monetary units, and financial capital maintenance in units of constant purchasing power.
Also known as fundamental value, it refers to the true value of a particular asset, or company based on the perception of both tangible and intangible features. The value is commonly calculated by discounting the present value from the potential income created by the asset, or company.
A software company’s stock is valued at $10 a share. News begins to circulate it will be launching a new product and bringing in leading programmers to develop it. This information will lead to investors calculating the intrinsic value of the stock at a higher price than it is currently being traded.
An investment multiplier abides by the principle that any increases in public or private investment will have a more than proportionate effect on cumulative incomes and the economy at large. In short, an investment multiplier attempts to measure the extent by which input generates output.
If a staff’s combined wages equate to $10m, the recipients’ disposable income will rise accordingly and be spent on goods, which will in turn generate demand. If the recipients were to spend $20m in total (double that of the initial sum), the multiplier would be two.
It refers to the department within a business that is devoted to supplying investors, both potential and existing with detailed information regarding the company’s affairs. It is designed to help shareholders make informed decisions on whether to buy or sell stocks in the company.
An investor is thinking about purchasing stocks in a company, but wants to make an informed decision. They can contact the company’s Investor Relations (IR) department, which will provide a detailed overview of the business. Another important role of the IR department is to liaise with investment analysts and institutional investors.
Internal Rate of Return. A discount rate used in capital budgeting that makes the net present value of cash flows in and out of one particular project or investment equal to zero. Projects with a higher IRR are typically prioritised by firms, as they tend to be safer investments. An IRR can sometimes be referred to as an Economic Rate of Return.
A company needs to buy some equipment for $300,000 which will only last three years, but will generate additional annual profit of $150,000 during those years. It can sell the equipment for $10,000 at the end of the three years. The IRR can be used to calculate whether buying the equipment is worthwhile over alternative investments that would generate increased profits of ten percent.
The equation is:
0 = -$300,000 + ($150,000)/(1+0.2431) + ($150,000)/(1+0.2431)2 + ($150,000)/(1+0.2431)3 + $10,000/(1+0.2431)4
The IRR is 24.31 percent.
Last In, First Out (LIFO)
Is an accounting technique used to manage inventory levels and the level of money tied up in the goods that makeup that inventory and used to reduce income tax. It assumes that the most recently acquired or produced items, will be the first ones to be used, sold or disposed of first.
At the beginning of the month a stationary store buys 20 notebooks costing $1 each. Later on the store buys 30 folders costing $5 each. At the end of the month the store has sold 20 items in total making $100 in revenue. Under LIFO the last item added to an inventory is the first recorded as sold.
Legally binding obligations a company has to settle debts. Listed on balance sheets, they can include accounts deferred revenues, payable, wages expense, and taxes. They are also split between current liabilities, which must be paid off within one year, and long-term liabilities, which are spread over a number of years.
Different liabilities include notes payable (written promises), accounts payable (oral promises), interests payable, sales payable, salaries payable, unclaimed dividends, and long or short term loans. For example, in order to borrow $10,000 from a bank, an authorised company representative must sign a formal loan agreement before the bank will give the money.
The level to which an asset or security can be traded on a market without fluctuating price, or the degree to which an asset can be quickly converted into cash. Liquid assets are inevitably safer investments than illiquid assets, as they can be easily bought or sold for cash. Empirical examples may include money market securities or other widely traded stocks.
If a company is able to meet all of its payment needs, either through having readily available cash or easy access to a loan, then it is seen as having liquidity. For example, Apple is said to have well over $100bn in cash reserves, allowing it to spend and invest freely, as well as covering any liabilities.
The term is used to refer to an individual or group of investors working in partnership, whose total voting share in a company is large enough that no other individual or block of shareholders can oppose a motion. Typically the investor(s) control 50 percent, plus one of total shares.
When a single investor owns 34 percent or more of the voting shares they have majority (controlling) interest. A two-thirds majority is required to approve a motion, which is presented to shareholders. Without that investor’s consent, no motion can be passed.
Management accounting, otherwise termed cost accounting, is the process of interpreting and relaying information deemed essential in the completion of an organisation’s given objectives. The process is often reverted to in supporting strategic business decisions at an executive level.
Management accounting consists of inventory costs, job costing, process costing, standard costing and joint costs, which are used to correctly calculate and assign company costs.
Also known as the going rate, it refers to the cost of specific goods or services in a free market. This price will naturally fluctuate based on supply and demand. Put simply if demand for a particular good or service goes up the price tends to increase accordingly and vice versa.
A good example is the housing market. An individual may put their home on the market at $500,000, but buyers may only be willing to pay $400,000. Thus, the market rate is $400,000.
A combination of two companies through an offer to stakeholders in one company shares in the other. It is usually arranged through mutual negotiations between the boards of each company, and is designed to create a business that will have a stronger presence in its industry.
One of the largest mergers in the entertainment industry occurred in 2006, when the Walt Disney company bought animation firm Pixar for $7.4bn in an all-share deal. The merge resulted in then Pixar – and Apple – CEO Steve Jobs joining Disney’s board of directors.
The term is used to refer to an individual or group of investors working in partnership whose ownership in a company, although significant, equates to less than 50 percent of total voting shares and as a result does not a control of that company.
Company A owns 80 percent of company Z, which is a $200m company. There would be a $40m liability in minority interest. This would symbolize the 20 percent of company Z, which company A does not have ownership, nor control of.
A brief statement outlining the purpose and goals of a company, explaining the company framework, strategies and decision-making process. Designed to both explain to investors what principles the company stands for, as well as making sure employees are focused on the company goals.
An example of a mission statement can be seen from food giant McDonald’s: “McDonald’s brand mission is to be our customers’ favourite place and way to eat and drink. Our worldwide operations are aligned around a global strategy called the Plan to Win, which center on an exceptional customer experience – People, Products, Place, Price and Promotion. We are committed continuously improving our operations and enhancing our customers’ experience.”
A mutual fund is a single investment vehicle comprising a number of funds from a select few investors. The fund is aligned with a specific objective dictated by the investors and is maintained by a money manager, whose job it is to invest in securities with the ultimate intention of yielding profits.
Mutual funds can be split into categories: money market funds, bond/income funds, balanced funds, equity funds, global/international funds, specialty funds and index funds. Each type has a specific purpose or strategy and attracts clients with similar objectives.
Net current assets
Also known as net working capital. A financial metric that determines a companies efficiency and short-term financial soundness.
Net working capital = Current assets – current liabilities.
If a companies assets do not exceed its liabilities then it might face a capital shortage in the short-term. Money that is invested or owed to a company cannot be considered in the equation because it cannot be used to pay off financial obligations.
Net present value
The difference between the present value of cash inflows and the present value of cash outflows. Calculated through a formula, net present value compares the value of an asset today to its value in the future.
exampleRt (1 + i)t
If the result is positive, it means an asset is increasing in value, if it is negative the asset is losing value with time. NPV is used for capital budgeting to measure excess shortfalls of cash flows.
It is an accounting term whereby the basis of a company’s financial statement must be supported by verifiable evidence as opposed to opinion or speculation. This stipulation helps in providing reliability to the information contained in the company’s financial statement.
A company invests in a large plot of land, which costs $100,000. Over time the price naturally appreciates in value. But, as stated by the objectivity principle, accounting figures should be based on fact. Meaning the original value is the only figure that can appear on the company balance sheet, not the perceived market value.
Simply put, opportunity costs refer to the hypothetical costs of taking an alternative course of action in business. The extent of the loss is calculated by subtracting the real profits from the potential gains and is often used as a measure of managerial shrewdness or short sightedness.
If you were paid an hourly rate of $1000 and could either employ a gardener to maintain your garden for $1500 or pay $500 for the tools and take four hours to do it yourself, the cost of four hours lost wages would be $4000, overall equating to an opportunity cost of $3000.
An audit performed by an outside accounting firm that verifies the authenticity performance figures of an asset manager’s aggregate results. Asset managers must maintain a degree of transparency in the financial results of their clientele in line with the CFA Institute’s global investment performance standards.
There is a tendency for managers to pick out favourable figures in order to meet expectations and a performance audit acts as a check against this.
A policy designed to increase opportunities for those of a certain race, sex, religion or other uncontrollable attribute that may be underrepresented in business of other areas of society. Often used as a means to counter historical discrimination, the validity and effectiveness of positive discrimination laws are heavily contested throughout the US and Europe.
Also known as price multiple or earnings multiple, the term refers to a valuation ratio used to analyse the stock valuation of a company’s shares in relation to the income the company generates. Calculated as: Market Value per Share divided by Earnings per Share (EPS).
A high price-earnings ratio means an investor expects high earnings growth. It shows how much an investor pays per dollar of earnings. For example, a company with a price-earnings ratio of 25 will attract an investor willing to pay $25 for $1 of current earnings.
Profit & loss account
A statement providing information on a company’s income and expenditures during a specific time period, usually quarterly or annually. Much like a balance sheet, a profit and loss account gives investors the ability to see an outline of revenue and the profits or losses a company has generated.
An agent that is legally authorised, usually through a power of attorney document, to act on the behalf of another party. A proxy is often used by shareholders unable to attend an AGM so that the absent investor may still cast their vote on corporate governance issues.
When Hewlett Packard attempted to acquire computing rival Compaq for $24.2bn, a proxy battle emerged between a number of large HP shareholders that were opposed to the deal, including the sons of the company’s founder, Walter Hewlett and David W. Packard. They were acting on behalf of a number of other shareholders, but the deal did eventually pass.
The time period surrounding a company’s AGM, thus named because so many investors tend to vote on key issues by proxy. Many companies will send shareholders a proxy statement prior to an AGM, explaining upcoming key issues and giving investors the opportunity to vote by returning a proxy ballot. The votes of shareholders who fail to vote by proxy tend to be counted in favour of the management.
The 2013 proxy season saw a focus on governance-related issues, most prominently the declassification of boards, the introduction of majority voting, the elimination of super majority requirements, the separation of CEO and chair roles, and the capacity to call impromptu meetings and actions by written consent.
A formal report issued by an internal or independent auditor that allows potential investors to review a company’s financials through a third party. This allows for an independent take on a company, in turn making it easier for auditees to attract investors and obtain loans.
A systematic, quarterly examination of a company’s processes, records and other activities. A quarterly audit ensures a company maintains clearly defined internal monitoring procedures that are linked to effective action. Audits are vital in order to satisfy regulatory concerns, and can also help the management to track and monitor company progress.
A quarterly filing that informs shareholders of a public company’s financial performance. A quarterly report will typically include information on the company’s net income, net sales, earnings from operations and EPS. Quarterly reports are usually filed in January, April, July and October.
Regular health checks
A statement containing a general update on a company’s financials, along with advice pertaining to noticeable hurdles and potential resolutions. Regular health checks are common especially amongst pension funds, and are typically conducted on a quarterly, biannual or yearly basis.
A health check addresses:
People, management and culture
Innovation/ ideas and IT
Marketing and sales
Operations and systems
(The PRIMO-F model was constructed using resources from the Durham University Business School)
Real estate investment trusts. Securities that invest directly in real estate via equities, mortgages or a hybrid of both. REITs are a highly liquid way to invest in real estate, and typically offer high yields. Most REITs can be bought directly on an open exchange, and come equipped with a dividend reinvestment plan.
Real Estate Investment Trusts can be found around the world. Some of the leading examples include the US-based Simon Property Group, which has assets worth more than $26.21bn and interests in 393 properties across the world. It is listed on the NYSE.
The money a company keeps on hand to meet short-term funding obligations or emergency needs, or a short-term liquid investment that can be quickly turned into cash if needed. Individuals are widely recommended to maintain an eight-month reserve fund in case of emergency.
Reserves are amounts of money saved for long-term investment projects. Apple is said to have cash reserves of over $100bn, which it uses for occasional strategic acquisitions or, more recently, paying out dividends to shareholders.
Residual equity shares
Residual equity is calculated by subtracting the debt claims from a firm’s total assets. Because equity holders are the last in line to be repaid by a company, they tend to take on the greatest risk by investing in shares. Residual equity is one of several theoretical approaches to investing, along with proprietary and entity shares.
Return on equity
A ratio measuring the return generated on shareholders’ equity. ROE is calculated by dividing the firm’s net income by the equity of shareholders, and is a useful ratio to determine how a company’s profitability compares to its competitors. High growth companies tend to produce a higher ROE.
Imagine net assets of two firms are equal to $100. But the net profit of firm A is $5 and firm B is $20. This would make the ROE five percent for A and 20 percent for B. Net assets of firm A would go from $100 to $125 in five years; meanwhile firm B will go from $100 to $200 in the same period.
The possibility that the actual return on an investment will be less than expected, including losing some or all of an original investment. Risk is calculated by measuring the standard deviation of historical or average returns for a specific investment. In general, high-risk investments tend to produce greater potential returns.
Return on investment. This is a performance measure used to evaluate the profitability of an investment. ROI is calculated as a percentage or ratio based upon the benefit of an investment, divided by the cost. The result of that calculation provides would-be investors with a simple determination as to the worth of any given investment opportunity.
Return on investment (ROI) = (net profit / cost of investment) x 100
If an investor bought $100 of stocks and sold them a year later for $150, the net profit would be $50. The ROI would be calculated as:
(50 / 100) x 100 = 50%
Return on total assets. This is a ratio that measures a company’s total net assets against its earnings before interest and taxes. The resulting coefficient indicates how effectively a company utilises assets to generate earnings. The greater a company’s earnings are in proportion to its assets, the more effectively its assets are being used.
Return on total assets (ROTA) = (net income / total assets)A number of investors include interest expense in net income to find operating returns before the cost of borrowing.
A 2002 law passed by US Congress that protects investors from exposure to the risk of fraudulent accounting by a corporation. The Sarbanes-Oxley Act was established in response to the accounting scandals that took place at firms such as Enron and Worldcom, and requires a company’s senior management to establish internal controls and certify the accuracy of all financial statements.
Enron was one of a number of large public companies that caused the passing of the Sarbanes-Oxley Act (SOX). It misrepresented earnings reports and embezzled money, leading to investors losing vast sums. SOX improved standards of corporate disclosure and accountability, and introduced fines for companies who fail to meet standards.
An individual, company or institution that holds stock in a firm. In a publicly-traded company, each shareholder that purchases a stock in that company becomes its part-owner. Consequently, shareholders earn dividends and voting rights based upon their level of investment.
A shareholder can be any person or institution that owns at least one share of a company. For example, an individual could have one share in Microsoft worth around $0.32, whereas founder Bill Gates has just under 400m shares around $13bn, and The Vanguard Group has around 350m shares worth $12bn.
A privilege that gives company shareholders the right to buy or sell a stock at a predetermined price and date. Stock options are often sold between parties or offered to employees as a means of long-term remuneration. Most stock options can be exercised anytime between the date of purchase and its expiration date.
If you don’t have the money to buy a $100,000 property you could negotiate a deal that allows you to buy it at a later date, provided you pay an immediate $1000 for the option. Regardless of any upward fluctuations in price up until that point, the owner is obligated to sell you the property for $100,000 because of the $1000 option.
Any excess amount received by a firm against the par value of its shares. Share premiums form a part of a company’s non-distributable reserves, and can only be used under a predefined bylaws. Share premiums are usually presented in a balance sheet as part of a company’s equity capital, and are sometimes referred to as a paid-in surplus.
A company sells 1000 shares of its $1 par value common stock at $10 a share. $1000 of the $10,000 would be recorded in the Common Stock account, while the remaining $9000 is recorded in the share premium account. A company obtains a share premium by selling stocks above the par value.
A form of compensation in which a company’s employees are given equity ownership rights. These rights typically come associated with caveats, including a vesting period and certain criteria for reselling shares. Share-based remuneration is often pursued with a view to increase overall company performance by aligning the interests of its employees, managers and shareholders alike.
Placing an excessive focus on short-term profit, at the likely expense of long-term interests. This type of nearsighted business approach can often destroy a company’s market value and discourage long-term investment. Short-termism is most often driven by profit maximisation and accounting-driven metrics.
An example of short-termism can be found in the current economic recession. The obsession of financial institutions and governments chasing the quarterly report has led to short-term gains at the expense of long-term economic stability. Managers will often neglect investment in R&D and skilled staff in order to hit quarterly targets.
A security representing partial ownership of a corporation and a claim on part of that firm’s earnings and assets. Also known as shares or equity, stocks are issued by companies with a view to raise money for new projects. In turn, investors who buy stock in a company earn voting rights in major decisions, as well as annual dividends on their investment.
The two main types of stock are common and preferred, both of which are similar. The key difference is when a company is wound up or declared bankrupt. Preferred stocks will receive payment first, before whatever proceeds left from the liquidation of the company are allocated to common stock holders. In the case of Jessops, preferred stock holders would have taken priority over common stock holders.
The process of identifying and developing a talent pool of internal candidates able to assume key roles if and when current company leaders become obsolete or otherwise incapacitated. Adequate succession planning ensures for a swift transition of power that does not affect a company’s functionality or services.
A corporate strategy that attempts to manage risks derived from environmental and societal issues. Unlike corporate social responsibility, sustainability combats company-related issues with a forward trajectory. In building upon its corporate sustainability, a company is generally able to drive growth indirectly by improving community relations.
A company’s gross sales or revenues, thus named because this information is generally reserved for the opening line of a company’s income statements. The top line is directly contrasted by a company’s bottom line, which encompasses a company’s net earnings per share.
If a company sells $500,000 of goods, its top line will be $500,000. From this number it is possible to derive the net sales value, which is the top line including discounts and returns. For example, if the company gave $25,000 in discounts and customers returned $2,000 of goods, then net sales would equal $473,000.
The level of access a company gives to its investors and the public concerning key financials, such as price levels, market depth and audit reports. This free flow of information helps to prevent corruption and tends to reduce price volatility. Some degree of transparency is enforced by federal regulations across most jurisdictions.
Those companies that freely publish as much information as possible in the reports, including negative information, can be considered transparent. Norwegian oil firm Statoil is considered to be one of the most transparent companies in the world, frequently publishing information about its anti-corruption programmes, subsidiaries and tax policies.
The predetermined date at which an individual earns the right to exercise their full stock options, profit sharing or retirement benefits. Some companies offer their employees full vestment on a gradual schedule, while others require employees to wait until the options have fully matured.
The time period for which stockholder must wait before they are able to exercise options in full. This definition most often applies to employees receiving share-based payments. During an employee’s vesting period, they accrue non-forfeitable rights and options, often pertaining to their pension plan.
Any person how reports insider knowledge of illegal activities being conducted at an organisation. A whistleblower could be a company employee, contractor, client, supplier or anyone else who has become aware of illicit behaviour. In most jurisdictions, whistleblowers are protected by various regulatory bodies against acts of retaliation.
One of the most high profile, recent examples of a corporate whistleblower would be Olympus’s former CEO Michael Woodford, who lasted in his job a mere two weeks in October 2011. He had uncovered evidence of large-scale corruption by the board of the Japanese electronic giant, which he revealed to investigators in the US and Europe.
A ratio that measures a company’s efficiency and short-term financial stability. Working capital is found by subtracting a company’s current liabilities from its current assets. The resulting ratio demonstrated whether a company possesses enough assets to cover its debts in the short-term. Companies with a negative working capital ratio may find themselves unable to repay creditors, potentially leading to bankruptcy.
Current assets – Current liabilities = Working capital
If a company has current assets of $100,000 and current liabilities of $20,000 then the company’s working capital is $80,000.
The dividends or interest investors receive from a security. Yields are generally expressed as an annual percentage, based upon a given investment’s face value and general costs. In general, there are four different types of bond yields: coupon, current, yield-to-maturity and tax-equivalent. Variations of each yield pertain primarily to fluctuations in interest rates and maturity arrangements.
In the case of bonds, the yield is calculated as follows:
Bond Yield = Coupon Rate / Current Market Price of Bond.
For example, if an investor pays $500 for a bond with a par value of $600 that pays 10 percent interest, or $60 per year. The yield would be 12 percent ($60 / 500 = 0.12).
Yield to maturity ratio
The rate of return a bondholder receives, if held until its maturity date. Yield to maturity ratios are expressed as a long-term, annual rate, and are calculated using a bond’s current market price, coupon interest rate, par value and time to maturity.