Glossary
All items in italics are defined elsewhere in the glossary
Acid test See quick ratio.
Activity ratios These measure the relationship between key assets and sales. They express how well assets are being utilized. For instance, ‘accounts receivable days’ (see debtor days) shows how long cash is tied up in accounts receivable; likewise inventory days. We use the sales to fixed assets ratio to give a measure of the output being generated by major fixed assets. The term ‘asset utilization ratios’ is also used in this context.
Amortization of loan The repayment of a loan by equal periodic payments that include both interest on outstanding balance plus some repayment of principal.
Annuity A series of equal payments made at equal intervals of time. Many financial calculations can be treated by the annuity formulae, for example repayment of a term loan, straight line depreciation charges, and so on.
Arbitrage The operation of buying and selling a security simultaneously in two different markets to take advantage of inconsistencies in pricing.
Asset backing Also known as ‘asset value per share’, it is calculated by dividing total ordinary funds in the balance sheet by the number of issued ordinary shares.
Asset utilization ratios See activity ratios.
Asset value per share See asset backing.
Authorized share capital The maximum value of share capital that can be issued. It is specified in the company Articles and can be increased only by permission of the shareholders.
Average collection period As debtor days.
Average interest rate paid The apparent rate of interest paid on loans, calculated by expressing the interest charge in the profit and loss account as a percentage of loan funds in the balance sheet. It must be kept in mind that loans at the balance sheet date may not be a true reflection of the average over the year.
Bear Term for an investor who anticipates a falling market in financial securities. This investor may sell securities not owned in order to profit from the expected drop in price. See also bull.
Beta value A measure of the risk in a share that cannot be eliminated by diversification. High risk brings the need for a high return. Therefore the beta value is used by analysts to derive an appropriate share value.
Blue chip A first-class commercial security.
Bond US term for medium- to long-term loan. Legally it is the certificate that gives the holder the right to periodic interest payments and repayment of principal.
Bonus issue New equity shares issued from reserves and given free to company shareholders in proportion to their existing share holdings.
Book value per share The value of a share based on the balance sheet values. See also asset backing.
Borrowing ratio Long-term plus short-term loans expressed as a percentage of ordinary funds plus preference shares less intangibles.
Break-even analysis A form of analysis that relates activity to totals of revenue and costs based on the classification of costs into fixed and variable types.
Break-even point The level of activity at which the fixed costs of an operation are just covered by the contribution from sales. At this point neither a profit nor a loss ensues.
Bull An investor who anticipates a rise in the price level of financial securities. This investor may purchase securities with the intention of resale before the time for settlement is due. See also bear.
Bullet A single payment of the total amount of a loan at the end of the period (as opposed to periodic payments during its life).
Call The amount demanded from shareholders from the balance outstanding on non-paid-up shares.
Call option An option to purchase. See also option.
Capital asset pricing model (CAPM) A model that links risk and return for all types of security. Applied to the valuation of equity shares, it uses the risk coefficient (beta value) of the share to calculate the required risk premium. This risk premium is added to the risk-free rate (rate on gilts) to give the appropriate yield for the share.
Capital employed The total of the long-term funds in the balance sheet. It includes shareholders’ funds, long-term loans, preference shares, minority interests and miscellaneous long-term funds. It can also be expressed as total assets less current liabilities.
Capital market The financial market for long-term securities.
Capital project appraisal Evaluation of expenditure on capital assets to establish its rate of return with a view to deciding on whether or not to make the investment.
Capital reserves Shareholders’ funds that have originated from sources other than trading or the nominal value of new issues.
Capital structure The mix of financing in a company. It usually refers to the proportions of debt and equity in the balance sheet.
Cash cycle A model of working capital cash flow that identifies the time required for cash paid out for raw materials and expenses to come back in from accounts receivable.
Cash flow, incremental The extra cash in-flow or out-flow that comes from selecting one alternative over another in capital project appraisal.
Cash flow per share Profit after interest, tax, minority and preference dividends plus depreciation divided by the number of shares.
Caveat emptor ‘Let the buyer beware’ – an expression that emphasizes the duty of a party to a contract to ensure that his interests are protected.
Certificate of deposit (CD) A short-term negotiable certificate issued by a bank as evidence of a deposit that is repayable on a fixed date. It is a highly liquid bearer instrument.
Collateral A physical or financial asset used as security for a loan.
Commercial paper Loan notes issued by high-credit corporations to raise short-term funds direct from the money markets rather than from a lending institution.
Common size financial statements Statements that have been standardized by having each component expressed as a percentage of sales or total assets.
Compensating balance The minimum amount by which a company must stay in credit on a deposit account under the terms of a loan.
Consols UK Government stock secured on the Consolidated Fund. They are effectively non-redeemable loans to the government with a low nominal interest rate.
Constant growth model A valuation model, derived by Professor Gordon, that calculates a share value from its dividend flow to infinity under assumptions of constant growth.
Contingent liability A potential liability that may not arise but which must be mentioned in the notes to the published accounts of a company.
Conversion ratio The number of shares the holder of a convertible security receives for each bond on conversion.
Convertible loan A loan that gives the lender the option to convert into shares at a fixed price for a period of time.
Cost of capital The weighted average cost of funds to a company, based on the mix of equity and loan capital and their respective costs. A distinction is usually drawn between the average cost of all funds in an existing balance sheet and the marginal cost of raising new funds.
Covenant, restrictive A clause in a loan agreement to restrict the freedom of the borrower to act in a way that would weaken the position of the lender, such as increasing the amount of the dividend.
Credit period The number of days’ sales represented by the accounts receivable. It corresponds with the term debtor days.
Current assets The sum of inventories, accounts receivable, cash and cash equivalents and miscellaneous short-term assets.
Current liabilities The sum of accounts payable, short-term loans and miscellaneous accruals all due for repayment within one year.
Debenture A legal document that acknowledges a loan. In the US, the term refers to an unsecured loan. In the UK it may be secured by a fixed or floating charge on the assets.
Debtor days, or, accounts receivable days The figure for trade debtors in the balance sheet is divided by the average sales per day to express the average number of days’ credit taken by customers.
Debt to equity ratio The principal measure of the mix of funds in a company’s balance sheet. It can be expressed in a number of different ways. The most common way is to calculate the percentage that total interest bearing debt bears to ordinary plus preference shareholders’ funds.
Debt to total assets ratio One of the debt to equity measures. Long-term loans plus current liabilities are expressed as a percentage of total assets.
Deferred tax A taxation amount that has been charged to the profit and loss account but which has not been paid over to the authorities and is not currently payable. Timing differences between accounting and taxation computations of taxable profit on account of depreciation and so on are the root cause.
Departmental ratios The effectiveness of the major departments can be assessed by using an approach similar to that for the total operation, as illustrated in chapter 7. For each department, costs and assets classified under selected headings are related to sales, cost of sales or standard hours of work produced as appropriate. Suggested ratios for Marketing and Production are shown below:
- Marketing: cost to sales ratios
salaries and commission
travel expenses
advertising costs
sales office costs - Marketing: assets to sales ratios
fixed assets: office
fixed assets: cars/equipment
finished goods
accounts receivable - Production: cost to cost of sales ratios
direct material
direct labour
overtime
indirect labour
maintenance
production planning
supervision and so on - Production: assets to cost of sales ratios
fixed assets: factory premises
fixed assets: plant
fixed assets: vehicles
raw material
work in progress.
Dilution The reduction in the earnings per share value due to an increase in the number of shares issued or contracted to be issued in the future.
Discounted cash flow (DCF) A method of appraisal for investment projects. The total incremental stream of cash from a project is tested to assess the return it delivers to the investor. If the return exceeds the required, or, hurdle rate, the project is recommended on financial terms and vice versa. Two approaches can be used in the assessment: see net present value (NPV) and internal rate of return (IRR).
Discounting A technique used to calculate the present value of a cash flow occurring in some future time period. It is used in connection with the sale for immediate cash of a future debt and, more extensively, in translating future cash flow from an investment into present values.
Dividend cover Expresses the number of times that dividends to the ordinary shareholders are covered by earnings. See also payout ratio.
Dividend per share (DPS) The actual dividend paid on each ordinary share. It can be calculated from the accounts by dividing the total ordinary dividend by the number of ordinary shares.
Dividend yield Actual dividend per share expressed as a percentage of the current share price. In the UK, imputed tax is added to dividends paid and the calculation gives gross dividend yield.
Earnings per share (EPS) The profit earned for the ordinary shareholders as shown in the profit and loss account is divided by the number of issued ordinary shares to give earnings per share. (To be strictly orthodox, the weighted average number of shares should be used.)
Earnings yield Earnings per share expressed as a percentage of the current share price. In the UK, imputed tax is added to earnings to give gross yield.
EBITDA Earnings before interest, tax, depreciation and amortization (see appendix 1 for explanation).
Employee ratios To measure the productivity of labour, three major variables – sales, profits and assets – are related back to the number of employees and their remuneration. The principal ratios used are:
- remuneration to employee
- sales to employee
- sales to remuneration
- profit to employee
- profit to remuneration
- fixed assets to employee
- working capital to employee.
Equity gearing Common funds plus preference shares expressed as percentage of long-term loan plus current liabilities.
Eurodollar Deposits denominated in US dollars in a bank outside the US owned by a non-resident of the US.
Extraordinary item A significant transaction outside the normal activities of the business and likely to be non-recurring. An example would be the sale of the corporate head office at a large profit. There is a strong argument that such a transaction should not be allowed to distort the trading results and that it should be isolated from the reported earnings. However, the contrary argument that all such gains and losses should be included in the profit and loss account now prevails.
Factoring A method of raising funds by the selling of trade debtors.
Fixed assets Land and buildings, plant and equipment and other long-term physical assets on which the operations of the company depend.
Fixed cost A type of cost where the total expenditure does not vary with the level of activity or output.
Floating rate note (FRN) Loan on which the interest rate varies with prevailing short-term market rates.
Forward cover The purchase or sale of foreign currency for delivery at a fixed future time. It is used to cover against the risk of an adverse exchange rate movement.
Forward exchange rate A rate fixed to govern the exchange of currencies at a fixed future date.
Free borrowing percentage The percentage of non-equity funds that is made up of ‘free’ debt, that is accounts payable, accruals and deferred tax.
Futures contract A contract in an organized exchange to trade in a fixed quantity of a security at a fixed price at a future date.
Gearing A relationship between different types of funds in a company, such as loans and equity. The higher the amount of loan funds the higher the amount of fixed interest charge in the profit and loss account. Where interest charges are high, a small change in operating profit will have a much increased result in return to the equity for shareholders.
Gilts The term ‘gilt-edged’ refers to government longer term borrowing instruments. They are described as ‘short’ where the maturity is up to five years, ‘medium’ for periods of five to 15 years and ‘long’ for over 15 years to infinity.
Hedging A technique for reducing the risk of an exposed position by taking a compensating position in another security.
Hurdle rate The rate of return decided on by a company as the minimum acceptable for capital investment. It will be governed by the firms’ cost of capital and it may allow for different levels of risk.
Intangible assets Long-term non-physical assets in the balance sheet such as goodwill and brand values.
Interest cover A liquidity ratio that expresses the number of times the interest charged in the profit and loss account is covered by profit before interest and tax.
Internal rate of return (IRR) The rate of discount that brings the present value of all the cash flows associated with a capital investment to zero. It measures the effective yield on the investment. If this yield is greater than the ‘hurdle rate’ the investment is deemed to be financially desirable and vice versa.
Inventory days The inventory value in the balance sheet is expressed in terms of days. The divisor is usually the average daily cost of sales. Separate calculations are made for raw materials, work in progress and finished goods.
Investments Investments in subsidiary and associated companies and other long-term financial assets.
Junk bonds High-interest-bearing bonds with little security of assets issued by a company with good cash flow.
Lease – finance A lease under which the lessee assumes all the risks and rewards of ownership. It extends over the estimated economic life of the assets and cannot easily be canceled. Under current accounting rules, such a lease is treated as a loan.
Leverage See gearing.
Leveraged buy-out The acquisition of a firm by using large amounts of debt.
LIBOR London InterBank Offered Rate – the rate at which major banks in the short-term money market lend to each other. It is a benchmark for many international loans and floating-rate issues to corporations.
Liquidity The ability to provide cash to meet day-to-day needs as they arise.
Long-term loans (LTL) Bank and other loans of more than one year.
Market capitalization The notional total market value of a company calculated from the latest quoted market price of the share multiplied by the number of shares. The quoted price may not give an accurate value for the total shares, it may refer to only one small block of shares.
Market to book ratio The relationship between the balance sheet value of the ordinary shares and their market value. The expression ‘price to book’ is also used.
Market value weights In cost of capital calculations, the weighted cost can be derived using either the book value or market value weights to determine the overall weighted cost.
Matching principle A rule that a firm should match short-term uses of funds with short-term sources and long-term uses with long-term sources.
Minority interests The book value of shares in a subsidiary that are owned by members who are not shareholders of the parent company.
Miscellaneous current assets Sundry receivables and pre-payments due for realization within one year.
Miscellaneous long-term funds A composite entry in the balance sheet that may include deferred tax, unamortized government grants, provision for pensions and so on.
Money market A term applied to the trading in short-term financial instruments in London.
Mutually exclusive projects In an investment appraisal exercise these are projects that compete with one another so that the acceptance of one means the exclusion of the others.
Net present value (NPV) A positive or negative value arrived at by discounting the cash flow from a capital project by the desired rate of return. If the value is positive, it means that the project is financially desirable and vice versa.
Net working capital See working capital.
Net worth (NW) The sum of common ordinary shares plus all reserves plus preference shares less intangible assets.
NOPAT Net operating profit after tax (see chapter 17 for explanation).
Off-balance sheet A term that refers to borrowing that does not appear on the balance sheet. Sometimes achieved by a finance lease that gives the lessee all the risks and rewards, but not the legal status, of ownership.
Opportunity cost The alternative advantage foregone as a result of the commitment of resources to one particular end.
Optimal capital structure The point at which the cost of capital to a company is reduced to the minimum by the best mix of debt and equity.
Option A financial instrument that gives the holder the right, but not the obligation, to purchase or sell a specified asset at a specified price on or before a set date. See put option; call option.
Over the counter (OTC) Refers to the market where shares and financial instruments are traded outside the formal exchanges.
Overtrading A company is in an overtrading situation when there is not sufficient liquidity to meet comfortably the day-to-day cash needs of the existing level of business. There is constant danger of bankruptcy, even though the company may be trading profitably. Such a situation can come about because of past trading losses, excessive expansion and so on, but can be cured by the injection of long-term funds or, maybe, the sale of fixed assets.
Owners’ funds (OF) The sum of the issued shares, capital reserves and revenue reserves. The total represents the assets remaining to the shareholders after all prior claims have been satisfied.
Paid borrowing percentage The percentage of non-equity funds consisting of interest-bearing debt.
Par value A notional value assigned to a share largely for accounting purposes.
Payback period A term used in investment appraisal. It refers to the time required for the non-discounted cash in-flow to accumulate to the initial cash out-flow in the investment.
Payout ratio The percentage of earnings available for distribution that is paid out in dividends. This ratio is the reciprocal of dividend cover.
Preference capital Shares that have preferential rights over common shares. These rights normally relate to distribution of dividends and repayment of capital. The shares usually carry a fixed dividend but also carry very little voting power.
Preferred creditors Creditors who, in an insolvency, have a statutory right to be paid in full before any other claims. Employees who have pay due to them would normally be in this category.
Present value (PV) A sum calculated by discounting the stream of future cash flow from a project using an interest rate equal to the desired rate of return. It differs from net present value in that the amount of the investment is not included in the cash flows.
Price to earnings multiple (PE) The value derived by dividing the current share price by the earnings per share. Latest reported earnings or prospective earnings for the coming year may be used in the calculation.
Prime rate The rate at which banks lend to corporations with the highest credit ratings.
Profit after tax (PAT) Profit available for the shareholders after interest and tax has been deducted.
Profit before interest and tax (PBIT) Operating profit plus other income.
Profit before interest, tax and depreciation (PBITD) This value corresponds very closely to cash flow from trading.
Profit before tax (PBT) Operating profit plus other income less total interest charged.
Profitability index A measure for assessing the relative merit of an investment by expressing the present value of the future cash flows as a percentage of the investment amount.
Pro forma statements Projected financial statements.
Proxy vote Vote cast by an authorized person on behalf of another.
Put option An option to sell. See also option.
Quick ratio (acid test) A short-term liquidity ratio calculated by dividing current assets less inventories by current liabilities.
Repurchase agreement (REPO) A technique for providing short-term cash to a borrower who agrees to sell a security at one price and buy it back at a slightly higher price in the future. The price difference is the effective interest payment to the lender.
Retained earnings (RE) The final figure from the profit and loss account that is transferred to reserves in the balance sheet.
Return on assets (ROA) Profit before interest and tax as percentage of total assets. The corresponding term used in this book is return on total assets.
Return on capital This is profit before tax but after interest as a percentage of capital employed.
Return on capital employed (ROCE) Capital employed includes all the long-term funds in the balance sheet, that is shareholders’ funds plus long-term loan plus miscellaneous long-term funds. Profit before tax is often expressed as a percentage of this to give return on capital employed. However, as the denominator includes long-term loan, the corresponding interest on these loans should be added back into the numerator.
Return on equity (ROE) A measure of the percentage return generated by a company for the equity shareholders. It is calculated by expressing profit after tax as a percentage of shareholders’ funds. (Where preference shares exist, they should first be deducted from shareholders’ funds and the preference dividends also be deducted from the profit figure.)
Return on invested capital (ROIC) See chapter 17 for explanation.
Return on investment (ROI) A term that is very widely used in connection with the performance of a company or project. It is calculated in many different ways. Usually a pre-tax profit figure is expressed as a percentage of either the long-term funds or the total funds in the balance sheet.
Return on total assets (ROTA) Profit before interest and tax expressed as a percentage of total assets.
Revenue reserves Increases in shareholders’ funds that have arisen from retained profits and are available for distribution as dividends.
Rights issue A new issue of shares made by a company to its existing shareholders at a price below the current market value.
Risk-free rate of interest The yield available on government gilts.
Sales and leaseback agreement A method of raising finance whereby a firm sells property to the funding agency and simultaneously signs a long-term lease agreement. The company receives an immediate lump sum in exchange for a series of lease payments in the future.
Sales to fixed assets (times) An activity and performance ratio, calculated by dividing the net fixed assets value in the balance sheet into the sales turnover figure.
Senior debt Debt that ranks ahead of junior, or, subordinated debt in the event of a liquidation. See subordinated debt.
Sensitivity analysis Analysis of the change in the output values of an equation from small changes in input values. It is used to assess the risk in an investment project.
Share premium The difference between a share’s nominal value and its sale price.
Shareholders’ funds Issued ordinary shares plus reserves plus preference shares.
Short-term loans (STL) The bank overdraft, current portion of long-term debt and other interest-bearing liabilities due within one year.
Spontaneous financing Short-term financing that automatically results from the normal operations of the business. Creditors/accounts payable and certain accruals are the main sources.
Subordinated debt Debt that ranks for repayment after senior debt.
Subsidiaries A company is a subsidiary of another if the other owns more than 50 per cent of the equity or effectively controls the company by means of voting shares or composition of the board of directors.
Sundry accruals An entry in the current liabilities section of the balance sheet that includes sundry accounts payable plus accrued dividends, interest, tax plus other accruals.
SWAP The exchange of debt and/or currency obligations between parties to their mutual benefit. The benefit can arise from their differing needs for currency and/or fixed/floating interest charges.
Tangible assets The total of all assets in the balance sheet less intangibles, such as goodwill.
Tax rate The apparent rate of tax on profit found by expressing tax charged in the accounts as a percentage of profit before tax.
Term loan Usually a medium-term loan (three to seven years) repaid in fixed, periodic instalments that cover both interest and principal over the life of the loan.
Terminal value A notional cash in-flow attributed to a capital project to allow for value remaining in the project at the final year of the assessment.
Total assets The sum of fixed assets plus intangibles plus investments plus current assets.
Treasury stock Ordinary or common shares that have been repurchased by the company.
Ultra vires ‘Beyond authorized powers’. An act is deemed to be ultra vires if carried out by an agent or director of a company in excess of their authority. The person who so acts may incur personal liability.
Underwriting Banks or other financial institutions guarantee to take up an issue of shares at a specific price in order to ensure the success of the issue. This process in called underwriting.
Variable costs A type of cost where the total expenditure varies in proportion to activity or output.
Warrant Sometimes attached to loan stock as a sweetener at the time of issue, warrants give an option to the holder to purchase a stated amount of equities at a fixed price for a defined period.
Weighted average cost of capital (WACC) See cost of capital.
Window dressing The alteration of financial statements at the time of publication to give an artificially improved appearance to the company situation. For instance the temporary sale of inventories to a bank with agreement to repurchase could give an enhanced view of company liquidity.
Working capital The excess of current assets over current liabilities.
Working capital days The length of the working capital cycle is often calculated as inventories plus accounts receivable less accounts payable days.
Working capital to sales A liquidity ratio that is calculated by expressing working capital as a percentage of sales.
Z-growth factor A value that gives an indication of the self-funding growth rate of a company. It is calculated by expressing retained earnings before extraordinary items as a percentage of opening owners’ funds. It is assumed for this calculation that all assets are linearly related to sales, likewise all items in the profit and loss account. It also assumes that existing debt to equity ratios will be maintained.
Zero coupon bond A bond that pays no interest but is issued at a discount on its face value. The redemption of the bond at par ensures the desired yield to the purchaser.