Part of building your commercial awareness involves developing your business and financial knowledge. We’ve built this glossary to help you get started. From accounts payable to working capital, we’ve got you covered.
A
Accounting reference date
When a company is incorporated, it will usually have an accounting reference date that is the last day of the month in which the anniversary of its incorporation falls. Directors can change the accounting reference date by filing an appropriate form with the Registrar of Companies. It marks the end of the annual accounting period and is also known as the balance sheet date.
Accounts payable
Amounts owed by an organisation or individual to another for goods or services it has received.
Accounts receivable
Amounts due to an organisation or individual from another for goods or services it has supplied.
Accrual
A term used in company accounts where income is due or a cost is incurred during an accounting period but has not been received or paid.
Adjusted earnings
If a company’s earnings figures are distorted either positively or negatively by exceptional one-off occurrences in the year, its directors can choose to clarify the performance by releasing adjusted earnings. In other words, earnings with the exceptional items stripped out which they believe are more representative of its underlying performance.
Administration
An insolvency procedure, in which a company is in severe trouble, but still with some hope of recovery, may be put into the charge of a court-appointed administrator. Going into administration means the company cannot be wound up without the court’s permission.
Amortisation
An annual charge made in a company’s profit and loss account to reduce the value of an intangible asset to zero over a period of years. A common example has been goodwill amortisation, but that has been abolished under international accounting standards. The goodwill, acquired through a takeover, is instead subjected to an annual impairment test.
Annual return
The total annual return on an investment which includes dividend payments and capital gains/losses. Not included are transaction costs and taxes. An obligatory return, submitted annually to the Registrar of Companies, detailing information about a company’s operations including business description, details of directors and company secretary, and share capital, etc.
Asset turnover
The ratio of annual sales divided by net assets employed in the business. Asset turnover measures a company’s efficiency at using its assets to generate sales or revenue. The higher the number the better.
B
Balance sheet
One of the main components of a company’s report and accounts, the balance sheet provides a snapshot of everything the company owes and owns at the end of the financial year in question. On a specific date it lists the assets, liabilities, issued share capital and reserves. Where the profit and loss account tells you how the company has performed in the previous year, the balance sheet reveals things about its fundamental health, like whether it can pay its debts and how good its cash management is. A ‘strong’ balance sheet is one where liabilities (including borrowings) are considerably outweighed by assets (including cash). If the company is having problems, the balance sheet (together with the cash flow statement) will tell you whether it can stand the strain.
C
Cash flow
Cash flow is regarded by many as the ultimate test of financial health. Seasoned analysts do not entirely trust the figure a company puts on its profits, since profits can be ‘massaged’, whereas cash is more difficult to manipulate. Profit, as they say, is a matter of opinion. Cash is a matter of fact. The best way to check the cash flow position of a company is to scrutinise the cash flow statement in its annual report and accounts. It provides fact on whether a company has generated or consumed cash in the year, and how. It can be used in conjunction with the P&L to assess the trading results, or it can be used in conjunction with the balance sheet to assess liquidity, solvency and financial flexibility.
Corporate bond
Corporate bonds are issued by companies to raise capital. They are an alternative to issuing new shares on the stock market (equity finance) and are a form of debt finance. A bond is basically an IOU—a promise to pay back your original investment (the ‘principal’) at a maturity date, plus interest payments (the ‘yield’ or ‘coupon’) at regular intervals between now and then. The bond is a tradable instrument in its own right, which means that you can buy and sell it during its life, and its value will tend to rise and fall as interest rates change.
Creditor days
A ratio measuring how long on average it takes a company to pay its creditors. Calculated by dividing the trade creditors shown in its accounts by its cost of sales, or sales, and then multiplying by 365. For example, a company with creditors of 900,000 and sales of 12 million, takes on average just over 27 days to pay its bills. Within reason, the higher the number the better, although if a company is very slow in paying its creditors (say 100 days plus) it is worth asking if this is because it has problems generating enough cash quickly enough to pay them.
Current assets
Assets of a company that are regularly turned over and can readily be converted into cash, including stocks, work in progress, marketable securities and debtors.
Current liabilities
A balance sheet item that equals the debts owed by a company that are due for settlement within 12 months. These include trade creditors, taxes due and bank overdrafts.
Current ratio
A financial ratio which shows how easily the company could pay its bills if all its creditors demanded payment at once. Calculated as: (current assets) divided by (current liabilities). In theory, this figure should be at least 1, because if it’s lower than 1 it means that the company does not have the liquidity to pay all its creditors straight away. That said, some companies, notably supermarkets, happily survive on current ratios of less than 0.5. As always, it’s best to compare the ratio of one company with others in its sector. Over 1.5 suggests excessive caution on the part of management.
D
Debt financing
The raising of capital by the issuance/sale of debt instruments such as bonds.
Debt to equity ratio
Net borrowings of a company divided by shareholders’ funds. The ratio shows the amount of financing that is provided by sources other than the shareholders. ‘Net borrowings’ means the total borrowings of the company from banks, other financial institutions, debenture holders and preference shareholders, less any cash that is readily available and any short term cash holdings. Both figures can be found in a company’s balance sheet. The ratio is often multiplied by 100 and expressed as a percentage. The higher the percentage, the more risky for lenders to the company. Most lenders like the percentage to be below 50%. If it is above 100%, the company is said to be highly geared.
Debtor days
A ratio used to work out how many days on average it takes a company to get paid for what it sells. Calculated by dividing the figure for trade debtors shown in its accounts by its sales, and then multiplying by 365. For example, a company with debt of £700,000 and sales of £12m, takes an average of just over 21 days to collect its debts. The lower the number of debtor days, the better. An abnormally high figure suggests inefficiency, potential bad debts, window-dressing of the sales figures, or deliberate bullying by large customers trying to improve their own cash management. Cash businesses, including most retailers, should have very low debt collection multiples, because they get their money at the same time as they sell the goods.
Depreciation
The charge in a company’s accounts which reflects the reduction in value of an asset over time as its useable life is exhausted. Depreciation is charged before calculation of profit, on the grounds that the use of capital assets is one of the costs of being in business and one of the contributors to profit. There are two main methods of depreciation:
- Straight line: the residual (scrap) value of the asset is deducted from its original cost, and the resultant figure is divided by the estimated life of the asset. The result of that is deducted annually over the life of the asset. So an asset that costs £10,000 and that has a residual value of £200 with a useable life of 4 years is depreciated by £2450 per year.
- Reducing balance: the amount of annual depreciation is a constant proportion of the cost of the asset. Depreciation has no effect on cash flow. It is just an accounting procedure.
Discounted cashflow
A formula closely related to Net Present Value which springs from the idea that £1 received in 10 years’ time is not worth as much as £1 received now because the £1 received now could be invested for those 10 years and compound into a higher value. Discounted cashflow applies a discount rate to future cashflows to establish their present worth. Added to the company’s terminal value (ie what you’d get if you sold its assets), this gives you a total value for the whole business.
Dividend
The distribution of part of a company’s earnings to shareholders, usually twice a year in the form of a main dividend and an interim dividend. Normally, the dividend is expressed on a ‘per share’ basis, for instance, 3p per share. This makes it easy to see how much of the company’s profits are being paid out, and how much are being retained by the company to plough back into the business. So a company that has earnings per share in the year of 6p, and pays out 3p per share as a dividend, is passing half of its profits on to shareholders and retaining the other half. Directors of a company have discretion as to how much of a dividend to declare, and they don’t have to pay a dividend at all. Indeed, for young growth companies making no profits dividends are not generally expected. When they are expected, however, the City hates to be disappointed! Fund managers rely on big companies producing consistent dividends year after year, and woe-betide the company that surprises the City by announcing a reduced or nil dividend. Note that dividends are nearly always paid in cash, but they can also be in the form of stock (scrip dividend).
Dividend cover
The ratio between a company’s earnings (net profit after tax) and the net dividend paid to shareholders, calculated as earnings per share divided by the dividend per share. So if a company has earnings per share of 8p and it pays out a dividend of 2.1p, the dividend cover is 8/2.1 = 3.80 Generally speaking, a ratio of 2 or higher is considered safe (in the sense that the company can well afford the dividend), but anything below 1.5 is risky. If the ratio is under 1, the company is using its retained earnings from a previous year to pay this year’s dividend.
Dividend yield
The annual dividend income per share received from a company divided by its current share price. Put simply—how much income are you getting out of the company for the capital you’ve got locked up in it? Dividend yields are calculated on the net dividend. Example: a company declares a net dividend of 2.1p per share. Its share price is 150p. To get the dividend yield, divide the net dividend by the current share price: 2.10 /150 = 1.4%. The dividend yield is 1.4%. Note that the higher the share price, the lower the dividend yield. Using the above example, if the shares rose to 200p, the yield would fall to 1.05% (2.10/200 = 1.05%). If a company has a low dividend yield compared to other companies in its sector, it can mean one of two things. Either it means the company’s share price is high because the market reckons it’s got great growth prospects and doesn’t care too much about income, or it means that the company’s a busted flush and can’t afford to pay decent dividends.
E
Earnings
The annual profits of a company after deduction of tax, dividends to preference shareholders and bondholders. Earnings are usually expressed on a per-share basis (eg 7p), and the earnings per share (EPS) figure is calculated by dividing total earnings by the average number of shares in issue for the relevant accounting period. For example, earnings of £2 million, with 10 million shares in issue would give an EPS of 20p. You may see earnings used in several ways:
- reported earnings: the figure in the company’s accounts
- underlying earnings: the figure derived from reported earnings by excluding any one-off items (eg profit from the sale of land which is not part of the company’s normal business)
- diluted earnings: earnings after adjustment has been made for shares that may be issued in the future if holders of options, warrants and convertibles choose to exercise their rights.
Earnings per share
Earnings per Share (EPS) = Earnings/Number of Shares in Issue. EPS is a key ratio used in share valuations. It shows how much of the company’s profits, after tax, each shareholder owns. Example: Goodco makes a post-tax profit of £1.2 million. There are 20 million shares in issue EPS = £0.6. What starts out as an easy calculation gets complicated because the rules on what constitute earnings are fuzzy, especially when it comes to ‘extraordinary’ items:
- When an industrial manufacturer sells a large parcel of land to a developer should that profit be treated the same as the profits from its mainstream activities?
- If its profits one year are wiped out by an uninsurable natural disaster at its plant, should that event be regarded as just a normal cost of doing business?
EBIT
Earnings before interest and tax. Calculated by taking the pre-tax profit of a company and adding back only the total interest charges which it has paid on debt. EBIT is a commonly used way of measuring the profitability of a company.
EBITDA
Earnings before interest, tax, depreciation and amortisation. EBITDA is a commonly used way of measuring the profitability of a company.
Equity
The amount which shareholders own in a publicly quoted company. Equity is the risk-bearing part of the company’s capital and contrasts with debt capital which is usually secured in some way and which has priority over shareholders if the company becomes insolvent and its assets are distributed. For most companies there are two types of equity: ordinary shares, which have voting rights, and preference shares which do not. Owners of preference shares rank ahead of ordinary shareholders in a liquidation.
Exceptional items
Costs which affect a company’s profit (or loss) which are associated with normal activities but are exceptional in magnitude.
F
Fixed assets
Assets of a company such as buildings and machinery which are regularly used over a long period of time for the purpose of generating profits.
G
Gearing
The most common use of the term ‘gearing’ is to describe the level of a company’s debt compared with its equity capital, and usually it is expressed as a percentage. So a company with gearing of 60 per cent has levels of debt which are 60% of its equity capital. The significance of the gearing ratio is that it shows at a glance how encumbered a company is with debt. Depending on the industry, a gearing ratio of 15% would be considered prudent, while anything over 100% would be considered risky or ‘highly geared’.
Goodwill
The value of a business to a purchaser over and above its net asset value. It reflects the value of intangible assets such as:
- reputation
- brand name
- good customer relations
- high employee morale, and other factors which improve the company’s business.
Gross margin
The difference between the selling price of an item and the purchase or manufacturing cost, expressed as a percentage of the selling price. For example, if it costs a company £6 to manufacture an item and the selling price is £10, the gross margin is: (£10 – £6)/£10 x 100 = 40%. When looking at a company’s report and accounts, the gross margin of the business as a whole is its turnover less the cost of sales, divided by the turnover, multiplied by 100.
Gross profit
The difference between (i) turnover and (ii) the cost of making a product or providing a service, before taking into account overheads, salaries and wages, and interest payments. The logical step after calculating gross profit is to go on to calculate the gross profit margin, which is the gross profit as a percentage of turnover.
I
Interest cover
Interest cover measures the amount of interest paid by a company on its borrowings against its operating profit in the same period. The ratio shows the impact of gearing on a company’s profit and loss account. If the figure is low, a small reduction in operating profits, or a rise in the cost of borrowing, can wipe out pre-tax profits. To calculate interest cover, divide the operating profits by the interest paid. Example: a company which has profits of £4 million and which pays net interest of £1 million, has interest cover of 4.
Interim dividend
The dividend declared before annual earnings are established. Companies in the UK usually pay two dividends per year, the interim dividend and the final dividend. The interim dividend is usually the smaller of the two.
Internal rate of return
The interest rate which, when used as the discount rate for a series of cash flows, gives a net present value of zero. To understand this, remember the fundamental concept that £1 received in 10 years is not worth as much as £1 received now, because £1 received now can be invested for ten years and compound into a higher amount. So if you are a project financier, and you are considering the viability of a project that requires up front capital expenditure, which will be recouped by net cash inflows in years 3, 4 and 5, you have to discount the earnings in those later years to establish their net present value. The discount you apply is the crucial thing, but the IRR gives you a starting point—it is the discount rate at which the project will break even. If you apply a discount rate to future cashflows that is higher than the IRR, the project will make a loss in real terms. If you apply a discount that is lower than the IRR, the project will be profitable.
Issued share capital
The amount of authorised share capital that shareholders have actually subscribed to a company for share ownership.
L
Long-term debt
Debt liabilities due in one year or more.
Long-term liabilities
Debts of a company which are not due for repayment in the next accounting period.
N
Net assets
The total assets of a company (current assets plus fixed assets) less its current liabilities.
Net earnings
Net earnings is one of the most important measures of a company’s performance. It is the company’s profit once all the costs of business and other charges, including debt servicing and taxes, have been paid. Sometimes called net income or the bottom line. When divided by the number of shares in issue to give earnings per share, it is then used to calculate the popular price/earnings, or P/E, ratio for quoted companies.
Net present value
A calculation which is based on the idea that £1 received in 10 years’ time is not worth as much as £1 received now because the £1 received now could be invested for those 10 years and compound into a higher value. The NPV calculation establishes what the value of future earnings is in today’s money. To do the calculation you apply a discount % rate to the future earnings. The further out the earnings are (in years) the more reduced their present value is. NPV is at the heart of securities analysis. Analysts use predictions of a company’s future earnings and dividend payments, appropriately discounted back to current value, to establish a ‘fundamental’ value for the shares. If the current share price is below that value, then the shares are, on the face of it, attractive. If lower, they are ‘overvalued’. In practice, the analysis is more sophisticated, but it is based on the concept of NPV.
P
Preference shares
Shares in a company which give their holders an entitlement to a fixed dividend but which do not usually carry voting rights. The important difference between preference and ordinary shares are:
- The dividend on ordinary shares is uncertain and variable (high when the company does well, poor or non-existent when it does badly). Preference shareholders get a fixed dividend which, if not paid, usually accrues until it can be.
- Each ordinary share usually carries a vote. Preference shares do not usually carry a vote unless dividends fall into arrears.
- In the event of a winding up, preference shares are usually repayable at par value, and rank above the claims of ordinary shareholders (but behind bank and trade creditors).
P/E ratio
The P/E equals the current share price of a company divided by its earnings per share in the latest reported period. For example, a company with a share price of 100 and earnings per share (EPS) of 5 has a P/E ratio of 100/5 = 20. A company’s P/E (also known as its multiple) shows how high its shares are priced in relation to its historic earnings, and it is one of the most commonly used tests of market value. Although mathematically it relates share price to past performance, the reality is that P/Es are more about forward expectations than the past. A high P/E indicates that markets expect the company’s earnings to grow rapidly in the future.
Q
Qualified accounts
Company accounts on which the auditor has expressed reservations about whether they represent a true and fair view of the company’s financial condition.
R
Redeemable preference shares
Preference shares which the issuing company reserves the right to redeem. The shares may, or may not have a specific redemption date or dates.
Reserves
The retained profits of a company which form part of its capital.
Return on capital employed (ROCE)
A measure of a company’s profitability. It may be defined as: earnings before interest and tax divided by total capital employed plus short-term borrowings minus total intangibles. ROCE takes all the assets employed in the business, including borrowings, and measures the return the company made on them. If a company has a low ROCE, it is using its resources inefficiently, even if its profit margin is high. Calculation: multiply operating profit by 100, and divide the result by total capital employed. Example: Company A made an operating profit of £897 million on total capital employed of £4,342 million. ROCE was therefore (897 x 100)/4,342= 20.66% Yardstick: a company’s ROCE should be higher than the return on gilts (the benchmark for a risk-free investment return). And unless it is higher than the cost of borrowing, any increase in the company’s borrowings or the general level of interest rates will reduce shareholders’ earnings. A ROCE of 20% or more is considered very good.
Return on equity
The adjusted profit of a company divided by its equity. For instance, if the adjusted profit of a company is £1 million and Equity is £10 million, the Return on Equity is 10%. Adjusted profit is the profit of the company adjusted to exclude the impact of non-recurring exceptional gains, losses, income and charges. The figure can be found in the company’s Profit and Loss Account. Equity is the total of ordinary share capital plus reserves, and both figures appear in the company’s Balance Sheet. In calculating Return on Equity, you can use the Equity at the end of the year or the average between the opening and closing equity.
Return on total assets
A measure of how good a company is at ‘squeezing’ earnings out of the assets employed in its business, which is calculated as follows: Return on assets = (profit before interest and tax)/(fixed assets + current assets). If you are using this ratio to evaluate a company, you need to consider what kind of business the company is in. ‘People’ businesses, such as advertising agencies, need very few capital assets compared with a manufacturer which typically needs to invest large amounts in plant and equipment. In general, a return of 12% is adequate and a return of 16% or more is considered good.
S
Short-term debt
Debts (or current liabilities) due soon, typically within one year.
Stock turn
A financial ratio which shows how fast a company sells its goods, calculated as: sales divided by year-end stocks. If, for example, a company has sales of £60 million and a year-end stock figure of £3.2 million, its stock turn multiple is 18.85. Stock turn is particularly relevant for manufacturing or retailing businesses. The higher the figure, the more efficient the company is in processing stock. The typical multiple for a manufacturer is 5 to 6. Retailers that are doing well and run efficiently will have a much higher multiple because they should be able to put the burden of carrying stock on their suppliers. Another way of looking at stock is to calculate the number of days on average that a company keeps its stock. This is expressed as the year-end stock figure divided by the sales, and multiplied by 365. Using the figures above, £3.2 million divided by £60 million, then multiplied by 365 = 19.46 days.
W
Working capital
A company’s current assets (cash, debtors, work in progress) less its current liabilities (creditors, taxes due). This capital is used by a company to run its business.
Produced in partnership with Paul Gilbert and Lawrence Smith of LBC Wise Counsel