SOME USEFUL ACCOUNTING TERMS

The accrued interest The accrued interest on a bond is the amount of interest that has been deemed to have accumulated on a bond but which has not yet been paid. It is the amount of interest that would have been paid, if interest was paid daily, but which has not become actually payable yet. A simple example of this would be a £100 bond which pays 10% interest annually, so it makes a single £10 payment each year. Six months after an interest payment would be exactly half way between interest payments so the accrued interest would be half the annual payment, or £5. Three months after an interest payment, we would be a quarter of the way to the next payment so the accrued interest would be a quarter of the payment, or £2.50. Accrued interest is calculated using a days convention, which may or may not be the actual times elapsed since and between interest payments. The most common reason for calculating the accrued interest is to calculate the clean price of a bond from the dirty price.  

Cash flow Statement Unlike the profit and loss account, which follows the accruals principal, the cashflow statement records only the movement in cash in a given period. i.e, all cash received (inflows) by the company , and spent (outflows) by the company will be shown in this statement. The cashflow statement is harder to manipulate than the other main accounting statements (the profit & loss account and the balance sheet
Cash will come into the company largely by sales, which may be supplemented by other income (income from investments) and sales of assets. The cash outflow will largely consist of payments to suppliers (raw material and labour) and investment. The company will also have to pay those who lent it money (interest payment to banks), the government (tax) and the shareholders (dividends).
Not only should an investor look at the P & L and the balance sheet, but they should also look at the cash flow to get an idea as to where the money is going. If a company is generates profits, but fails to generate cash, the company may either be using the money to fund growth (expenditure on new stores, more stock) or may be loosing money due to poor management.
As in most cases, investors can get more information by looking at the cash flow on a theme by theme basis.
Like profit, cash flow can be measured at a number of levels. For example roughly corresponds to operating profit with the effects on non-cash items stripped out. The main items typically are:
• Cash flow from operating activities
• Returns on investments and servicing of finance
• Taxation
• Capital expenditure and financial investments
• Acquisitions and disposals
• Equity dividends paid
• Management of liquid resources
• Financing
The returns on investments and servicing of finance, will include divided income received and any interest received from investments. It will also include the interest paid to the debenture holders and banks (those who provide debt). However, the dividend payment, which is not obligatory is shown separately. Taxation is the amount of money the company paid during the period. It is important to remember that only the movements in cash will be recorded in the cashflow statement. (i.e, The P & L may show £10m as the final tax charge for an year, where as the cashflow may show £5m. The £10m is the actual charge for the year, of which the company paid £5m during the year) Capital investments and financial investments will show the cashflow relating to the purchase and disposal of fixed assets. Cashflow incurred due to the acquisition/disposal of a subsidiary/joint venture or an associate will be shown under acquisitions and disposals. Management of liquid resources refers to current asset investments which are highly liquid. These investments are easily convertible to cash, and the amount is certain. Financing refers to cash movements arising from the issue of shares and issues or redemption of debentures. Operating cash flow is very often looked at by investors. The capital expenditure item is a quicker way of finding out how heavily the company is investing than looking at the balance sheet (and then correcting for depreciation etc.) but it has two weaknesses : it does not record purchases not yet paid for and it does not allow one to separate capital expenditure on operating assets from long term financial investments. A more complex use of the cash flow is the calculation of free cash flow which can be used in valuation ratios and DCF valuations. All the items in the cash flow provide a useful check on items in the other accounting statements and are a vital part of the financial modelling used for forecasting.  

Book Value The book value of an asset is the value at which the asset is included in the accounts - specifically in the balance sheet. The book value shown in the accounts is usually the cost of an asset less accumulated depreciation. There are other adjustments that may be made, for example impairment. This is sometimes called the net book value.
When a company sells such an asset, if the price at which it is sold is more than the book value, the difference is shown as a profit on disposal in the profit and loss account - conversely if an asset is sold for less than the book value a loss is shown. The book value of an entire company, or of a division of a company, is its net asset value.   

Net Asset Value (NAV)
The total value of a company’s assets less the total value of its liabilities is its NAV. For valuation purposes it is common to divide net assets by the number of shares in issue to give the net assets per share. This is the value of the assets that belong to each share, in the same way that PE measures ownership of profits. NAV is useful for valuation of shares in sectors where the value of a company comes from the assets it holds rather than the profit stream generated by the business. The most obvious examples of these are investment companies (investment trust) and real estate companies. Both of these are largely convenient ways in which investors can buy diversified bundles of the assets they hold. NAV is calculated as total assets minus total liabilities, hence the term ‘net’ assets. The value of the assets may be taken at market price or at book value (the value recorded in the books of the company, usually historical cost). Which is used tends to depend on the sector and the circumstances. The net asset value of a mutual fund, unit trust, OEIC or investment trust is calculated on the market value of the company’s total assets minus its total liabilities. For example, if an investment company has securities and other assets worth £10m and has liabilities of £2m, the investment company’s NAV will be £8m. The value of the underlying assets will change daily, therefore the NAV will also change daily. For funds it is usual to calculate the NAV at the end of every business day and it is usual to calculate the NAV per share. The share price of mutual funds or unit trusts is based on their NAV. The price that investors pay to purchase mutual fund or unit trust shares is the approximate per share NAV, plus any fees that the fund imposes at purchase (such as sales loads or purchase fees). The price that investors receive on redemptions is the approximate per share NAV at redemption, minus any fees that the fund deducts at that time (such as deferred sales loads or redemption fees). Unlike unit trusts and OEICs, investment trusts have a fixed number of shares available and no mechanism for on-going redemptions or issues of shares. Because of this shares can trade at a substantial discount (or, more rarely, a premium) to NAV. NAV is also used to value real estate companies because, in theory, the company’s value should reflect that of its underlying portfolio. Traditionally, property companies trade at a small discount to their NAV. While NAV can be computed for any company it is of little relevance in service industries because there is little invested in plant and equipment, and its profitability is driven by people and ideas. Where there is a reasonable component of fixed investment, NAV gives some indication of what underpins a company’s share price and is liked by some value investors.  

Fair Values 
Fair value is in essence the value of an asset or liability in an arms length transaction between unrelated willing and knowledgeable parties. The concept of fair value is used in many accounting standards including the IFRSs covering acquisitions, and the valuation of security, but is not limited to these. Some methods of determining fair value are preferred to others as they are more accurate when they can be used. The methods used are as follows:
• Level 1: If there are identical transactions in the market, the assets and liabilities should be valued with reference to such transactions.
• Level 2:If identical transactions do not exist (which is likely), but similar transactions exist, the fair value should be estimated making the necessary adjustments and using market based assumptions.
• Level 3:If either of the above methods cannot be used, then the company should use other valuation methods (such as present value) using its own assumptions
Fair value is subjective as the majority of valuations are likely to use the latter two methods. 

Fair value of intangible assets
The fair value of intangible assets, especially goodwill has a significant effect on reported profits and balance sheets. The common exclusion of goodwill for valuation purposes makes this less important for investors. After the initial recognition of goodwill, it should be tested for impairment annually.
Two methods can be used to value intangible assets:
• Market methods: largely use level 1 and level 2 methodologies
• Income methods: values the asset using future economic benefits derived from owning the asset.
The income method identifies the cash flows related to that particular intangible asset, and uses the DCF method to value the asset; however this is not the only method that can be used for such a valuation. 

Fair value of securities
• Level 1:Quoted market prices should be used if available.
• Level 2:The fair value should be estimated by using valuation techniques by using market data and with reference to the current fair value of another instrument that is similar to the one that is being valued.
• Level 3:Where the above methods cannot be used, a company should use cost less impairment.  

Annuity 
An annuity, usually purchased from a life insurance company, pays a regular income until the death of the purchaser in return for a lump sum. The insurance company needs to use the lump sum and the income they get from investing it to meet the annuity payments, as the length of each person’s life is uncertain the insurance company is bearing a risk. A life assurance policy can be thought of as the opposite of an annuity. With a life assurance policy the insurance company makes a loss when each insured person dies within the term of the policy as it has to make a payment. With an annuity the insurance company makes a gain when each insured person dies. This means that the annuities and insurance company sells hedges (offsets) certain risks to its life policy payouts and vice-versa. For example if death rate rises the insurance company will have to payout more on life policies but less of annuities.  

Assets Turnover 
Asset turnover measures how effectively the assets invested in the business are at generating sales. It is calculated as:
Sales ÷ assets
The question is what measure of assets should be used. The most obvious is total assets, i.e. fixed assets + current assets. This measures how many pounds in sales is generated for each pound invested in assets. From an investors point of view it can be argued that current assets should be deducted from the amount of assets used as investors are concerned with returns on their investment and the funding of current assets from current liabilities can be ignored. Taking this further what investors care about is the sales generated by their investment, i.e. equity + debt. This leaves us using the same denominator as ROCE. Using this definition thereby gives us a nice decomposition:
ROCE = EBIT margin × Asset turnover.
We would favour this definition and it seems to be the most widely used. 

Fixed Asset Turnover
Fixed asset turnover is calculated in the same way but using fixed assets. This is a narrower measure and measures how effectively sales are generated by fixed asset investments and ignores current assets. It is most likely to be useful in a capital intensive industry.
Tangible assets turnover narrows this down further by using only tangible fixed assets. This is reasonable for the same reasons that intangible assets, especially goodwill are ignored in calculating many valuation ratios. However the same could be achieved for any of the asset ratios above by deducting either goodwill (as we would suggest) or the total value all intangible assets from the assets figure.  

Fixed Assets 
Fixed assets, as opposed to current assets, are those assets with a remaining useful life of over an year. In accordance with the accruals principal, these assets are depreciated, and treated as an expense in the P & L account.
There are two types of fixed assets:
• Tangible fixed assets
• Intangible fixed assets
Tangible fixed assets include physical assets such as land and building, motor vehicles, furniture etc. Long term investments are also considered tangible. The most prominent intangible fixed asset is goodwill. Other intangibles includes patents, copyrights, trademarks and brands.  

Current Assets 
Those assets which are expected to be used (sold or consumed) within a year (unlike fixed assets) are known as current assets. Current assets are shown in the balance sheet, and is listed order of increasing liquidity (i.e. how easy they are to convert ot cash). Usually stocks will be listed first, followed by debtors, with cash last.
The current asset position of a company is important, both for tracking the company’s financial position (see current and quick asset ratios) and for guaging its operational efficiency. 

Intangible Assets 
Intangible assets are those assets that do not have a physical form. Intangible assets are shown in the balance sheet together with tangible fixed assets under the heading of fixed assets.
Under IAS 38, for an asset to be regarded as an intangible asset, it should be:
• Identifiable
• Controlled by the company
• Should increase future profits
The intangible asset should be identifiable.
What this means is that the asset should exist in its’ own right; i.e., it should be separately identifiable (the company can sell it, license it, etc). E.g., patents, copy rights licenses etc are covered in this standard. Goodwill, another intangible asset is covered in another standard (IFRS 3). Intangible assets can arise from a purchase (e.g.: a purchase of a patent) or generated within the organization (e.g., expenditure of research and development). The question arise as to whether such expenditure (a purchase of a patent, expenditure on R & D) should be treated as an expense, or capitalized as an asset, as some expenses may increase future long term profits.
In order to bring consistency amongst companies, and to prevent widow dressing a company should follow rules when deciding whether such an expense should be capitalized or not. If the intangible asset was purchased, and satisfies the following criteria, the expenditure should be capitalized.
• The asset will generate profits
• The cost of the asset is measurable
If the conditions are not met, such expenditure should be treated as an expense in the relevant period. Once treated as an expense, the company cannot reinstate such expenditure at a latter date as an intangible asset. If the intangible was generated in house, as a minimum, the expenditure should satisfy the above two conditions. There are other conditions as well. Research costs should be written off as an expense, but development expenditure should be capitalized provided the product is technically feasible, and profitable. However advertising costs, training costs etc should be treated as an expense. Once intangible assets are recognized, the company should identify the life of the asset. If the asset has a limited life, the value should be amortized over the period. If the asset has an indefinite life period, the company should review on an yearly basis for any changes in conditions to verify that the assumption is still valid. Subsequent expenditure on an intangible asset should be treated as an expense. However if the expenditure materially increased the future earning potential, and the cost is identifiable, the company should capitalized the expenditure. Investors should read the notes to the intangibles thorouly, esp. if they make up a large portion of the asset value. If there was an impairment in value, or an increase in value, investors should read and understand the conditions under which such changes occurred. Certain impairments (such as a loss of patent) will result in lower earnings in the future. 

Current Liabilities 
Those liabilities, which are expected to be settled in less than a year are known as current liabilities. These include trade creditors, debt due within an year (including debt repayable on demand such as overdrafts). Current liabilities are one of the major groups of items on the balance sheet. Current liabilities are very important in gauging a company’s financial health as the company needs to have the money to meet these commitments in the short term - see current and quick asset ratios.  

Contingent Liability 
Contingent liabilities are possible future liabilities which will be crystallised (i.e. made certain)by the occurrence or non occurrence of a future event. future event being once over which the company has a low degree of control. i.e, the company will have a lower degree of certainty over whether the liability will crystallise than with a provision. Therefore the company should not make a provision for contingent liabilities, but should provide a note in its accounts. Generally one may find the following under contingent liabilities:
• Guarantees given to banks and other parties
• Potential fines (from court rulings and other disputes)
More often than not contingent liabilities do not materialise, but one should keep an eye out for sharp movements and large numbers appearing in the notes. The types of contingent liabilities that may worry investors include:
• Guarantees given with insufficient apparent reason, particularly to companies that are not part of the same group
• Contingent liabilities that do not seem realted to the company’s normal activities
• Those that are unusually large.  

Goodwill 
Goodwill arises when a company buys another business at a price greater than the book value (i.e. what is shown on the balance sheet) of its assets. The price paid minus the book value is shown as an asset called goodwill in the balance sheet of the acquiring company.
As goodwill does not have any relationship to future cashflows, but only the past, it is often ignored by investors who commonly use profit measures such as EBITDA and EBITA. Measures of financial strength such as gearing should also exclude goodwill.
The book value used in calculating goodwill is not the amount shown in the acquired businesses accounts before it is bought but the “fair value” which is what the newly purchased assets are valued at in the purchaser’s accounts. fair value is defined as price which a willing seller (i.e, excluding liquidation and forced sales) would have received in an arms length transaction, by informed and willing parties
Goodwill may be negative if the fair value of the assets is greater than the purchase price. Negative goodwill is less common than positive goodwill.
In the past companies amortised goodwill if it was positive, or added it to the profit and loss account (P & L) over several years if it was negative - either way the impact was even spread over several years.
This is changing with the introduction of international accounting standards, and IFRS 3 now requires companies to add negative goodwill to profits in whole and immediately. Positive goodwill (i.e. the usual situation) is shown as an asset but is not amortized every year. Instead companies who have goodwill on their balance sheets are required to review the value of the goodwill annually and, if its value has been impaired, take the amount of the impairment as a cost in the P & L. If the value of goodwill is not impaired its can be shown in the balance sheet indefinitely.  

Breakeven 
The break-even point is the level of sales (in either monetary terms of volume of product terms) needed to cover the fixed costs, i.e. the level at which a company (or a business within a company, or a product) does not make either a profit or a loss.
The point of breakeven analysis is that it helps analyse the chances of a new venture succeeding and it gives and indication of the level of operational gearing. This is because operational gearing is greater if sales are close to the breakeven point. The breakeven point in number of units sold is:
Fixed cost ÷ contribution per unit.
or in monetary terms:
Fixed costs ÷ (1 - contribution margin)  

Balance Sheet 
The balance sheet is one of the most important statements in a company’s accounts. It shows what assets and liabilities the company has and how the business is funded (by shareholders and by debt, the financial structure of the company). The balance sheet provides information that is useful to asses the financial stability of a company, and a number of financial ratios are commonly calculated for this purpose, including gearing, the current assets ratio and the quick assets ratio. However ratios based on profits and cash flow are at least as important for assessing financial stability: the most important of these are interest cover and cash interest cover. We would argue that the profit and cash based ratios, as well as direct examination of the cash flow statement, are more important as they directly address the key question: can the company afford to keep up with the payments on its debt? If it can afford to meet the payments there will not be a problem, if it can not there will be.  

Current Ratio 
The current assets ratio measures a company’s ability to pay the liabilities that it is most likely to have to pay soon with that assets that should yield cash the quickest. It is calculated by dividing the current assets by the current liabilities.
As a rule of thumb, a current assets ratio of more than 2 is generally considered adequate, but this should be considered in the context of the company: the nature of the assets in question, the company’s ability to borrow further to meet liabilities and the stability of its cash flows.  

Quick assets ratio
One of the problems with the current assets ratio is that the assets counted include stocks which may or may not be quickly sellable (or which may only be sellable quickly at a lower price).
The quick assets ratio deducts stocks from the current assets, so it is calculated as (current assets - stocks) ÷ current liabilities.
A quick assets ratio of more than one is usually considered enough, but the same caveats apply as with the current assets ratio.  

Stock Turnover 
Stock (inventory) turnover measures how well a company coverts stocks into sales. It is closely related to asset turnover and is similarly a measure of efficiency. It is calculated as:
Annual sales ÷ stocks
Stock turnover is the more component of asset turnover for companies that have little tied up in fixed assets but hold large amounts of stock, usually trading rather than manufacturing companies. For more capital intensive businesses )i.e. with high fixed asset investments) fixed asset turnover becomes more important. 

Stock Days
Stock days measures the same thing as stock turnover but is calculated in a way that puts it on a more similar basis to debtor days and creditor days:
(Stocks ÷ cost of sales) × 365
Sales can be used as a proxy for cost of sales where gross margins are low, as with creditor days. Stock days is useful largely because it makes it easier to see how changes in stock days, debtor days and creditor days combine to change the working capital ratio.  

Long Term Liability 
Long term liabilities are those that are due to be paid in more than an year - those due in less than a year or on demand are current liabilities. The most important type of long term liabilities is debt, including bank loans and bonds. Preference shares are not included but given that they are “debt like” this is something investors should adjust for.
Long term liabilities are looked at by investors assessing a company’s financial health using ratios such as interest cover. Because of gearing gearing high debt enhances the benefits of growth.
Like shareholders, the holders of long term debt (i.e. banks and bondholders) are suppliers of funds to a company. They rank higher than shareholder’s in getting their money back if a company fails and therefore their money is safer, however, they do not have much to gain if the company performs better than the minimum necessary to pay back its debt.  

Interest cover
Interest cover is a measure of the adequacy of a company’s profits to keep up with the interest payments on its debt, the lower the interest cover the more the risk that profits will fall below the required level. It is calculated by dividing EBIT by net interest paid.
A value of more than 2 is normally considered reasonably safe, but companies with very volatile earnings may require an even higher level, whereas companies that have very stable earnings, such as utilities, may well be very safe at a lower level. Similarly cyclical companies at the bottom of their cycle may well have a low interest cover but investors who are confident of recovery may not be overly concerned by the apparent risk. If a company has capitalised interest, i.e. added the interest costs related to acquiring an asset to the balance sheet value of that asset, then it will not show the capitalised interest as interest paid in the profit and loss (P & L)account. When calculating interest cover capitalized interest should be included - i.e. the number used should be net interest paid as shown on the P & L plus interest capitalized. This is one of the problems avoided by using cash interest cover.  

Cash Interest Cover 
As it is necessary to pay interest immediately the cash interest cover uses the operating cash flow in place of EBIT and the net interest paid (interest paid minus interest received) as shown by the cash flow statement. Cash interest cover avoids some of the weaknesses of the P & L based interest cover, but has its own. For example interest may be incurred but the actual payment may be delayed on certain types of bonds, and these could mean that either interest paid or received could be seriously understated in the cash flow. We would suggest that cash interest cover is used as a supplement to interest cover rather than a substitute.  

Time Value of Money 
The time value of money is one the fundamental concepts of financial theory. It is a very simple idea: a given amount of money now is worth more than the certainty of receiving the same amount of money at some time in the future. Furthermore a given amount of money to be received at a given future date is worth more than the same amount of money to be received at a date further in the future. This is fairly self evident: would you rather receive a £1,000 right now or a promise (that you are certain will be kept) of £1,000 at the end of next year?
The question is of course, how much is a given amount of money on a future date worth than cash now? Fortunately there is a market rate that can be used to determine this. When investors buy government bonds, they are exchanging cash now for a greater amount of money on a future date. Therefore the risk free rate of return can be used to calculate the present value of a certain future payment.
Of course if a future payment is not certain its value needs to be adjusted for risk as well as time value and therefore its present value needs to be calculated using a discount rate that reflects both time value and risk, such as those calculated using CAPM.  

Net Present Value 
Net Present Value is the value of a stream of future cash flows, negative or positive, as the present time. The NPV includes all cash flows, for example cost of acquisition, whereas a present value does not. For example in looking at the possible purchase of a security the net present value would include the purchase price as an initial negative cash flow. The present value would only include the cash flows the security would generate after purchase.
A given interest rate needs to be used and it is applied like this:
Where CF1 is the cash flow the investor receives in the first year, CF2 the cash flow the investor receives in the second year etc. and r is the interest rate then:
NPV = CF0 + CF1/(1+r) + CF2/(1+r)2 + CF3/(1+r)3……..
Periods other than an year could be used but the interest rate needs to be adjusted. Assuming we start from an annual interest rate than to adjust to another period we would use, to get a rate i, given annual rate r, for a period x, where x is a fractions (e.g. six months = 0.5 or a multiple of the number of years):
i + 1 = (r + 1)x
If we need to use interest rates that vary over time (so r1 = rate in the first period, r2 = rate in the second period etc.) we would have to resort to a more basic form of the calculation:
NPV = CF0 + CF1/(1+r1) + CF2/((1+r1) × (1+r2)) + CF3/((1+r1) × (1+r2) × (1+r3))
This would be tedious to calculate by hand but is fairly quickly implementable in a spreadsheet.
For more on choosing interest rates please see discounted cash flows and the capital asset pricing model  

Bad debt 
Bad debt is money due, which is unlikely to be recovered. In the case of a bank or financial institution this could be loans (such as credit card debts) which have not been paid. In the case of a manufacturing or trading organization, this would (usually) be trade debts unpaid by a customer. Bad debts are an expense for the organization incurring them and are charged to the profit statement. All businesses experience some level of bad debt and it is usual to set aside a provision every year to take account of possible bad debts. For banks and other lending institution whose primary business is the lending of money bad debts are a key performance measure. The level of non-performing loans is a leading indicator of bad debts. The adequacy of bad debt provisions in relation to the level of loans and the level of non-performing loans needs to be considered. 

Non Performing Loan 
Non-performing advances or non performing assets, sometimes referred to as non-performing loans. These are loans that are not being repaid or serviced through interest payments on time. For a bank, a loan that it gives out is an ‘asset’ since it earns revenue while a deposit is a ‘liability’ because it has to be repaid at some point in time.
Typically, bank would treat an asset or loan as ‘non-performing’ or bad when it has not been serviced - typically that the interest and/or installment of principal has remained ‘past due’ or unpaid for more than 90 days. A high level of non-performing assets compared to similar lenders may be a sign of problems, as may an sudden increase. However this needs to be looked at in the context of the type of lending being done - some banks lend to higher risk customers than others and therefore tend to have a higher proportion of non-performing debt but will make up for this by charging higher interest rates to borrowers, increasing their spreads. For example a mortgage lender will almost certainly have lower non-performing assets than a credit card specialist, but the latter will have higher spreads and may well make a bigger profit on each pound lent, even if it eventually has to write off the non-performing loans.  

Provision 
A provision takes into account a liability which may occur in the future. A company will create a provision in the current period when the likely liability becomes apparent, thus reducing the reported profit (the idea behind is to reduce the overstatement of profit).
As an example, consider a company which sells on credit, which has debtors of £10,000 and on past experience it expects to fail to recover about 5% of customer’s debts - i.e. £500. Therefore the company will create a provision (provision for doubtful debtors) by reducing this year’s profits by £500 and reducing the amount of due debtors in the balance sheet by £500. In the next year, say the company has £8,000 worth of debtors, thus the amount it needs to provide as doubtful is £400 (5% × £8,000), this will increase that years profit by £100 (while the provision will reduce from £500 to £400).
It is correct to provide a provision for doubtful debtors as there is a possibility of some of the debtors not paying up. Before the introduction of a financial reporting standard (FRS 12), certain companies created provision on highly profitable years, and set off certain costs against the provision on bad times by which they artificially increased the profits. (e.g. make a provision of £100,000 on a good year, and on a bad year, write of some of the costs against the £100,000 instead of recognising the cost as an expense in the P & L)
FRS 12, effectively tries to stop companies from creating provisions as and when it pleases. To create a provision, two conditions must necessarily be satisfied:
• The company has an existing obligation, which will probably have to be settled
• A reliable estimate of the obligation can be made
The main areas to look out for with regard to provision are:
• Restructuring
• Litigation
• Environmental
• Bad debt
There are various restrictions in making the above provisions. For example, a restructuring provision should not include the costs of retraining or relocating staff, or marketing costs. An investor should look at any movement or creation of a provision. The reasons should be clear. Typically, the details of the provisions will be found in the notes to the accounts. Lack of clarity may be a sign of smoothing (moving profits from good year’s to bad) or other manipulation.  

Initial Public Offering (IPO)
An IPO is the sale of shares to the public as a precursor to the shares trading on an exchange for the first time. IPOs are not the only type of public offer (they are also sometimes used to sell very large stakes, usually by a former controlling shareholder) but they are the most common. IPOs are also not the only way in which to bring a company to market, but again they are the most common.
The process of the IPO can vary but it will involve some sort of application process for shares. The price at which the shares are sold will either be pre-determined, or determined by an auction process. An IPO also usually needs a mechanism for deciding how to distribute shares when there are too many applications (the offer is “over-subscribed”). This may be partly solved by an auction, but even auctions can have too many applications at a particular price point (i.e. higher prices will not buy the whole issue, at this price it is over-subscribed).
The terms of any particular IPO are described in detail in the offer document. In fact the level of disclosure available during an IPO tends to be extremely good, and can be better than that of similar listed companies (or the company’s own disclosure post-IPO). This results from the need to compensate for the lack of a track record at a listed company. An IPO would usually be priced low enough to ensure that the entire offer is taken. It is common for an underwriters (usually an investment bank) to agree to buy the entire offer at the offer price if it is not taken by the public. The fees paid to advisers for an IPO are substantial and, along with mergers and acquisition, they are a major source of revenue for investment banks, especially when bullish markets and high valuations tempt private companies to list. 

Management buy-outMBO 
A management buy-out (MBO) is the acquisition of a business by its existing management, most often as part of a consortium. When the owners (the existing shareholders) of a business want to sell out, the existing management are often the people in the best position buy them out, and to take the business forward. They have expert knowledge of the company and its work-force and are therefore in a strong position both to value it (to decide if it is worth buying) and subsequently run it. The cynical may also take the view that they will work harder or better for themselves than for other people.
The main problems for the buy-out team will be securing the necessary finance. MBOs generally require more capital than a start-up or expansion. Many MBOs are part-financed by venture capital or private equity firms.
A typical MBO would involve the managers setting up a new holding company, which together with the financier will purchase the shares of the target company. Variations include a management buy-in (MBI), in which external management buy the business, and a buy-in management buy-out (BIMBO), which is a combination of the two.
A management buy in may happen where the business is under-performing due to weak management or lack of suitable expertise or where the business growth demands a more knowledgeable and experienced management team.  

Par Value 
The par value of a share is the amount that is shown on the face of a share as its value. The par value is an arbitrary amount that is determined when a company is incorporated. Its only real importance is that (in the UK at least) shares cannot be issued at less than their par value.
It is possible to issue shares for a payment that is less than their par value, with shareholder’s then liable to pay the remainder later, however this does not happen with listed companies shares so it is of little importance to investors.
The par value of a share multiplied by the number of shares is shown in a company’s balance sheet as its share capital. In addition when shares are issued at more than their par value the excess is added to the share premium reserve on the balance sheet. A company can change the par value of its shares or adjust the amount in the share premium reserve, but it is not able to do so as and when the directors and shareholders wish. These changes require permission from a court and are usually associated with large returns of capital, share splits or consolidations.
The par value must not be confused with the net assets (NAV) per share. The latter gives investors some information about what a share is worth, the par value does not. Unless a company has accumulated losses grater than its accumulated profits the NAV will be greater than the par value, as the NAV includes undistributed profits and the value of other reserves.  

Preference Share 
Preference shares (prefs) are legally shares but they are different from ordinary shares and are more similar to debt instruments, and they, like convertibles, are regarded as hybrids of debt and equity:
• Dividends on preference shares have to be paid before dividends on ordinary shares
• Preference shareholders have a higher priority if a company is liquidated than ordinary shareholders, although a lower priority than debt holders
• Dividends on ordinary shares may not be paid unless the fixed dividends on preference shares is paid first
• In the case of cumulative prefs, the if the dividend is not paid in full, the unpaid amount is added to the next dividend due.
• Preference dividends are fixed - i.e. they do not participate in increases in profits as ordinary shareholders do
The effect of these is to make the income stream from preference shares more similar to that from debt than that from ordinary shares.Most importantly fixed dividends are similar to interest payments. However because prefs are legally shares they have some characteristics of shares - their tax treatment for example. 

Cumulative Preference Shares
It is usual that a company may fail to pay a preference divided. This is usually allowed provided that no dividend is paid on ordinary shares either. In the case of cumulative prefs the amount of the unpaid dividend is added to the dividend increases in the following year, Therefore, unless a company is in a very poor financial condition, holders of redeemable prefs can be fairly sure of getting the due pseudo-interest, although the timing is somewhat more uncertain than would be the case with bonds. 

Redeemable Preference Shares
Redeemable prefs are repayable, usually at a fixed rate. Therefore they are even more similar to bonds in that an investor will receive what is in effect interest for a fixed period of time and then receive a complete return of the capital originally invested.  

Treasury Shares 
Treasury share are a company’s holdings of its own shares. A company acquires treasury shares by buying them on the market. In the UK, Treasury shares can be cancelled, sold, or used in employee share (or share option) schemes. Companies are required to disclose their holding of treasury shares and any sales, cancellations or transfers.
The commonest use of treasury share among UK listed companies seems to be to hold shares for employee share schemes. Treasury shares do not receive dividends or rights and they can not be used to vote at or attend company meetings. They are shown on the balance sheet, but they are deducted from share capital. Treasury shares are disregarded in calculating undiluted EPS.  

Equity 
Equity is share capital, one of the two main sources of funding for companies, the other being debt. The most important form of equity is ordinary shares. Ordinary share usually have equal voting rights to all other shares (one share, one vote), and are entitled to equal dividends. Some companies may have special classes of shares that have extra rights over ordinary shares but this has become increasingly less common.
Some companies also have classes of share that have fewer rights than ordinary shares, most commonly non-voting shares, which typically are entitled to the same share of profits as ordinary shares, but do not give the shareholder a vote. Again, these are becoming less common. Investors are generally (quite rightly) very wary of companies where the voting rights are structured so as to distribute control differently from economic interests in the company. This tends to mean that a minority of shareholders can run the company to suit themselves. The other common form of shares are preference shares, which have some characteristics that make them more akin to bonds, although they are legally (and therefore for tax purposes) shares. A company’s articles define the rights of different classes of shareholders and endless variations on the above are possible. Changes to the rights of different classes of shareholders usually require the agreement of the majority of shareholders of each class of shares affected, even if these are non-voting shares.  

Limited Liability 
Shareholders are not liable for the debts of a company they own shares in (with certain very limited exceptions which are not relevant to shareholders in listed companies). This is known as limited liability. Apart from the obvious consequence (shareholders can not lose more than what the actually put into buying shares), limited liability has a number of consequences for the valuation of both equity and debt. Limited liability means that debt holders have no recourse other than to a company’s own assets (except where explicit guarantees have been given, or other special circumstances exist). This simplifies the valuation of debt although it reduces it.
Limited liability also creates an agency problem, by creating a conflict of interest between shareholders and debt holders. Shareholders can, in effect, walk away from a failed company, leaving creditors with its assets. This means that changes in (business not investment) strategy that make a company more risky but increases expected returns for shareholders and increase the risk for debt holders. For the same reason, limited liability also means that shares can (although they rarely are) be valued as options - if the business (i.e. a company’s EV) becomes worth less than its debt, then shareholders walk away (i.e. exercise a put option) leaving the assets and business of a company (the underlying security) to its creditors.  

Risk 
In the context of investment, risk may be defined as the probability that the actual outcome (or return) may differ from the expected. The key difference from the use of the word risk in the most other context is in an investment context risk covers the possibility that the actual outcome may be better than expected, as well as worse than expected. The terms upside risk and down side risk are used to describe the positive and negative risk respectively. For example an analyst who comments on the upside risk to a share price is talking about the chances of the price rising.
When investors talk of managing risk, it is mainly downside risk that is being minimised. However strategies for reducing downside risk involve trade-offs and so will either reduce the expected return (for example hedging with options) or the upside risk (for example selling a very volatile share to buy something more stable). 

Variable Cost 
On the other hand variable costs change with sales. Examples of variable costs are raw materials, shipping and depletion. The opposite of variable costs are fixed costs. Semi-variable costs have fixed and variable elements. A high level of variable costs means a low level of operational gearing.  

Semi Variable Cost 
Semi-variable costs are those that have both fixed cost and variable cost elements. For example a manufacturer’s electricity bill may include elements that are fixed (such as lighting that is required regardless of the level of production) and elements that are variable (such as the electricity used by machinery directly involved in manufacturing).  

Fixed Cost 
Fixed costs are those that do not change with the level of sales. If sales increase or decrease but nothing else changes then fixed costs remain the same. Common examples of fixed costs include rents, salaries of permanent employees and depreciation. A high level of fixed costs increases operational gearing.
Costs that are not fixed are variable or semi-variable.  

Working Capital 
Working capital is the amount of money that a company has tied up in funding its day to day operations - i.e. without the value of its fixed assets and other investments. A company has to tie up money to fund its stocks, credit sales and other current assets, but this is offset by its ability to fund this from short term liabilities such as purchases on credit - if a company buys on credit it does not have to tie up (as much) money in its stocks. In some businesses (such as grocery retail) working capital can even be negative - if you buy on credit and sell for cash your suppliers are partly funding your business. The most common definitions of working capital are:
• current assets minus current liabilities
• stocks + trade debtors - trade creditors.
The advantage of the second definition is that it focuses on the most important parts of working capital from the point of view of judging the efficiency of a business’s operations and avoids some short term liabilities (such as overdrafts) which reflect the financing of the business rather than the capital requirements of its operations. The working capital ratio (stocks + trade debtors - trade creditors) ÷ sales is an indicator of the efficiency of a company’s management of stocks, debtors and creditors. If the ratio is 0.2, this means the company needs 20p for every £1 in sales as working capital - i.e. if the company needs to undertake a £100,000 order, the company will need to find £20,000 to fund the order. Changes in the working capital ratio can be further analysed by decomposing them into changes in debtor days, creditor days and stock days. It is also worth looking at trends in working capital, and in particular the reasons for increases or decreases. For example if working capital is growing faster than sales it could mean that the company is offering over generous credit terms to get sales, or that it is over stocking - to name two of many possibilities. Either of these would also slow the conversion of profits into cashflow. Working capital, particularly when defined as current assets minus current liabilities, is closely related to key measures of financial stability such as the current asset ratio and the acid test (quick assets) ratio.  

Capital Adequacy 
Capital adequacy is a measure of the financial strength of a bank or securities firm, usually expressed as a the of its capital to its assets as a percentage. It measures the extent to which a bank can absorb losses. Bank regulators ensure that banks and other financial institutions have sufficient capital to keep them out of difficulty. This not only protects depositors the wider economy - because the failure of a big bank has extensive knock-on effects. The risk of knock on effects that have repercussions on the level of the entire financial sector is called systemic risk to the banking system. A failing bank fails to meet obligations to both its depositors and to other banks. This can trigger further failure which then spread. The lack of confidence in the financial system caused by a bank failure can cause a run on banks (lots of withdrawals) which can cause further failures.
An international capital adequacy standard for banks was specified by the Basel committee of the Bank for International Settlements in 1992. This ratio, now known as known as Basel 1, required banks to have capital equal to 8% of their risk the total weighted value of their assets. Each class of asset has a weight of between zero and 1 (or 100%). Very safe assets such as government debt is likely to have a zero weighting, high risk assets (such as unsecured loans) will have a rating of one, with other assets somewhere in between. The weighted value of an asset is its value multiplied by the weight for that type of asset. The Basel 1 accord is to be replaced, in stages from the end of 2006, by new rules (known as Basel 2) . Basel 2 is based on three ‘pillars’: minimum capital requirements, supervisory review process and market forces. The first “pillar” is similar to the Basle one requirement, the second is the use of sophisticated risk models to ascertain whether additional capital (i.e. more than required by pillar 1) is necessary.
The third pillars uses market forces by requiring more disclosure of risks, capital and risk management policies. This encourages the markets to react to the taking of high risks. In addition to specifying levels of capital adequacy, most countries (including the UK) have regulator run guarantee funds that will pay depositors at least part of what they are owed. It is also usual for regulators to intervene to prevent outright defaults.  

Cash Cycle 
The cash cycle, also called the cash conversion cycle, is a measure of the length of time it takes to get from paying cash for stock (inventory) to getting cash after selling it. It is equal to:
stock days + debtor days - creditor days
The length of the cash cycle dictates the amount of money that needs to be tied up in working capital (for a given level of sales). Obviously a shorter cash conversion cycle is better, other things being equal. It is possible for the cash conversion cycle to be negative, this is most likely for retailers who buy on credit and sell on cash - but it also requires high stock turnover.  

Cost of Sales 
Cost of sales, or cost of goods sold, measures the cost of the goods (or services) supplied in a period. The cost of what a company sells is accrued with the cost of producing or supplying it. It is the difference between sales and gross profit. The cost of goods sold is one of two costs deducted in arriving at the operating profit, the other being S, G & A costs. Because stocks may be revalued, the cost of sales accrued to the sales in a particular period reflects both an revaluations of stocks and the methods of allocating the cost of stocks (e.g. FIFO or LIFO).
As the cost of sales excludes overheads, it has a higher proportion of variable costs than the operating costs as a whole, however it still contains some fixed costs - labour costs for example. However there are many cases where the cost of goods almost wholly contains variable costs.  

Gross Profit 
Gross profit is a very simple measure of profit. It is:
sales minus cost of sales
Given that it excludes many costs, including all overheads and all financing costs it is not a good measure of how profitable a company is as a whole, but rather how much of a mark up it can make on sales. Changes and trends in gross profit margin often give investors useful information.  

Non Interest Income 
There are two common measures of the income banks generate other than from interest: the non-interest income level and the fee income level. Different banks have very different sources of income and this in turn means they have different drivers. Interest income is influenced by both the economic cycle and the level on interest rates, fee income is cyclical, non-interest income other than fees (i.e. primarily bank charges) is comparatively defensive. 

Non-interest income level
Non-interest income ÷ operating income
This measures total non-interest income as a proportion of operating income -i i.e. it shows how much of profits come from all sources other than interest spreads including fee income.  

Fee income level
Fee income ÷ operating income
Fee income covers most income which is neither interest income or bank charges. This includes a wide range of sources of income including fund management fees, loan arrangement fees, fees for advice, trust and custody fees, and commission on sales of third party financial products such as insurance.  

Inflation 
Inflation is a deceptively simple concept: as everyone already knows, it is the rate at which prices rise. However the accurate definition and measurement of inflation is not that easy. There are far too many goods and services produced in and imported by an economy for it to be feasible to gather data on the prices and sales volumes of every single one. Inflation is therefore usually measured as the percentage change in a representative basket of goods.
It are also difficulties in deciding how to treat financial services. For example higher mortgage interest payments make peoples lives more expensive. However, strictly speaking, they represent economic rents, transfers of wealth, rather than payments for services, and therefore should be excluded from inflation measures. In the UK a number of different inflation measures are published by the Office of National Statistics, of these the consumer price index excludes mortgage interest payments and certain other housing related costs, the retail price index includes them.
Another difficulty is that the products available at different times may be different in ways that make direct price comparisons less meaningful. For example the quality of products may be improved by advancing technology - for example consider a comparison of the cost of a song on CD with that of a vinyl recording from thirty years previously. The (partial and rather difficult) solution is the use of hedonic price indices. 

Deflation
Deflation is simply negative inflation. In general inflation is positive at the level of an economy as a whole. However inflation can turn negative during recessions. Deflation is also not uncommon in certain industries - in certainly technology sectors it is usual. 

GDP Deflator
The GDP deflator is the inflation measure that is used to adjust economic growth statistics.  

Recession
In macroeconomics, a recession is a decline in a country's gross domestic product (GDP), or negative real economic growth, for two or more successive quarters of a year.
An alternative, less accepted definition of recession is a downward trend in the rate of actual GDP growth as promoted by the business-cycle dating committee of the National Bureau of Economic Research.[1] That private organization defines a recession more ambiguously as "a significant decline in economic activity spread across the economy, lasting more than a few months." A recession has many attributes that can occur simultaneously and can include declines in coincident measures of activity such as employment, investment, and corporate profits. A severe or prolonged recession is referred to as an economic depression.