Tag business terms

Part two in my series of “Financial Terms You Should Know”

1. Capital stock – Total amount of a firm’s capital, represented by the value of its issued common and preferred stock (ordinary and preference shares).
2. Cash flow – Incomings and outgoings of cash, representing the trading (operating) activities of a firm. In accounting, cash flow is the difference in amount of cash available at the beginning of a period (opening balance) and the amount at the end of that period (closing balance). It is called ‘positive’ if the closing balance is higher than the opening balance, otherwise called ‘negative.’ Cash flow is increased by (1) selling more goods or services, (2) selling an asset, (3) reducing costs, (4) increasing the selling price, (5) collecting faster, (6) paying slower, (7) bringing in more equity, or (8) taking a loan. It is termed the ‘life blood’ of a firm—more firms (including the asset-rich ones) go out of business due to an anemic cash flow than for any other reason. However, the level of a firm’s cash flow is not a good measure of its performance, and vice versa: high levels of cash flow do not necessarily mean high or even any profit; and high levels of profit do not automatically translate into high or even positive cash flow.
3. Compound growth rate – A measure of how much something grew on average, per year, over a multiple-year period, after considering the effects of compounding.
4. Current assets – A balance sheet item which equals the sum of cash and cash equivalents, accounts receivable, inventory, marketable securities, prepaid expenses, and other assets that could be converted to cash in less than one year. A company’s creditors will often be interested in how much that company has in current assets, since these assets can be easily liquidated in case the company goes bankrupt. In addition, current assets are important to most companies as a source of funds for day-to-day operations.
5. Current ratio – An indication of a company’s ability to meet short-term debt obligations; the higher the ratio, the more liquid the company is. Current ratio is equal to current assets divided by current liabilities. If the current assets of a company are more than twice the current liabilities, then that company is generally considered to have good short-term financial strength. If current liablities exceed current assets, then the company may have problems meeting its short-term obligations. For example, if XYZ Company’s total current assets are $10,000,000, and its total current liabilities are $8,000,000, then its current ratio would be $10,000,000 divided by $8,000,000, which is equal to 1.25. XYZ Company would be in relatively good short-term financial standing.
6. Days accounts receivable – Average number of days a firm takes to collect payments on goods sold. Numbers much higher than 40 to 50 days indicate collection problems and significant pressure on cash flows. Numbers much lower than 40 to 50 days indicate overly-strict credit policies that might be preventing higher sales revenue. Also called days sales in receivables or debtor days. Formula: Average accounts receivable x 365 ÷ sales revenue.
7. Days sales in inventory – A measure of performance, calculated by average inventory divided by average daily cost of sales. This returns a figure equivalent to the number of days an item is held as inventory before it is sold. The lower the days inventory, the more efficient the company is, all other things being equal. Days inventory is the first step measured in the cash conversion cycle, followed by Days Sales Outstanding and days payable outstanding.
8. Debt service coverage – A measure of a company’s or individual’s ability to cover, or pay off, debt. Debt service coverage refers to the amount of cash or cash flow required to pay off a debt, and how much the total debt actually is. The better the debt service coverage, the better off a company or individual is.
9. Debt/equity ratio – A measure of a company’s financial leverage. Debt/equity ratio is equal to long-term debt divided by common shareholders’ equity. Typically the data from the prior fiscal year is used in the calculation. Investing in a company with a higher debt/equity ratio may be riskier, especially in times of rising interest rates, due to the additional interest that has to be paid out for the debt. For example, if a company has long-term debt of $3,000 and shareholder’s equity of $12,000, then the debt/equity ratio would be 3000 divided by 12000 = 0.25. It is important to realize that if the ratio is greater than 1, the majority of assets are financed through debt. If it is smaller than 1, assets are primarily financed through equity.
10. Direct costs or expenses – A cost directly attributable to the manufacturing of a product.
11. Direct labor – Employees or workers who are directly involved in the production of goods or services. Direct labor costs are assignable to a specific product, cost center, or work order.
12. Dividends – Share of the after-tax profit of a firm, distributed to its stockholders (shareholders) according to the number and class of stock (shares) held by them. Smaller firms distribute dividend usually at the end of an accounting year, whereas larger, publicly held firms usually distribute it every quarter. The amount and timing of the dividend is decided by the board of directors, who also determine whether it is paid out of current earnings or the past earnings kept as reserve. Holders of preferred stock (preference shares) receive dividend at a fixed rate and are paid first. Holders of common stock (ordinary shares) are entitled to receive any amount of dividend, based on the level of profit and the firm’s need for cash for expansion or other purposes. Corporate legislation generally forbids payment of dividend out of anticipated but not yet received (unrealized) profit. Normally all dividend payments are taxable, often at the source (the firm).