Glossary of Financial Analysis Terms
Accounts payable
A current liability representing the amount owed to trade creditors for merchandise or services purchased on open account (i.e., without giving a note or other evidence of debt).
Accounts payable period (days)
Expressed in days, it represents the length of time it typically takes to pay trade creditors. This is calculated by dividing cost of goods sold by accounts payable, which is equal to accounts payable turnover, and then dividing 365 by this turnover. If the period being measured is not a year, then cost of goods sold should be annualized before making this calculation.
Accounts receivable
A current asset representing money owed for merchandise or services sold on open account.
Accounts receivable aging
Grouping accounts receivable per due dates that represent the length of time an account has been outstanding, such as:
0–30 days
31–60 days
61–90 days
Over 90 days
Accounts receivable collection period (also known as days’ sales outstanding or DSO)
Expressed in days, it represents the length of time it typically takes to collect outstanding accounts receivable. This is calculated by dividing sales by accounts receivable, which is equal to accounts receivable turnover, and then dividing 365 by this turnover. If the period being measured is not a year, then sales should be annualized before making this calculation.
Accrual-basis accounting
The practice of record keeping by which revenue is recorded when earned, and expenses are recorded when incurred, even though cash may not be received or paid out until later. This is opposed to cash-basis accounting, which only recognizes revenue when cash is received, or expenses when cash is paid.
Accrued expenses
A current liability representing expenses incurred during a fiscal period, but not actually paid by the end of that fiscal period.
Accumulated depreciation
Also referred to as allowance or reserve for depreciation. The total of all depreciation taken on a fixed asset since its purchase.
Administrative expenses
Also referred to as general and administrative expenses (G&A), operating expenses, indirect expenses, or overhead. These expenses typically include utilities, advertising, legal, accounting, travel, entertainment, administrative salaries, office expenses, professional fees, taxes and licenses, etc.
Amortization expense
The gradual write-off of an intangible asset, such as copyright or goodwill, over a period of years. It is a noncash charge against earnings, like depreciation.
Appreciation
The increase in the value of an asset more than its cost or book value, which is due to economic and other conditions.
Asset
Anything owned by an individual or a business. Assets may consist of specific property or claims against others. Assets are reflected on the balance sheet at the lower of cost or current value.
Bad debts
The amounts due on open accounts that have been proven uncollectible.
Balance sheet
An itemized statement of all the assets, liabilities, and equity of an individual or business at a given point in time. It is known as a position statement.
Balance sheet spread
The organization of several years of balance sheets on one piece of paper for ease of analysis of trends and calculation of financial ratios.
Book value
The value of the assets, liabilities, and equity as reflected on the balance sheet. The book value of a business is determined by deducting total liabilities from total assets. Book value of the assets of a company may have little or no relationship to the actual fair market value of the assets.
Break-even point
The point at which revenue and expenses are equal. A combination of revenue and expenses that will yield zero net profit.
Budget
An itemized listing of the amount of all estimated revenue that a given business anticipates receiving and the listing and segregation of the amount of all estimated expenses that will be incurred in obtaining the income during a given period, such as a month, a year, etc.
Capital
The amount of money invested in the business by shareholders. It consists of the initial stock investment and retained earnings It is also referred to as equity or net worth.
Capital assets
A term that includes all fixed assets, consisting of vehicles, furniture and fixtures, land, buildings, machinery, etc.
Capital budgeting
The practice of allocating funds set aside for investment in fixed assets in the most effective manner. It takes into consideration the risks and possible returns of various potential investments. It is the process of determining whether an asset should be purchased based upon its estimated generated cash flows. It is the process of planning expenditures for capital (fixed) assets.
Capital gain or loss
The gain or loss between the book value and sale price of a capital (fixed) asset.
Capital stock
The shares of a corporation authorized by its articles of incorporation, including preferred and common stocks.
Cash-basis accounting
The practice of recording income and expenses only when cash is received or paid out. This is opposed to accrual-basis accounting, which recognizes revenue when items or services are sold and expenses when they are incurred, versus when they are paid.
Cash budget
A schedule forecasting of cash inflows and cash outflows over a specified period.
Cash flow
This term may have different meanings, depending upon who is using the term and in what context. Bankers usually define it as net profit plus all noncash expenses (depreciation and amortization), but it can also be defined as the difference between cash receipts and disbursements over a specified period. This text describes operating cash flow and financing cash flow, which differ slightly from the definitions applied by a CPA in their statement of cash flow as provided with CPA-prepared financial statements.
Collateral
Assets that secure a loan.
Common-sized balance sheet or income statement
The process of dividing individual revenue and expense account balances by total revenue or dividing an individual asset, liability, or equity account by total assets to determine each account’s value as a percentage of revenue or total assets. For the balance sheet, each account is divided by total assets. For the income statement, each account is divided by sales/revenue.
Comprehensive financial plan
A comprehensive financial plan is comprised of an historical review and a one to three-year projection of the income statement, balance sheet, cash flow, and financial ratios.
Contribution margin
The difference between revenue and variable expenses:
revenue $400,000
minus variable expenses ($150,000)
equals contribution margin $250,000
This tells you that you have $250,000 left after paying variable expenses to pay fixed expenses. If your fixed expenses exceed $250,000, then you need to either increase revenue or reduce fixed expenses, or both, to avoid losing money.
Contribution margin ratio (CMR)
The contribution margin expressed as a percentage of revenue.
revenue ÷ contribution margin = contribution margin ratio.
Corporation
A type of business organization chartered by a state and given legal rights as a separate entity. A C corporation is a tax-paying entity, and an S corporation is not a tax-paying entity but passes its profits (or losses) through to its shareholders.
Cost of goods sold
Expenses related directly to the production of revenue for a business. This usually includes raw materials, direct labor, freight, and factory overhead for a manufacturing company; merchandise costs for a wholesaler or retailer; and direct labor and materials for a service company. This is also referred to as direct expenses for a service company.
Current assets
Current assets are those assets of a company that are reasonably expected to be converted to cash or consumed during the next twelve months from the date of the balance sheet. Current assets include cash, accounts receivable, inventories, and prepaid expenses (note that accounts receivable and prepaid expenses exist only on an accrual-basis balance sheet).
Current liabilities
Liabilities that are due within twelve months of the date of the balance sheet. Current liabilities include such accounts as bank line of credit, accrued liabilities, accounts payable, and current portion of long-term debt (note that accounts payable and accrued expenses exist only on an accrual-basis balance sheet).
Current ratio
This ratio is a measure of liquidity and the company’s ability to pay its bills. It is calculated by dividing current assets by current liabilities.
Debt-to-equity ratio
This ratio is a measure of the company’s safety and ability to survive adversity. It is calculated by dividing total liabilities by equity. This is an important ratio for banks, since it is one way to measure a company’s risk level.
Depreciation expense
The amount of expense a company charges against earnings to write off the cost of fixed assets over their useful lives. If the expense is assumed to be incurred in equal amounts in each business period over the life of the asset, the depreciation method used is straight line (SL). If the expense is assumed to be front-loaded and incurred in decreasing amounts in each business period over the life of the asset, the method used is accelerated. Usually straight line depreciation is chosen for financial statement purposes, and accelerated depreciation is chosen for tax return purposes. This produces a lower profit on the tax return and is permitted by IRS regulations.
Direct expenses
This is the same as cost of goods sold. Usually used in reference to a service type business.
Dividend
That portion of a corporation’s earnings that is paid to the stockholders and not retained in the business.
Entrepreneur
A person who assumes the risk of starting a business.
Equity
The net worth or ownership interest in a company. It is the difference between the assets and the liabilities of a company. In a corporation, net worth or owner’s equity consists of capital stock, capital surplus, and retained earnings.
Financial gap
The financial gap represents the amount of funding the business is unable to generate internally to purchase the assets required to support revenue. The business must make up the difference with either debt or additional equity.
Fixed assets
Those assets of a noncurrent nature, which will not normally be converted into cash during the next twelve months (which are current assets). Examples are furniture and fixtures, land, buildings, and equipment. A fixed asset that is to be sold within a twelve-month period is not considered to be a current asset.
Fixed expenses
Those expenses that do not vary directly with sales or revenue. Examples include rent, depreciation, lease expense, office expenses, legal, and accounting.
Fluctuating current assets
Those assets that go up and down with seasonal fluctuations in revenue. Typically, they are the seasonal demands for inventory and accounts receivable.
Goodwill
Goodwill is an intangible asset that is created to the extent that the purchase price of a company is greater than the fair market value of the total assets. It is synonymous with the term blue sky, and it can only arise on a balance sheet as the result of purchasing a business. Treatment of goodwill for tax or accounting purposes changes from time to time, and it is therefore necessary to ask your CPA how it should be handled.
Gross profit
The difference between revenue and the cost of goods sold.
$1,500,000 revenue
($975,000) minus cost of goods sold (direct expenses)
$525,000 equals gross profit
This tells you that you have $525,000 in gross profit to pay overhead or indirect expenses. If your overhead exceeds $525,000, then you either need to increase your gross profit margin, reduce overhead, or both.
Gross profit margin (GPM)
The gross profit expressed as a percentage of revenue.
Revenue ÷ gross profit = gross profit margin
A gross profit margin of 35 percent would mean that there is $0.35 in gross profit for every $1.00 in revenue.
Income statement
The statement of revenue, expenses, and profit for a period. It is known as a period statement.
Indirect expense
Same as operating expense, general and administrative expense (G&A) or overhead. Usually used about a service-type business.
Intangible assets
Nonphysical assets such as goodwill, patents, copyrights, operating authorities, and trademarks.
Inventory turnover
The number of times a business turns its inventory over during the year. This is calculated by dividing cost of goods sold by inventory.
Liabilities
Amounts owed to creditors by a person or a business.
Limited liability company (LLC)
A form of business, like a corporation, with liability protection for all the owners (referred to as members). It is taxed in the same fashion as an S corporation.
Line of credit
agreement whereby a bank agrees to lend a customer funds up to agreed maximum amount. A line of credit is typically used for seasonal needs to finance inventory and/or accounts receivable and is secured by accounts receivable that do not exceed ninety days.
Liquidity
A term to describe a firm’s ability to meet its current obligations. It is measured by the current ratio.
Long-term debt
Liabilities that are due more than one year from the date of the balance sheet.
Markup
The difference between the cost and selling prices of merchandise, usually expressed as a percentage. To calculate markup as a percentage, use the difference between the cost and selling prices for the numerator and the cost for the denominator. An item that cost $1.00 and had a selling price of $1.50 would have a 50 percent markup ($0.50 ÷ $1.00). This is not the same as, but is often confused with, the gross profit margin. In the above example, the gross profit margin would be thirty-three percent (.50 ÷ 1.50). Markup is applied to the cost and gross profit margin is applied to the sales price.
Mortgage
A long-term debt with real estate pledged as collateral.
Net income
Often used by CPAs to signify net profit after tax.
Net loss
The excess of total expenses over total income for a fiscal period, either before or after tax.
Net present value (NPV)
The net present value is equal to the present value of future returns, minus the present value of future payments.
Net profit
The excess of total income over the total expenses for a fiscal period, before income taxes.
Net profit margin
The net profit (before tax) as expressed as a percentage of revenue.
net profit ÷ revenue equals net profit margin.
Note payable
A written promise to a person or business to pay a certain amount at a certain time.
Operating cash flow
The cash flow the company generates from its day-to-day operations. The description of operating cash flow in chapter four is slightly different from the one provided by a CPA-prepared statement of cash flow.
Operating expenses
Those expenses pertaining to the normal operation of the business. Interest expense and nonrecurring losses are not included as operating expenses. Also referred to as overhead or indirect expense.
Operating profit
The difference between the gross profit and overhead or indirect expenses. This tells you the amount of profit that has been generated from operations of your business.
Revenue $950,000
Cost of goods sold 500,000
Gross profit 450,000
Overhead expenses 400,000
Operating profit 50,000
Operating profit margin
The operating profit expressed as a percentage of revenue.
Operating profit ÷ revenue equals operating profit margin (OPM).
50,000 ÷ 950,000 = 5.3%
Permanent current assets
Represents the permanent base of current assets (inventory, accounts receivable, and cash) that a business will have on hand based on the revenue level of the business at its lowest period. In other words, current assets do not go down to zero, and the lowest amount during the year represents the amount of permanent current assets that the business will have.
Preferred stock
Stock that grants its owners certain preference rights over common stockholders, usually dividend and/or voting rights.
Present value
The value today of a future receipt or payment of money, discounted at an appropriate discount rate. The present value of an amount to be received in the future is worth less than the future face amount because of the need to wait for the payment, thus preventing you from earning any return (like interest) on it. Receiving $1.00 in one year’s time is the same as a present value of $0.95 if it is discounted at 5 percent. In other words, if you had $0.95 today, it would be worth $1.00 in a year if it were invested at 5 percent. Net present value is the difference between the present value of future receipts and the present value of future payments.
Quick assets
Cash, accounts receivable, and marketable securities.
Quick ratio
The quick ratio is calculated by dividing quick assets by current liabilities. This ratio is not typically calculated for service businesses because it will be very like the current ratio.
Retained earnings
Earnings of the business that have been retained in the business and not paid out to stockholders.
Return on assets (ROA)
Return on assets is the ratio of net profit (before taxes) to total assets.
Net profit ÷ total assets = return on assets
Return on equity (ROE)
Return on equity is the ratio of net profit (before taxes) to equity or net worth. This may also be referred to as return on investment (ROI).
Net profit ÷ equity = return on equity
Revenue
Synonymous with sales. Usually used in a service business.
Sales to assets ratio
This is the ratio of sales or revenue divided by total assets.
Sales ÷ total assets = sales to assets ratio
Sales to net fixed assets ratio
This is the ratio of sales or revenue divided by net fixed assets.
Sales ÷ net fixed assets = sales to net fixed assets ratio
Secured loan
A loan that is secured by some sort of collateral, as opposed to an unsecured loan. Secured loans may be either long-term or short-term loans.
Self-liquidating loan
A short-term commercial loan, usually supported by a lien on a given product or commodity, which is liquidated from the proceeds of the sale of the product or commodity.
Stockholder
A person owning shares of the capital stock of a corporation. Also referred to as a shareholder.
Term loan
A long-term loan due more than one year.
Trend analysis
The process of measuring financial data over a given period to note any significant changes in performance from period to period.
Variable assets
Those assets that go up or down with sales or revenue volume, such as accounts receivable. These assets are needed to support revenue.
Variable expenses
Expenses that are caused by revenue, and go up or down with sales or revenue volume. Examples include commissions, direct wages, supplies, and bad debts.
Variable liabilities
Those liabilities that go up or down with revenue volume. They typically are accounts payable and accrued expenses.
Working capital
This is defined as current assets minus current liabilities. All financially stable companies need adequate working capital so that they can make payments when they are due, either to vendors, employees, or creditors. A current ratio of 2.00 means that there is $2.00 in current assets to pay every $1.00 in current liabilities, or $1.00 in working capital ($2.00 minus $1.00).