Financial Terms Glossary

by John Kind

Financial Terms Glossary: D – F

D

DEBENTURE

A form of long-term borrowing which may be secured by a mortgage or charge on a specific asset such as a building and/or land. A stated rate of interest is paid. Normally, a debenture has a fixed repayment date (or range of repayment dates). Some debentures may be traded on the Stock Exchange.

 

DEBT

Interest-bearing liabilities such as short and long-term bank loans.

 

DEBT TO EQUITY RATIO

The relationship between debts which are interest-bearing liabilities or borrowings and equity. Equity is the finance provided by and attributable to shareholders. The debt-equity ratio measures the financing provided by outsiders (debt) relative to the financing provided by owners or shareholders (equity). The higher the debt-equity ratio, the greater the financial risk because an organisation will have to pay higher interest charges and repay higher levels of borrowings.

The average debt-equity ratio is about 65 per cent in Europe. This means that for every £100 contributed by shareholders, borrowings provide an additional £65 of funding.

The debt-equity ratio is also known as the gearing or leverage ratio. A common definition is net debt (total borrowings less short-term deposits and cash balances) expressed as a percentage of equity.

 

DEBTORS

Amounts due to an organisation from third parties. The largest element is usually accounts receivable or trade debtors; amounts due from customers.

 

DEPRECIATION

As a fixed or non-current asset such as a car or plant and machinery is used, its value falls. This fall in value is recognised as a cost in the income statement or profit and loss account. The fall in value will also be a deduction from the original cost of the asset in the balance sheet.

The purpose of depreciation is to reduce or write down the cost, less any salvage value, of a fixed asset over its estimated commercial life. It is a bookkeeping entry and does not represent a cash outlay.

The most common depreciation method is ‘straight line’ depreciation. A fixed asset is reduced in value in equal annual instalments over its estimated life.

 

DISCOUNTED CASH FLOW (DCF)

A method used to calculate the present value of cash flows taking into account the ‘time value’ of money. This ‘time value’ recognises that cash received today is worth more than cash received in the future because, in the meantime, it can earn a return.

 

DIVIDEND

The discretionary cash payment recommended by the board of directors and approved by the shareholders to be distributed pro rata among the shares outstanding. ‘Non-cash’ dividends can also be paid, for example, when a company issues more shares to the value of the dividend.

On preference shares, the dividend is usually a fixed amount. On ordinary shares, the dividend varies with the performance of the organisation and the amount of cash available. It may be reduced or omitted if performance is poor or if cash is retained to finance acquisitions and to invest in new projects. Sometimes a company will pay a dividend based on past performance even if it is not profitable. In this case, the dividend is said to be ‘uncovered’.

Dividends are sometimes paid in two installments – an interim dividend paid during the financial year and a final dividend paid after the end of the financial year.

 

DIVIDEND COVER

The profit attributable to shareholders called ‘earnings’, divided by the total dividend. It is a measure of the security of a dividend. The higher the dividend cover, the more secure the dividend will be since, if earnings fall, the less likely it will be that the dividend will be reduced. A typical dividend cover is two which means that earnings are double the dividend.

An uncovered dividend will have a dividend cover of less than one. Such a situation may lead to future dividends being reduced or passed (no dividend being paid at all).

An alternative measure to dividend cover is the payout ratio. This is the annual dividend expressed as a percentage of the earnings. A dividend cover of two is equivalent to a payout ratio of 50 per cent.

 

DIVIDEND YIELD

The annual dividend per share expressed as a percentage of the share price.

A relatively low dividend yield implies that an investor is prepared to accept a low dividend because the company is perceived to have favourable longer-term prospects. An investor expects to be rewarded by an increase in the share price with higher dividends being paid later. Alternatively, a low dividend yield may mean that the business concerned cannot afford to pay a dividend or can only afford to pay a small dividend because it needs to conserve its cash.

A relatively high dividend yield implies that an investor is not prepared to wait for an appreciation in the share price because the outlook for earnings growth is perceived to be poor and/or the risk of holding the company’s shares is perceived to be high. In this situation, an investor requires a relatively high dividend income as compensation for the uncertain future prospects.

The average dividend yield for leading companies in the UK is about 3.5 per cent.

 

DOUBLE ENTRY BOOKKEEPING

The standard method for recording financial transactions. Every item is entered as a debit or credit in one account and a corresponding credit or debit is made in another account.

 

E

EARNINGS or NET INCOME

The profit after all costs including taxation less any preference dividends and the minority interest. It is the ‘bottom line’. It is the profit attributable to the owners of a company; the ordinary shareholders before they receive a dividend. The American expression for earnings is ‘net income’. The term ‘net profit’ may also be used.

 

EARNINGS PER SHARE (EPS)

Earnings divided by the number of issued ordinary shares. Growth in EPS is an important financial performance indicator. Fully diluted earnings per share is worked out after allowing for the extra shares that may be issued in the future, for example, from employee share option schemes.

 

EBITDA

This stands for earnings before interest, tax, depreciation and amortisation. It is equivalent to revenues less the cash cost of sales and less cash operating costs.

Depreciation and amortisation are ‘non-cash’ costs and are, therefore, excluded from cash costs. Ebitda is also equivalent to operating profit plus depreciation and amortisation.

Ebitda is both a measure of profitability and an indicator of the ability of a business to generate short term cash flows from its trading activities. For this reason, ebitda may be referred to as ‘operating cash flow’.

 

EQUITY

The financing of an organisation attributable to and provided by the owners or shareholders.

Equity is equal to total assets less short and long term creditors. This is equivalent to issued share capital plus retained profit/earnings plus other reserves such as a revaluation reserve.

Equity can be referred to as net assets, net worth, share capital and reserves, shareholders’ funds, shareholders’ interest or equity shareholders’ funds.

 

EXCEPTIONAL ITEMS

Unusual items in an income statement or profit and loss account such as redundancy or re-organisation costs and significant write-downs or write-offs in the value of assets and investments. Financial results are shown both before and after exceptional items.

 

F

FACTORING / INVOICE DISCOUNTING

The receipt of cash immediately from a specialist factoring company. This is arranged against the security of approved sales invoices for a fee. In the case of factoring, the finance company maintains the sales ledger and collects the cash from customers.

In the case of invoice discounting, the finance company does not maintain the sales ledger. Instead, the client company collects cash from customers. It is then credited to the account of the finance company.

 

FIFO (First-in first-out)

A method of inventory or stock valuation. It is based on the assumption that the items remaining in stock are those that were purchased most recently. This means that the oldest stock is assumed to be used first.

 

FIXED ASSETS or NON-CURRENT ASSETS

Assets such as equipment, buildings, intellectual property, land and machinery. They are expected to be used in the organisation for more than a year and are relatively long term. Tangible fixed assets have a physical shape like a building. Intangible fixed assets, such as intellectual property, do not.

 

FIXED CHARGE

A type of security for a lender such as a mortgage. The charge is on a specific asset, for example, a building.

 

FIXED COST

A cost that stays constant for a period regardless of the level of activity or production. Examples include business rates, rent, depreciation, insurance premiums, telephone rental charges and salaries. Fixed costs can be referred to as operating costs (‘opex’), indirect costs, overhead costs or ‘revenue’ expenditure (‘revex’).

Cash fixed costs exclude depreciation and amortisation because they are non-cash items.

A semi-fixed cost is a cost that is fixed for a specific period but, thereafter, increases or decreases as the level of sales volume or production changes. For example, direct or ‘shop floor’ labour costs may remain fixed for a certain period. But as capacity expands, additional labour might be recruited resulting in a ‘step’ increase in direct labour costs.

 

FLEXIBLE BUDGET

A budget that changes according to the actual level of activity or output achieved.

 

FLOATING CHARGE

A type of security for a lender. A floating charge applies to all the assets of an organisation.

 

FORECAST

The best assessment of what is likely to be the outcome or result for a financial period. This takes into account:

  • actual performance so far during the financial period
  • additional information that was not available or included in the budget when it was prepared, for example, a rise in interest rates
  • future actions that were not part of the budget and will take effect during the rest of the financial period, for example, additional cost savings.

Unlike a forecast, the budget is the financial plan for a period and is likely to remain unchanged.