Financial Terms Glossaryby John Kind
Financial Terms Glossary: P –R
The length of time or the exposure period before the present value of the cumulative cash flows for a project becomes positive. This is equivalent to the length of time taken before a project recovers the present value of the initial cash outflows. It is the ‘break-even’ time and is a measure of risk. The shorter the payback period, the better.
For cumulative preference shares, all past unpaid preference dividends must be paid before an ordinary share dividend is paid.
Preference shares should not be regarded as part of a company’s equity since preference shareholders are not owners.
Cash paid in advance during a financial period for a cost applicable to a future period. This means that the cost is incurred in the future period’s income statement even though the cash payment takes place in the current period. Examples are insurance premiums and rent paid in advance.
The value today of cash receivable at some time in the future. It is calculated by multiplying future net cash flows by discount factors which depend on when the net cash flows are expected to be received. Net cash flow, in this context, means the difference between cash receivable and cash payable in a financial period. This period will normally be 12 months.
The market price of a share divided by the earnings per share to give the number of years’ earnings per share represented by the current share price. It is a financial status symbol.
The higher the P/E ratio, the more attractive a company’s earnings prospects are perceived to be. The lower the P/E ratio, the less attractive a company’s earnings prospects are perceived to be. The average P/E ratio for leading companies in the UK is 15.
The historic P/E ratio is based on the latest reported earnings per share. The forward or prospective P/E ratio is based on forecast earnings per share.
The difference between revenues and the costs incurred during a financial period.
In view of the accruals or ‘matching’ principle, earning a ‘profit’ is not the same as generating cash. Revenues are recognised in the financial period when goods or services are supplied or when work is done for a customer rather than when the customer pays.
Similarly, costs are incurred during the financial period to which they relate which may not be when they are paid for in cash. And some costs, such as depreciation, do not involve cash outlays at all.
It is important to note that there are a number of different measures of profit such as gross profit and operating profit.
The net present value of cash flows divided by the present value of negative cash flows. It is a measure of capital efficiency which ranks projects according to the net present value they generate per £ of investment.
The profitability index can also be defined as the present value of cash inflows divided by the present value of cash outflows. Project rankings are unchanged regardless of the definition used.
The profitability index is relevant when the cash available for capital projects is limited. This is referred to as ‘capital rationing’. Projects with a relatively high profitability index may be approved whereas those with a relatively low profitability index may be rejected even though they are economically viable on a ‘stand alone’ basis.
The operating or trading margin is the operating profit or the profit before interest and taxation expressed as a percentage of sales. The operating margin may also be referred to as ‘return on sales’. The average operating margin for leading companies in Europe is 10 per cent approximately.
Examples of provisions are the estimated cost of redundancies and the costs of reorganising a business. Provisions may be disclosed separately as exceptional items if they are significant. A provision is included as a cost in the income statement and as a short or long term liability in the balance sheet.
A distinction may be drawn between an accrued charge when the precise amount is known and a provision which is an estimate.
Assets may be valued at their replacement cost rather than their historic cost. This is sometimes done in management accounts so that a business is charged with current rather than historic costs and is particularly important during periods of inflation.
Realised and unrealised gains which have added value to an organisation. These gains are part of equity.
Realised gains produce profit. Unrealised gains arise from revaluations of assets such as property. Unrealised gains become realised when assets are sold.
The profit for the year after deducting all costs and the distribution of dividends to shareholders. It is the additional wealth produced by an organisation during a financial period. In view of the ‘accruals’ principle, this additional wealth is not usually available in the form of cash.
The figure for retained earnings at the balance sheet date will be the accumulated retained earnings since the organisation started to operate. It may be described as ‘revenue reserves’.
Operating profit expressed as a percentage of capital employed. ROCE is the most important measure of profitability. Using this definition, an acceptable benchmark is 15 per cent approximately.
The ROCE measures the return earned by a business from its trading activities. This return is then compared with the return required by the shareholders and lenders financing the business. The return required by investors and lenders is called the cost of capital. For an organisation to create economic value, the ROCE should exceed the cost of capital.
The difference between the original cost of an asset, usually property, and its current market value. The difference is added to the original cost of the property and added to equity as a revaluation reserve.
See retained profit.
The sale of additional shares by a company to its existing shareholders, in proportion to their existing holdings, normally at a discount to the current market price in order to ensure a successful issue.