Financial Terms Glossaryby John Kind
Financial Terms Glossary: C
The sum of fixed or non-current assets plus working capital. Capital employed represents the long and short term resources required by an organisation to enable it to operate or trade. The lower the level of these resources, the more efficient an organisation becomes.
Net capital expenditure is capital expenditure less the cash proceeds from non-current or fixed asset disposals.
The proportion of short and long borrowings (debt) in relation to equity. It is calculated by expressing debt as a percentage of equity. The higher the debt/equity ratio, the higher a company’s gearing. For this purpose, debt is normally defined as total borrowings or interest bearing obligations, including leases, less cash balances and short-term investments such as cash on deposit. The higher the debt-equity ratio, the greater the financial risk because an organisation will incur higher interest charges and will need to repay higher levels of borrowings. The average debt-equity ratio for European companies is 65 per cent approximately. In America, gearing is known as leverage.
A number of meanings:
- The interest payable on borrowings for a building or maintenance expenditure on equipment is capitalised if, instead of it being charged to the income statement, it is added to the capital cost of the project or the equipment. In this sense, ‘capitalise’ means to treat as an asset.
- Reserves are capitalised when retained profit is converted into share capital by way of a scrip or bonus issue.
- To capitalise a company means putting cash into it in the form of share capital.
The proportion of an organisation’s financing provided by shareholders or owners. It consists of issued share capital, share premium, retained profit or retained earnings and any other reserves. Other terms for capital and reserves include equity, shareholders’ interest, shareholders’ funds, equity shareholders’ funds, net assets and net worth.
The generation of cash by an organisation. It is the most important measure of financial health. There are a number of different measures of ‘cash flow’. Organisations’ terminology differs when ‘cash flow’ is being discussed so it is important to clarify the particular definition that is being used.
Operating cash flow is sales less the cash cost of sales and cash operating costs. These cash operating costs exclude amortisation and depreciation, financing charges and tax. Operating cash flow is equivalent to operating profit plus depreciation and amortisation. It may be referred to as ebitda; earnings before interest, tax, depreciation and amortisation.
Cash flow from operations is equal to operating cash flow less capital expenditure, plus or minus the decrease or increase in working capital during a period. In arriving at cash flow from operations, capital expenditure may be excluded according to the definition that an organisation is using.
If cash flow from operations is positive, it means that a business is generating enough cash to meet its day to day commitments; it is cash self sufficient. If cash flow from operations is negative, a business is not generating enough cash to support its day-to-day requirements. It is not cash self sufficient. The organisation concerned will need to use its existing cash balances and/or additional borrowings and/or extra share capital to finance the cash shortfall.
‘Free’ cash flow is the cash flow from operations less financing charges and corporation tax. This cash flow is ‘free’ in the sense that it is available to repay loans and to pay dividends to shareholders.
Net cash flow is ‘free’ cash flow less loan and dividend payments. It is the cash remaining after an organisation has met all its commitments.
A statement explaining the change in an organisation’s cash position between the beginning and end of a financial period.
A cash flow forecast is an essential management tool so that an organisation can estimate what its financing needs might be and/or to decide how to use its cash surpluses.
The average length of time taken by a customer to pay a sales invoice. It is calculated by dividing accounts receivable or trade debtors by annual revenues times 365 days to give the average number of days for which the sales invoice has been unpaid. In the UK, the average collection period or DSO is 50 days approximately; the shorter, the better.
Financial statements are prepared for the parent company and its subsidiaries as if the parent company and the subsidiaries are all one entity. A parent company is a company which owns more than 50 per cent of the voting share capital in one or more other companies. These other companies are called subsidiary companies.
A liability that depends upon the occurrence or non-occurrence of a future event. For example, potential warranty claims if equipment does not perform as stipulated and legal fees if a contractual dispute is lost. Contingent liabilities are disclosed in notes to the financial statements.
The difference between revenues and direct or variable costs before charging indirect or fixed costs. Direct or variable costs may be called ‘cost of sales.’ Contribution may also be called gross profit. The word ‘contribution’ is used because the difference between revenues and direct costs provides the contribution towards the recovery of indirect or fixed costs.
The tax levied on an organisation’s taxable profit. Taxable profit is not the same as the ‘profit before taxation’ in the income statement or profit and loss account because various items are allowable and disallowable for tax purposes. The current rate of corporation tax for larger organisations is 28 per cent of taxable profit.
The charge against revenues for the use of resources during a financial period. The cost charged or incurred in the income statement is not necessarily the same as the cash actually spent on the cost in the period in view of adjustments for amortisation, depreciation, accruals and prepayments.
A unit within an organisation such as a department, function or section for which costs are calculated.
An alphabetical and/or numbering system used to describe the type, source and purpose of all costs.
The return required by those providing finance to an organisation; lenders and/or shareholders. The return they require reflects the risks they face.
The weighted average cost of capital (WACC) is the required rate of return reflecting the relative proportions of funding provided by lenders and shareholders. The cost of capital is also referred to as the hurdle rate, the discount rate or the test discount rate.
For major companies in the UK, the after-tax cost of capital is in the range, 7 per cent to 10 per cent.
This is the direct cost of the products or services sold to customers such as raw material, packaging and direct labour costs.
Any person or organisation to whom another organisation has a commitment. For example, suppliers of goods for whom unpaid bills are outstanding called accounts payable or trade creditors and borrowings due to banks.
It is an accounting requirement to distinguish between short-term creditors called current liabilities (due to be paid within 12 months) and long-term creditors (amounts due to be paid after one year).
Note that funding attributable to and provided by shareholders is called equity. Equity is not a creditor.
Creditor days or payable days is the average length of time an organisation takes to pay its suppliers. It is equal to trade creditors or accounts payable divided by the cost of sales expressed as a percentage. This percentage is then converted into a ‘number of days’ by multiplying it by 365 days.
An assessment of an organisation’s creditworthiness; its ability and willingness to repay its short and long term debts on time. The two leading credit rating agencies are Moodys and Standard and Poors. For Standard and Poors, the highest credit rating is AAA. The lowest is CCC.
Assets such as accounts receivable or trade debtors and inventories or stocks. These assets can be converted into cash within 12 months of an accounting date. Cash balances and short-term investments (such as cash on deposit and stock market investments) are also part of current assets. Cash balances and short term investments are sometimes referred to as liquid resources.
Short-term liabilities which have to be paid within 12 months of an accounting date. Examples are trade creditors, bank overdrafts (which are repayable on demand), VAT and accrued charges or unpaid expenses.
This is equal to total current assets divided by total current liabilities. It is an approximate measure of the ability of an organisation to meet its short-term commitments or liabilities. A benchmark of 2:1 is sometimes given for the current ratio but it is the trend in the ratio that is more important.