Important terms and definitions
Below is a glossary of terms and definitions for the most common financial analysis ratios terms. When calculating financial ratios using vertical and horizontal analysis, and ultimately the pyramid of ratios, it’s important to have a solid understanding of basic terms. The below information is taken from CFI’s Financial Analysis Fundamentals Course.
Synonyms: payables, creditors
Accounts Payable is the amount owed by an organization to others for goods or services received. Buying from suppliers on credit will generate accounts payable.
Synonyms: receivables, debtors
Accounts Receivable is the amount due to an organization for goods delivered or services rendered. Selling to customers on credit will generate accounts receivable for a business.
Accounts payable / COGS x 365. Average number of days a firm takes to pay for items purchased.
Cost of sales / Accounts payable (either the ending balance or average balance). This ratio measures how effective management is in paying its suppliers.
Accounts receivable / Sales x 365. Average number of days a firm takes to collect payments on goods sold.
Sales / Accounts receivable (either the ending balance or average balance). This ratio measures how effective the company’s credit and collection policies are.
See quick ratio.
Administration costs / Sales. This margin shows the general overhead cost for each dollar of sales.
The gradual reduction of a financial amount over time.
Assets are resources owned and employed by an organization that confers future economic benefits.
Sales / Total assets. This ratio shows how effective the company is in generating sales from its assets.
Audit is the process of examination and verification of a firm’s books of account, transaction records, and other relevant documents, including financial models.
(Opening balance – Closing balance) / 2. This balance can be used to calculate efficiency/turnover ratios instead of using a closing balance.
The Balance Sheet is a snapshot of an organization’s assets and liabilities on a particular date. The balance sheet shows the sources of funds provided to an organization (called the capital employed and normally either equity or debt) and how those funds have been used by the organization to invest in fixed assets (assets the organization intends to keep for more than one year) and working capital (money tied up in the day-to-day operations of the business)
See capital employed.
Assets such as property, plant, and equipment employed to generate income.
Capital employed represents the funds provided to an organization in the form of equity or debt.
See contributed surplus.
Synonyms: stock, shares, share capital
There are two types of stock – common stock and preferred stock. Most shares tend to be common stock and generally carry one vote each and carry an equal right to a proportionate share of dividends. Capital stock is not a liability in the sense of other sources of funds (e.g., bank loans) since it is not generally paid back to shareholders unless the company is wound up.
The Cash Flow Statement is a summarized bank statement that shows an organization’s sources of cash during the financial year and the ways in which the cash has been used during that period (e.g., investments, fixed asset purchases, etc.).
Circular references occur when a formula includes a reference to the cell in which the formula appears.
See common stock.
Synonyms: common shares, ordinary shares
Most shares tend to be common stock carrying one vote each and with an equal right to a proportionate share of dividends. Common stock dividends tend to rise as profits grow. This is in contrast to preferred stock where the dividend tends to be fixed.
Synonyms: share premium, capital in excess of par value
Most stock is originally issued with a nominal/par value attached to it (e.g., one share in ABC Inc. has a nominal value of $1.00). However, if shareholders buy shares from the company for more than the nominal value (e.g. $1.50), then the excess is called the contributed surplus.
Ratios that analyze a company’s liquidity or its ability to “cover” its financial debt obligations. An example of a coverage ratio is EBITDA / Interest expense.
See accounts payable.
Current Assets are all assets other than fixed assets. They are either cash or assets expected to be converted into cash or consumed by the business during the year. Current assets include items such as cash, accounts receivable, and inventory.
An organization’s liabilities due within one year. Current Liabilities include items such as short-term loans, any element of long-term loans due within one year, and accounts payable.
Current assets / current liabilities. Current Ratio measures short-term liquidity, whether or not a company will have the ability to cover its obligations in the short term.
Discounted Cash Flow analysis. A financial evaluation method that takes the “time value of money” into account.
Debt is capital used to finance an organization that is subject to payment of interest over the life of the loan, at the end of which the loan is normally repaid.
Raising money for a business through loans or by issuing bonds.
See accounts receivable.
Depreciation of fixed assets is the process of allocating part of the cost of fixed assets to a particular accounting period. Depreciation is normally charged to the income statement on a straight-line basis (although there are alternative methods available). For example, if a car is bought for $15,000, has an expected life of 5 years, and has a residual value (expected scrap value) of $5,000, then the depreciation expense in the income statement will be $2,000 per year for 5 years. The value of the car in the balance sheet would start at $15,000 but would be reduced by $2,000 a year. At the end of year 1, the net book value (NBV) of the car in the balance sheet would be $13,000. At the end of year 2, the NBV would be $11,000. The accumulated depreciation for the car at the end of year 2 would be $4,000.
Direct costs are those that are directly attributable to the product or service provided by the organization. They are included in the cost of goods sold.
A share of a company’s net profits distributed by the company to a class of its stockholders.
Earnings Before Interest and Taxes. See operating profit.
EBIT / Sales.
Synonyms: shareholders’ equity, shareholders’ funds
Equity is total assets less total liabilities. Also called shareholders’ equity, net worth, or book value.
The money acquired from the business owners themselves or from other investors.
Financial Covenants are the promises made by the borrowing firm in a loan agreement to adhere to certain limits in the firm’s operations.
A Financial Model is a mathematical model describing the interrelationships among various financial variables. Typically, financial models are broken down into inputs, processing, and outputs.
Financial Statements are statements, in financial terms, of the financial position of an entity at a given date, or of the results of its operations for a given period. The statements are normally prepared in one of a number of standard formats. Most commonly, when people refer to financial statements, they mean the income statement, the balance sheet, the cash flow statement, and the related notes to the accounts.
Assets intended for use on a continuing basis in an organization’s activities (normally defined as assets an organization intends to keep for more than one year). There are three categories of fixed assets: intangible, tangible, and investments.
The projection or estimate of future sales, revenue, earnings, or costs.
When one company buys another company it typically pays more than the book value of the net assets acquired (because it is acquiring staff, name/reputation, and customer relationships). This excess of the purchase price over the fair book value of the net assets is called goodwill. Goodwill is normally included in the balance sheet as an intangible fixed asset.
Gross profit / Sales revenue. Gross margin shows how much was spent producing the good or service that was sold for every dollar of sales revenue.
Gross Profit is sales revenue less cost of sales.
Synonyms: profit and loss account, P&L statement, statement of earnings
The Income Statement is an organization’s financial history book and summarizes the revenue, expenses, and operating profit for the financial year. It also shows the tax charged against profit, how much of the profit for the year has been paid out in dividends, and how much has been retained in the business.
Financial model assumptions that are used to drive model outputs.
Intangible fixed assets have no physical presence. Examples include patents, goodwill, trademarks, and brand names.
These are liabilities that bear interest, normally short-term borrowings. They are excluded from some ratios in order to factor in the cost of financing.
Inventory normally refers to items held for resale and may include raw materials, work in progress, and finished goods.
Inventories / COGS x 365. The average number of days goods remain in inventory before being sold.
Sales / Inventory (either the ending balance or average inventory balance). This ratio illustrates how a company manages its inventory.
Deals or transactions involving sale or purchase of equipment, plant, properties, securities, or other assets.
Direct labor / Sales. Cost of goods sold is made up of labor, materials, and direct costs. This margin shows the proportion of labor that goes to make up each dollar of sales.
Sales / Land and buildings. The sales generated from land and buildings are measured by this ratio.
Leverage Ratios are ratios that analyze a company’s solvency or the level of its debt financing relative to its equity financing. An example of a leverage ratio is Total debt / Total shareholders’ equity.
Liabilities are money owed, or other financial obligations to other organizations and individuals.
Materials / Sales. Cost of goods sold is made up of labor, materials, and direct costs. This margin shows the proportion of materials that goes to make up each dollar of sales.
The framework around which a financial model is built.
Total assets less current liabilities (excluding IBCL’s).
Sales / Net assets. This ratio takes into account the financing of assets and measures management’s efficiency in relation to the use of assets.
Net book value typically refers to property plant and equipment (PP&E). The net book value of PP&E is calculated by taking the total gross cost of PP&E and deducting total accumulated depreciation/amortization.
Synonyms: net income, retained profit for the year, retained earnings for the year
The profits retained by an organization after all expenses including interest expenses, taxes, and dividends. The retained profits/earnings for a given year are reinvested in the business (hopefully making the organization grow, and increasing the value of its shares) and are added to retained earnings in the balance sheet (which represent all retained profits accumulated over an organization’s entire life to date which have been reinvested in the business).
See net earnings for Net Income.
Net income / Sales. Net Profit Margin shows how much is earned for every dollar of sales revenue.
Assets that are not expected to be converted into cash within 12 months of the balance sheet date.
Synonyms: earnings before interest and income taxes (EBIT), profit before interest and income taxes (PBIT)
Cash inflows and outflows relating to a company’s operations. Examples include receiving payments from customers, paying salaries, etc.
Assets acquired for or used throughout the operations of the business (such as cash, inventory, prepaid expenses, equipment).
Operating costs / Sales. This margin shows the operating expenses as a percentage of sales. This does not include cost of goods sold (as is the case with the operating profit margin), so it is an indication of the efficiency of the operation.
Synonyms: earnings before interest and income taxes (EBIT), profit before interest and income taxes (PBIT)
Sales revenues less all operating expenses. Operating profit is calculated before financing costs and taxes. It is often referred to as EBIT.
Operating Profit Margin is also known as the EBIT margin. Operating income / Sales. The performance ratio shows the cost of running the operation for each dollar of sales.
The net sales revenue accumulated by a firm.
See common stock.
Financial model calculations that are driven by one or more inputs.
Personnel costs / Sales. The personnel costs used in this ratio could be research and development specific, or general overhead personnel costs, or total personnel, depending upon the type of organization. This margin is useful in monitoring the amount spent on wages, salaries, and related expenses for each dollar of sales.
Sales / Plant and Machinery. This ratio measures the efficiency of the use of a company’s operating assets.
Synonyms: preference shares
Preferred stock has preferential rights over common stock to both dividends and also to assets in the event that a company is wound up (i.e., preferred stockholders are paid out before common stockholders). Typically, preferred stock dividends are fixed (e.g., 6 percent) and do not increase with rising profits.
The translation of financial model inputs or assumptions into financial model outputs.
Property, Plant, and Equipment (PP&E) are non-current fixed or capital assets such as buildings, computers, land, and vehicles.
Sales / Property, Plant & Equipment. This ratio measures the sales a company is able to generate from capital assets.
Current assets – Inventory / Current Liabilities. Quick Ratio is one of the financial analysis ratios that provides a more prudent measure of short-term liquidity recognizing that inventory cannot always be readily converted into cash.
Research and development costs / Sales. This margin shows how much the company invests in developing the next generation of products or services for each dollar of sales.
These expenses are directly attributable to researching and developing new or improved products or systems.
Reserves are part of shareholders’ equity. Reserves are subdivided into revenue reserves (e.g., retained earnings), which are available to be distributed to the shareholders by way of dividends, and capital reserves (e.g., contributed surplus), which for various reasons are not distributable as dividends.
Synonyms: P&L reserve, Retained earnings reserve
Retained earnings on the balance sheet represent all retained profits accumulated over an organization’s entire life to date which have been reinvested in the business. As the retained earnings ultimately belong to shareholders, they are included as part of shareholders’ equity.
See net earnings.
Synonyms: sales, sales revenue, turnover
Revenue includes both cash sales and credit sales of goods and services but does not include the sale of fixed assets.
Selling costs / Sales. This margin shows how much it costs to sell each dollar of sales.
Operational expenses that include direct and indirect selling expenses and all general and administrative expenses. Rent, heat, lights are all examples of general expenses.
See capital stock.
See contributed surplus.
See equity for the definition of Shareholders’ Equity.
See capital stock.
See income statement.
See capital stock for the definition of stock.
When a corporation buys back its own shares in the open market.
Synonyms: capital assets
Tangible Fixed Assets are fixed assets that have a physical presence and include things like land, buildings, machinery, equipment, computers, and so on.
The tax liability that companies, and individuals, are required to pay by law.
Tax / Sales. This financial analysis ratio shows how well management is managing tax.
Financial analysis ratios that measure an assets’ activity or efficiency in generating revenues or cash. Total assets / Sales.
Direct overhead / Sales. Cost of goods sold is made up of labor, materials, and direct costs. This financial analysis ratio shows the proportion of direct overhead that goes to make up each dollar of sales.
Working Capital is normally defined as money tied up in the day-to-day operations of an organization. It is approximately equal to current assets less current liabilities. However, many analysts will define working capital more explicitly as inventory and accounts receivable less accounts payable (and exclude other current assets).
Thank you for reading CFI’s list of terms and definitions of the most common financial analysis ratios glossary. As an analyst calculating financial ratios it’s critical to have a good understanding of basic terms. The information in this glossary is from CFI’s Financial Analysis Fundamentals Course.
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