Investopedia Flashcards
Balance Sheet
What is a ‘Balance Sheet’
A balance sheet reports a company’s assets, liabilities and shareholders’ equity at a specific point in time, and provides a basis for computing rates of return and evaluating its capital structure. It is a financial statement that provides a snapshot of what a company owns and owes, as well as the amount invested by shareholders.
Shareholders Equity
What is ‘Shareholders’ Equity (SE)’
Shareholders’ equity (SE), also referred to as the owner’s residual claim after debts have been paid, is equal to a firm’s total assets minus its total liabilities. Found on a company’s balance sheet, it is one of the most common financial metrics employed by analysts to assess the financial health of a company. Shareholders’ equity represents the net or book value of a company.
Shareholder
A shareholder is an individual or entity that owns the shares of a corporation. Share ownership entitles a shareholder to certain rights, which usually include the following for a common stockholder:
To vote for the Board of Directors of the corporation
To receive dividends when declared by the Board of Directors
To receive the annual financial statements of the business, once they are made available for issuance
There may be only a small number of shareholders (as is common with a privately-held business), or there may be thousands, as is common for a publicly-held company whose shares trade on a major stock exchange.
Shareholders buy shares in a business with the intent of earning a profit either from dividend payments made by the company, or through an appreciation in the market price of the shares. They may also buy shares in order to gain control over a business.
In the event of the liquidation or sale of a business, shareholders have residual rights to any remaining assets. This means that all creditors are paid from the assets or proceeds of the business first, after which remaining funds (if any) are distributed to the shareholders based their relative proportions of ownership of the business. If there are no residual assets remaining after creditors have been paid, then the shareholders will have lost their investment in the business.
Conceptually, shareholders have the greatest risk of loss of any stakeholders in a business, but can also profit the most handsomely from an increase in the value of the business.
Stakeholder
A stakeholder is any person or entity that has an interest in the success or failure of a business or project. Stakeholders can have a significant impact on decisions regarding the operations and finances of an organization. Examples of stakeholders are investors, creditors, employees, and even the local community. Here is more information about the various categories of stakeholder:
Shareholders are a subset of the stakeholder category, since shareholders have invested funds in the business, and so are automatically stakeholders. However, employees and the local community have not invested in the business, so they are stakeholders but not shareholders. Shareholders are the most likely to lose all of their money in the event of a business shutdown, since they are last in priority to be paid from any remaining funds.
Creditors lend money to the company, and may or may not have a secured interest in the company’s assets, under which they can be paid back from the sale of those assets. Creditors are ranked in front of stockholders to paid in the event of a business shutdown. Creditors include suppliers, bond holders, and banks.
Employees are stakeholders, because their continued employment is tied to the continued success of the company. If it fails, they may at most be paid severance, but will lose all other continuing income streams from the company.
Suppliers are stakeholders, because a potentially substantial proportion of their revenues may come from the company. If the company were to alter its purchasing practices, the impact on suppliers could be severe.
The local community is the most indirect set of stakeholders; it stands to lose the company’s business if it fails, as well as the business of any employees who would lose their jobs as a result of the business closure.
In short, stakeholders can comprise a substantially larger pool of entities than the more traditional group of shareholders who actually own a business.
Investor
An investor is an entity that commits money to a venture with an expectation of generating a return. The type of commitment made can be in many forms, such as a guarantee to pay creditors, a loan, an equity investment, tangible assets, or even the contribution of labor. An investor typically makes a commitment in exchange for either a fixed return (such as dividends or interest) or the prospect of being able to sell its investment to a third party at a later date for a higher price than the amount of the original investment.
An investor can be an individual or a corporate entity. For example, a corporation could contribute funds to a joint venture, in which case the corporation is an investor in the joint venture.
Equity
Equity is the net amount of funds invested in a business by its owners, plus any retained earnings. It is also calculated as the difference between the total of all recorded assets and liabilities on an entity’s balance sheet.
The equity concept also refers to the different types of securities available that can provide an ownership interest in a corporation. In this context, equity refers to common stock and preferred stock.
For an individual, equity refers to the ownership interest in an asset. For example, a person owns a home with a market value of $500,000 and owes $200,000 on the related mortgage, leaving $300,000 of equity in the home.
Retained Earning
Retained earnings are the profits that a company has earned to date, less any dividends or other distributions paid to investors. This amount is adjusted whenever there is an entry to the accounting records that impacts a revenue or expense account. A large retained earnings balance implies a financially healthy organization. The formula for ending retained earnings is:
Beginning retained earnings + Profits/losses - Dividends = Ending retained earnings
A company that has experienced more losses than gains to date, or which has distributed more dividends than it had in the retained earnings balance, will have a negative balance in the retained earnings account. If so, this negative balance is called an accumulated deficit.
The retained earnings balance or accumulated deficit balance is reported in the stockholders’ equity section of a company’s balance sheet.
A growing company normally avoids dividend payments, so that it can use its retained earnings to fund additional growth of the business in such areas as working capital, capital expenditures, acquisitions, research and development, and marketing. It may also elect to use retained earnings to pay off debt, rather than to pay dividends. Another possibility is that retained earnings may be held in reserve in expectation of future losses, such as from the sale of a subsidiary or the expected outcome of a lawsuit.
As a company reaches maturity and its growth slows, it has less need for its retained earnings, and so is more inclined to distribute some portion of it to investors in the form of dividends. The same situation may arise if a company implements strong working capital policies to reduce its cash requirements.
When evaluating the amount of retained earnings that a company has on its balance sheet, consider the following points:
Age of the company. An older company will have had more time in which to compile more retained earnings.
Dividend policy. A company that routinely issues dividends will have fewer retained earnings.
Profitability. A high profit percentage eventually yields a large amount of retained earnings, subject to the two preceding points.
Stockholders Equity
Stockholders’ equity is the amount of capital given to a business by its shareholders, plus donated capital and earnings generated by the operation of the business, less any dividends issued. On the balance sheet, stockholders’ equity is calculated as:
Total assets - Total liabilities = Stockholders’ equity
An alternative calculation of stockholders’ equity is:
Share capital + Retained earnings - Treasury stock = Stockholders’ equity
Both calculations result in the same amount of stockholders’ equity. This amount appears in the balance sheet, as well as the statement of stockholders’ equity.
The stockholders’ equity concept is important for judging the amount of funds retained within a business. A negative stockholders’ equity balance, especially when combined with a large debt liability, is a strong indicator of impending bankruptcy.
A number of accounts comprise stockholders’ equity, which typically include the following:
Common stock. This is the par value of common stock, which is usually $1 or less per share. In some states, par value may not be required at all.
Additional paid-in capital. This is the additional amount that shareholders paid for their shares, in excess of par value. The balance in this account usually substantially exceeds the amount in the common stock account.
Retained earnings. This is the cumulative amount of profits and losses generated by the business, less any distributions to shareholders.
Treasury stock. This account contains the amount paid to buy back shares from investors. The account balance is negative, and therefore offsets the other stockholders’ equity account balances.
Stockholders’ equity can be referred to as the book value of a business, since it theoretically represents the residual value of the entity if all liabilities were to be paid for with existing assets. However, since the market value and carrying amount of assets and liabilities do not always match, the concept of book value does not hold up well in practice.
Book Value
Book value is an asset’s original cost, less any accumulated depreciation and impairment charges that have been subsequently incurred. The book values of assets are routinely compared to market values as part of various financial analyses. For example, if you bought a machine for $50,000 and its associated depreciation was $10,000 per year, then at the end of the second year, the machine would have a book value of $30,000. If an impairment charge of $5,000 were to be applied at the end of the second year, the book value of the asset would decline further, to $25,000.
Book value is not necessarily the same as an asset’s market value, since market value is based on supply and demand and perceived value, while book value is simply an accounting calculation. However, the book value of an investment is marked to market periodically in an organization’s balance sheet, so that book value will match its market value on the balance sheet date.
Book value can also refer to the amount that investors would theoretically receive if an entity liquidated, which could be approximately the shareholders’ equity portion of the balance sheet if the entity liquidated all of its assets and liabilities at the values stated on the balance sheet.
The calculation of book value includes the following factors:
\+ Original purchase price \+ Subsequent additional expenditures charged to the item - Accumulated depreciation - Impairment charges = Book value
Mark to Market
Mark to market is the recognition of certain types of securities at their period-end market values at the end of a reporting period. The amount recognized may be a gain or a loss when compared to the acquisition cost of the security. The mark to market process is used to give the readers of an organization’s financial statements the most current view of the entity’s asset and liability valuations. However, this process can give readers a pessimistic view of a firm’s financial situation if there is a sudden downturn in asset values at month-end, from which market prices subsequently recover.
The concept is also used by brokerages to adjust the margin accounts of clients for daily profits and losses. Losses may trigger a margin call that requires clients to put more funds into their accounts.
Par Value
Par Value for Stock
Par value is the price at which a company’s shares were initially offered for sale. The intent behind the par value concept was that prospective investors could be assured that an issuing company would not issue shares at a price below the par value. However, par value is now usually set at a minimal amount, such as $0.01 per share, since some state laws still require that a company cannot sell shares below the par value; by setting the par value at the lowest possible unit of currency, a company avoids any trouble with future stock sales if its shares begin to sell in the penny stock range.
Some states allow companies to issue shares with no par value at all, so that there is no theoretical minimum price above which a company can sell its stock. Thus, the reason for par value has fallen into disuse, but the term is still used, and companies issuing stock with a par value must still record the par value amount of their outstanding stock in a separate account.
The amount of the par value of a share of stock is printed on the face of a stock certificate. If the stock has no par value, then “no par value” is stated on the certificate instead.
Par Value for Preferred Stock
The par value of a share of preferred stock is the amount upon which the associated dividend is calculated. Thus, if the par value of the stock is $1,000 and the dividend is 5%, then the issuing entity must pay $50 per year for as long as the preferred stock is outstanding.
Par Value for Bonds
The par value of a bond is usually $1,000, which is the face amount at which the issuing entity will redeem the bond certificate on the maturity date. The par value is also the amount upon which the entity calculates the interest that it owes to investors. Thus, if the stated interest rate on a bond is 10% and the bond par value is $1,000, then the issuing entity must pay $100 every year until it redeems the bond.
Bonds commonly sell on the open market at prices that may be higher or lower than the par value. If the price is higher than the par value, the issuing entity still only has to base its interest payments on the par value, so the effective interest rate to the owner of the bond will be less than the stated interest rate on the bond. The reverse holds true if an investor buys a bond at a price below its par value - that is, the effective interest rate to the investor will be more than the stated interest rate on the bond.
For example, ABC Company issues bonds having a $1,000 par value and 6% interest rate. An investor later buys an ABC bond on the open market for $800. ABC is still paying $60 in interest every year to whomever holds the bond. For the new investor, the effective interest rate on the bond is $60 interest ÷ $800 purchase price = 7.5%.
Preferred Stock
Preferred stock is a class of equity ownership that has a more senior claim on the earnings and assets of a business than common stock. In the event of liquidation, the holders of preferred stock must be paid off before common stockholders, but after secured debt holders. Preferred stock also pays a dividend; this payment is usually cumulative, so any delayed prior payments must also be paid before distributions can be made to the holders of common stock.
Preferred stock holders can have a broad range of voting rights, ranging from none to having control over the eventual disposition of the entity. Preferred stock may be sold when a company is unable to sell common shares at a reasonable price.
Earnings
Earnings are the profits generated by a business. They are derived by subtracting the cost of goods sold, operating expenses, and taxes from revenue. The generation of earnings is a key driving force behind the formation and subsequent operation of a business. Earnings can then be used to pay dividends to shareholders. If a company is still growing and does not have sufficient cash to distribute as dividends, earnings might instead be held within the business; if so, investors can profit from an increase in the market value of the company stock that they hold.
Earnings tend to be quite low or negative during the early years of a business, when it is spending money to build products and services, as well as to expand its market presence. Once the business is established, its earnings are typically both larger and more consistent. If the decision is made to run down and liquidate a business, it is possible that earnings will briefly be quite high, since the sales and marketing expenses that it usually incurs to maintain market share among customers are no longer being incurred. Thus, there is a definite pattern to the timing of earnings generation over the life of a business.
If a company is publicly held, the amount of earnings reported is a significant driver of its stock price. If the amount is lower than expected by analysts, the stock price could drop sharply, even though the amount may meet or exceed the company’s own expectations.
Asset
An asset is an expenditure that has utility through multiple future accounting periods. If an expenditure does not have such utility, it is instead considered an expense. For example, a company pays its electrical bill. This expenditure covers something (electricity) that only had utility during the billing period, which is a past period; therefore, it is recorded as an expense. Conversely, the company buys a machine, which it expects to use for the next five years. Since this expenditure has utility through multiple future periods, it is recorded as an asset.
An asset may be depreciated over time, so that its recorded cost gradually declines over its useful life. Alternatively, an asset may be recorded at its full value until such time as it is consumed. An example of the first case is a building, which may be depreciated over many years. An example of the latter case is a prepaid expense, which will be converted to expense as soon as it is consumed. An asset that is longer-term in nature is more likely to be depreciated, while an asset that is shorter-term in nature is more likely to be recorded at its full value and then charged to expense all at once. The one type of asset that is not considered to be consumed and is not depreciated is land. The land asset is presumed to continue in perpetuity.
An asset does not have to be tangible (such as a machine). It can also be intangible, such as a patent or a copyright.
At a less well-defined level, an asset can also mean anything that is of use to a business or individual, or which will yield some return if it is sold or leased.
On the balance sheet of a business, the total of all assets can be calculated by adding together all liabilities and shareholders’ equity line items.
Liability
A liability is a legally binding obligation payable to another entity. Liabilities are incurred in order to fund the ongoing activities of a business.
Examples of liabilities are accounts payable, accrued expenses, wages payable, and taxes payable. These obligations are eventually settled through the transfer of cash or other assets to the other party.
Liabilities expected to be settled within one year are classified as current liabilities on the balance sheet. All other liabilities are classified as long-term liabilities.
Current Asset
A current asset is an item on an entity’s balance sheet that is either cash, a cash equivalent, or which can be converted into cash within one year. If an organization has an operating cycle lasting more than one year, an asset is still classified as current as long as it is converted into cash within the operating cycle. Examples of current assets are:
Cash, including foreign currency
Investments, except for investments that cannot be easily liquidated
Prepaid expenses
Accounts receivable
Inventory
These items are typically presented in the balance sheet in their order of liquidity, which means that the most liquid items are shown first. The preceding example shows current assets in their order of liquidity.
Creditors are interested in the proportion of current assets to current liabilities, since it indicates the short-term liquidity of an entity. In essence, having substantially more current assets than liabilities indicates that a business should be able to meet its short-term obligations. This type of liquidity-related analysis can involve the use of several ratios, include the cash ratio, current ratio, and quick ratio.
The main problem with relying upon current assets as a measure of liquidity is that some of the accounts within this classification are not so liquid. In particular, it may be difficult to readily convert inventory into cash. Similarly, there may be some extremely overdue invoices within the accounts receivable number, though there should be an offsetting amount in the allowance for doubtful accounts to represent the amount that is not expected to be collected. Thus, the contents of current assets should be closely examined to ascertain the true liquidity of a business.
Current Liability
A current liability is an obligation that is payable within one year. The cluster of liabilities comprising current liabilities is closely watched, for a business must have sufficient liquidity to ensure that they can be paid off when due. All other liabilities are reported as long-term liabilities, which are presented in a grouping lower down in the balance sheet below current liabilities.
In those rare cases where the operating cycle of a business is longer than one year, a current liability is defined as being payable within the term of the operating cycle. The operating cycle is the time period required for a business to acquire inventory, sell it, and convert the sale into cash. In most cases, the one-year rule will apply.
Since current liabilities are typically paid by liquidating current assets, the presence of a large amount of current liabilities calls attention to the size and prospective liquidity of the offsetting amount of current assets listed on a company’s balance sheet. Current liabilities may also be settled through their replacement with other liabilities, such as with short-term debt.
The aggregate amount of current liabilities is a key component of several measures of the short-term liquidity of a business, including:
Current ratio. This is current assets divided by current liabilities.
Quick ratio. This is current assets minus inventory, divided by current liabilities.
Cash ratio. This is cash and cash equivalents, divided by current liabilities.
For all three ratios, a higher ratio denotes a larger amount of liquidity and therefore an enhanced ability for a business to meet its short-term obligations.
Tangible Asset
A tangible asset is physical property - it can be touched. The term is most commonly associated with fixed assets, such as machinery, vehicles, and buildings. It is not used to describe shorter-term assets, such as inventory, since these items are intended for sale or conversion to cash. Tangible assets comprise the key competitive advantage of some organizations, especially if they use the assets efficiently to produce sales.
Tangible assets are frequently used as collateral for loans, since they tend to have robust, long-term valuations that are valuable to a lender. These assets typically require a significant amount of maintenance to uphold their values and productive capabilities, and likely require insurance protection.
The opposite of a tangible asset is an intangible one, which is not physically present. Examples of intangible assets are copyrights, patents, and operating licenses.
Intangible Asset
An intangible asset is a non-physical asset having a useful life greater than one year. If an intangible asset is determined to have a useful life, then its book value is amortized over that useful life. If at any point there is judged to be a decline in the remaining value of an intangible asset below its carrying amount, then the difference is recognized as an impairment expense in the current period; that is, the impairment charge is not spread out over a number of periods. Examples of intangible assets are:
Marketing-related intangible assets Trademarks Newspaper mastheads Internet domain names Noncompetition agreements Customer-related intangible assets Customer lists Order backlog Customer relationships Artistic-related intangible assets Performance events Literary works Musical works Pictures Motion pictures and television programs Contract-based intangible assets Licensing agreements Service contracts Lease agreements Franchise agreements Broadcast rights Employment contracts Use rights (such as drilling rights or water rights) Technology-based intangible assets Patented technology Computer software Trade secrets (such as secret formulas and recipes) The other type of long-term asset is a tangible fixed asset, such as a vehicle, office equipment, or machinery.
Short Term Asset
A short term asset is an asset that is to be sold, converted to cash, or liquidated to pay for liabilities within one year. In the rare cases where the operating cycle of a business is longer than one year (such as in the lumber industry), the applicable period is the operating cycle of the business, rather than one year. An operating cycle is the time period from when materials are acquired for production or resale to the point when cash is received from customers in payment for those materials or the products from which they are derived.
All of the following are typically considered to be short term assets:
Cash
Marketable securities
Trade accounts receivable
Employee accounts receivable
Prepaid expenses (such as prepaid rent or prepaid insurance)
Inventory of all types (raw materials, work-in-process, and finished goods)
If it is anticipated that any prepaid expenses will not be charged to expense within one year, then they must instead be classified as long-term assets. Later, when it is expected that they will be charged to expense within one year, they are reclassified at that time as short term assets.
Long Term Asset
Long-term assets are assets that are not expected to be consumed or converted into cash within one year. Examples are fixed assets, intangible assets, and long-term investments. These assets are typically recorded at their purchase costs, which are subsequently adjusted downward by depreciation, amortization, and impairment charges.
All assets not classified as long-term assets are classified as current assets on the balance sheet of an entity.
Fixed Asset
A fixed asset is an item with a useful life greater than one reporting period, and which exceeds an entity’s minimum capitalization limit. A fixed asset is not purchased with the intent of immediate resale, but rather for productive use within the entity. An inventory item cannot be considered a fixed asset, since it is purchased with the intent of either reselling it directly or incorporating it into a product that is then sold. The following are examples of general categories of fixed assets:
Buildings Computer equipment Computer software Furniture and fixtures Intangible assets Land Leasehold improvements Machinery Vehicles Fixed assets are initially recorded as assets, and are then subject to the following general types of accounting transactions:
Periodic depreciation (for tangible assets) or amortization (for intangible assets) Impairment write-downs (if the value of an asset declines below its net book value) Disposition (once assets are disposed of) A fixed asset appears in the financial records at its net book value, which is its original cost, minus accumulated depreciation, minus any impairment charges. Because of ongoing depreciation, the net book value of an asset is always declining. However, it is possible under international financial reporting standards to revalue a fixed asset, so that its net book value can increase.
A fixed asset does not actually have to be “fixed,” in that it cannot be moved. Many fixed assets are portable enough to be routinely shifted within a company’s premises, or entirely off the premises. Thus, a laptop computer could be considered a fixed asset (as long as its cost exceeds the capitalization limit).
A fixed asset is also known as Property, Plant, and Equipment.
Related Courses
Expense
An expense is the reduction in value of an asset as it is used to generate revenue. If the underlying asset is to be used over a long period of time, the expense takes the form of depreciation, and is charged ratably over the useful life of the asset. If the expense is for an immediately consumed item, such as a salary, then it is usually charged to expense as incurred. Common expenses are:
Cost of goods sold Rent expense Wages expense Utilities expense If an expenditure is for a minor amount that may not be consumed for a long period of time, it is usually charged to expense at once, to eliminate the accounting staff time that would otherwise be required to track it as an asset.
Under cash basis accounting, an expense is usually recorded only when a cash payment has been made to a supplier or an employee. Under the accrual basis of accounting, an expense is recorded as noted above, when there is a reduction in the value of an asset, irrespective of any related cash outflow.
The purchase of an asset may be recorded as an expense if the amount paid is less than the capitalization limit used by a company. If the amount paid had been higher than the capitalization limit, then it instead would have been recorded as an asset and charged to expense at a later date, when the asset was consumed.
The accounting for an expense usually involves one of the following transactions:
Debit to expense, credit to cash. Reflects a cash payment.
Debit to expense, credit to accounts payable. Reflects a purchase made on credit.
Debit to expense, credit to asset account. Reflects the charging to expense of an asset, such as depreciation expense on a fixed asset.
Debit to expense, credit to other liabilities account. Reflects a payment not involving trade payables, such as the interest payment on a loan, or an accrued expense.
Under the matching principle, expenses are typically recognized in the same period in which related revenues are recognized. For example, if goods are sold in January, then both the revenues and cost of goods sold related to the sale transaction should be recorded in January.
An expense is not the same as an expenditure. An expenditure is a payment or the incurrence of a liability, whereas an expense represents the consumption of an asset. Thus, a company could make a $10,000 expenditure of cash for a fixed asset, but the $10,000 asset would only be charged to expense over the term of its useful life. Thus, an expenditure generally occurs up front, while the recognition of an expense might be spread over an extended period of time.
Expense management is the concept of reviewing expenses to determine which ones can be safely reduced or eliminated without having an offsetting negative impact on revenues or on the development of future products or services. Budgets and historical trend analysis are expense management tools.
Capitalization Limit (Cap Limit)
The capitalization limit is the amount paid for an asset, above which an entity records it as a long-term asset. If an entity pays less than the capitalization limit for an asset, it charges the asset to expense in the period incurred. This limit is imposed in order to reduce the record keeping associated with long-term assets.
Depreciation
Depreciation is the systematic reduction of the recorded cost of a fixed asset. Examples of fixed assets that can be depreciated are buildings, furniture, leasehold improvements, and office equipment. The only exception is land, which is not depreciated (since land is not depleted over time, with the exception of natural resources). The reason for using depreciation is to match a portion of the cost of a fixed asset to the revenue that it generates; this is mandated under the matching principle, where you record revenues with their associated expenses in the same reporting period in order to give a complete picture of the results of a revenue-generating transaction. The net effect of depreciation is a gradual decline in the reported carrying amount of fixed assets on the balance sheet.
It is very difficult to directly link a fixed asset with a revenue-generating activity, so we do not try - instead, we incur a steady amount of depreciation over the useful life of each fixed asset, so that the remaining cost of the asset on the company’s records at the end of its useful life is only its salvage value.
Inputs to Depreciation Accounting
There are three factors to consider when you calculate depreciation, which are:
Useful life. This is the time period over which the company expects that the asset will be productive. Past its useful life, it is no longer cost-effective to continue operating the asset, so it is expected that the company will dispose of it. Depreciation is recognized over the useful life of an asset.
Salvage value. When a company eventually disposes of an asset, it may be able to sell it for some reduced amount, which is the salvage value. Depreciation is calculated based on the asset cost, less any estimated salvage value. If salvage value is expected to be quite small, then it is generally ignored for the purpose of calculating depreciation.
Depreciation method. You can calculate depreciation expense using an accelerated depreciation method, or evenly over the useful life of the asset. The advantage of using an accelerated method is that you can recognize more depreciation early in the life of a fixed asset, which defers some income tax expense recognition into a later period. The advantage of using a steady depreciation rate is the ease of calculation. Examples of accelerated depreciation methods are the double declining balance and sum-of-the-years digits methods. The primary method for steady depreciation is the straight-line method. The units of production method is also available if you want to depreciate an asset based on its actual usage level, as is commonly done with airplane engines that have specific life spans tied to their usage levels.
Carrying Amount
The carrying amount is the recorded cost of an asset, net of any accumulated depreciation or accumulated impairment losses. The term also refers to the recorded amount of a liability.
The carrying amount of an asset may not be the same as its current market value. Market value is based on supply and demand, while the carrying amount is a simple calculation based on the gradual depreciation charged against an asset.
The concept also applies to bonds payable, where the carrying amount is the initial recorded liability for bonds payable, minus any discount on bonds payable or plus any premium on bonds payable.
Market Value
Market value is the price at which a product or service could be sold in a competitive, open market. The concept is the basis for several accounting analyses to determine whether the book value of an asset should be written down. Market value can be determined most easily when there are a large number of willing buyers and sellers that engage in purchases and sales of similar products on an ongoing basis.
Market value is more difficult to determine when the preceding factors are not present. If so, an appraiser may be used to compile a reasonable approximation of market value.
The concept also refers to the market capitalization of a publicly-held entity, which is the number of its shares outstanding multiplied by the current price at which the shares trade.
Salvage Value
Salvage value is the estimated resale value of an asset at the end of its useful life. Salvage value is subtracted from the cost of a fixed asset to determine the amount of the asset cost that will be depreciated. Thus, salvage value is used as a component of the depreciation calculation.
For example, ABC Company buys an asset for $100,000, and estimates that its salvage value will be $10,000 in five years, when it plans to dispose of the asset. This means that ABC will depreciate $90,000 of the asset cost over five years, leaving $10,000 of the cost remaining at the end of that time. ABC expects to then sell the asset for $10,000, which will eliminate the asset from ABC’s accounting records.
If it is too difficult to determine a salvage value, or if the salvage value is expected to be minimal, then it is not necessary to include a salvage value in depreciation calculations. Instead, simply depreciate the entire cost of the fixed asset over its useful life. Any proceeds from the eventual disposition of the asset would then be recorded as a gain.
The salvage value concept can be used in a fraudulent manner to estimate a high salvage value for certain assets, which results in the under-reporting of depreciation and therefore of higher profits than would normally be the case.
Salvage value is not discounted to its present value.
Present Value
Present value is the current worth of cash to be received in the future with one or more payments, which has been discounted at a market rate of interest. The present value of future cash flows is always less than the same amount of future cash flows, since you can immediately invest cash received now, thereby achieving a greater return than from a promise to receive cash in the future.
The concept of present value is critical in many financial applications, such as the valuation of pension obligations, decisions to invest in fixed assets, and whether to purchase one type of investment over another. In the latter case, present value provides a common basis for comparing different types of investments.
An essential component of the present value calculation is the interest rate to use for discounting purposes. While the market rate of interest is the most theoretically correct, it can also be adjusted up or down to account for the perceived risk of the underlying cash flows. For example, if cash flows were perceived to be highly problematic, a higher discount rate might be justified, which would result in a smaller present value.
The concept of present value is especially important in hyperinflationary economies, where the value of money is declining so rapidly that future cash flows have essentially no value at all. The use of present value clarifies this effect.
Cash
Cash is bills, coins, bank balances, money orders, and checks. Cash is used to acquire goods and services or to eliminate obligations.
Items that do not fall within the definition of cash are post-dated checks and notes receivable. Most forms of cash are electronic, rather than bills and coins, since cash balances can be stated in the computer records for investment accounts.
Cash is listed first in the balance sheet, since the reporting sequence is in order by liquidity, and cash is the most liquid of all assets. A related accounting term is cash equivalents, which refers to assets that can be readily converted into cash.
A business is more likely to retain a large amount of cash on hand if it routinely deals with cash transactions (such as a pawn shop), and is less likely to retain much cash if it has an excellent cash forecasting system and can therefore invest in more illiquid but higher yielding investments with confidence.
Cash is assumed to be stated at its fair value at all times.
Cash Flow
Cash flow is the net amount of cash that an entity receives and disburses during a period of time. A positive level of cash flow must be maintained for an entity to remain in business. The time period over which cash flow is tracked is usually a standard reporting period, such as a month, quarter, or year. Cash inflows come from the following sources:
Operations. This is cash paid by customers for services or goods provided by the entity.
Financing activities. An example is debt incurred by the entity.
Investment activities. An example is the gain on invested funds.
Cash outflows originate with the following sources:
Operations. This is expenditures made as part of the ordinary course of operations, such as payroll, the cost of goods sold, rent, and utilities.
Financing activities. Examples are interest and principal payments made by the entity, or the repurchase of company stock, or the issuance of dividends.
Investment activities. Examples are payments made into investment vehicles, loans made to other entities, or the purchase of fixed assets.
An alternative way to calculate the cash flow of an entity is to add back all non-cash expenses (such as depreciation and amortization) to its net after-tax profit, though this approach only approximates actual cash flows.
Cash flow is not the same as the profit or loss recorded by a company under the accrual basis of accounting, since accruals for revenues and expenses, as well as for the delayed recognition of cash already received, can cause differences from cash flow.
A persistent, ongoing negative cash flow based on operational cash flows should be a cause of serious concern to the business owner, since it means that the business will require an additional infusion of funds to avoid bankruptcy.
A summary of the cash flows of an entity is formalized within the statement of cash flows, which is a required part of the financial statements under both the GAAP and IFRS accounting frameworks.
Accounts Receivable
Accounts receivable refers to short-term amounts due from buyers to a seller who have purchased goods or services from the seller on credit. Credit is usually granted in order to gain sales or to respond to the granting of credit by competitors. Accounts receivable is listed as a current asset on the seller’s balance sheet.
The total amount of accounts receivable allowed to an individual customer is typically limited by a credit limit, which is set by the seller’s credit department, based on the finances of the buyer and its past payment history with the seller. Credit limits may be reduced during difficult financial conditions when the seller cannot afford to incur excessive bad debt losses.
Accounts receivable are commonly paired with the allowance for doubtful accounts (a contra account), in which is stored a reserve for bad debts. The combined balances in the accounts receivable and allowance accounts represent the net carrying value of accounts receivable.
The seller may use its accounts receivable as collateral for a loan, or sell them off to a factor in exchange for immediate cash.
Accounts receivable may be further subdivided into trade receivables and non trade receivables, where trade receivables are from a company’s normal business partners, and non trade receivables are all other receivables, such as amounts due from employees.
Accounts Payable
Accounts payable is the aggregate amount of an entity’s short-term obligations to pay suppliers for products and services which the entity purchased on credit. If accounts payable are not paid within the payment terms agreed to with the supplier, the payables are considered to be in default, which may trigger a penalty or interest payment, or the revocation or curtailment of additional credit from the supplier.
When individual accounts payable are recorded, this may be done in a payables subledger, thereby keeping a large number of individual transactions from cluttering up the general ledger. Alternatively, if there are few payables, they may be recorded directly in the general ledger. Accounts payable appears within the current liability section of an entity’s balance sheet.
Accounts payable are considered a source of cash, since they represent funds being borrowed from suppliers. When accounts payable are paid, this is a use of cash. Given these cash flow considerations, suppliers have a natural inclination to push for shorter payment terms, while creditors want to lengthen the payment terms.
From a management perspective, it is of some importance to have accurate accounts payable records, so that suppliers are paid on time and liabilities are recorded in full and within the correct time periods. Otherwise, suppliers will be less inclined to grant credit, and the financial results of a business may be incorrect.
Other types of payables that are not considered accounts payable are wages payable and notes payable.
The reverse of accounts payable is accounts receivable, which are short-term obligations payable to a company by its customers.
Working Capital
Working capital is the amount of an entity’s current assets minus its current liabilities. The result is considered a prime measure of the short-term liquidity of an organization. A strongly positive working capital balance indicates robust financial strength, while negative working capital is considered an indicator of impending bankruptcy.
A 2:1 ratio of current assets to current liabilities is considered healthy, though the ratio can vary by industry. The ratio may also be reviewed on a trend line, with the intent of spotting any declines or sudden drops that could indicate liquidity problems.
As an example of the calculation of working capital, a business has $100,000 of accounts receivable, $40,000 of inventory, and $35,000 of accounts payable. Its working capital is:
Trend Line
A trend line is a series of plotted data points that indicate a direction. The trend line may be extended to indicate a future direction, using a moving average calculation, exponential smoothing, or some similar technique. Trend line analysis is useful for budgeting and forecasting, and is commonly used in technical analysis.
Liquidity
Liquidity is the ability of an entity to pay its liabilities in a timely manner, as they come due for payment under their original payment terms. Having a large amount of cash and current assets on hand is considered evidence of a high level of liquidity.
When applied to an individual asset, liquidity refers to the ability to convert the asset into cash on short notice and at a minimal discount. Having an active market with many buyers and sellers typically results in a high level of liquidity.
Active Market
An active market is a market that routinely experiences high transaction volumes. There is usually a small spread between bid and ask prices, since there are so many buyers and sellers who are interested in trading. Some investors only want to buy securities and other assets that are traded in an active market, because their investments can be easily liquidated and doing so has only a minor impact on prices.
Bid and Ask Prices
Bid and asked refers to the prices at which securities are sold in the over-the-counter market. The bid price is the highest price at which an investor is willing to buy a security, while the asked price is the lowest price at which the owner is willing to sell. The two prices are grouped together, comprising the quotation for the security. The difference between these two prices is the spread, which is the market maker’s profit. When the spread is quite small, it indicates that there is a significant amount of trading in the security.
Security
A security is a financial instrument issued by a business entity or government, which gives the buyer the right to either interest payments or a share of the earnings of the issuer. Securities form a key part of the financial structure of an economy. Examples of securities are stocks, bonds, options, and warrants.
The concept can also refer to the collateral on a loan, which gives a lender the right to take possession of the collateral if a borrower cannot pay back a loan.
Capital
Capital is the investment by an entity’s owners in a business, plus the impact of any accumulated gains or losses. This is may be considered the residual wealth of a business after all of its liabilities have been settled.
Capital is also defined as the aggregate wealth of an individual.
Balance Sheet
A balance sheet lays out the ending balances in a company’s asset, liability, and equity accounts as of the date stated on the report. The balance sheet is commonly used for a great deal of financial analysis of a business’ performance. Some of the more common ratios that include balance sheet information are:
Accounts receivable collection period Current ratio Debt to equity ratio Inventory turnover Quick ratio Return on net assets Working capital turnover ratio Many of these ratios are used by creditors and lenders to determine whether they should extend credit to a business, or perhaps withdraw existing credit.
The information listed on the balance sheet must match the following formula:
Total assets = Total liabilities + Equity
The balance sheet is one of the key elements in the financial statements, of which the other documents are the income statement and the statement of cash flows. A statement of retained earnings may sometimes be attached.
The format of the balance sheet is not mandated by accounting standards, but rather by customary usage. The two most common formats are the vertical balance sheet (where all line items are presented down the left side of the page) and the horizontal balance sheet (where asset line items are listed down the first column and liabilities and equity line items are listed in a later column). The vertical format is easier to use when information is being presented for multiple periods.
The line items to be included in the balance sheet are up to the issuing entity, though common practice typically includes some or all of the following items:
Current Assets:
Cash and cash equivalents Trade receivables and other receivables Investments Inventories Assets held for sale Non-Current Assets:
Property, plant, and equipment
Intangible assets
Goodwill
Current Liabilities:
Trade payables and other payables Accrued expenses Current tax liabilities Current portion of long-term debt Other financial liabilities Liabilities held for sale Non-Current Liabilities:
Loans payable
Deferred tax liabilities
Other non-current liabilities
Equity:
Capital stock
Additional paid-in capital
Retained earnings
Creditor
A creditor is an individual or entity that is owed money. Examples of creditors are suppliers and lenders. There are several varieties of creditor, which include the following:
Secured creditor. This creditor is legally entitled to take certain borrower property and sell it in the event of a payment default.
Unsecured creditor. This creditor is not legally entitled to take any borrower property in the event of a default.
Senior creditor. This creditor will be paid before junior creditors in the event of a borrower’s bankruptcy.
Junior creditor. This creditor will only be paid after senior creditors have been paid in full, if there is a borrower bankruptcy.
Collateral
Collateral is an asset or group of assets that a borrower or guarantor has pledged as security for a loan. The lender has the legal right to seize and sell the asset(s) if the borrower is unable to pay back the loan by the agreed date. An example of collateral is the house bought with a mortgage.
Because of the extra security provided to the lender by having collateral, the amount borrowed may be higher and/or the associated interest rate may be reduced. In many cases, it is not possible for a borrower to obtain a loan without collateral.
There is no collateral associated with credit card debt, which (in part) explains the high interest rates charged by credit card providers.
Loan
A loan is an arrangement under which a lender allows another party the use of funds in exchange for an interest payment and the return of the funds at the end of the lending arrangement. Loans provide liquidity to businesses and individuals, and as such are a necessary part of the financial system.
The terms associated with a loan are contained within a promissory note. These terms may include the following:
The interest rate to be paid by the borrower, which may be a variable or fixed rate
The maturity date of the loan
The size and dates of the payments to be made to the lender
The amount of any collateral to be posted against the note
A loan that can be called by the lender is a demand loan. If a loan is to be repaid over time in accordance with a fixed schedule, it is called an installment loan.
Lender
A lender is an entity that makes cash loans to other entities or individuals in exchange for either a fixed or variable interest rate and a promise of repayment. Lenders are needed for several reasons, including the following:
To provide funding for major purchases
To increase the amount of working capital funding
To provide a backup line of credit to support irregular cash flows
Lenders may choose to offer only certain types of loans, or to restrict their lending activities to certain types of entities. For example, a lender may specialize in mortgages to individuals, or lines of credit to businesses.
Demand Loan
A demand loan is a borrowing instrument that allows the lender to recall the loan on short notice. Once notified, the borrower must repay the full amount of the loan and any associated interest. This arrangement also allows the borrower to repay the loan at any time without an early repayment penalty. An example of a demand loan is an overdraft arrangement.
Overdraft Loan
An overdraft is a short-term line of credit granted by a bank to an account holder when checks presented against the account exceed the amount of cash available in the account. An account usually has to be designated as having overdraft protection before this feature will be operable. The amount of an overdraft is usually capped at an overdraft limit, so that account holders will not abuse the privilege. This service keeps account holder checks from bouncing.
The interest charges and transaction fees charged for overdrafts generate significant profits for banks. However, when faced with excessive usage and the prospect of not being paid back by an account holder, a bank may unilaterally cancel overdraft protection.
Interest
Interest is the cost of funds loaned to an entity by a lender. This cost is usually expressed as a percentage of the principal on an annual basis. Interest can be calculated as simple interest or compound interest, where compound interest results in a higher return to the investor. Depending on the tax laws of the applicable government entity, interest expense is tax deductible for a borrower.
The interest concept can also refer to the equity ownership by an investor in a business entity.
Promissory Note
A promissory note is a written agreement under which one party agrees to pay another party a certain amount of cash on a future date. The date may be a fixed date sometime in the future, or on demand. The note typically contains the following information:
Name of the payee
Name of the maker (payer)
The sum to be paid
The interest rate that applies to the debt
The maturity date
The signature of the issuer and the date signed
The payee is the holder of a promissory note. Once the underlying funds have been paid to the payee, the payee cancels the note and returns it to the maker. A promissory note differs from an IOU in that the note states the specifics of repayment, while an IOU only acknowledges that a debt exists.
Maker (payer)
A maker is the individual who signs a check, promissory note, or other negotiable instrument. This person, or the entity he or she represents, assumes responsibility for payment of the underlying obligation.
Check
A check is an authorization to draw funds from a bank account. In order to do this, a check must state the name of the payee, the amount to be paid, and the date. A check is usually negotiable, so that the payee can assign it to another person by endorsing it. The person to whom the check is assigned becomes the new payee. The use of checks allows two parties to a transaction to engage in a monetary transaction without physically exchanging any currency. There are several variations on the check concept, including the following:
A cashier’s check, where a bank is responsible for the payment of funds.
A certified check, where a bank guarantees that the drawer’s account has sufficient funds in it to keep the check from bouncing.
A payroll check, where the payment is intended to compensate employees for their work.
The use of checks has declined as electronic forms of payment, such as ACH payments and wire transfers, have increased.
Payee
A payee is a person or entity that receives or is scheduled to receive a payment. The payment may be in any form, including bills, coins, a check, an electronic transfer, a promissory note, or in kind. The person or entity making the payment is the payer. The reason for the payment is a transfer of value from the payee to the payer, such as the legal right to an asset.
Payer
A payer is the person or business responsible for making a payment to a payee. Thus, a person making a mortgage payment to a lender is designated at the payer, and the lender is the payee.
Mortgage
A mortgage is a loan that is used to pay for a portion of the price of real estate. The loan typically requires a fixed schedule of repayments. The underlying real estate is used as collateral on the loan. If the borrower does not make loan payments on a timely basis, the lender can seize and sell the property, using the proceeds to pay off the remaining loan balance. The most common mortgage is the fixed-rate variety, which locks in a fixed interest rate for the life of the loan. An adjustable-rate loan is also available, which tracks the prime rate. Adjustable-rate loans are riskier for the borrower, since a jump in the prime rate can trigger a substantial increase in mortgage payments.
In-Kind
In-kind refers to a payment made with goods or services, rather than currency. The concept most commonly refers to contributions to charities that are made with goods or services. For example, a grocery store could provide in-kind food contributions to a soup kitchen. Similarly, a construction company could provide in-kind labor to construct a home for a homeless family.
Contributions
The contributions account is a revenue account used by nonprofit entities. It is intended to record all donations received from third parties that are intended for the use of the nonprofit.
The term is also used by all types of entities as a general ledger expense account. In this role, the account is used for the recordation of all contributions made to other entities. The account may be further split into taxable contributions and nontaxable contributions accounts, if necessary.
Non-Profit
A nonprofit organization is an entity that does not have owners, and which has the purpose of serving society. Under the United States tax laws, a nonprofit entity has tax-exempt status, so that it does not pay income taxes on those of its earnings that relate to its principle mission. If approved by application to the Internal Revenue Service, the contributions made to a nonprofit can be tax deductible. To be classified as a nonprofit, an entity’s primary mission must be to support one or more of the following:
Amateur sports Charity Educational activities Literary activities Prevention of cruelty to animals Public safety Religion Science Common examples of nonprofit organizations are churches, hospitals and schools.
Earnings
Earnings are the profits generated by a business. They are derived by subtracting the cost of goods sold, operating expenses, and taxes from revenue. The generation of earnings is a key driving force behind the formation and subsequent operation of a business. Earnings can then be used to pay dividends to shareholders. If a company is still growing and does not have sufficient cash to distribute as dividends, earnings might instead be held within the business; if so, investors can profit from an increase in the market value of the company stock that they hold.
Earnings tend to be quite low or negative during the early years of a business, when it is spending money to build products and services, as well as to expand its market presence. Once the business is established, its earnings are typically both larger and more consistent. If the decision is made to run down and liquidate a business, it is possible that earnings will briefly be quite high, since the sales and marketing expenses that it usually incurs to maintain market share among customers are no longer being incurred. Thus, there is a definite pattern to the timing of earnings generation over the life of a business.
If a company is publicly held, the amount of earnings reported is a significant driver of its stock price. If the amount is lower than expected by analysts, the stock price could drop sharply, even though the amount may meet or exceed the company’s own expectations.
Tax-Deductible
An expenditure is considered to be tax deductible when it can be subtracted from the adjusted gross income line item on a tax return, thereby reducing the amount of income that is subject to taxation. Tax laws specify which expenditures can be treated in this manner. Examples of tax deductible expenditures are charitable contributions and mortgage interest.
Adjusted Gross Income
Adjusted gross income (AGI) is a variation on an individual’s total income, upon which income taxes are based. AGI is less than a person’s gross income, with the difference coming from a variety of deductions, such as medical expenses, alimony, losses from asset sales, and retirement plan contributions. A complete listing of all available deductions can be found on the website of the Internal Revenue Service. Once AGI has been calculated, exemptions and standard or itemized deductions are applied, which then leads to the calculation of the amount of tax owed.
Tax planning involves close attention to these deductions, in order to reduce AGI to the lowest possible amount.
Gross Income
Gross income is a person’s total pay prior to taxes and other deductions. For many individuals, gross income is simply the total amount of wage or salary payments received within one year. Other sources of gross income are dividends, alimony, interest income, pensions, rental income, and capital gains. Some types of income are not included in gross income, such as municipal bond income, social security benefits, and gifts below a certain threshold level. Thus, if a person has been paid wages of $65,000 and also received $3,000 of interest income and $500 of dividend income, her total gross income is $68,500.
Gross income is sometimes used by lenders as a guideline for determining the total amount of debt that a borrower can sustain. For example, a common lending guideline is that a borrower cannot borrow more than 28% of her gross income.
Wage
A wage is the remuneration paid to an employee, usually on an hourly or piece rate basis. Wages are one of the primary expenses of an organization, comprising an especially high proportion of total expenses in service-oriented firms. Wages are more likely to be paid for unskilled or manual labor. A wage differs from a salary in the following ways:
The total amount paid tends to vary, based on the number of hours worked, whereas a salary is a fixed amount, irrespective of the number of hours worked.
Wages tend to be paid more frequently than salaries, usually on a weekly basis.
Wages may be paid in cash, especially when wages are being paid on a daily basis or to temporary laborers.
Piece Rate Pay
A piece rate pay plan can be used by a business that wants to pay its employees based on the number of units of production that they complete. Using this type of pay plan converts compensation into a cost that directly varies with sales, assuming that all produced goods are immediately sold. If goods are instead stored in inventory for a time and then sold at a later date, there is not such a perfect linkage in the financial statements between sales generated and piece rate labor costs incurred.
Use the following method to calculate wages under the piece rate method:
Rate paid per unit of production × Number of units completed in the pay period
If a company uses the piece rate method, it must still pay its employees for overtime hours worked. There are two methods available for calculating the amount of this overtime, which are:
Multiply the regular piece rate by at least 1.5 to arrive at the overtime piece rate, and multiply it by the hours worked during an overtime period. You can only use this method when both the company and the employee have agreed to use it prior to the overtime being worked.
Divide hours worked into the total piece rate pay, and then add the overtime premium (if any) to the excess number of hours worked.
In addition, an employer using the piece rate pay system must still ensure that its employees are at least paid the minimum wage. Thus, if the piece rate pay is less than the minimum wage, the amount paid must be increased to match the minimum wage.
Piece Rate Pay Example
October Systems manufactures customized cellular phones, and pays its staff a piece rate of $1.50 for each phone completed. Employee Seth Jones completes 500 phones in a standard 40-hour work week, for which he is paid $750 (500 phones × $1.50 piece rate).
Mr. Jones works an additional 10 hours, and produces another 100 phones during that time. To determine his pay for this extra time period, October Systems first calculates his pay during the normal work week. This is $18.75 (calculated as $750 total regular pay, divided by 40 hours). This means that the overtime premium is 0.5 × $18.75, or $9.375 per hour. Consequently, the overtime portion of Mr. Jones’ pay for the extra 10 hours worked is $93.75 (calculated as 10 hours × $9.375 overtime premium).
If October Systems had instead set the piece rate 50% higher for production work performed during the overtime period, this would have resulted in the overtime portion of his pay being $75 (calculated as $0.75 per unit × 100 phones produced).
The difference in the payout between the two overtime calculation methods was caused by the lower productivity level of Mr. Jones during the overtime period. He assembled 25 fewer phones during the overtime period than his average amount during the normal work week, and so would have earned $18.75 less ($0.75 overtime premium × 25 phones) under the second calculation method.
Salary
A salary is a fixed amount that is paid to an employee at regular intervals, irrespective of the hours or amount of work performed. The amount of a salary is usually stated as the full annual amount to be paid, such as $80,000 per year. Salaries are usually paid at bi-weekly, semi-monthly, or monthly intervals. A salaried employee is typically paid through the date of each paycheck, since the amount paid never varies.
Someone who is paid a wage instead of a salary is usually paid based on the hours or amount of work performed, and is typically paid on a more frequent basis. The amount paid is usually as of several days prior to the date of the paycheck, since it takes time to calculate wages, which may vary by paycheck.
Capital Gain
A capital gain is the amount by which an asset’s value exceeds its original purchase price. This amount is realized when the asset is sold. If the holding period prior to sale is less than one year, the gain is classified as a short-term capital gain. If the holding period is longer, the gain is classified as a long-term capital gain. Different income tax rates apply to each of these classifications.
Long-term capital gains are taxed at a much lower rate than short-term gains, in order to encourage the retention of assets and securities for long periods of time.
Dividend
Dividends are a portion of a company’s earnings which it returns to investors, usually as a cash payment. The company has a choice of returning some portion of its earnings to investors as dividends, or of retaining the cash to fund internal development projects or acquisitions. A more mature company that does not need its cash reserves to fund additional growth is the most likely to issue dividends to its investors. Conversely, a rapidly-growing company requires all of its cash reserves (and probably more, in the form of debt) to fund its operations, and so is unlikely to issue a dividend.
Dividends may be required under the terms of a preferred stock agreement that specifies a certain dividend payment at regular intervals. However, a company is not obligated to issue dividends to the holders of its common stock.
Those companies issuing dividends generally do so on an ongoing basis, which tends to attract investors who seek a stable form of income over a long period of time. Conversely, a dividend tends to keep growth-oriented investors from buying a company’s stock, since they want the firm to re-invest all cash in the business, which presumably will jump-start earnings and lead to a higher stock price.
There are several key dates associated with dividends, which are:
Declaration date. This is the date on which a company’s board of directors sets the amount and payment date of a dividend.
Record date. This is the date on which the company compiles the list of investors who will be paid a dividend. You must be a stockholder on this date in order to be paid.
Payment date. This is the date on which the company pays the dividend to its investors.
A number of publicly held companies offer dividend reinvestment plans, under which investors can reinvest their dividends back into the company by purchasing additional shares, usually at a discount from the market price on the reinvestment date, and without any brokerage fees. This approach allows a company to maximize its cash reserves, while also providing an incentive for investors to continue holding company stock.
Dividends may also be paid in the form of other assets or additional stock.
Once a dividend is paid, the company is worth less, since it has just paid out part of its cash reserves. This means that the price of the stock should fall immediately after dividends have been paid. This may not be the case if the proportion of total assets paid out as a dividend is small.
The dividend payout ratio is the percentage of a company’s earnings paid out to its shareholders in the form of dividends. The dividend yield ratio shows the amount of dividends that a company pays to its investors in comparison to the market price of its stock. These ratios are closely watched by investors.
Dividend Yield Ratio
The dividend yield ratio shows the amount of dividends that a company pays to its investors in comparison to the market price of its stock. Thus, the dividend yield ratio is the return on investment to an investor if the investor were to have bought the stock at the market price on the measurement date.
To calculate the ratio, divide the annual dividends paid per share of stock by the market price of the stock at the end of the measurement period. Since the market price of the stock is measured on a single date, and that measurement may not be representative of the stock price over the measurement period, consider using an average stock price instead. The basic calculation is:
Annual dividends paid per share ÷ Market price of the stock
Dividend Yield Ratio Example
ABC Company pays dividends of $4.50 and $5.50 per share to its investors in the current fiscal year. At the end of the fiscal year, the market price of its stock is $80.00. Its dividend yield ratio is:
$10 Dividends paid ÷ $80 Share price
= 12.5% Dividend yield ratio
A problem with the measurement is whether you should include in the numerator only dividends paid, or also dividends declared but not yet paid. It is possible that there will be overlap in the measurement periods if you use both dividends paid and dividends declared. For example, a company pays $10.00 in dividends during the fiscal year, but then also declares a dividend just before the end of the reporting period. If you are measuring based on cash received, you should not include the amount of the dividend declared; instead, measure it in the following fiscal year, when you receive the cash from the dividend. Doing so is essentially using the cash basis of accounting.
This measurement is not useful when a company refuses to pay any dividends, preferring to instead plow cash back into the business, which presumably leads to an increased share price over time as the underlying business is perceived by the investment community to be more valuable.
Dividend Payout Ratio
The dividend payout ratio measures the proportion of earnings paid out to shareholders as dividends. The ratio is used to determine the ability of an entity to pay dividends, as well as its reliability in doing so. A public company in a mature industry, or one whose sales are no longer growing rapidly, usually has a high dividend payout ratio. Such companies tend to attract investors who buy shares almost exclusively for the reliability of dividend payments; growth investors do not invest in these companies.
Newer companies that are using all of their cash flow to sustain a high rate of growth usually have a zero dividend payout ratio, and attract growth investors who are not concerned with dividends, but prefer instead to earn a profit on the appreciation of their shares in the business.
The ratio also reveals whether a company can sustain its current level of dividend payouts. If the ratio is greater than 100%, then the company is dipping into its cash reserves to pay dividends. This situation is not sustainable, and may result in the eventual termination of all dividends or the financial decline of the business.
It is also useful to examine the inverse of the ratio, which reveals how much cash the company is retaining for its own uses. If the retention amount is declining, this indicates that the company does not see a sufficient return on investment to be worthy of plowing additional cash back into the business.
There are two ways to calculate the dividend payout ratio; each one results in the same outcome. One version is to divide total dividends paid by net income. The calculation is:
Total dividends paid ÷ Net income
The alternative version essentially calculates the same information, but at the individual share level. The formula is to divide total dividend payments over the course of a year on a per share basis by earnings per share for the same period. The calculation is:
Annual dividend paid per share ÷ Earnings per share
For example, the Conemaugh Cell Phone Company paid out $1,000,000 in dividends to its common shareholders in the last year. In the same time period, the company earned $2,500,000 in net income. The dividend payout ratio is:
$1,000,000 Dividends paid ÷ $2,500,000 Net income
= 40% Dividend payout ratio
Be sure to track the dividend payout ratio over multiple years, so that you can spot any trends in the ability of the company to pay dividends. Trend analysis will also likely reveal the points when a company’s board of directors decides to change the amount of dividends paid, which may also trigger a change in the types of investors who own the company’s stock.
Earnings Per Share
Earnings per share represents that portion of company income that is available to the holders of its common stock. The measure is closely monitored by investors, who use it to estimate the performance of a business.
The formula for earnings per share is a company’s net income minus any dividends on preferred shares, divided by the number of common shares outstanding. The number of shares outstanding is commonly expressed as the weighted average number of shares outstanding over the reporting period. The formula is:
(Net income - Preferred stock dividends) ÷ Number of common shares outstanding
For example, a business reports $100,000 of net income. The entity also issued $20,000 as a dividend to the holders of its preferred stock. The weighted average number of common shares outstanding during the period was 1,000,000. The calculation of its earnings per share is as follows:
($100,000 Net income - $20,000 Preferred dividends) ÷ 1,000,000 Common shares outstanding
= $0.08 earnings per share
Diluted earnings per share expands on the basic earnings per share concept by also including the effects of the conversion of convertible instruments and outstanding stock warrants (which reduces the amount of earnings per share). If a business has issued a large number of these convertible instruments, the amount of diluted earnings per share could be substantially less than the basic earnings per share figure.
The earnings per share concept can be expanded upon to also calculate the percentage change in earnings per share over time, which gives investors a better view of how they are trending. The measure is also useful for comparing the results of businesses that are of different sizes, since their results are reduced down to a common measure.
The earnings per share concept is of some value to the investor, but it ignores several other factors, such as:
The efficiency with which a business uses capital to fund its operations
The outlook for future sales of its products
Trends in its expenses over time
The value of the intangible assets generated by a business, such as its branding efforts
Consequently, the investor should consider earnings per share to be just one of several factors to consider when evaluating a business.
Earnings
Earnings are the profits generated by a business. They are derived by subtracting the cost of goods sold, operating expenses, and taxes from revenue. The generation of earnings is a key driving force behind the formation and subsequent operation of a business. Earnings can then be used to pay dividends to shareholders. If a company is still growing and does not have sufficient cash to distribute as dividends, earnings might instead be held within the business; if so, investors can profit from an increase in the market value of the company stock that they hold.
Earnings tend to be quite low or negative during the early years of a business, when it is spending money to build products and services, as well as to expand its market presence. Once the business is established, its earnings are typically both larger and more consistent. If the decision is made to run down and liquidate a business, it is possible that earnings will briefly be quite high, since the sales and marketing expenses that it usually incurs to maintain market share among customers are no longer being incurred. Thus, there is a definite pattern to the timing of earnings generation over the life of a business.
If a company is publicly held, the amount of earnings reported is a significant driver of its stock price. If the amount is lower than expected by analysts, the stock price could drop sharply, even though the amount may meet or exceed the company’s own expectations.
Profit
Profit is the positive amount remaining after subtracting expenses incurred from the revenues generated over a designated period of time. This is one of the core measurements of the viability of a business, and so is closely watched by investors and lenders.
The resulting profit may not match the amount of cash flows generated during the same reporting period; this is because some of the accounting transactions required under the accrual basis of accounting do not match cash flows, such as the recordation of depreciation and amortization.
The amount of profit reported is then shifted into retained earnings, which appears in a company’s balance sheet. These retained earnings may be kept within the business to support further growth, or may be distributed to owners in the form of dividends.
Profitability can be quite hard to achieve for a startup business, since it is struggling to create a customer base and is not yet certain of the most efficient way in which to operate.
Profitability
Profitability is a situation in which an entity is generating a profit. Profitability arises when the aggregate amount of revenue is greater than the aggregate amount of expenses in a reporting period. If an entity is recording its business transactions under the accrual basis of accounting, it is quite possible that the profitability condition will not be matched by the cash flows generated by the organization, since some accrual-basis transactions (such as depreciation) do not involve cash flows.
Profitability can be achieved in the short term through the sale of assets that garner immediate gains. However, this type of profitability is not sustainable. An organization must have a business model that allows its ongoing operations to generate a profit, or else it will eventually fail.
Profitability is one of the measures that can be used to derive the valuation of a business, usually as a multiple of the annual amount of profitability. A better approach to business valuation is a multiple of annual cash flows, since this better reflects the stream of net cash receipts that a buyer can expect to receive.
Profitability is measured with the net profit ratio and the earnings per share ratio.
Accrual Based Accounting
The accrual basis of accounting is the concept of recording revenues when earned and expenses as incurred. Accrual basis accounting is the standard approach to recording transactions for all larger businesses. This concept differs from the cash basis of accounting, under which revenues are recorded when cash is received, and expenses are recorded when cash is paid. For example, a company operating under the accrual basis of accounting will record a sale as soon as it issues an invoice to a customer, while a cash basis company would instead wait to be paid before it records the sale. Similarly, an accrual basis company will record an expense as incurred, while a cash basis company would instead wait to pay its supplier before recording the expense.
The accrual basis of accounting is advocated under both generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS). Both of these accounting frameworks provide guidance regarding how to account for revenue and expense transactions in the absence of the cash receipts or payments that would trigger the recordation of a transaction under the cash basis of accounting.
The accrual basis of accounting tends to provide more even recognition of revenues and expenses over time, and so is considered by investors to be the most valid accounting system for ascertaining the results of operations, financial position, and cash flows of a business. In particular, it supports the matching principle, under which revenues and all related expenses are to be recorded within the same reporting period; by doing so, it should be possible to see the full extent of the profits and losses associated with specific business transactions within a single reporting period.
The accrual basis requires the use of estimates in certain areas. For example, a company should record an expense for estimated bad debts that have not yet been incurred. By doing so, all expenses related to a revenue transaction are recorded at the same time as the revenue, which results in an income statement that fully reflects the results of operations. Similarly, the estimated amounts of product returns, sales allowances, and obsolete inventory may be recorded. These estimates may not be entirely correct, and so can lead to materially inaccurate financial statements. Consequently, a considerable amount of care must be used when estimating accrued expenses.
A small business may elect to avoid using the accrual basis of accounting, since it requires a certain amount of accounting expertise. Also, a small business owner may choose to manipulate the timing of cash inflows and outflows to create a smaller amount of taxable income under the cash basis of accounting, which can result in the deferral of income tax payments.
A significant failing of the accrual basis of accounting is that it can indicate the presence of profits, even though the associated cash inflows have not yet occurred. The result can be a supposedly profitable entity that is starved for cash, and which may therefore go bankrupt despite its reported level of profitability. Consequently, you should pay attention to the statement of cash flows of a business, which indicates the flows of cash into and out of a business.
Cash Based Accounting
The cash basis of accounting is the practice of only recording revenue when cash has been received from a customer, and recording expenses only when cash has been paid out. The cash basis is commonly used by individuals and small businesses (especially those with no inventory).
An alternative method for recording transactions is the accrual basis of accounting, under which revenue is recorded when earned and expenses are recorded when liabilities are incurred or assets consumed, irrespective of any inflows or outflows of cash. The accrual basis is most commonly used by larger businesses. A start-up company will frequently begin keeping its books under the cash basis, and then switch to the accrual basis when it has grown to a sufficient size.
Accounting software can be configured to work under either the cash basis or the accrual basis of accounting, usually by setting a flag in a setup table.
The cash basis of accounting has the following advantages:
Taxation. The method is commonly used to record financial results for tax purposes, since a business can accelerate some payments in order to reduce its taxable profits, thereby deferring its tax liability.
Ease of use. A person requires a reduced knowledge of accounting to keep records under the cash basis.
However, the cash basis of accounting also suffers from the following problems:
Accuracy. The cash basis of accounting yields less accurate results than the accrual basis of accounting, since the timing of cash flows do not necessarily reflect the proper timing of changes in the financial condition of a business. For example, if a contract with a customer does not allow a business to issue an invoice until the end of a project, the company will be unable to report any revenue until the invoice has been issued and cash received.
Manipulation. A business can alter its reported results by not cashing received checks or altering the payment timing for its liabilities.
Lending. Lenders do not feel that the cash basis generates overly accurate financial statements, and so may refuse to lend money to a business reporting under the cash basis.
Audited financial statements. Auditors will not approve financial statements that were compiled under the cash basis of accounting, so a business will need to convert to the accrual basis if it wants to have audited financial statements.
Management reporting. Since the results of cash basis financial statements can be inaccurate, management reports should not be issued that are based upon it.
In short, the numerous problems with the cash basis of accounting usually cause businesses to abandon it after they move beyond their initial startup phases.
Cost of Goods Sold
Cost of goods sold is the accumulated total of all costs used to create a product or service, which has been sold. These costs fall into the general sub-categories of direct labor, materials, and overhead. In a service business, the cost of goods sold is considered to be the labor, payroll taxes, and benefits of those people who generate billable hours (though the term may be changed to “cost of services”). In a retail or wholesale business, the cost of goods sold is likely to be merchandise that was bought from a manufacturer.
In the income statement presentation, the cost of goods sold is subtracted from net revenues to arrive at the gross margin of a business.
In a periodic inventory system, the cost of goods sold is calculated as beginning inventory + purchases - ending inventory. The assumption is that the result, which represents costs no longer located in the warehouse, must be related to goods that were sold. Actually, this cost derivation also includes inventory that was scrapped, or declared obsolete and removed from stock, or inventory that was stolen. Thus, the calculation tends to assign too many expenses to goods that were sold, and which were actually costs that relate more to the current period.
In a perpetual inventory system the cost of goods sold is continually compiled over time as goods are sold to customers. This approach involves the recordation of a large number of separate transactions, such as for sales, scrap, obsolescence, and so forth. If cycle counting is used to maintain high levels of record accuracy, this approach tends to yield a higher degree of accuracy than a cost of goods sold calculation under the periodic inventory system.
The cost of goods sold can also be impacted by the type of costing methodology used to derive the cost of ending inventory. Consider the impact of the following two inventory costing methods:
First in, first out method. Under this method, known as FIFO, the first unit added to inventory is assumed to be the first one used. Thus, in an inflationary environment where prices are increasing, this tends to result in lower-cost goods being charged to the cost of goods sold.
Last in, first out method. Under this method, known as LIFO, the last unit added to inventory is assumed to be the first one used. Thus, in an inflationary environment where prices are increasing, this tends to result in higher-cost goods being charged to the cost of goods sold.
For example, a company has $10,000 of inventory on hand at the beginning of the month, expends $25,000 on various inventory items during the month, and has $8,000 of inventory on hand at the end of the month. What was its cost of goods sold during the month? The answer is:
$10,000 Beginning inventory + $25,000 Purchases - $8,000 Ending inventory
= $27,000 Cost of goods sold
The cost of goods sold can be fraudulently altered by a number of means in order to change reported profit levels, such as:
Armortization
Amortization is the write off of an asset over its expected period of use, which shifts the asset from the balance sheet to the income statement. It essentially reflects the consumption of an intangible asset over its useful life.
Amortization is most commonly used for the gradual write-down of the cost of those intangible assets that have a specific useful life. Examples of intangible assets are patents, copyrights, taxi licenses, and trademarks.
The amortization concept also applies to such items as the discount on notes receivable and deferred charges. The term is also used in lending, where an amortization schedule itemizes the beginning balance of a loan, less the interest and principal due for payment in each period, and the ending loan balance. The amortization schedule shows that a larger proportion of loan payments go toward paying off interest expense early in the term of the loan, with this proportion declining over time as more and more of the loan’s principal balance is paid off.
Amortization Schedule
An amortization schedule is a table that states the periodic payments to be made as part of a loan agreement. The table may be issued by a lender to a borrower, to document the progression of future loan payments. The schedule notes the following information on each line of the table:
Payment number Payment due date Payment total Interest component of payment Principal component of payment Ending principal balance remaining Thus, the calculation on each line of the amortization schedule is designed to arrive at the ending principal balance, for which the calculation is:
Beginning principal balance - (Payment total - Interest expense) = Ending principal balance
The typical amortization schedule will show that a disproportionate amount of earlier payments are comprised of interest expense, while later payments contain an increasing proportion of principal.
The amortization schedule is extremely useful for accounting for each payment in a term loan, since it separates the interest and principal components of each payment. The schedule is also useful for modeling how the remaining loan liability will vary if you accelerate or delay payments, or alter their size. An amortization schedule can also encompass balloon payments and even negative amortization situations where the principal balance increases over time.
Inventory
Inventory is an asset that is intended to be sold in the ordinary course of business. Inventory may not be immediately ready for sale. Inventory items can fall into one of the following three categories:
Held for sale in the ordinary course of business; or
That is in the process of being produced for sale; or
The materials or supplies intended for consumption in the production process.
This asset classification includes items purchased and held for resale. In the case of services, inventory can be the costs of a service for which related revenue has not yet been recognized.
In accounting, inventory is typically broken down into three categories, which are:
Raw materials. Includes materials intended to be consumed in the production of finished goods.
Work-in-process. Includes items that are in the midst of the production process, and which are not yet in a state ready for sale to customers.
Finished goods. Includes goods ready for sale to customers. May be termed merchandise in a retail environment where items are bought from suppliers in a state ready for sale.
Inventory is typically classified as a short-term asset, since it is usually liquidated within one year.
Merchandise
Merchandise inventory is goods that have been acquired by a distributor, wholesaler, or retailer from suppliers, with the intent of selling the goods to third parties. This can be the single largest asset on the balance sheet of some types of businesses. If these goods are sold during an accounting period, then their cost is charged to the cost of goods sold, and appears as an expense in the income statement in the period when the sale occurred. If these goods are not sold during an accounting period, then their cost is recorded as a current asset, and appears in the balance sheet until such time as they are sold.
If the market value of merchandise inventory declines below its recorded cost, then you must reduce the recorded cost down to its market value and charge the difference to expense, under the lower of cost or market rule.
Merchandise inventory may be located in three areas: in transit from suppliers (under FOB shipping point terms), in the company’s storage facilities, or on consignment in locations owned by third parties. When compiling the total cost of inventory for recordation at month end in the company’s accounting records, you need to include all of the merchandise in all three of these locations. Doing so is easiest with a perpetual inventory system, which maintains up-to-date balances of all unit quantities. A less reliable method is the periodic inventory system, under which a period-end physical count is needed to verify quantities on hand.
Good Will
Goodwill is the excess of the purchase price paid for an acquired entity and the amount of the price not assigned to acquired assets and liabilities. It arises when an acquirer pays a high price to acquire another business. This asset only arises from an acquisition; it cannot be generated internally. Goodwill is an intangible asset, and so is listed within the long-term assets section of the acquirer’s balance sheet.
Negative goodwill arises when an acquirer pays less for an acquiree than the fair value of its assets and liabilities. This situation usually only arises as part of a distressed sale of a business.
The value of goodwill is highly subjective, especially since it does not independently generate cash flows. Consequently, the accounting standards require that an acquirer regularly test its goodwill asset for impairment, and to write down the asset if impairment can be proven.
Operating Cycle
The operating cycle is the average period of time required for a business to make an initial outlay of cash to produce goods, sell the goods, and receive cash from customers in exchange for the goods. This is useful for estimating the amount of working capital that a company will need in order to maintain or grow its business.
A company with an extremely short operating cycle requires less cash to maintain its operations, and so can still grow while selling at relatively small margins. Conversely, a business may have fat margins and yet still require additional financing to grow at even a modest pace, if its operating cycle is unusually long. If a company is a reseller, then the operating cycle does not include any time for production - it is simply the date from the initial cash outlay to the date of cash receipt from the customer.
The following are all factors that influence the duration of the operating cycle:
The payment terms extended to the company by its suppliers. Longer payment terms shorten the operating cycle, since the company can delay paying out cash.
The order fulfillment policy, since a higher assumed initial fulfillment rate increases the amount of inventory on hand, which increases the operating cycle.
The credit policy and related payment terms, since looser credit equates to a longer interval before customers pay, which extends the operating cycle.
Thus, several management decisions (or negotiated issues with business partners) can impact the operating cycle of a business. Ideally, the cycle should be kept as short as possible, so that the cash requirements of the business are reduced.
Examining the operating cycle of a potential acquiree can be particularly useful, since doing so can reveal ways in which the acquirer can alter the operating cycle to reduce cash requirements, which may offset some or all of the cash outlay needed to buy the acquiree.
Revenue
Revenue is an increase in assets or decrease in liabilities caused by the provision of services or products to customers. It is a quantification of the gross activity generated by a business. Under the accrual basis of accounting, revenue is usually recognized when goods are shipped or services delivered to the customer. Under the cash basis of accounting, revenue is usually recognized when cash is received from the customer following its receipt of goods or services. Thus, revenue recognition is delayed under the cash basis of accounting, when compared to the accrual basis of accounting.
The Securities and Exchange Commission imposes more restrictive rules on publicly-held companies regarding when revenue can be recognized, so that revenue may be delayed when collection from customers is uncertain.
There are several deductions that may be taken from revenues, such as sales returns and sales allowances, which can be used to arrive at the net sales figure. Sales taxes are not included in revenue, since they are collected on behalf of the government by the seller. Instead, sales taxes are recorded as a liability.
Revenue is listed at the top of the income statement. A variety of expenses related to the cost of goods sold and selling, general, and administrative expenses are then subtracted from revenue to arrive at the net profit of a business.
There were many standards governing revenue recognition, which have been consolidated into the GAAP standard relating to contracts with customers.
Expenditure
An expenditure is a payment in cash or barter credits, or the incurrence of a liability by an entity, in exchange for goods or services. Evidence of the documentation triggered by an expenditure is a sales receipt or an invoice. Organizations tend to maintain tight controls over expenditures, to keep from incurring losses.
A capital expenditure is an expenditure for a high-value item that is to be recorded as a long-term asset. A business usually sets a capitalization limit (or cap limit) for classifying expenditures as capital expenditures. A cap limit is established in order to keep an organization from recognizing low-cost items as fixed assets (which can be time consuming).
An expenditure is not necessarily the same as an expense, since an expense represents the reduction in value of an asset, whereas an expenditure simply indicates the procurement of an asset. Thus, an expenditure covers a specific point in time, while an expense may be incurred over a much longer period of time. Effectively, there is no difference between the two terms when an expenditure automatically triggers the incurrence of an expense; for example, office supplies are typically charged to expense as soon as they are procured. Conversely, the advance payment of rent is an expenditure, but does not become expense until the period has passed to which the rent payment applies.
