Alpha Financials Ltd

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The world of finance can often be confusing and confounding – that’s even before you start considering the amount of jargon involved!

Here we aim to de-mystify much of the language associated with the industry:

Amortisation

Amortisation is the process by which a company repays its loans back in instalments.

It is sometimes confused with depreciation.

Asset based valuation

One of three basic valuation methods, ‘Asset based valuations’ are used only to value companies.

This particular method simply derives value from historical costs as recorded in the balance sheet, thus the total value of investors shares is equal to Shareholders’ Funds. As a general rule, asset based valuations tend to consistently undervalue companies due to the use of historic rather than current cost accounting, together with the under-stating or absence of such intangible assets as brand values.

Balance Sheet

Represents the financial state of a company at a specific point in time.

Within the annual accounts, the balance sheet, along with the Profit and Loss and Cashflow, is one of the three primary statements produced. The balance sheet represents the financial state of a company on a specific date and does not directly show performance during the year. It always contains two equal and opposite sides that can be presented in different ways depending on national conventions and the particular accounting standards followed.

In the UK, SME balance sheets are usually presented from the perspective of shareholders, so that the ‘passive’ side represents the owner’s claims on the company split into equity capital and reserves (undistributed profits) – collectively known as Shareholders’ Funds. It will automatically balance with the other side of the balance sheet, which is called Net Assets.

Balanced Scorecard

A short summary of the overall health of the business.

A Balanced Scorecard (BSC) is typically a one page summary of the overall health of the business that identifies the latest key operational, financial, customer and employee performance indicators and their trends against future targets.

An effective BSC becomes one of the prime management reporting tools. Its use is constantly improved either through improvements in the measurement of indicators (which are not always easy or straightforward) or through changing them completely as needs change or better indicators evolve.

Black Box Valuation Method

A fast and cheap method for calculating a simple indication of value.

This valuation method refers to a mechanistic technique whereby data, often based on past performance, is entered into a simplified and unseen model for calculating a company’s value. Whilst this method is fast and cheap (it’s often even offered for free on–line), it can only offer a simple ‘ball-park’ indication of value. In particular, as a potential seller, this method tends to understate value and does not identify the drivers of value.

Alpha Financials strongly advises against the use of the black box approach and promotes the use of a Discounted Cash Flow (DCF) approach.

Budget

A target spend, income or profit for a company, department or activity, usually covering a trading year and set before that period commences.

Capital Asset Pricing Model (CAPM)

Used to calculate the cost of capital for investments, or at least the equity component within it.

CAPM is a theory that has been accepted and used for decades and its basic principle is that returns for any stock quoted on a stock market are comprised of two elements: a risk free rate of return (usually estimated from long-term government bond yields) and a modified equity risk premium. The equity risk premium is the average return, in excess of the risk free rate, that stock markets demonstrate over a long period of time. It is modified for a particular company by being multiplied by a Beta factor, which is one for the market as a whole (average risk overall). A high risk company will have a Beta in excess of one, which means that if the overall market moves by 10% (up or down) then its price will change by more than 10%. Conversely, a low risk company will have a Beta less than one and its price will change on average by less than 10%. Several companies collect the daily movement of stock prices, stretching back over many decades, in order to calculate both the equity risk premium and the Beta factors for quoted companies. There are established techniques for adding long-term debt costs to these equity costs in order to obtain an overall cost of capital and to modify them so they.

Capital Employed

The size of a business extracted from a company.

Cash

The sum of cash combined with any marketable (readily transferred into cash) securities as reported on the balance sheet.

Cash Flow

The total change in cash generated or consumed by a business over a given period of time.

It is typically broken down into its main components of cash flows from operations (revenues, operating costs and working capital, taxation), investment (purchase or disposal of long term assets), financing (payment of interest and dividends), and funding (raising or repayment of equity and debt).

Cash Flow Statement

Shows the total cash generated or consumed by the business during the year.

Within the annual accounts, along with the profit and loss and balance sheet, the cash flow statement is one of the three primary statements produced. It shows the total cash generated or consumed by the business during the year, split into its various components. The ability of a company to generate cash not only determines its underlying value, but also indicates whether it is solvent and can pay its debts when due. It is arguably just as important, if not more so, than the profit and loss statement.

Cost of Debt Ratio (average cost of debt ratio)

Estimates the weighted average cost of debt by dividing the total interest cost by the average outstanding debt over a given period, usually a trading year.

Cost of Goods Sold (COGS)

Total direct costs attributable to total sales made.

COGS will include most, if not all, variable costs incorporating materials, labour, and direct production costs. Costs of materials are often calculated indirectly by subtracting closing stock from the addition of opening stock plus purchases.

Cost of Sales (COS)

See Cost of Goods Sold

Current Assets

Assets soon to be converted into cash.

This refers to cash and all its equivalents that are expected to be converted to cash in the.

Current Liabilities

That portion of a company’s debts due for repayment within 12 months, such as trade creditors, short term lease payments, bank overdraft, corporation tax, VAT, etc.

Current Ratio

This expresses the relationship between current assets and current liabilities, stating the possibility of a company to meet all its short-term obligations. As such, it is an indication of the liquidity of a business and consequently is referred to as the Liquidity Ratio.

Depreciation

The apportionment of the cost of a capital or long life asset over an agreed period, based on its useful economic life expectancy. As it is an allocation of an actual cost, depreciation has no impact on cash flows.

Direct Costs

Costs that can be clearly and directly related to the production of a product, service or project are known as direct costs (eg the materials cost of a physical product).

Discount Rate

Rate of return that investors require.

The discount rate, or cost of capital, reflects the rate of return that investors require if they are to invest in the type of project under consideration. It is a blended rate that incorporates both debt and equity and a given level of long-term gearing. In essence, the higher the risk, the higher the returns demanded by investors to tempt them to invest and, therefore, the higher the discount rate. High discount rates reduce Net Present Values (NPVs). Discount rates vary by sector (e.g. utilities generally have lower discount rates than IT companies) and within each sector (e.g. Microsoft will have a lower discount rate than an IT start-up company). Whilst the principles are straightforward, actually calculating a discount rate is hard and prone to error. A standard and widely accepted technique used is the Capital Asset Pricing Model (CAPM).

Discounted Cash Flow Valuation (DCF)

One of three basic valuation methods, DCF can be used to value a company or a project.

DCF takes all relevant, future marginal cash flows from an investment decision – to invest in a project or company – and expresses them in a single monetary value, in today.

Dividend

How shareholders receive cash in return for their investment.

A dividend is the way shareholders in a company receive a cash return from holding their investment. It is paid from after-tax profits and a company must have sufficient profits (or reserves from previously earned but not distributed profits) to pay for this distribution. Valuations of equity are often based on discounted cash flows of future dividends or on multiples of the current dividend.

Earnings

Profits left after deductions.

Used inter-changeably with profits, earnings are measured at several different levels. On their own, they mean profits after all deductions, including tax, meaning they will either be distributed as dividends to shareholders or retained in the business to help fund future investments.

Another very common form is EBITDA (earnings before interest, tax, depreciation and amortization), which is used as a proxy for cash generation ? particularly where a company has made large up-front investments in the past.

Another often used option is EBIT (Earnings Before Interest and Tax), which indicates pre-tax returns for all providers of finance and EBT (Earnings Before Tax) – pre-tax earnings for shareholders.

Earnings Based Valuation

Method for valuing a company or project.

One of three basic valuation methods used to value a company or project. This particular method calculates value by multiplying some form of earnings by a given multiple or modification to it (e.g. a P/E ratio). It is primarily used to value companies, but can also be used to value projects.

Equity

Represents shareholders’ interest in a company and has the same meaning as Shareholders’ Funds.

Financial Accounts

Overview of company’s performance over a period of time.

Financial Accounts seek to accurately report on the historical performance of a company by presenting a picture of performance typically covering a 12 month period. They generally need to be produced within nine months of an SME’s financial year end and comprise of a profit and loss sheet, balance sheet and cash flow statement. Companies store these results in-house and are publicly available at nominal cost. Small companies are allowed to file a reduced amount of information – balance sheet only – meaning that third parties cannot identify performance during the year.

Fixed Assets

Assets held for use by the business rather than for sale or conversion into cash.

Through use, most of these are steadily reduced in value over time and are therefore depreciated according to a pre-determined formula. Examples include plant, equipment, buildings, etc.

Fixed Costs

A cost that does not vary in line with changing sales or production volumes.

Examples include rent, rates, staff costs, depreciation, etc.

Forecast

A predicted outcome spend, income or profit for a company, department or activity, usually covering a trading year and set after that period commences.

Gearing

Describes the financial structure of a company by comparing the ratio of long-term debt to shareholders.

Goodwill

Difference between money paid for equity capital and its balance sheet value.

An intangible asset representing the difference, usually an excess, between the money paid to acquire a company.

Gross Profit

Total sales, less cost of goods or services sold, also called gross profit margin; i.e. profits before all indirect costs and overheads.

Hire Purchase

A renting scheme with option to own.

Under a Hire Purchase scheme, an SME is committed to paying a portion of an asset.

Indirect Costs

Costs that cannot be directly related to the production of a product, service or project are known as indirect costs. Overheads are a good example of indirect costs since they support more than one product or service and often cannot easily be attributed to any one of these.

Initial Public Offering (IPO)

The first sale of privately owned share capital to the public and other investing institutions.

IPOs are usually utilised by small, young and fast growing companies in order to sustain their growth ambitions.

Intangible Assets

Those assets that one cannot physically hold, touch or take. Examples are patents, copyrights, intellectual property and goodwill.

Leasing

Leasing comes in one of two forms: Financial Leasing and Operational Leasing.

In the former, the SME essentially accepts the risks and rewards of using the asset that will appear on his balance sheet. The SME generally pays for the entire cost of the asset plus a finance charge over the life of the lease. In substance there is little difference between a financial lease and taking out a bank loan and purchasing the asset – although the tax differences can be significant.

Under operating leases, the SME has the option to terminate the service early so that in effect the leasing company is primarily accepting the risks and rewards of ownership Operating leases offer flexibility and easy financing for SMEs, but can prove expensive in the long-term.

See Hire Purchase for another form of raising finance not that dissimilar to leasing.

Liabilities

What the business owes.

Appear in the Balance Sheet and show what the business owes, both long-term and short-term (or current). Long-term liabilities consist of obligations with a life of more than one year from the date of the accounts, whilst Current Liabilities consist of short-term items such as debts to suppliers, HMRC for any tax, NI or VAT owed, and any overdraft.

Liquidity Ratio

Shows how well a company can meet short-term debt obligations.

This ratio is calculated at the current assets divided by the current liabilities (CA/CL) and indicates how.

Management Accounts

Analysis of current and future performance.

Management Accounts are primarily an analysis of current and future performance which, if done properly, are a vital tool in assisting the daily management of a business. They generally focus on cash generation and profit by product or service type and seek to explain deviations from plan. They are quite different from Financial Accounts, which are by definition backward looking.

Return on Capital Employed (ROCE)

Measures profit earned by all investors as percentage of what they invested.

A key financial performance measure, usually at the company level, which measures the profit earned by all investors as a percentage of what they have invested; i.e., it is a rate of return comparable to a simple interest rate. It is usually calculated as PBIT divided by total capital employed.

Net Assets

The sum of all Fixed Assets and Current Assets less current Liabilities and long-term Liabilities.

This is the opposite side of Shareholders.

Net Current Assets

Current Assets less Current Liabilities.

Net Present Value (NPV)

A key measurement in business investment decisions.

NPV essentially measures all future cash flows (revenues minus costs) that result from a particular investment, minus the cost of the investment itself. This investment can be a project, an additional product line, a proposal, or even an entire business.

If the calculated NPV is positive, it is profitable and is worthy of consideration. In laymen.

Share Capital

The balance sheet nominal value paid by shareholders into the business at the time(s) shares were issued.

Often shareholders pay more than the nominal value for each share, in which case the excess is allocated to share premium reserves.

Net Profit

Profit after the deduction of all variable costs and all expenses, fixed costs and overheads ? including depreciation ? but before the deduction of corporation tax.

It can therefore be used interchangeably with Profit Before Tax or PBT.

Overhead

A general expense that ‘serves’ many different parts of a business’ activities.

Depending on the activity of a company, examples can include Head Office rent, the HR department, bank charges, etc.

Pay-Back Period

A simple indicator of how quickly an investment outlay will be recovered.

It is usually the period of time taken for the post-tax, pre-financing cash flows to exceed the up-front cash outflow. The shorter the payback period the better, or more profitable, the project will be. It does not take into account the time value of money.

Shareholders’ Funds

Measures equity shareholders.

Peer-to-Peer Lending

Low interest lending option for SMEs.

Peer-to-Peer Lending emerged following the worldwide recession in 2007. With interest rates at 0.5% (March 2012) and SME borrowing rates rarely below 12%, there is an opportunity for SMEs to lend to their peers at terms attractive to both lenders and borrowers alike. These networks can offer more efficiency than traditional banks that, in any case, are often reluctant to lend to SMEs.

Price Earnings Ratio (P/E ratio)

Price per share divided by the earnings after tax per share.

A Price Earnings Ratio is an extremely popular measure used by investors when appraising quoted company performance and is simply the price per share divided by the earnings after tax per share. It shows how much investors are prepared to pay for each ? of earnings they are entitled to and, with just a cursory glance at the financial press, will quickly show how volatile this number is both between different sectors and within each sector.

One way of interpreting P/E ratios is by considering them as a payback period. In the example above, an investor would need to wait 5.6 years before his investment would be recouped if earnings were maintained at current levels and fully distributed.

FTSE Company / Sector PE Inverted PEROR
Electricity 5.6 17.9%
Aerospace 7.9 12.7%
Retailers 9.6 10.4%
Technology 21.17 4.7%

Source: Financial Times March 2012

An alternative analysis involves taking the reciprocal of the P/E in order to obtain a rate of return easily comparable with alternative investments; e.g. bank interest rates. Thus, the table also shows rates of return apparently nearly four times higher in electricity than technology. If this seems counter-intuitive, it is and simply highlights the drawback of P/E ratios. What

Profit and Loss account (P&L)

Depicts the annual performance of the business in terms of costs and revenues.

One of the three key business reporting and measuring instruments (the other two being the balance sheet and cash flow statement). The P&L attempts to depict the underlying performance of the business by recognising only those portions of total costs and revenues that relate to the reporting year under consideration. Short-term items (e.g. monthly payroll costs) will often be shown in their entirety, but longer-term items (e.g. investment in long life fixed assets) need to be allocated over many different accounting years to reflect their useful lives. In this respect, the P&L will appear radically different from a cash flow since it.

Tangible Net Worth (TNW)

A physical valuation measurement that uses the tangible net worth of a company.

Reserves

That portion of the accumulated profit (and losses) after tax, since the company was founded, which has not been distributed to shareholders.

Quick Ratio

Obtained by dividing the current assets that can easily be converted into cash (mostly current assets minus stock) by the current liabilities.

It is also referred to as the ‘Acid Test’ and offers a firmer measure of liquidity than the liquidity ratio.

Valuation Method

Approach to valuing a business or project.

Valuation methods can generally be classified into one of three groups. The first is an asset based valuation, which simply derives value directly from the balance sheet. The second is earnings based valuation, which calculates value by multiplying some form of earnings from the profit and loss statement by a given multiple.

Our preferred approach is to value on the basis of future cash flows using a Discounted Cashflow process, which we feel ? despite its imperfections ? is an intrinsically better method than the rest.

Variable Cost

A cost that varies depending on the level of sales or on the volumes of the operations.

Common variable costs include raw materials, fuel and commission payments. This as against fixed costs, which stay the same even if sales increase or decrease (e.g. rent/mortgage).

Working Capital

Current assets less current liabilities.

Working Capital represents an additional investment in the business even where the individual components are continually circulating. Often a volatile total and is difficult to predict.