Investopedia Flashcards
1
Q
Balance Sheet
A
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.
2
Q
Shareholders Equity
A
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.
3
Q
Shareholder
A
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.
4
Q
Stakeholder
A
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.
5
Q
Investor
A
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.
6
Q
Equity
A
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.
7
Q
Retained Earning
A
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.
8
Q
Stockholders Equity
A
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.
9
Q
Book Value
A
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
10
Q
Mark to Market
A
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.
11
Q
Par Value
A
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%.
12
Q
Preferred Stock
A
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.
13
Q
Earnings
A
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.
14
Q
Asset
A
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.
15
Q
Liability
A
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.
16
Q
Current Asset
A
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.
17
Q
Current Liability
A
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.
18
Q
Tangible Asset
A
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.
19
Q
Intangible Asset
A
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.
20
Q
Short Term Asset
A
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.
21
Q
Long Term Asset
A
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.
22
Q
Fixed Asset
A
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
23
Q
Expense
A
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.
24
Q
Capitalization Limit (Cap Limit)
A
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.
25
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.
26
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.
27
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.
28
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.
29
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.
30
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.
31
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.
32
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.
33
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.
34
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:
35
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.
36
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.
37
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.
38
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.
39
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.
40
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.
41
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
42
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.
43
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.
44
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.
45
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.
46
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.
47
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.
48
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.
49
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.
50
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.
51
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.
52
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.
53
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.
54
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.
55
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.
56
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.
57
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.
```
58
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.
59
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.
60
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.
61
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.
62
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.
63
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.
64
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.
65
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.
66
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.
67
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.
68
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.
69
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.
70
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.
71
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.
72
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.
73
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.
74
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.
75
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:
76
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.
77
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.
78
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.
79
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.
80
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.
81
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.
82
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.
83
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.
84
Perpetual Inventory System
Perpetual Inventory System Overview
Under the perpetual inventory system, an entity continually updates its inventory records to account for additions to and subtractions from inventory for such activities as:
Received inventory items
Goods sold from stock
Items moved from one location to another
Items picked from inventory for use in the production process
Items scrapped
Thus, a perpetual inventory system has the advantages of both providing up-to-date inventory balance information and requiring a reduced level of physical inventory counts. However, the calculated inventory levels derived by a perpetual inventory system may gradually diverge from actual inventory levels, due to unrecorded transactions or theft, so you should periodically compare book balances to actual on-hand quantities and adjust the book balances as necessary.
Perpetual inventory is by far the preferred method for tracking inventory, since it can yield reasonably accurate results on an ongoing basis, if properly managed. The system works best when coupled with a computer database of inventory quantities and bin locations, which is updated in real time by the warehouse staff using wireless bar code scanners, or by sales clerks using point of sale terminals. It is least effective when changes are recorded on inventory cards, since there is a significant chance that entries will not be made, will be made incorrectly, or will not be made in a timely manner.
The perpetual inventory system is a requirement for any organization planning to install a material requirements planning system.
85
Hypothecation
What is 'Hypothecation'
Hypothecation occurs when an asset is pledged as collateral to secure a loan, without giving up title, possession or ownership rights, such as income generated by the asset. However, the lender can seize the asset if the terms of the agreement are not met.
BREAKING DOWN 'Hypothecation'
Hypothecation occurs most commonly in mortgage lending. The borrower technically owns the house, but as the house is pledged as collateral, the mortgage lender has the right to seize the house if the borrower cannot meet the repayment terms of the loan agreement – which occurred during the foreclosure crisis. Auto loans are similarly secured by the underlying vehicle.
As hypothecation provides security to the lender because of the collateral pledged by the borrower, it is easier to secure a loan, and the lender may offer a lower interest rate than on an unsecured loan.
Hypothecation in Investing
Margin lending in brokerage accounts is another common form of hypothecation. When an investor chooses to buy on margin or sell-short, they are agreeing that those securities can be sold if necessary if there is a margin call. The investor owns the securities in their account, but the broker can sell them if they issue a margin call that the investor cannot meet, to cover the investors’ losses.
When banks and brokers use hypothecated collateral as collateral to back their own transactions and trades with their client’s agreement, in order to secure a lower cost of borrowing or a rebate on fees — this is called rehypothecation. While certain types of rehypothecation can contribute to market functioning, if collateral collected to protect against the risk of counterparty default has been rehypothecated, it may not be available in the event of a default. This, in turn, may increase systemic risk and amplify market stresses by causing a chain reaction of asset sales. So, when collateral is rehypothecated, investors need to understand how long the collateral chain is.
Read more: Hypothecation https://www.investopedia.com/terms/h/hypothecation.asp#ixzz5TIkBhyUi
Follow us: Investopedia on Facebook
86
Buying on Margin
What is 'Buying On Margin'
Buying on margin is the purchase of an asset by using leverage and borrowing the balance from a bank or broker. Buying on margin refers to the initial or down payment made to the broker for the asset being purchased; for example, 10 percent down and 90 percent financed. The collateral for the borrowed funds is the marginable securities in the investor's account. Before buying on margin, an investor needs to be approved and open a margin account with his or her broker. The buying power you have in your brokerage account reflects the total dollar amount of purchases you can make using your cash plus available margin capacity. In addition to buying on margin, short sellers of stock also use margin to borrow and then sell those shares.
In the United States, the Federal Reserve Board regulates the amount of margin that an investor must pay for a security. As of 2016, the board requires an investor to fund at least 50 percent of a security's purchase price with cash. The investor may borrow the remaining 50 percent from a broker or a dealer.
Read more: Buying On Margin https://www.investopedia.com/terms/b/buying-on-margin.asp#ixzz5TIkP57zd
Follow us: Investopedia on Facebook
87
Marginable
DEFINITION of 'Marginable'
Marginable securities trade on margin through a brokerage or other financial institution. Securities with high liquidity and market capitalization are more likely to be marginable, such as stocks like Apple (AAPL) and Bank of America (BOA). Other securities, such as stocks priced below $5 per share and initial public offerings (IPOs), are typically not marginable due to the higher risks associated with them. Most brokers publish a full list of the marginable securities they offer on their website.
88
IPO - Initial Public Offering
What is an 'Initial Public Offering - IPO'
An initial public offering is when a private company or corporation raises investment capital by offering its stock to the public for the first time. Growing companies seeking capital to expand are those that generally use initial public offerings, but large, privately owned companies or corporations looking to become publicly traded can also do them. In an initial public offering, the issuer, or company raising capital, brings in an underwriting firm or investment bank, to help determine the best type of security to issue, offering price, amount of shares and timeframe for the market offering.
BREAKING DOWN 'Initial Public Offering - IPO'
Some people refer to an initial public offering as a public offering. There are other ways to go public other than an initial public offering, including a direct listing or direct public offering. When a company starts the IPO process, a specific set of events occurs. The chosen underwriters facilitate these steps.
An external initial public offering team is formed, comprising an underwriter, lawyers, certified public accountants and Securities and Exchange Commission experts.
Information regarding the company is compiled, including financial performance and expected future operations. This becomes part of the company prospectus, which is circulated for review.
The financial statements are submitted for an official audit.
The company files its prospectus with the SEC and sets a date for the offering.
89
DPO - Direct Public Offering
What is a 'Direct Public Offering - DPO'?
A direct public offering (DPO) is a type of offering where the company offers its securities directly to the public to raise capital. An issuing company using a DPO eliminates the middlemen – investment banks, broker-dealers, and underwriters – that are typical in initial public offerings (IPO), and self-underwrites its securities.
Cutting out the intermediaries from a public offering substantially lowers the cost of capital of a DPO. Therefore, a DPO is attractive to small companies and companies with an established and loyal client base. A DPO is also known as direct placement.
When a firm issues securities through a direct public offering (DPO), it raises money independently without the restrictions associated with bank and venture capital financing. The terms of the offering are solely up to the issuer who guides and tailors the process according to the company's best interests. The issuer sets the offering price, the minimum investment per investor, the limit on the number of securities that any one investor can buy, the settlement date, and the offering period within which investors can purchase the securities and after which the offering will be closed.
In some cases where there is a large number of shares to be issued or time is of the essence, the issuing company may employ the services of a commission broker to sell a portion of the shares to the broker’s clients or prospects on a best efforts basis.
Preparing a DPO can take a few days or a few months. During the preparation stage, the company initiates an offering memorandum which describes the issuer and the type of security that will be sold. Securities that can be sold through a DPO include common shares, preferred shares, REITs, and debt securities, and more than one type of investment can be offered through the DPO. The company also decides which medium will be used to market the securities such as newspaper and magazine ads, social media platforms, public meetings with prospective shareholders, and telemarketing campaigns.
Before finally offering its securities to the public, the issuing company has to prepare and file compliance documents to the securities regulators under the Blue Sky Laws of each State where it intends on conducting a DPO. These documents would normally include the offering memorandum, articles of incorporation, and up-to-date financial statements that show the health of the company. Receiving regulatory approval on a DPO application could take two weeks or two months depending on the state.
Issuing companies can raise capital from the public without the stringent security measures and costs required by the Securities Exchange Commission (SEC). Most DPOs do not require the issuers to register with the SEC because they qualify for certain federal securities exemption. For example, the intrastate exemption or Rule 147 excludes registration with the SEC as long as the company is incorporated in the state where it is offering securities and only selling the securities to residents of that state.
After receiving approval, the issuing company running a DPO uses a tombstone ad to formally announce its new offering to the public. The issuer opens up the securities for sale to accredited and non-accredited investors or investors that the issuer already knows subject to any limitations by the regulators. These investors may include acquaintances, clients, suppliers, distributors, and employees of the firm. The offering closes when all securities offered have been sold or when the closing date for the offering period has been clocked. A DPO that has an intended minimum and maximum number of securities to be sold will be canceled if the interest or number of orders received for the securities falls below the minimum required. In this case, all funds received will be refunded to the investors. If the number of orders exceeds the maximum number of shares offered, the investors would be served on a first-come basis or have their shares prorated among all investors.
90
Real Estate Investment Trust - REIT
Real Estate Investment Trust - REIT
What is a 'Real Estate Investment Trust - REIT'
A real estate investment trust, or REIT, is a company that owns, operates or finances income-producing real estate. For a company to qualify as a REIT, it must meet certain regulatory guidelines. REITs often trades on major exchanges like other securities and provide investors with a liquid stake in real estate.
REITs are not a new financial innovation. Established by Congress in 1960 as an amendment to the Cigar Excise Tax Extension of 1960, REITs operate in a manner comparable to mutual funds as they allow for individual investors to acquire ownership in commercial real estate portfolios that receive income from properties such as apartment complexes, hospitals, office buildings, timber land, warehouses, hotels and shopping malls.
Most REITs specialize in a specific real-estate sector – for example office REITs or healthcare REITs. Within this space, REITS must purchase and operate its holdings as a part of its portfolio. In most cases, REITs operate by leasing space and passing on collected rent payments to its investors in the form of dividends.
REIT Guidlines
A company must meet the following requirements to be qualified as a REIT:
Invest at least 75% of its total assets in real estate, cash or U.S. Treasuries
Receive at minimum 75% of its gross income from rents from real property, interest on mortgages financing real property or from sales of real estate
Pay a minimum of 90% percent of its taxable income in the form of shareholder dividends each year
Be an entity that is taxable as a corporation
Be managed by a board of directors or trustees
Have a minimum of 100 shareholders
Have no more than 50% of its shares held by five or fewer individuals
Different REIT Categories
REITs typically fall within three categories.
Most REITs are equity REITs. Equity REITs invest in and own income-producing real estate properties and give investors the opportunity to invest in these portfolios. They must distribute at least 90% of the portfolio’s income to its shareholders in the form of dividends.
Mortgage REITs invest in and own property mortgages. These REITs loan money to real estate owners and operators not only for mortgages but also for different types of real estate loans or through purchasing mortgage-backed securities. Their earnings are generated primarily by the net interest margin, the spread between the interest they earn on mortgage loans and the cost of funding these loans. This model makes them potentially sensitive to interest rate increases.
Hybrid REITs invest in both properties and mortgages.
How to Invest in REITs
Individuals can invest in REITs either by purchasing their shares directly on an open exchange or by investing in a mutual fund that specializes in public real estate. Some REITs are SEC-registered and public, but not listed on an exchange; others are private.
Many REITs will invest specifically in one area of real estate—shopping malls, for example—or in one specific region, state or country. Others are more diversified. There are several REIT ETFs available, most of which have fairly low expense ratios. The ETF format can help investors avoid over-dependence on one company, geographical area or industry.
91
Securities And Exchange Commission - SEC
What is the 'Securities And Exchange Commission - SEC'
The U.S. Securities and Exchange Commission (SEC) is an independent federal government agency responsible for protecting investors, maintaining fair and orderly functioning of securities markets and facilitating capital formation. It was created by Congress in 1934 as the first federal regulator of securities markets. The SEC promotes full public disclosure, protects investors against fraudulent and manipulative practices in the market, and monitors corporate takeover actions in the United States.
Generally, issues of securities offered in interstate commerce, through the mail or on the Internet, must be registered with the SEC before they can be sold to investors. Financial services firms, such as broker-dealers, advisory firms and asset managers, as well as their professional representatives, must also register with the SEC to conduct business.
The SEC's primary function is to oversee organizations and individuals in the securities markets, including securities exchanges, brokerage firms, dealers, investment advisors and various investment funds. Through established securities rules and regulations, the SEC promotes disclosure and sharing of market-related information, fair dealing and protection against fraud. It provides investors with access to registration statements, periodic financial reports and other securities forms through its comprehensive electronic, data gathering, analysis and retrieval (EDGAR) database.
There are various laws that are at the SEC's disposal for accomplishing its objectives. They are:
Securities Act of 1933
Securities Exchange Act of 1934
Trust Indenture Act of 1939
Investment Company Act of 1940
Investment Advisers Act of 1940
Sarbanes-Oxley Act of 2002
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
Jumpstart Our Business Startups (JOBS) Act of 2012
Founding of the SEC
When the U.S. stock market crashed in 1929, securities issued by numerous companies became worthless as a result of previously stated false or misleading information. Public faith in securities markets plunged. To restore confidence, Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934, which created the SEC. The SEC's primary tasks were to monitor that companies made truthful statements about their businesses and to ensure that securities institutions, such as brokers, dealers and exchanges, treated investors in an honest and fair manner.
Organization of the SEC
The SEC is headed by five commissioners who are appointed by the president, one of which is designated as chairman of the SEC. Each commissioner's term lasts five years, but they may serve for an additional 18 months before a replacement is found. The law requires that no more than three of the five commissioners be from the same political party to promote nonpartisanship.
The SEC consists of five divisions and 23 offices. Their goals are to interpret and take enforcement actions on securities laws; issue new rules; provide oversight over securities institutions; and coordinate regulation among different levels of government. The five divisions are:
Division of Corporate Finance: Ensures investors are provided with material information in order to make informed investment decisions
Division of Enforcement: In charge of enforcing SEC regulations by investigating cases and prosecuting civil suits and administrative proceedings
Division of Investment Management: Regulates investment companies, variable insurance products and federally registered investment advisors
Division of Economic and Risk Analysis: Integrates financial economics and data analytics into the core mission of the SEC
Division of Trading and Markets: Establishes and maintains standards for fair, orderly and efficient markets
Authority of the SEC
The division of enforcement of the SEC is the primary department in charge of assisting the Commission with executing its law enforcement function. It does so by recommending the commencement of investigations of securities law violations and prosecuting such cases on behalf of the Commission. The SEC is only allowed to bring civil actions, both in federal court or before an administrative judge. Criminal cases are under the jurisdiction of law enforcement agencies within the Department of Justice; however, the SEC often works closely with such agencies to provide evidence and assist with court proceedings.
In civil suits, the SEC seeks two main sanctions: 1) injunctions, which are orders that prohibit future violations; a person who ignores an injunction is subject to fines or imprisonment for contempt; and 2) civil money penalties and the disgorgement of illegal profits. In certain cases, the Commission may also seek a court order barring or suspending individuals from acting as corporate officers or directors. The SEC may also bring a variety of administrative proceedings, which are heard by internal officers and the Commission. Common proceedings include cease and desist orders, revoking or suspending registration, and imposing bars or suspensions of employment.
The SEC also serves as the first level of appeal for actions sought by self-regulatory organizations, such as FINRA or the New York Stock Exchange.
The SEC Office of the Whistleblower
Among all the SEC's offices, the office of the whistleblower stands out as one of the most potent means of securities laws enforcement. Created as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the SEC's whistleblower program rewards eligible individuals for sharing original information that leads to successful law enforcement actions with monetary sanctions in excess of $1 million. Eligible individuals can receive 10% to 30% of the total sanctions' proceeds.
Enforcement Record of the SEC
The SEC brings numerous civil enforcement actions against firms and individuals that violate securities laws every year. It is involved in every major case of financial misdemeanor, either directly or in aid of the Justice Department. Typical offenses prosecuted by the SEC include accounting fraud, dissemination of misleading or false information, and insider trading.
After the Great Recession of 2008, the SEC was instrumental in prosecuting the financial institutions that caused the crisis and returning billions of dollars to investors. In total, it charged 204 entities or individuals, and collected close to $4 billion in penalties, disgorgement and other monetary relief. Goldman Sachs for example paid $550 million, the largest penalty for a Wall Street firm and the second largest in SEC history, second only to the $750 million paid by WorldCom. Still, many criticized the SEC for not doing enough to prosecute the brokers and senior managers who were involved, almost all of whom were never found guilty of significant wrongdoing. So far, only one Wall Street executive has been jailed for crimes related to the crisis: Kareem Serageldin, a former investment banker at Credit Suisse. The rest either settled for a monetary penalty or accepted administrative punishments.
Read more: Securities And Exchange Commission (SEC) https://www.investopedia.com/terms/s/sec.asp#ixzz5TInv3Ufd
Follow us: Investopedia on Facebook
92
Underlying Asset
What is an 'Underlying Asset'
Underlying asset is a term used in derivatives trading. Options are an example of a derivative. A derivative is a financial instrument with a price that is based on a different asset. The underlying asset is the financial instrument on which a derivative's price is based.
Underlying assets give derivatives their value. For example, an option on stock XYZ gives the holder the right to buy or sell XYZ at the strike price up until expiration. The underlying asset for the option is the stock of XYZ.
An underlying asset can be used to identify the item within the agreement that provides value to the contract. The underlying asset supports the security involved in the agreement, which the parties involved agree to exchange as part of the derivative contract.
Example
In cases involving stock options, the underlying asset is the stock itself. For example, with a stock option to purchase 100 shares of Company X at a price of $100, the underlying asset is the stock of Company X. The underlying asset is used to determine the value of the option up till expiration. The value of the underlying asset may change before the expiration of the contract, affecting the value of the option. The value of the underlying asset at any given time lets traders know whether the option is worth exercising or not.
The underlying asset could also be a currency or market index, such as the S&P 500. In the case of stock indexes, the underlying asset is comprised of the common stocks within the stock market index.
Understanding derivatives contracts
The price of an option or futures contract is derived from the price of an underlying asset. In an option contract, the writer must either buy or sell the underlying asset to the buyer on the specified date at the agreed-upon price. The buyer is not obligated to purchase the underlying asset, but they can exercise their right if they choose to do so. If the option is about to expire, and the underlying asset has not moved favorably enough to make exercising the option worthwhile, the buyer can let the expire and they will lose the amount they paid for the option.
Futures are an obligation to the buyer and a seller. The seller of the future agrees to provide the underlying asset at expiry, and the buyer of the contract agrees to buy the underlying at expiry. The price they receive and pay, respectively, is the price they entered the futures contract at. Most futures traders close out their positions prior to expiration since retail traders and hedge funds have little need to take physical possession of barrels of oil, for example. But, they can buy or sell the contract at one price, and if it moves favorably they can exit the trade and make a profit that way. Futures are a derivative because the price of an oil futures contract is based on the price movement of oil, for example.
93
Strike Price
The strike price is the price at which a derivative can be exercised, and refers to the price of the derivative’s underlying asset. In a call option, the strike price is the price at which the option holder can purchase the underlying security. For a put option, the strike price is the price at which the option holder can sell the underlying security.
For instance, Heather pays $100 to buy a call option priced at $1 on ABC Inc.’s shares, with a strike price of $50. The option expires in six months. That means that any time in the next six months Heather can exercise her option to buy 100 shares at $50 regardless of the current market price of ABC shares.
Strike price is one of the factors used to determine the profit in an unexpired option. The strike price is compared to the current market price to determine if an option is in or out of the money. The strike price, time to expiration and asset volatility and interest rates are the key determinates of an option’s market price.
For instance, Heather’s ABC call option is in the money any time ABC’s market price is above $51. That’s because Heather’s cost of the ABC stock will be $50 per share, plus the $1 per share cost of the option. If the ABC stock is below $51, the option is said to be out of the money.
94
Exercise
Exercise means to put into effect the right specified in a contract. In options trading, the option holder has the right, but not the obligation, to buy or sell the underlying instrument at a specified price on or before a specified date in the future. If the holder decides to buy or sell the underlying instrument (rather than allowing the contract to expire worthless or closing out the position), he or she will exercise the option, and make use of the right available in the contract.
In options trading, the buyer (or holder) of a call contract may exercise his or her right to buy the underlying shares at the specified price (the strike price); the buyer of a put contract may exercise his or her right to sell the underlying shares at the agreed-upon price. If the buyer chooses to exercise the option, he or she must inform the option seller (the writer of the option contract). This is achieved through an exercise notice, the broker's notification that a client wishes to exercise his or her right to buy or sell the underlying security. The exercise notice is forwarded to the option seller via the Options Clearing Corporation. Even though the buyer has the right but not the obligation to exercise the option, the seller is obligated to fulfill the terms of the contract if the buyer decides to exercise the option.
The majority of options contracts are not exercised, but instead are allowed to expire worthless or are closed by opposing positions. For example, an option holder can close out a long call or put prior to expiration by selling it (assuming the contract has market value). If an option expires unexercised, the holder no longer has any of the rights granted in the contract. In addition, the holder loses the premium that was paid for the option, along with any commissions and fees related to its purchase.
95
Options Clearing Corporation (OCC)
The Options Clearing Corporation (OCC) is an organization that acts as both the issuer and guarantor for option and futures contracts. The OCC operates under the jurisdiction of the U.S. Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC). Under its SEC jurisdiction, the OCC clears transactions for put and call options, stock indexes, foreign currencies, interest rate composites and single-stock futures.
As a registered derivatives clearing organization (DCO) regulated by the CFTC, the OCC provides clearing and settlement services for transactions in futures products, as well as options on futures. For securities lending transactions, the OCC offers central counterparty clearing and settlement services.
96
Clearing House
What is a 'Clearing House'
Clearing houses are an intermediary between buyers and sellers of financial instruments. Further, it is an agency or separate corporation of an exchange responsible for settling trading accounts, clearing trades, collecting and maintaining margin monies, regulating delivery of the bought/sold instrument, and reporting trading data. Clearing houses act as third parties to all futures and options contracts, as buyers to every clearing member seller, and as sellers to every clearing member buyer.
Clearing houses take the opposite position of each side of a trade. When two investors agree to the terms of a financial transaction, such as the purchase or sale of a security, a clearing house acts as the middle man on behalf of both parties. The purpose of a clearing house is to improve the efficiency of the markets and add stability to the financial system.
The futures market is most commonly associated with a clearing house, since its financial products are leveraged and require a stable intermediary. Each exchange has its own clearing house. All members of an exchange are required to clear their trades through the clearing house at the end of each trading session and to deposit with the clearing house a sum of money, based on clearinghouse's margin requirements, sufficient to cover the member's debit balance.
Assume that one trader buys an index futures contract. The initial margin required to hold this trade overnight is $6,160. This amount is held as a "good faith" assurance that the trader can afford the trade. This money is held by the clearing firm, within the trader's account, and can't be used for other trades. This helps offset any losses the trader may experience while in a trade.
If the price goes against the trader, and they start losing money, exchanges also set maintenance margin requirements. If the account balance drops below a certain amount,say $5,600, the trader is required to top up the account to meet the initial margin. This is a margin call. If the trader doesn't meet the margin call, the trade will be closed since the account cannot reasonably withstand further losses. This way, there is always sufficient money in the account to cover on any losses which may occur.
Profits and are realized when the trade is closed. When the trade is closed, the remaining margin funds are released and the trader can use them for other trades.
This process helps reduce the risk to individual traders. For example, if two people agree to trade, and there is no one else to verify and back the trade, it is possible that one party could back out of the the agreement, or come into financial trouble be unable to produce the funds to hold up their end of the bargain. The clearing firm takes this risk away from the individual trader, as each trader knows that the clearing firm wil be collecting enough funds from all trading parties that they don't need to worry about credit or default risk of the person on the other side of the transaction.
Stock Market Clearing Houses
Stock exchanges, such as the New York Stock Exchange (NYSE) and the NASDAQ, have clearing firms. They assure that stock traders have enough money in their account, whether using cash or broker-provided margin, to fund the trades they are taking.
The clearing division of these exchanges acts as the middle man, helping facilitate the smooth transfer of funds. When an investor sells a stock they own, they want to know that the money will be delivered to them. The clearing firms makes sure this happens. Similarly, when someone buys a stock, they need to be able to afford it. The clearing firm makes sure that the appropriate amount of funds is set aside for trade settlement when someone buys stocks.
97
Maintenance Margin
What is a 'Maintenance Margin'
Maintenance margin is the minimum amount of equity that must be maintained in a margin account. In the context of the NYSE and FINRA, after an investor has bought securities on margin, the minimum required level of margin is 25% of the total market value of the securities in the margin account. Keep in mind that this level is a minimum, and many brokerages have higher maintenance requirements of 30-40%.
Maintenance margin is also referred to as "minimum maintenance" or "maintenance requirement."
As governed by the Federal Reserve's Regulation T, when a trader buys on margin, key levels must be maintained throughout the life of the trade. First off, a broker cannot extend any credit to accounts with less than $2,000 in cash or securities. Second, the initial margin of 50% is required for a trade to be entered. Finally, the maintenance margin says that an equity level of at least 25% must be maintained. The investor will be hit with a margin call if the value of securities falls below the maintenance margin.
Maintenance Margin Basics
A margin account is an account with a brokerage firm that allows an investor to buy securities, be they stocks, bonds or options, with cash loaned by the broker. Trading on margin is used to increase the purchasing power of investors so that they can buy more stock without paying for it entirely out of pocket. Buying more stocks that then increase in value results in a greater gain for the investor; however, buying more stocks that lose value exposes the investor to much more substantial losses.
98
Margin Call
A margin call happens when a broker demands that an investor deposits additional money or securities so that the margin account is brought up to the minimum maintenance margin. A margin call occurs when the account value falls below the broker's required minimum value.
Basically, this means that one or more of the securities held in the margin account has decreased in value below a certain point. The investor must either deposit more money in the account or sell some of the assets held in the account.
A margin call arises when an investor borrows money from a broker to make investments. When an investor uses margin to buy or sell securities, he pays for them using a combination of his own funds and borrowed money from a broker. An investor is said to have equity in the investment, which is equal to the market value of securities minus borrowed funds from the broker. A margin call is triggered when the investor's equity, as a percentage of the total market value of securities, falls below a certain percentage requirement, which is called the maintenance margin. While the maintenance margin percentage can vary among brokers, federal law establishes a minimum maintenance margin of 25%.
Example of a Margin Call
An investor buys $100,000 of a company's stock by using $50,000 of his own funds and borrowing the remaining $50,000 from the broker. The investor's broker has a maintenance margin of 25%. At the time of purchase, the investor's equity as a percentage is 50%.
Investor's Equity As Percentage = (Market Value of Securities - Borrowed Funds) / Market Value of Securities
In our example: 50% = ($100,000 - $50,000) / ($100,000)
This is above the 25% maintenance margin, but suppose on the second trading day, the value of the purchased securities falls to $60,000. This results in the investor's equity of $10,000 (the market value of $60,000 minus the borrowed funds of $50,000), or 16.67%.
16.67% = ($60,000 - $50,000) / ($60,000)
This is now below the maintenance margin of 25%. The broker makes a margin call, requiring the investor to deposit at least $5,000 to meet the maintenance margin. The amount required to meet the maintenance margin is calculated as:
Amount to Meet Minimum Maintenance Margin = (Market Value of Securities x Maintenance Margin) - Investor's Equity
In our example, the required $5,000 is calculated as:
$5,000 = ($60,000 x 25%) - $10,000
The investor needs at least $15,000 of equity (the market value of securities of $60,000 times the 25% maintenance margin) in his account to be eligible for margin, but only has $10,000 in investor's equity, resulting in a $5,000 deficiency. The margin call is for $5,000, and if the investor does not deposit the money in a timely manner, the broker can liquidate securities for the value sufficient to bring the account into compliance with the maintenance margin rules.
99
Margin Account
A margin account is a brokerage account in which the broker essentially lends the customer cash to purchase securities. The loan in the account is collateralized by the securities purchased and cash, and comes with a periodic interest rate. Because the customer is investing with borrowed money, the customer is using leverage, and will magnify both losses and gains because of it.
A margin account lets an investor borrow money from a broker to purchase securities up to certain limits. For example, an investor with $2,500 in a margin account wants to buy Company A’s stock for $5 per share. The customer could use additional margin funds of $2,500 supplied by the broker to purchase $5,000 of Company A’s stock, or 1,000 shares. If the stock appreciates to $10 per share, the investor can sell his shares for $10,000. If he does so, after repaying the broker's $2,500, he will have profited $7,500, assuming no other costs. In reality, the investor will also have to pay interest on the margin lent to him by the broker, as well as other trading costs, so his profit will be less.
Margin Account Pros and Cons
If an investor purchases securities with margin funds, and those securities appreciate in value beyond the interest rate charged on the funds, the investor will earn a better total return than if he had only purchased securities with his own cash. This scenario is the advantage of using margin funds. On the downside, the brokerage firm charges interest on the margin funds for as long as the loan is outstanding, increasing the investor’s cost of buying the securities. If the securities decline in value, the investor will be underwater on the margin funds, and will have to pay interest to the broker on top of that. In addition, if a margin account’s equity drops below the maintenance margin, the brokerage firm will make a margin call to the investor. Within a specified number of days, typically within three days, the investor must deposit more cash or sell some stock to offset all or a portion of the difference between the security’s price and the maintenance margin.
A brokerage firm has the right to increase the minimum amount required in a margin account, sell the investor’s securities without notice or sue the investor if he does not fulfill a margin call. Therefore, the investor has the potential to lose more money than the funds deposited in his account. For these reasons, a margin account is most suitable for a sophisticated investor with a thorough understanding of the additional investment risks and requirements.
Federal Regulations on Margin Accounts
A margin account may not be used for buying stocks on margin in an individual retirement account, Uniform Gift to Minor accounts, a trust or other fiduciary accounts, as these accounts require cash deposits. In addition, a margin account cannot be used when purchasing less than $2,000 in stock, buying stock in an initial public offering, buying stock trading at less than $5 per share or for stocks trading anywhere other than the New York Stock Exchange (NYSE) or the NASDAQ.
Read more: Margin Account https://www.investopedia.com/terms/m/marginaccount.asp#ixzz5TLxA6cHy
Follow us: Investopedia on Facebook
100
Buying Power
What is 'Buying Power'
Buying power, also referred to as excess equity, is the money an investor has available to buy securities when considering the term in a trading context. Buying power is the money an investor has available to buy securities and equals the total cash held in the brokerage account plus all available margin.
While buying power can take on a different meaning depending on the context or industry, in the world of trading and investments, buying power refers to the amount of money available for investors to purchase securities in a leveraged account. This is referred to as a margin account, as traders are allowed to take out a loan based on the amount of cash held in the brokerage account.
Buying Power of Margin Accounts
The amount a brokerage can margin a particular customer depends on the brokerage house and the customer. Some margin accounts offer investors twice as much as the cash held in the account. Other margin accounts offer much more. The more leverage a brokerage house gives an investor, the harder it is to recover from a margin call. In other words, leverage gives the investor an opportunity to make increased gains with the use of more buying power, but it also increases the risk of having to cover the loan. For a non-margin account, the buying power is equal to the amount of cash in the account.
For example, assume an investor has $1 million worth of cash in a brokerage account. The investor wants to purchase common shares in company A. A retail investor's initial margin is normally set at around 50 percent to enter a trade, but maintenance margin, which is the amount of equity required for margin trading, can be as low as 25 percent but is normally 30 to 40 percent at retail brokerages. The total buying power is calculated by dividing the amount of cash in the brokerage account by the margin percentage. Thus, we divide the cash balance of $1 million by the initial maintenance margin requirement of 50 percent, or $2 million. As a result, the investor can purchase up to $2 million in securities. That said, the value of the margin account changes with the value of the securities held and the closer an investor gets to margin limits the more likely the chance of a margin call.
101
Call Money Rate
The call money rate is the interest rate on a type of short-term loan that banks give to brokers who in turn lend the money to investors to fund margin accounts. For both brokers and investors, this type of loan does not have a set repayment schedule and must be repaid on demand. The investor who owns the margin account pays their broker the call money rate plus a service fee in return for using the margin capabilities offered by the broker.
The call money rate is also called the broker loan rate.
The call money rate is used to compute the borrowing rate an investor will pay when trading on margin in their brokerage account. Trading on margin is a risky strategy in which investors make trades with borrowed money. Trading with borrowed money increases the investor's leverage which in turn amplifies the risk level of the investment.
The advantage of margin trading is that investment gains are magnified; the disadvantage is that losses are also amplified. When investors trading on margin experience a decline in equity past a certain level relative to the amount they have borrowed, the brokerage will issue a margin call that requires them to deposit more cash in their account or to sell enough securities to make up the shortfall. This can increase losses to the investor because margin calls most likely occur when the securities in the account have significantly decreased in value. Selling securities at the time when they have lost value forces the investor to lock in losses as opposed to continuing to hold the investment and wait for a time when the value has recovered in order to sell.
102
Repayment
Repayment is the act of paying back money previously borrowed from a lender. Repayment is typically executed through periodic payments that include part principal plus interest. Failure to keep up with debt repayments can force an individual to declare bankruptcy, which will negative affect their credit rating.
Borrowers should explore every alternative before declaring bankruptcy because doing so can affect a borrower's ability to obtain financing in the future. Alternatives to bankruptcy are earning additional income or refinancing and negotiating with creditors before declaring bankruptcy. The specific loan contract might also reveal options for a borrower who is unable to repay loans.
Federal Student Loans
Federal student loans allow for a lower payment amount, postponed payments and, in some cases, loan forgiveness. The options provide repayment flexibility as a recipient's life changes. This is especially helpful if a recipient is faced with a health crisis or a financial crisis.
103
Credit Rating
A credit rating is an assessment of the creditworthiness of a borrower in general terms or with respect to a particular debt or financial obligation. A credit rating can be assigned to any entity that seeks to borrow money — an individual, corporation, state or provincial authority, or sovereign government.
Credit assessment and evaluation for companies and governments is generally done by a credit rating agency such as Standard & Poor’s (S&P), Moody’s, or Fitch. These rating agencies are paid by the entity that is seeking a credit rating for itself or for one of its debt issues.
A loan is essentially a promise, and a credit rating determines the likelihood that the borrower will pay back a loan within the confines of the loan agreement, without defaulting. A high credit rating indicates a high possibility of paying back the loan in its entirety without any issues; a poor credit rating suggests that the borrower has had trouble paying back loans in the past, and might follow the same pattern in the future. The credit rating affects the entity's chances of being approved for a given loan or receiving favorable terms for said loan.
Credit ratings apply to businesses and government, while credit scores apply only to individuals. Credit scores are derived from the credit history maintained by credit-reporting agencies such as Equifax, Experian, and TransUnion. An individual's credit score is reported as a number, generally ranging from 300 to 850 (for details, see What is a Good Credit Score?). Similarly, sovereign credit ratings apply to national governments, while corporate credit ratings apply solely to corporations.
104
Corporate credit rating
A corporate credit rating is an opinion of an independent agency regarding the likelihood that a corporation will fully meet its financial obligations as they come due. A company’s corporate credit rating indicates its relative ability to pay its creditors and gives investors an idea of how the company’s debt securities should be priced in term of yields. Corporate credit ratings are an opinion, not fact.
Corporate credit ratings are not a guarantee that a company will repay its obligations, but the overall, long-term track record of these ratings is indicative of the differences in creditworthiness among rated companies. In one study, for example, Standard & Poor’s found that “the average five-year default rate for investment-grade corporate issuers was 1.07%, compared with 16.03% for speculative-grade (junk-rated) companies.”
S&P, Moody’s and Fitch are the three main providers of corporate credit ratings. Each agency has its own ratings system that does not necessarily equate to another company’s ratings scale, but they are all similar. Fitch and Standard & Poor’s use AAA for the highest credit quality, AA for the next best, followed by A, then BBB for good credit. Everything below BBB is considered speculative or worse, down to a D rating, which indicates default.
Since the ratings are opinions, ratings of the same company can differ among rating agencies. Investment research firm Morningstar also provides corporate credit ratings that range from AAA for extremely low default risk to D for payment default.
Reliability of Corporate Credit Ratings
During the financial crisis of 2008, companies that had received glowing ratings from various credit rating agencies were downgraded to junk levels, calling into question the reliability of the ratings themselves. The main criticism that has plagued rating agencies is that they are not truly unbiased. In order to secure the job to conduct a rating, a rating agency will, according to the criticism, give the client a rating that it wants or sweep under the rug hairballs that would negatively impact a credit rating. Credit agencies came under intense fire, for good reason, when the post-mortem on the credit crisis was performed.
105
Corporate Bond
What is a 'Corporate Bond'
A corporate bond is a debt security issued by a corporation and sold to investors. The backing for the bond is usually the payment ability of the company, which is typically money to be earned from future operations. In some cases, the company's physical assets may be used as collateral for bonds.
Corporate bonds are considered to have a higher risk than government bonds. As a result, interest rates are almost always higher on corporate bonds, even for companies with top-flight credit quality.
How Corporate Bonds Work
Corporate bonds are issued in blocks of $1,000 in par value, and almost all have a standard coupon payment structure. As the investor owns the bond, he receives interest from the issuer until the bond matures. At that point, the investor can reclaim the face value of the bond. Corporate bonds may also have call provisions to allow for early prepayment if prevailing rates change, and investors may also opt to sell bonds before they mature.
The least expensive bonds from some corporations may cost $5,000 or $10,000 rather than $1,000. In Australia, the face value of most corporate bonds is $100. Like other types of debt, bonds may have fixed interest rates that stay the same throughout the life of the bond, or they may have floating rates that change.
Why Do Corporations Sell Bonds?
Corporate bonds are a form of debt financing. They can be a major source of capital for many businesses, along with equity, bank loans and lines of credit. Generally speaking, a company needs to have some consistent earnings potential to be able to offer debt securities to the public at a favorable coupon rate. If a company's perceived credit quality is higher, it becomes easier to issue more debt at low rates. When corporations need a very short-term capital boost, they may sell commercial paper, which is very similar to a bond but typically matures in 270 days or less.
The Difference Between Corporate Bonds and Stocks
When an investor buys a corporate bond, he lends money to the company. Conversely, when an investor purchases stocks, he essentially buys a piece of the company. The value of stocks rises and falls with the value of the company, allowing the investors to earn profits but also subjecting the investors to losses. With bonds, investors only earn interest rather than profits. If a company goes into bankruptcy, it pays its bondholders along with other creditors before its stockholders, making bonds arguably safer than stocks.
Asset-Backed Securities
A type of bond, asset-backed securities (ABS) bundle together consumer debt, such as home loans, home equity lines of credit and credit card receivables. They may also include loans on mobile homes but not traditional mortgages. Institutional investors typically purchase ABS. ABS may be included in corporate bond mutual funds.
d. Corporate Bonds: these are obligations issued by either public companies or those being taken private through leverage, though the latter category may be often be subsumed under high yield bonds.
```
Mortgage Bond - a form of secured bond with the highest priority among all claims on assets pledged as collateral.
Open-End Indentures - the corporation may issue more bonds of the same class at a later date which are secured by the same collateral backing the original issue with equal liens on the property.
Closed-End Indentures - the corporation is not permitted to issue more bonds of the same class in the future. Subsequent issues have a subordinated claim on the collateral.
Prior Lien Bonds - the corporation would issue a bond taking precedence over first-mortgage bonds only with the first mortgage bondholders' consent which is unlikely.
Debenture - these are obligations issued by corporations backed only by the creditworthiness of the company. Accordingly, their yield is higher than corporate bonds with similar terms backed by hard assets. These, in turn, may fall within either the investment grade or high yield categories.
Investment Grade - these are corporate obligations with a credit rating of BBB/Baa from the two major credit rating agencies, Standard & Poor's and Moody's, respectively. Bonds with this level of creditworthiness are that much more likely to be able to pay interest and repay principal. Price appreciation is subject to short or long term capital gains tax, while coupon income is taxed as ordinary income at the taxpayer's marginal tax rate. These bonds' creditworthiness affords them greater liquidity.
High-Yield - refers to that segment of the bond market that enables non-investment grade companies to obtain capital.[Credit ratings below BB-B/Ba-B from Standard & Poors and Moody's respectively are non-investment grade.] Once considered an outcast of the fixed income arena, high yield debt is today a relatively stable market with improved overall credit quality, less of a financing tool for buyouts and acquisitions and more of one for growth capital. Because of their higher risk profile, some analysts are inclined to view them almost as equities in bond clothing. Additionally, the below-investment grade rating causes such bonds often to be excluded from qualified retirement plans. Most are plan vanilla fixed-rate, cash-pay structures, but some alternatives exist with features such as deferred payments (income bonds which trade flat, e.g. without interest), step-up payments, extendible maturity/coupon reset or payment-in-kind arrangements (where the option exists to pay interest or like-kind securities). The more creative offerings exist to accommodate cash poor higher risk companies in certain industries such as cable, media and telecommunications. About three quarters of outstanding high yield debt is callable. Coupon income is taxable as ordinary income and gains on the sale of a bond are taxed at prevailing capital gains tax rates. Because many of the research tools needed to perform the requisite credit analysis on such bonds are beyond the grasp of and availability to most individual investors, professionally managed funds may often be a more prudent approach.
Convertible - nominally fixed income, these are more of a hybrid security, conferring upon the holder the right to convert the bond into a specified quantity of shares of the issuer[One should note the term exchangeable bond which enables the bondholder to exchange the issue for a specified number of shares of common stock of a corporation different from the issuer of the bond. (Fabozzi, Frank J. PhD, CFA FIXED INCOME ANALYSIS for the Chartered Financial Analyst ® Program Second Edition, 2004)]. Therefore, it is a bond with an embedded option granted to the investor (bondholder). Valuation is more complex for two reasons. Since such bonds may be callable or putable [A LYON (Liquid Yield Option Note) contains both call and put features. A zero coupon convertible bond, a [A LYON (Liquid Yield Option Note) contains both call and put features. A zero coupon convertible bond, a [A LYON (Liquid Yield Option Note) contains both call and put features. A zero coupon convertible bond, a [A LYON (Liquid Yield Option Note) contains both call and put features. A zero coupon convertible bond, a LYON may be called by the issuer or put back to the issuer by the holder.], their value depends on how interest rates change, affecting the value of any call or put feature. Additionally, changes in the market price of the issuer's underlying stock affect the value of the conversion option. The presence of this feature is advantageous to the issuing company as it may offer a lower yield in exchange for giving the bondholders the opportunity to convert. Such a feature is less favorable to the bondholder who accepts a lower yield for the possibility of converting the bond into stock. That possibility may not materialize [Busted convertible or fixed income equivalent are terms used interchangeably to describe a bond with no possibility of conversion due to too low a share price of the issuer.]. Beneficial to the bondholder is the ability to convert the bond into shares if worthwhile, yet have the downside protection and income stream of a fixed income instrument. Convertibles offer equity participation with seniority in a company's capital structure as they are bonds. Convertible bonds exhibit a higher correlation with equity securities due to the conversion option and may afford the investor the opportunity to diversify. Note formulas including break-even time.
```
106
Asset-Backed Security - ABS
An asset-backed security (ABS) is a financial security collateralized by a pool of assets such as loans, leases, credit card debt, royalties or receivables. For investors, asset-backed securities are an alternative to investing in corporate debt. An ABS is similar to a mortgage-backed security, except that the underlying securities are not mortgage-based.
Asset-backed securities allow issuers to generate more cash, which, in turn, is used for more lending while giving investors the opportunity to invest in a wide variety of income-generating assets. Usually, the underlying assets of an ABS are illiquid and can't be sold on their own. But pooling the assets together and creating a financial security, a process called securitization, enables the owner of the assets to make them marketable. The underlying assets of these pools may be home equity loans, automobile loans, credit card receivables, student loans or other expected cash flows. Issuers of ABS can be as creative as they desire. For example, ABS have been created based on cash flows from movie revenues, royalty payments, aircraft leases and solar photovoltaics. Just about any cash-producing situation can be securitized into an ABS.
Example of Asset-Backed Security
Assume that Company X is in the business of making automobile loans. If a person wants to borrow money to buy a car, Company X gives that person the cash, and the person is obligated to repay the loan with a certain amount of interest. Perhaps Company X makes so many loans that it runs out of cash to continue making more loans. Company X can then package its current loans and sell them to Investment Firm X, thus receiving cash that it can use to make more loans.
Investment Firm X will then sort the purchased loans into different groups called tranches. These tranches are groups of loans with similar characteristics, such as maturity, interest rate and expected delinquency rate. Next, Investment Firm X will issue securities that are similar to typical bonds on each tranche it creates.
Individual investors then purchase these securities and receive the cash-flows from the underlying pool of auto loans, minus an administrative fee that Investment Firm X keeps for itself.
```
Typical Tranches
Usually an ABS will have three tranches: class A, B and C. The senior tranche, A, is almost always the largest tranche and is structured to have an investment-grade rating to make it attractive to investors.
```
The B tranche has lower credit quality and thus has a higher yield than the senior tranche. The C tranche has a lower credit rating than the B tranche and might have such poor credit quality that it can't be sold to investors. In this case, the issuer would keep the C tranche and absorb the losses.
107
Securitization
Securitization is the procedure whereby an issuer designs a financial instrument by merging various financial assets and then markets tiers of the repackaged instruments to investors. This process can encompass any type of financial asset and promotes liquidity in the marketplace.
The process of securitization creates liquidity by enabling smaller investors to purchase shares in a larger asset pool. It can involve the pooling of contractual debts such as auto loans and credit card debt obligations, or any assets that generate receivables. Mortgage-backed securities are a perfect example of securitization. By combining mortgages into one large pool, the issuer can divide the pool into smaller pieces based on each mortgage's inherent risk of default and then sell those smaller pieces to investors. With a mortgage-backed security, individual retail investors can purchase portions of a mortgage as a type of bond. Without the securitization of mortgages, retail investors may not be able to afford to buy into a large pool of mortgages.
In securitization, the company holding the loans, also known as the originator, gathers the data on the assets it would like to remove from its associated balance sheets. These assets are then grouped together by factors, such as the time remaining on a loan, the level of risk, the amount of remaining principal and others. This gathered group of assets, now considered a reference portfolio, is then sold to an issuer. The issuer creates tradable securities representing a stake in the assets associated with the portfolio, selling them to interested investors with a rate of return.
Securitization provides creditors with a mechanism to lower their associated risk through the division of ownership of the debt obligations. The investors effectively take the position of lender by buying into the security. This allows a creditor to remove the associated assets from their balance sheets.
The investors earn a rate of return based on the associated principal and interest payments being made by the included debtors on their obligation. Unlike some other investment vehicles, these are backed by tangible goods. Should a debtor cease payments on his asset, it can be seized and liquidated to compensate those holding an interest in the debt. Like other investments, the higher the risk, the higher potential rate of return. This correlates with the higher interest rates less qualified borrowers are generally charged. Even though the securities are back by tangible assets, there is no guarantee that the assets will maintain their value should a debtor cease payment.
108
Mortgage-Backed Security
A mortgage-backed security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages. This security must also be grouped in one of the top two ratings as determined by an accredited credit rating agency, and usually pays periodic payments that are similar to coupon payments. Furthermore, the mortgage must have originated from a regulated and authorized financial institution.
An MBS is also known as a "mortgage-related security" or a "mortgage pass through." An MBS can be bought and sold through a broker and the minimum investment varies between issuers. It is issued by either a federal government agency company, government-sponsored enterprise (GSE), or private financial company.
Read more: Mortgage-Backed Security - MBS https://www.investopedia.com/terms/m/mbs.asp#ixzz5TMEgmohy
Follow us: Investopedia on Facebook
109
Incumbency Certificate
What is an 'Incumbency Certificate'
An incumbency certificate is an official document issued by a corporation or LLC, that lists the names of its current directors, officers and, occasionally, shareholders. It specifies who holds which positions within the organization, and is most frequently used to confirm the identity of individuals who are authorized to enter into legally binding transactions on the company's behalf.
Incumbency certificates go by many other names outside the United States, such as Register of Directors, Secretary’s Certificate, Officer’s Certificate or Certificate of Officers. But they all essentially provide the same information, such as certificate of incumbency, certificate of officers, officer's certificate, register of directors or secretary's certificate.
Content of Incumbency Certificate
Incumbency certificates are issued by the corporate secretary and often bear the corporate seal – and may be notarized by a public notary. Because the secretary is the officer in charge of keeping company records, the incumbency certificate is an official act of the company, and third parties can reasonably rely on its accuracy.
An incumbency certificate contains all relevant particulars regarding the company's directors and officers, such as the incumbent's name, position, whether elected or appointed and the term of office. It also usually includes a signature sample for comparison purposes.
A typical incumbency certificate may be worded as follows: "The undersigned, X, Secretary of ABC Inc. (the "Company"), hereby certifies that the persons named below do hold the position set forth opposite his or her names with the Company, that the signature appearing opposite each such person's name is the true signature of such person, and that they are duly authorized to ..." This mention would then be followed by a list of the directors and officers, the date, and the secretary's signature.
Practical Use
Anyone who is involved in a transaction with a company and needs to confirm the stated position of an officer within the company may request an incumbency certificate from the secretary of the company. In practice, an incumbency certificate is often required by a bank or another financial institution when opening an account to ensure that the person who claims to be the authorized signatory of a company truly is. Similarly, when attorneys are drafting contracts for transactions involving companies, they usually require an official incumbency certificate to determine who can legally bind the company in the contracts.
110
Over-the-Counter
Over-the-counter (OTC) or off-exchange trading is done directly between two parties, without the supervision of an exchange. It is contrasted with exchange trading, which occurs via exchanges. A stock exchange has the benefit of facilitating liquidity, providing transparency, and maintaining the current market price. In an OTC trade, the price is not necessarily published for the public.
OTC trading, as well as exchange trading, occurs with commodities, financial instruments (including stocks), and derivatives of such products. Products traded on the exchange must be well standardized. This means that exchanged deliverables match a narrow range of quantity, quality, and identity which is defined by the exchange and identical to all transactions of that product. This is necessary for there to be transparency in trading. The OTC market does not have this limitation. They may agree on an unusual quantity, for example.[1] In OTC, market contracts are bilateral (i.e. the contract is only between two parties), and each party could have credit risk concerns with respect to the other party. The OTC derivative market is significant in some asset classes: interest rate, foreign exchange, stocks, and commodities.[2]
In 2008 approximately 16 percent of all U.S. stock trades were "off-exchange trading"; by April 2014 that number increased to about forty percent.[1] Although the notional amount outstanding of OTC derivatives in late 2012 had declined 3.3% over the previous year, the volume of cleared transactions at the end of 2012 totalled US$346.4 trillion.[3] "The Bank for International Settlements statistics on OTC derivatives markets showed that notional amounts outstanding totalled $693 trillion at the end of June 2013... The gross market value of OTC derivatives – that is, the cost of replacing all outstanding contracts at current market prices – declined between end-2012 and end-June 2013, from $25 trillion to $20 trillion."[4]
111
Exchange (Organized Market)
An exchange, or bourse /bʊərs/ also known as a trading exchange or trading venue, is an organized market where (especially) tradable securities, commodities, foreign exchange, futures, and options contracts are sold and bought.
In the seventeenth century, the Dutch were the first to use the stock market to finance companies.[4] The first company to issue stocks and bonds was the Dutch East India Company, introduced in 1602.
The London Stock Exchange started operating and listing shares and bonds in 1688.[5]
In 1774, the Paris Stock Exchange (founded in 1724), say the courts, must now necessarily be shouted to improve the transparency of operations.[citation needed] In the nineteenth century, the industrial revolution enables rapid development of stock markets, driven by the significant capital requirements for finance industry and transport. Since the computer revolution of the 1970s, we are witnessing the dematerialization of securities traded on the stock exchange.
In 1971, the NASDAQ became the primary market quotes computer. In France, the dematerialization was effective from November 5, 1984.[citation needed]
112
Stock Exchange
A stock exchange, securities exchange or bourse,[note 1] is a facility where stock brokers and traders can buy and sell securities, such as shares of stock and bonds and other financial instruments. Stock exchanges may also provide for facilities the issue and redemption of such securities and instruments and capital events including the payment of income and dividends.[citation needed] Securities traded on a stock exchange include stock issued by listed companies, unit trusts, derivatives, pooled investment products and bonds. Stock exchanges often function as "continuous auction" markets with buyers and sellers consummating transactions at a central location such as the floor of the exchange.[6] Many stock exchanges today use electronic trading, in place of the traditional floor trading.
113
Public Offering
A public offering is the offering of securities of a company or a similar corporation to the public. Generally, the securities are to be listed on a stock exchange. In most jurisdictions, a public offering requires the issuing company to publish a prospectus detailing the terms and rights attached to the offered security, as well as information on the company itself and its finances. Many other regulatory requirements surround any public offering and they vary according to jurisdiction.
Initial public offering (IPO) is one type of public offering. Not all public offerings are IPOs. An IPO occurs only when a company offers its shares (not other securities) for the first time for public ownership and trading, an act making it a public company. However, public offerings are also made by already-listed companies. The company issues additional securities to the public, adding to those currently being traded. For example, a listed company with 8 million shares outstanding can offer to the public another 2 million shares. This is a public offering but not an IPO. Once the transaction is complete, the company will have 10 million shares outstanding. Non-initial public offering of equity is also called seasoned equity offering.
A shelf prospectus is often used by companies in exactly that situation. Instead of drafting one before each public offering, the company can file a single prospectus detailing the terms of many different securities it might offer in the next several years. Shortly before the offering (if any) actually takes place, the company informs the public of material changes in its finances and outlook since the publication of the shelf prospectus.
Other types of securities, besides shares, can be offered publicly. Bonds, warrants, capital notes and many other kinds of debt and equity vehicles are offered, issued and traded in public capital markets. A private company, with no shares listed publicly, can still issue other securities to the public and have them traded on an exchange. A public company may also offer and list other securities alongside its shares.
Most public offerings are in the primary market, that is, the issuing company itself is the offerer of securities to the public. The offered securities are then issued (allocated, allotted) to the new owners. If it is an offering of shares, this means that the company's outstanding capital grows. If it is an offering of other securities, this entails the creation or expansion of a series (of bonds, warrants, etc.). However, more rarely, public offerings take place in the secondary market. This is called a secondary market offering: existing security holders offer to sell their stake to other, new owners, through the stock exchange. The offerer is different from the issuer (the company). A secondary market offering is still a public offering with much the same requirements, including a prospectus.
The services of an underwriter are often used to conduct a public offering.
114
Securities Underwriting
Securities underwriting is the process by which investment banks raise investment capital from investors on behalf of corporations and governments that are issuing securities (both equity and debt capital). The services of an underwriter are typically used during a public offering in a primary market.
This is a way of distributing a newly issued security, such as stocks or bonds, to investors. A syndicate of banks (the lead managers) underwrites the transaction, which means they have taken on the risk of distributing the securities. Should they not be able to find enough investors, they will have to hold some securities themselves. Underwriters make their income from the price difference (the "underwriting spread") between the price they pay the issuer and what they collect from investors or from broker-dealers who buy portions of the offering.
115
Underwriting Spread
The underwriting spread is the difference between the amount paid by the underwriting group in a new issue of securities and the price at which securities are offered for sale to the public. It is the underwriter's gross profit margin, usually expressed in points per unit of sale (bond or stock). Spreads may vary widely and are influenced by the underwriter's expectation of market demand for the securities offered for sale, interest rates, and so on.
Components of an underwriting spread in an initial public offering (IPO) typically include the following (on a per share basis): Manager's fee, Underwriting fee—earned by members of the syndicate, and the Concession—earned by the broker-dealer selling the shares. The Manager would be entitled to the entire underwriting spread. A member of the syndicate is entitled to the underwriting fee and the concession. A broker dealer who is not a member of the syndicate but sells shares would receive only the concession, while the member of the syndicate who provided the shares to that broker dealer would retain the underwriting fee.[1]
116
(IPO) Initial Public Offering (Wiki Article)
Initial public offering (IPO) or stock market launch is a type of public offering in which shares of a company are sold to institutional investors[1] and usually also retail (individual) investors; an IPO is underwritten by one or more investment banks, who also arrange for the shares to be listed on one or more stock exchanges. Through this process, colloquially known as floating, or going public, a privately held company is transformed into a public company. Initial public offerings can be used: to raise new equity capital for the company concerned; to monetize the investments of private shareholders such as company founders or private equity investors; and to enable easy trading of existing holdings or future capital raising by becoming publicly traded enterprises.
After the IPO, shares traded freely in the open market are known as the free float. Stock exchanges stipulate a minimum free float both in absolute terms (the total value as determined by the share price multiplied by the number of shares sold to the public) and as a proportion of the total share capital (i.e., the number of shares sold to the public divided by the total shares outstanding). Although IPO offers many benefits, there are also significant costs involved, chiefly those associated with the process such as banking and legal fees, and the ongoing requirement to disclose important and sometimes sensitive information.
Details of the proposed offering are disclosed to potential purchasers in the form of a lengthy document known as a prospectus. Most companies undertake an IPO with the assistance of an investment banking firm acting in the capacity of an underwriter. Underwriters provide several services, including help with correctly assessing the value of shares (share price) and establishing a public market for shares (initial sale). Alternative methods such as the Dutch auction have also been explored and applied for several IPOs.
117
Broker-Dealer
In financial services, a broker-dealer is a natural person, company or other organization that engages in the business of trading securities for its own account or on behalf of its customers. Broker-dealers are at the heart of the securities and derivatives trading process.[1]
Although many broker-dealers are "independent" firms solely involved in broker-dealer services, many others are business units or subsidiaries of commercial banks, investment banks or investment companies.
When executing trade orders on behalf of a customer, the institution is said to be acting as a broker. When executing trades for its own account, the institution is said to be acting as a dealer. Securities bought from clients or other firms in the capacity of dealer may be sold to clients or other firms acting again in the capacity of dealer, or they may become a part of the firm's holdings.
In addition to execution of securities transactions, broker-dealers are also the main sellers and distributors of mutual fund shares.[2]
118
Bond Market
The bond market (also debt market or credit market) is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the secondary market. This is usually in the form of bonds, but it may include notes, bills, and so on.
Its primary goal is to provide long-term funding for public and private expenditures.[1] The bond market has largely been dominated by the United States, which accounts for about 44% of the market.[2] As of 2009, the size of the worldwide bond market (total debt outstanding) is estimated at $82.2 trillion,[3] of which the size of the outstanding U.S. bond market debt was $31.2 trillion according to Bank for International Settlements (BIS), or alternatively $35.2 trillion as of Q2 2011 according to Securities Industry and Financial Markets Association (SIFMA).[3]
The bond market is part of the credit market, with bank loans forming the other main component. The global credit market in aggregate is about 3 times the size of the global equity market.[1] Bank loans are not securities under the Securities and Exchange Act, but bonds typically are and are therefore more highly regulated. Bonds are typically not secured by collateral (although they can be), and are sold in relatively small denominations of around $1,000 to $10,000. Unlike bank loans, bonds may be held by retail investors. Bonds are more frequently traded than loans, although not as often as equity.[1][4][5]
Nearly all of the average daily trading in the U.S. bond market takes place between broker-dealers and large institutions in a decentralized over-the-counter (OTC) market.[6] However, a small number of bonds, primarily corporate ones, are listed on exchanges. Bond trading prices and volumes are reported on FINRA's Trade Reporting and Compliance Engine, or TRACE.[4][5]
An important part of the bond market is the government bond market, because of its size and liquidity. Government bonds are often used to compare other bonds to measure credit risk. Because of the inverse relationship between bond valuation and interest rates (or yields), the bond market is often used to indicate changes in interest rates or the shape of the yield curve, the measure of "cost of funding". The yield on government bonds in low risk countries such as the United States or Germany is thought to indicate a risk-free rate of default.[4][5] Other bonds denominated in the same currencies (U.S. Dollars or Euros) will typically have higher yields, in large part because other borrowers are more likely than the U.S. or German Central Governments to default, and the losses to investors in the case of default are expected to be higher. The primary way to default is to not pay in full or not pay on time.[1][4][5]
119
5 Bond Markets
The Securities Industry and Financial Markets Association (SIFMA) classifies the broader bond market into five specific bond markets.
```
Corporate
Government and agency
Municipal
Mortgage-backed, asset-backed, and collateralized debt obligations
Funding
```
120
Bond Market Participants
Bond market participants are similar to participants in most financial markets and are essentially either buyers (debt issuer) of funds or sellers (institution) of funds and often both.
Participants include:
Institutional investors
Governments
Traders
Individuals
Because of the specificity of individual bond issues, and the lack of liquidity in many smaller issues, the majority of outstanding bonds are held by institutions like pension funds, banks and mutual funds. In the United States, approximately 10% of the market is held by private individuals.
121
Asset Backed Security
An asset-backed security (ABS) is a security whose income payments and hence value are derived from and collateralized (or "backed") by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets which are unable to be sold individually. Pooling the assets into financial instruments allows them to be sold to general investors, a process called securitization, and allows the risk of investing in the underlying assets to be diversified because each security will represent a fraction of the total value of the diverse pool of underlying assets. The pools of underlying assets can include common payments from credit cards, auto loans, and mortgage loans, to esoteric cash flows from aircraft leases, royalty payments and movie revenues.
122
Securitization
Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations (or other non-debt assets which generate receivables) and selling their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs). Investors are repaid from the principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).
123
Mortgage Backed Securities
A mortgage-backed security (MBS) is a type of asset-backed security (an 'instrument') which is secured by a mortgage or collection of mortgages. The mortgages are sold to a group of individuals (a government agency or investment bank) that securitizes, or packages, the loans together into a security that investors can buy.[1] The mortgages of an MBS may be residential or commercial, depending on whether it is an Agency MBS or a Non-Agency MBS; in the United States they may be issued by structures set up by government-sponsored enterprises like Fannie Mae or Freddie Mac, or they can be "private-label", issued by structures set up by investment banks. The structure of the MBS may be known as "pass-through", where the interest and principal payments from the borrower or homebuyer pass through it to the MBS holder, or it may be more complex, made up of a pool of other MBSs. Other types of MBS include collateralized mortgage obligations (CMOs, often structured as real estate mortgage investment conduits) and collateralized debt obligations (CDOs).[2]
A mortgage bond is a bond backed by a pool of mortgages on a real estate asset such as a house. More generally, bonds which are secured by the pledge of specific assets are called mortgage bonds. Mortgage bonds can pay interest in either monthly, quarterly or semiannual periods. The prevalence of mortgage bonds is commonly credited to Mike Vranos.
124
Tranche
In structured finance, a tranche is one of a number of related securities offered as part of the same transaction. The word tranche is French for slice, section, series, or portion, and is cognate to English trench ('ditch'). In the financial sense of the word, each bond is a different slice of the deal's risk. Transaction documentation (see indenture) usually defines the tranches as different "classes" of notes, each identified by letter (e.g., the Class A, Class B, Class C securities) with different bond credit ratings.
All the tranches together make up what is referred to as the deal's capital structure or liability structure. They are generally paid sequentially from the most senior to most subordinate (and generally unsecured), although certain tranches with the same security may be paid pari passu. The more senior rated tranches generally have higher bond credit ratings (ratings) than the lower rated tranches. For example, senior tranches may be rated AAA, AA or A, while a junior, unsecured tranche may be rated BB. However, ratings can fluctuate after the debt is issued and even senior tranches could be rated below investment grade (less than BBB). The deal's indenture (its governing legal document) usually details the payment of the tranches in a section often referred to as the waterfall (because the moneys flow down).
Tranches with a first lien on the assets of the asset pool are referred to as senior tranches and are generally safer investments. Typical investors of these types of securities tend to be conduits, insurance companies, pension funds and other risk averse investors.
Tranches with either a second lien or no lien are often referred to as "junior notes". These are more risky investments because they are not secured by specific assets. The natural buyers of these securities tend to be hedge funds and other investors seeking higher risk/return profiles.
"Market information also suggests that the more junior tranches of structured products are often bought by specialist credit investors, while the senior tranches appear to be more attractive for a broader, less specialised investor community".[1] Here is a simplified example to demonstrate the principle:
125
Special Purpose Entity
A special-purpose entity (SPE; or, in Europe and India, special-purpose vehicle/SPV, or, in some cases in each EU jurisdiction – FVC, financial vehicle corporation) is a legal entity (usually a limited company of some type or, sometimes, a limited partnership) created to fulfill narrow, specific or temporary objectives. SPEs are typically used by companies to isolate the firm from financial risk. A formal definition is "The Special Purpose Entity is a fenced organization having limited predefined purposes and a legal personality".[1]
Normally a company will transfer assets to the SPE for management or use the SPE to finance a large project thereby achieving a narrow set of goals without putting the entire firm at risk. SPEs are also commonly used in complex financings to separate different layers of equity infusion. Commonly created and registered in tax havens, SPEs allow tax avoidance strategies unavailable in the home district. Round-tripping is one such strategy. In addition, they are commonly used to own a single asset and associated permits and contract rights (such as an apartment building or a power plant), to allow for easier transfer of that asset. They are an integral part of public private partnerships common throughout Europe which rely on a project finance type structure.[2]
126
Round Tripping
Round-tripping, also known as round-trip transactions or "Lazy Susans", is defined by The Wall Street Journal as a form of barter that involves a company selling "an unused asset to another company, while at the same time agreeing to buy back the same or similar assets at about the same price." Swapping assets on a round-trip produces no net economic substance, but may be fraudulently reported as a series of productive sales and beneficial purchases on the books of the companies involved, violating the substance over form accounting principle. The companies appear to be growing and very busy, but the round-tripping business does not generate profits. Growth is an attractive factor to speculative investors, even if profits are lacking; such investment benefits companies and motivates them to undertake the illusory growth of round-tripping.
Round trips are characteristic of the New Economy companies. They played a crucial part in temporarily inflating the market capitalization of energy traders such as Enron, CMS Energy, Reliant Energy, and Dynegy.
127
Substance Over Form
Substance over form is an accounting principle used "to ensure that financial statements give a complete, relevant, and accurate picture of transactions and events". If an entity practices the 'substance over form' concept, then the financial statements will show the overall financial reality of the entity (economic substance), rather than the legal form of transactions (form).[1] In accounting for business transactions and other events, the measurement and reporting is for the economic impact of an event, instead of its legal form. Substance over form is critical for reliable financial reporting. It is particularly relevant in cases of revenue recognition, sale and purchase agreements, etc. The key point of the concept is that a transaction should not be recorded in such a manner as to hide the true intent of the transaction, which would mislead the readers of a company's financial statements.
128
Revenue Model
A revenue model is a framework for generating revenues. It identifies which revenue source to pursue, what value to offer, how to price the value, and who pays for the value.[1] It is a key component of a company's business model.[2] It primarily identifies what product or service will be created in order to generate revenues and the ways in which the product or service will be sold.
Without a well defined revenue model, that is, a clear plan of how to generate revenues, new businesses will more likely struggle due to costs which they will not be able to sustain. By having a clear revenue model, a business can focus on a target audience, fund development plans for a product or service, establish marketing plans, begin a line of credit and raise capital.[3]
129
Business Value
In management, business value is an informal term that includes all forms of value that determine the health and well-being of the firm in the long run. Business value expands concept of value of the firm beyond economic value (also known as economic profit, economic value added, and shareholder value) to include other forms of value such as employee value, customer value, supplier value, channel partner value, alliance partner value, managerial value, and societal value. Many of these forms of value are not directly measured in monetary terms.
Business value often embraces intangible assets not necessarily attributable to any stakeholder group. Examples include intellectual capital and a firm's business model. The balanced scorecard methodology is one of the most popular methods for measuring and managing business value.
130
Profit
In economics, profit in the accounting sense of the excess of revenue over cost is the sum of two components: normal profit (regular income) and economic profit (loss of the difference of income and sale output of the opportunity cost of the inputs used, or simplified: bulk profit - costs of buying stock of product = re balanced profit or economic profit). Normal profit is the profit that is necessary to just cover the opportunity costs (the value of the best alternative solution) of the owner-manager or of the firm's investors. In the absence of this much profit, these parties would withdraw their time and funds from the firm and use them to better advantage elsewhere. In contrast, economic profit, sometimes called excess profit, is profit in excess of what is required to cover the opportunity costs.
131
Opportunity Costs
In microeconomic theory, the opportunity cost, also known as alternative cost, is the value (not a benefit) of a choice, relative to an alternative. When an option is chosen from two mutually exclusive alternatives, the opportunity cost is the "cost" incurred by not enjoying the benefit associated with the alternative choice.
Opportunity cost is a key concept in economics, and has been described as expressing "the basic relationship between scarcity and choice."[2] The notion of opportunity cost plays a crucial part in attempts to ensure that scarce resources are used efficiently.[3] Opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be considered an opportunity cost.
132
Scarcity
Scarcity is the limited availability of a commodity, which may be in demand in the market. Scarcity also includes an individual's lack of resources to buy commodities.
Scarcity refers to a gap between limited resources and theoretically limitless wants [2]. The notion of scarcity is that there is never enough (of something) to satisfy all conceivable human wants, even at advanced states of human technology. Scarcity involves making a sacrifice—giving something up, or making a tradeoff—in order to obtain more of the scarce resource that is wanted.[3]
The condition of scarcity in the real world necessitates competition for scarce resources, and competition occurs "when people strive to meet the criteria that are being used to determine who gets what".[3]:p. 105 The price system, or market prices, are one way to allocate scarce resources. "If a society coordinates economic plans on the basis of willingness to pay money, members of that society will [strive to compete] to make money"[3]:p. 105 If other criteria are used, we would expect to see competition in terms of those other criteria.[3]
133
Trade-Off
A trade-off (or tradeoff) is a situational decision that involves diminishing or losing one quality, quantity or property of a set or design in return for gains in other aspects. In simple terms, a tradeoff is where one thing increases and another must decrease.
134
Profit (accounting)
Profit, in accounting, is an income distributed to the owner in a profitable market production process (business). Profit is a measure of profitability which is the owner’s major interest in income formation process of market production. There are several profit measures in common use.
Gross profit equals sales revenue minus cost of goods sold (COGS), thus removing only the part of expenses that can be traced directly to the production or purchase of the goods. Gross profit still includes general (overhead) expenses like R&D, S&M, G&A, also interest expense, taxes and extraordinary items.
Earnings before interest, taxes, depreciation, and amortization (EBITDA) equals sales revenue minus cost of goods sold and all expenses except for interest, amortization, depreciation and taxes. It measures the cash earnings that can be used to pay interest and repay the principal. Since the interest is paid before income tax is calculated, the debt holder can ignore taxes.
Earnings before interest and taxes (EBIT) or operating profit equals sales revenue minus cost of goods sold and all expenses except for interest and taxes. This is the surplus generated by operations. It is also known as Operating Profit Before Interest and Taxes (OPBIT) or simply Profit Before Interest and Taxes (PBIT).
Earnings before taxes (EBT) or net profit before tax equals sales revenue minus cost of goods sold and all expenses except for taxes. It is also known as pre-tax book income (PTBI), net operating income before taxes or simply pre-tax income.
Net income or earnings after tax or net profit after tax equals sales revenue after deducting all expenses, including taxes (unless some distinction about the treatment of extraordinary expenses is made). In the US, the term net income is commonly used. Income before extraordinary expenses represents the same but before adjusting for extraordinary items.
Retained earnings equals earnings after tax minus payable dividends.
To accountants, economic profit, or EP, is a single-period metric to determine the value created by a company in one period—usually a year. It is earnings after tax less the equity charge, a risk-weighted cost of capital. This is almost identical to the economists' definition of economic profit.
There are analysts who see the benefit in making adjustments to economic profit such as eliminating the effect of amortized goodwill or capitalizing expenditure on brand advertising to show its value over multiple accounting periods. The underlying concept was first introduced by Eugen Schmalenbach, but the commercial application of the concept of adjusted economic profit was by Stern Stewart & Co. which has trade-marked their adjusted economic profit as Economic Value Added (EVA).
Optimum profit is a theoretical measure and denotes the "right" level of profit a business can achieve. In the business, this figure takes account of marketing strategy, market position, and other methods of increasing returns above the competitive rate.
Accounting profits should include economic profits, which are also called economic rents. For instance, a monopoly can have very high economic profits, and those profits might include a rent on some natural resource that a firm owns, whereby that resource cannot be easily duplicated by other firms.
135
Income
INCOME = REVENUE MINUS EXPENSES
Gross income can be defined as sum of all revenue. Net income = Revenue - Expenses .
Income is money that an individual or business receives in exchange for providing a good or service or through investing capital. Income is used to fund day-to-day expenditures. People aged 65 and under typically receive the majority of their income from a salary or wages earned from a job.
In businesses, income can refer to a company's remaining revenues after paying all expenses and taxes. In this case, income is referred to as "earnings.” Most forms of income are subject to taxation.
BREAKING DOWN Income
Individuals receive income through earning wages by working and/or making investments into financial assets such as stocks, bonds and real estate. For instance, an investor’s stock holding may pay income in the form of an annual 5% dividend. In most countries, earned income is taxed by the government before it is received. The revenue generated by income taxes finances government actions and programs as determined by federal and state budgets. The Internal Revenue Service (IRS) calls income from sources other than a job, such as investment income, “unearned income.”
Taxable Income
Income from wages, salaries, interest, dividends, business income, capital gains and pensions received during a given tax year are considered taxable income in the United States. Other taxable income includes annuity payments, rental income, farming and fishing income, unemployment compensation, retirement plan distributions and stock options. Lesser known taxable income includes gambling income, bartending income and jury duty pay.
136
Shares Outstanding
Shares outstanding are all the shares of a corporation or financial asset that have been authorized, issued and purchased by investors and are held by them. They have rights and represent ownership in the corporation by the person who holds the shares. They are distinguished from treasury shares, which are shares held by the corporation itself and have no exercisable rights. Shares outstanding plus treasury shares together amount to the number of issued shares.
Shares outstanding can be calculated as either basic or fully diluted. The basic count is the current number of shares. Dividend distributions and voting in the general meeting of shareholders are calculated according to this number. The fully diluted shares outstanding count, on the other hand, includes diluting securities, such as warrants, capital notes or convertibles. If the company has any diluting securities, this indicates the potential future increased number of shares outstanding.
137
Treasury Stock (shares)
A treasury stock or reacquired stock is stock which is also bought back by the issuing company, reducing the amount of outstanding stock on the open market ("open market" including insiders' holdings).
Stock repurchases are used as a tax efficient method to put cash into shareholders' hands, rather than paying dividends, in jurisdictions that treat capital gains more favorably. Sometimes, companies do it when they feel that their stock is undervalued on the open market. Other times, companies do it to reduce dilution from incentive compensation plans for employees. Another motive for stock repurchase is to protect the company against a takeover threat.
The United Kingdom equivalent of treasury stock as used in the United States is treasury share. Treasury stocks in the UK refers to government bonds or gilts.
Treasury stock is not entitled to receive a dividend
Treasury stock has no voting rights
Total treasury stock can not exceed the maximum proportion of total capitalization specified by law in the relevant country
When shares are repurchased, they may either be canceled or held for reissue. If not canceled, such shares are referred to as treasury shares. Technically, a repurchased share is a company's own share that has been bought back after having been issued and fully paid.
A company cannot own itself. The possession of treasury shares does not give the company the right to vote, to exercise preemptive rights as a shareholder, to receive cash dividends, or to receive assets on company liquidation. Treasury shares are essentially the same as unissued capital and no one advocates classifying unissued share capital as an asset on the balance sheet, as an asset should have probable future economic benefits. Treasury shares simply reduce ordinary share capital.
In an efficient market, a company buying back its stock should have no effect on its price per share valuation.[citation needed] If the market fairly prices a company's shares at $50/share, and the company buys back 100 shares for $5,000, it now has $5,000 less cash but there are 100 fewer shares outstanding; the net effect should be that the underlying value of each share is unchanged. Additionally, buying back shares will improve price/earnings ratios due to the reduced number of shares (and unchanged earnings) and improve earnings per share ratios due to fewer shares outstanding (and unchanged earnings).
If the market is not efficient, the company's shares may be underpriced. In that case a company can benefit its other shareholders by buying back shares. If a company's shares are overpriced, then a company is actually hurting its remaining shareholders by buying back stock.
One other reason for a company to buy back its own stock is to reward holders of stock options. Call option holders are hurt by dividend payments, since, typically, they are not eligible to receive them. A share buyback program may increase the value of remaining shares (if the buyback is executed when shares are under-priced); if so, call option holders benefit. A dividend payment short term always decreases the value of shares after the payment, so, for stocks with regularly scheduled dividends, on the day shares go ex-dividend, call option holders always lose whereas put option holders benefit. This does not apply to unscheduled (special) dividends since the strike prices of options are typically adjusted to reflect the amount of the special dividend. Finally, if the sellers into a corporate buyback are actually the call option holders themselves, they may directly benefit from temporary unrealistically favorable pricing.
138
Issued Shares
Issued shares is a term of law and finance for the number of shares of a corporation which have been allocated (allotted) and are subsequently held by shareholders.[1][2] The act of creating new issued shares is called issuance, allocation or allotment. Allotment is simply the creation of shares and their transfer to a subscriber. After allotment, a subscriber becomes a shareholder, though usually that also requires formal entry in the share registry.[3]
The authorized capital of a company (sometimes referred to as the authorized share capital, registered capital or nominal capital, particularly in the United States) is the maximum amount of share capital that the company is authorized by its constitutional documents to issue (allocate) to shareholders. Part of the authorized capital can (and frequently does) remain unissued. The authorized capital can be changed with shareholders' approval. The part of the authorized capital which has been issued to shareholders is referred to as the issued share capital of the company.
The device of the authorized capital is used to limit or control the ability of the directors to issue or allot new shares, which may have consequences in the control of a company or otherwise alter the balance of control between shareholders. Such an issue of shares to new shareholders may also shift the profit distribution balance, for example if new shares are issued at face value and not at market value.
The requirement for a company to have a set authorized capital was abolished in Australia in 2001, and in the United Kingdom, it was abolished under the Companies Act 2006.[1]
139
Corporate Social Responsibility
Corporate social responsibility (CSR, also called corporate sustainability, sustainable business, corporate conscience, corporate citizenship or responsible business)[1] is a type of international private business self-regulation.[2] While once it was possible to describe CSR as an internal organisational policy or a corporate ethic strategy,[3] that time has passed as various international laws have been developed and various organisations have used their authority to push it beyond individual or even industry-wide initiatives. While it has been considered a form of corporate self-regulation[4] for some time, over the last decade or so it has moved considerably from voluntary decisions at the level of individual organisations, to mandatory schemes at regional, national and even transnational levels.
140
Interests of the Company
The interest of the company (sometimes company benefit or commercial benefit) is a concept that the board of directors in corporations are in most legal systems required to use their powers for the commercial benefit of the company and its members.[1] At common law, transactions which were not ostensibly beneficial to the company were set aside as being void as against the company.
141
Board of Directors
A board of directors is a recognized group of people who jointly oversee the activities of an organization, which can be either a for-profit business, nonprofit organization, or a government agency. Such a board's powers, duties, and responsibilities are determined by government regulations (including the jurisdiction's corporations law) and the organization's own constitution and bylaws. These authorities may specify the number of members of the board, how they are to be chosen, and how often they are to meet.
The board of directors appoints the chief executive officer of the corporation and sets out the overall strategic direction.
The board is accountable to, and might be subordinate to, the organization's full membership, which usually vote for the members of the board. In a stock corporation, non-executive directors are voted for by the shareholders and the board is the highest authority in the management of the corporation.
Other names include board of directors and advisors, board of governors, board of managers, board of regents, board of trustees, or board of visitors. It may also be called "the executive board" and is often simply referred to as "the board".
Typical duties of boards of directors include:[5][6]
governing the organization by establishing broad policies and setting out strategic objectives;
selecting, appointing, supporting and reviewing the performance of the chief executive (of which the titles vary from organization to organization;
the chief executive may be titled chief executive officer, president or executive director);
terminating the chief executive;
ensuring the availability of adequate financial resources;
approving annual budgets;
accounting to the stakeholders for the organization's performance;
setting the salaries, compensation and benefits of senior management;
The legal responsibilities of boards and board members vary with the nature of the organization, and between jurisdictions. For companies with publicly trading stock, these responsibilities are typically much more rigorous and complex than for those of other types.
Typically, the board chooses one of its members to be the chairman (often now called the "chair" or "chairperson"), who holds whatever title is specified in the by-laws or articles of association. However, in membership organizations, the members elect the president of the organization and the president becomes the board chair, unless the by-laws say otherwise.[7]
142
Chairman
The chairman (also chair) is the highest officer of an organized group such as a board, a committee, or a deliberative assembly. The person holding the office is typically elected or appointed by the members of the group, and the chairman presides over meetings of the assembled group and conducts its business in an orderly fashion.
In some organizations, the chairman position is also called president (or other title),[2][3] in others, where a board appoints a president (or other title), the two different terms are used for distinctly different positions.
143
Bye-Laws
A by-law (bye-law, bylaw, byelaw) is a rule or law established by an organization or community to regulate itself, as allowed or provided for by some higher authority. The higher authority, generally a legislature or some other government body, establishes the degree of control that the by-laws may exercise. By-laws may be established by entities such as a business corporation, a neighborhood association, or depending on the jurisdiction, a municipality.
Bylaws widely vary from organization to organization, but generally cover topics such as...
1. the purpose of the organization, who are its members,
2, how directors are elected,
3. how meetings are conducted, and
4. what officers the organization will have and a description of their duties.
A common mnemonic device for remembering the typical articles in bylaws is
NOMOMECPA
pronounced "No mommy, see pa!"
```
It stands for
Name,
Object,
Members,
Officers,
Meetings,
Executive board,
Committees,
Parliamentary authority,
Amendment.
```
Organizations may use a book such as Robert's Rules of Order Newly Revised for guidelines on the content of their bylaws.[12] This book has a sample set of bylaws of the type that a small, independent society might adopt.
The wording of the bylaws has to be precise. Otherwise, the meaning may be open to interpretation. In such cases, the organization decides how to interpret its bylaws and may use guidelines for interpretation.
144
Articles of Incorporation (association)
Articles of incorporation, also referred to as the certificate of incorporation or the corporate charter, are a document or charter that establishes the existence of a corporation in the United States and Canada. They generally are filed with the Secretary of State or other company registrar.
An equivalent term for limited liability companies (LLCs) in the United States is articles of organization. For terms with similar meaning in other countries, see articles of association.
Articles of Association
In corporate governance, a company's articles of association (AoA, called articles of incorporation in some jurisdictions) is a document which, along with the memorandum of association (in cases where the memorandum exists) form the company's constitution, defines the responsibilities of the directors, the kind of business to be undertaken, and the means by which the shareholders exert control over the board of directors.
It refers to that document of the company in which rules of internal management to achieve the objective laid down in the memorandum of association are stated.
Articles of Organization
The articles of organization are a document similar to the articles of incorporation, outlining the initial statements required to form a limited liability company (LLC) in many U.S. states. Some states refer to articles of organization as a certificate of organization or a certificate of formation.[1] Once filed and approved by the Secretary of State, or other company registrar, the articles of organization legally create the LLC as a registered business entity within the state.
Operating agreement
An operating agreement is a key document used by LLCs because it outlines the business' financial and functional decisions including rules, regulations and provisions. The purpose of the document is to govern the internal operations of the business in a way that suits the specific needs of the business owners. Once the document is signed by the members of the limited liability company, it acts as an official contract binding them to its terms. Many states in the United States require an LLC to have an operating agreement. LLCs operating without an operating agreement are governed by the state's default rules contained in the relevant statute and developed through state court decisions. An operating agreement is similar in function to corporate by-laws, or analogous to a partnership agreement in multi-member LLCs.
145
Bye-Law Enforcement Officer
A bylaw enforcement officer is a law enforcement employee of a municipality, county or regional district, charged with the enforcement of non-criminal bylaws, rules, laws, codes or regulations enacted by local governments.
This terminology is commonly used in Canada and some other Commonwealth countries. In the Canadian province of Ontario, bylaw enforcement officers are generally titled municipal law enforcement officers, and in Newfoundland & Labrador, the term municipal enforcement officer is also used.
Municipalities in the United States more frequently use the terms code enforcement officer or municipal regulations officer, although code enforcement officers in the United States often have a narrower scope of duties than municipal bylaw enforcement officers in Canada. Code enforcement officers in the United States are more like property standards officers in Canada. In the United Kingdom, the word warden is commonly used to describe various classes of non-police enforcement officers, and sometimes the title of inspector is also used in various jurisdictions. An environmental warden in Edinburgh, Scotland has duties very similar to those of a bylaw enforcement officer employed by a similar-sized city in Canada.
In Australia, the terms law enforcement officer, Shire Ranger or local laws officer are used for general-duty bylaw enforcement, traffic officer for parking enforcement only, and animal management officer (formerly known as ranger or council ranger) for animal-related enforcement.
Today, all bylaw enforcement officers employed in Canada are de facto Peace Officers; in numerous provinces, bylaw officers are also de jure Peace Officers for the purpose of enforcing municipal laws, having been sworn under various Police Acts. Courts have ruled on several occasions, most recently in 2000 (in R. v. Turko), that the definition of Peace Officer under section 2 of the Criminal Code of Canada includes bylaw officers as "other person[s] employed for the preservation or maintenance of the public peace or for the service or execution of civil process."[4] As such, while actually engaged in the execution of their duties, Bylaw Enforcement Officers are Peace Officers, independent of whether they are sworn or unsworn constables.
146
Police Officer
A police officer is a warranted law employee of a police force.
The more general term for the function is law enforcement officer or peace officer. A sheriff is typically the top police officer of a county, with that word coming from the person enforcing law over a shire.[5] A person who has been deputized to serve the function of the sheriff is referred to as the deputy.
Police officers are generally charged with the apprehension of criminals and the prevention and detection of crime, protection and assistance of the general public, and the maintenance of public order. Police officers may be sworn to an oath, and have the power to arrest people and detain them for a limited time, along with other duties and powers. Some officers are trained in special duties, such as counter-terrorism, surveillance, child protection, VIP protection, civil law enforcement, and investigation techniques into major crime including fraud, rape, murder, and drug trafficking. Although many police officers wear a corresponding uniform, some police officers are plain-clothed in order to dissimulate as ordinary. In most countries police officers are given exemptions from certain laws to perform their duties. For example a officer may used force if necessary to arrest or detain a person when it would ordinarily be assault. Officers can also break road rules to perform their duties.[
147
Sheriff
A sheriff is a government official, with varying duties, existing in some countries with historical ties to England, where the office originated. There is an analogous although independently developed office in Iceland that is commonly translated to English as sheriff, and this is discussed below.
Historically, a sheriff was a legal official with responsibility for a shire, the term being a contraction of "shire reeve" (Old English scīrgerefa). In British English, the political or legal office of a sheriff, term of office of a sheriff, or jurisdiction of a sheriff, is called a shrievalty[1] in England and Wales, and a sheriffdom[2] in Scotland.
The Old English term designated a royal official (a reeve) responsible for keeping the peace throughout a shire or county on behalf of the king.[4] The term was preserved in England notwithstanding the Norman Conquest.
148
Reeve (England)
Originally in Anglo-Saxon England the reeve was a senior official with local responsibilities under the Crown, e.g., as the chief magistrate of a town or district. Subsequently, after the Norman conquest, it was an office held by a man of lower rank, appointed as manager of a manor and overseer of the peasants. In this later role, historian H. R. Loyn observes, "he is the earliest English specialist in estate management."
Before the Conquest, a reeve (Old English ġerēfa; similar to the titles greve/gräfe in the Low Saxon languages of Northern Germany) was an administrative officer who generally ranked lower than the ealdorman or earl. The Old English word ġerēfa was originally a general term, but soon acquired a more technical meaning.
Land was divided into a large number of hides—an area containing enough farmable land to support one household. Ten hides constituted a tithings, and the families living upon it (in theory, 10 families) were obliged to undertake an early form of neighbourhood watch, by a collective responsibility system called frankpledge.
Tithings were organised into groups of 10, called hundreds due to containing 100 hides; in modern times, these ancient hundreds still mostly retain their historic boundaries, despite each generally now containing vastly more than a mere 100 families. Each hundred was supervised by a constable, and groups of hundreds were combined to form shires, with each shire being under the control of an earl. Each unit had a court, and an officer to implement decisions of that court: the reeve.
```
Thus different types of reeves were attested, including...
high-reeve,
town-reeve,
port-reeve,
shire-reeve (predecessor to the sheriff,
reeve of the hundred,
and the reeve of a manor.
```
After the Norman conquest, feudalism was introduced, forming a parallel administrative system to the local courts. The feudal system organised land on a manorial basis, with stewards acting as managers for the landlords. The Norman term describing the court functionary—bailiff—came to be used for reeves associated with lower level courts, and with the equivalent role in the feudal courts of landlords.
Courts fulfilled administrative, as well as judicial, functions, and on the manorial level its decisions could concern mundane field management, not just legal disputes. The manorial bailiff thus could be set tasks such as ensuring certain crops were gathered, as well as those like enforcing debt repayment. Sometimes, bailiffs would have assistants to carry out these tasks, and the term reeve now came to be used for this position—someone essentially assisting the steward, and sometimes a bailiff, by effectively performing day-to-day supervision of the work done on the land within a particular manor.
This reeve has been described as "the pivot man of the manorial system". He had to oversee the work which the peasants were bound to perform, as an obligation attached to their holding of land in the Manor, for the lord of the manor on the demesne land; such reeves acted generally as the overseer of the serfs and peasants on the estate. He was also responsible for many aspects of the finances of the manor such as the sale of produce, collection of monies and payment of accounts.
He was usually himself a peasant, and was chosen once a year, generally at Michaelmas. In some manors the reeve was appointed by the lord of the manor, but in others he was elected by the peasants, subject or not to a right of veto by the lord. It depended on the custom of the manor, but there was an increasing tendency for election to be favoured. No doubt an elected reeve was more willingly obeyed, and sometimes the peasants generally would be made financially liable if an elected reeve defaulted.[3]
Although this reeve was subject to the steward, the steward might not always be resident within the manor, and may manage many, and would not usually concern himself with day-to-day working. A good reeve who carried out his duties efficiently, and was trusted by the lord and the peasants alike, was likely to stay in office more or less permanently. By the 14th century the reeve was often a permanent officer of the manor.
With the subsequent decline of the feudal system, and the subversion of its courts by the introduction of Justices of the Peace (magistrates), this use of reeve fell out of practice.
149
Steward (office)
A steward is an official who is appointed by the legal ruling monarch to represent them in a country, and may have a mandate to govern it in their name; in the latter case, synonymous with the position of regent, vicegerent, viceroy (for Romance languages), governor, or deputy (the Roman rector, praefectus or vicarius).
From Old English stíweard, stiȝweard, from stiȝ "hall, household" + weard "warden, keeper"; corresponding to Dutch: stadhouder, German Statthalter "place holder", a Germanic parallel to French lieutenant.
The Old English term stíweard is attested from the 11th century. Its first element is most probably stiȝ- "house, hall" (attested only in composition; its cognate stiȝu is the ancestor of Modern English sty). Old French estuard and Old Norse stívarðr are adopted from the Old English.
In medieval times, the steward was initially a servant who supervised both the lord's estate and his household. However over the course of the next century, other household posts arose and involved more responsibilities. This meant that in the 13th century, there were commonly two stewards in each house—one who managed the gang estate and the other, the majordomo, to manage domestic routine. Stewards commonly earned up to 3 to 4 pounds per year. Stewards took care of their lord's castles when they were away. Also, stewards checked on the taxes of the serfs on his lord's manor.
150
Estate (historical)
Historically, an estate comprises the houses, outbuildings, supporting farmland, and woods that surround the gardens and grounds of a very large property, such as a country house or mansion. It is the modern term for a manor, but lacks a manor's now-abolished jurisdictional authority. It is an "estate" because the profits from its produce and rents are sufficient to support the household in the house at its center, formerly known as the manor house. Thus, "the estate" may refer to all other cottages and villages in the same ownership as the mansion itself, covering more than one former manor. Examples of such great estates are Woburn Abbey in Bedfordshire, England, and Blenheim Palace, in Oxfordshire, England, built to replace the former manor house of Woodstock.
"Estate", with its "stately home" connotations, has been a natural candidate for inflationary usage during the 20th century. The term estate properly alludes to estates comprising several farms, and is not well used to describe a single farm.
More generally and usually in modern times, an estate is any large packet of land in single ownership.
In the United States: Long Island, Westchester County, Bar Harbor on Mount Desert Island, and other affluent East Coast enclaves; the San Francisco Bay Area, early Beverly Hills, California, Montecito, California and other affluent West Coast enclaves are estates;[dubious – discuss] all had strong traditions of large agricultural, grazing, and productive estates modeled on those in Europe. However, by the late 1940s and early 1950s, many had been demolished and subdivided, in some cases resulting in suburban villages named for the former owners, as in Baxter Estates, New York.
Today large houses on at least several acres are often referred to as "estates", in a contemporary updating of the word's usage. In some real estate ventures however, the term's application is stretched, as in Jamaica Estates, Queens and others.
151
Municipality
A municipality is usually a single urban administrative division having corporate status and powers of self-government or jurisdiction as granted by national and state laws to which it is subordinate. It is to be distinguished (usually) from the county, which may encompass rural territory or numerous small communities such as towns, villages and hamlets.
The term municipality may also mean the governing or ruling body of a given municipality.[1] A municipality is a general-purpose administrative subdivision, as opposed to a special-purpose district.
The term is derived from French municipalité and Latin municipalis.[2] The English word municipality derives from the Latin social contract municipium (derived from a word meaning "duty holders"), referring to the Latin communities that supplied Rome with troops in exchange for their own incorporation into the Roman state (granting Roman citizenship to the inhabitants) while permitting the communities to retain their own local governments (a limited autonomy).
Powers of municipalities range from virtual autonomy to complete subordination to the state. Municipalities may have the right to tax individuals and corporations with income tax, property tax, and corporate income tax, but may also receive substantial funding from the state.
In various countries, municipalities are usually referred to as "communes", notably in Romance languages (derived from Latin) such as French commune (France, French-speaking areas of Belgium and Switzerland, French-speaking countries of Africa, e.g. Benin), Italian comune, Romanian comună, and Spanish comuna (Chile), and in Germanic languages such as German Kommune (in political parlance, the official term being Gemeinde), Swedish kommun, Faroese kommuna, and Norwegian, Danish kommune. However, in Moldova and Romania exists both municipalities (municipiu; urban administrative units) and communes (comună; rural units), and a commune may be part of a municipality (see more: communes of Moldova, communes of Romania).
152
Unfunded Liability
An Unfunded Liability is any liability that does not have savings set aside for it.
or...
Future payment obligations exceed the expected future stream of income or funding.
Debt payments owed exceed income minus operating expenses.
Profits are insufficient to pay debt service.
A liability is a future debt or performance obligation that one party owes to another at some future date in time. It is commonly settled through a payment or performance of a service.
In respect to governments, an unfunded liability is simply a future financial commitment that has not yet been paid for. By some accounts the Canadian government has well over a $1 trillion dollars in unfunded liabilities.
Two major unfunded liabilities in Canada are found in our health care system and pension plans.
153
NPV
NET-PRESENT-VALUE
Net Present Value (NPV)
What is Net Present Value (NPV)?
Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.
———————————————-
A positive net present value indicates that the projected earnings generated by a project or investment - in present dollars - exceeds the anticipated costs, also in present dollars. It is assumed that an investment with a positive NPV will be profitable, and an investment with a negative NPV will result in a net loss.
How to Calculate Net Present Value (NPV)
Money in the present is worth more than the same amount in the future due to inflation and to earnings from alternative investments that could be made during the intervening time. In other words, a dollar earned in the future won’t be worth as much as one earned in the present. The discount rate element of the NPV formula is a way to account for this.
————————————————
DISCOUNT RATE AND ALTERNATIVE INVESTMENTS
If one investment is “guaranteed” to result in a 5% return in a year, and another may possibly return 8% in a year with more risk, then the investor must “discount” 5% from 8% to get 3% which is the “additional potential return” for (accepting added risk). The investor must “decide” whether or not the “added risk” is “worth 3%” more on his investment.
This decision space is the nature of the bet.
An investor might be willing to wait a year to earn an extra 5%, but that may not be acceptable for all investors. In this case, the 5% is the discount rate which will vary depending on the investor. If an investor knew they could earn 8% from a relatively safe investment over the next year, they would not be willing to postpone payment for 5%. In this case, the investor’s discount rate is 8%.
A company may determine the discount rate using the expected return of other projects with a similar level of risk or the cost of borrowing money needed to finance the project. For example, a company may avoid a project that is expected to return 10% per year if it costs 12% to finance the project or an alternative project is expected to return 14% per year.
Imagine a company can invest in equipment that will cost $1,000,000 and is expected to generate $25,000 a month in revenue for five years. The company has the capital available for the equipment and could alternatively invest it in the stock market for an expected return of 8% per year. The managers feel that buying the equipment or investing in the stock market are similar risks.
———————————————-
What is the Net Present Value Rule?
The net present value rule is the idea that company managers and investors should only invest in projects or engage in transactions that have a positive net present value (NPV). They should avoid investing in projects that have a negative net present value. It is a logical outgrowth of net present value theory.
———————————————-
What is Net Present Value (NPV)?
The difference between the current value of cash inflows and the current value of cash outflows, the NPV sees utilisation in capital budgeting when an analysis on a projected investment or financed venture is called for or simply necessary.
In general, when an investment shows a positive net present value, it is deemed as highly profitable. A positive NPV indicates that the projected future returns on investment generated by the projected or financed venture will be higher than the expected costs. It follows, then, that a negative NPV means net loss.
This premise is the core of the net present value rule, which dictates that if one expects good returns of investment, only take up prospective business/investment ventures with positive NPV values.
Remember that sometimes, determining the value of a prospective venture can become quite complex, since there are a number of ways to arrive at a measurement of the value of future cash flows.
This complexity might be brought about by earnings that could be made during the course of the intervening time, and because of inflation—a very real, and very important factor that needs to be accounted for when trying to determine the NPV.
To mitigate possible complexities in determining the net present value, account for the discount rate of the NPV formula. Bear in mind that different businesses and companies also have different methods in arriving at a discount rate, probably because each business accounts for their own specific business situation and investment realities.
————————————————————
154
Shares Outstanding
What Are Shares Outstanding?
Shares outstanding refer to a company's stock currently held by all its shareholders, including share blocks held by institutional investors and restricted shares owned by the company’s officers and insiders. Outstanding shares are shown on a company’s balance sheet under the heading “Capital Stock.” The number of outstanding shares is used in calculating key metrics such as a company’s market capitalization, as well as its earnings per share (EPS) and cash flow per share (CFPS). A company's number of outstanding shares is not static and may fluctuate wildly over time.
Understanding Shares Outstanding
Any authorized shares that are held by or sold to a corporation’s shareholders, exclusive of treasury stock which is held by the company itself, are known as outstanding shares. In other words, the number of shares outstanding represents the amount of stock on the open market, including shares held by institutional investors and restricted shares held by insiders and company officers.
A company’s outstanding shares can fluctuate for a number of reasons. The number will increase if the company issues additional shares. Companies typically issue shares when they raise capital through an equity financing, or upon exercising employee stock options (ESO) or other financial instruments. Outstanding shares will decrease if the company buys back its shares under a share repurchase program.
KEY TAKEAWAYS
Shares outstanding refer to a company's stock currently held by all its shareholders, including share blocks held by institutional investors and restricted shares owned by the company’s officers and insiders.
A company's number of shares outstanding is not static and may fluctuate wildly over time.
155
Market Capitalization
What is Market Capitalization
Market capitalization refers to the total dollar market value of a company's outstanding shares of stock. Commonly referred to as "market cap," it is calculated by multiplying the total number of a company's outstanding shares by the current market price of one share. As an example, a company with 10 million shares selling for $100 each would have a market cap of $1 billion. The investment community uses this figure to determine a company's size, as opposed to using sales or total asset figures.
Using market capitalization to show the size of a company is important because company size is a basic determinant of various characteristics in which investors are interested, including risk. It is also easy to calculate. A company with 20 million shares selling at $100 a share would have a market cap of $2 billion.
Understanding Market Capitalization
Given its simplicity and effectiveness for risk assessment, market cap can be a helpful metric in determining which stocks you are interested in, and how to diversify your portfolio with companies of different sizes.
KEY TAKEAWAYS
Market capitalization refers to how much a company is worth as determined by the stock market. It is defined as the total market value of all outstanding shares.
To calculate a company's market cap, multiply the number of outstanding shares by the current market value of one share.
Companies are typically divided according to market capitalization: large-cap ($10 billion or more), mid-cap ($2 billion to $10 billion), and small-cap ($300 million to $2 billion).
156
Float
What Is Float?
In financial terms, the float is money within the banking system that is briefly counted twice due to time gaps in the registering of a deposit or withdrawal, usually due to the delay in processing paper checks. A bank credits a customer’s account as soon as a check is deposited. However, it takes some time to receive a check from the payer’s bank and record it. Until the check clears the account it's drawn on, the amount it's written for "exists" in two different places, appearing in the accounts of both the recipient’s and payer’s banks.
KEY TAKEAWAYS
The float is essentially double-counted money: a paid sum which, due to delays in processing, appears simultaneously in the accounts of the payer and the payee.
Individuals and companies alike can use float to their advantage, gaining time or earning interest before payment clears their bank.
Playing with float can spill into the realm of wire fraud or mail fraud if it involves the use of others' funds.
The Basics of Float
The Federal Reserve defines two types of float. Holdover float results from delays at the processing institution, typically due to the weekend and seasonal backlogs. Transportation float occurs due to inclement weather and air traffic delays and is, therefore, highest in the winter months.
157
Cash Reserves
What are Cash Reserves?
Cash reserves refer to the money a company or individual keeps on hand to meet short-term and emergency funding needs. Short-term investments that enable customers to quickly gain access to their money, often in exchange for a lower rate of return, can also be called cash reserves. Examples include money market funds and Treasury Bills (T-Bills).
KEY TAKEAWAYS
Cash reserves refer to the money a company or individual keeps on hand to meet emergency funding needs.
Short-term, highly liquid investments, such as money market funds and Treasury Bills, can also be called cash reserves.
Cash reserves are useful when money is needed right away for a large purchase or to cover unexpected
158
Called Up Share Capital
Called-Up Share Capital vs. Paid-Up Share Capital: An Overview
The difference between called-up share capital and paid-up share capital is that investors have already paid in full for paid-up capital. Called-up capital has not yet been completely paid, though payment has been requested by the issuing entity.
Share capital consists of all funds raised by a company in exchange for shares of either common or preferred stock. The amount of share capital or equity financing a company has can change over time. A company that plans to raise more equity and be approved to issue additional shares, thereby increasing its share capital.
Called-Up Share Capital
Depending on the jurisdiction and the business in question, some companies may issue shares to investors with the understanding they will be paid at a later date. This allows for more flexible investment terms and may entice investors to contribute more share capital than if they had to provide funds upfront. The amount of share capital shareholders owe, but have not paid, is referred to as called-up capital.
Paid-Up Share Capital
Any amount of money that has already been paid by investors in exchange for shares of stock is paid-up capital. Even if an investor has not paid in full, the amount already remitted is included as paid-up capital. All paid-up capital is listed under the shareholders' equity section of the issuing company's balance sheet.
159
Authorized Share Capital
What is Authorized Share Capital?
Authorized share capital is the number of stock units (shares) that a company can issue as stated in its memorandum of association or its articles of incorporation. Authorized share capital is often not fully used by management in order to leave room for future issuance of additional stock in case the company needs to raise capital quickly. Another reason to keep shares in the company treasury is to retain a controlling interest in the business.
Understanding Authorized Share Capital
Depending on the jurisdiction, authorized share capital is sometimes also called "authorized stock," "authorized shares" or "authorized capital stock." In order to be fully understood, authorized share capital must be viewed in a context where it relates to paid-up capital, subscribed capital and issued capital. Although all these terms are interrelated, they are not synonyms.
"Authorized share capital" is the broadest term used to describe a company's capital. It comprises every single share of every category that the company could issue if it needed or wanted to. Next, subscribed capital represents a portion of the authorized capital that potential shareholders have agreed to purchase from the company's treasury. Paid-up capital is the portion of the subscribed capital for which the company has received payment from the subscribers. Finally, issued capital is the shares that have actually been issued by the company to the shareholders.
KEY TAKEAWAYS
Authorized share capital refers to all the shares issued for a company.
Companies often hold back a portion of their authorized share capital for future financing needs.
A company's authorized share capital will not increase without shareholder approval.
Example of Authorized Share Capital
Imagine a company with authorized capital of 1 million common shares at a par value of $1 each, for a total of $1 million. However, the actual issued capital of the company is only 100,000 shares, leaving 900,000 in the company's treasury available for future issuance.
160
Earnings Per Share
What Is Earnings Per Share – EPS?
Earnings per share (EPS) is calculated as a company's profit divided by the outstanding shares of its common stock. The resulting number serves as an indicator of a company's profitability. It is common for a company to report EPS that is adjusted for extraordinary items and potential share dilution. The higher a company's EPS, the more profitable it is considered.
Formula and Calculation for EPS
The earnings per share value are calculated as the net income (also known as profits or earnings) divided by the available shares. A more refined calculation adjusts the numerator and denominator for shares that could be created through options, convertible debt, or warrants. The numerator of the equation is also more relevant if it is adjusted for continuing operations.
161
Price to earnings ratio
What Is Price-to-Earnings Ratio – P/E Ratio?
The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS). The price-to-earnings ratio is also sometimes known as the price multiple or the earnings multiple.
P/E ratios are used by investors and analysts to determine the relative value of a company's shares in an apples-to-apples comparison. It can also be used to compare a company against its own historical record or to compare aggregate markets against one another or over time.
KEY TAKEAWAYS
The price-earnings ratio (P/E ratio) relates a company's share price to its earnings per share.
A high P/E ratio could mean that a company's stock is over-valued, or else that investors are expecting high growth rates in the future.
Companies that have no earnings or that are losing money do not have a P/E ratio since there is nothing to put in the denominator.
Two kinds of P/E ratios - forward and trailing P/E - are used in practice
162
Earnings Yield
What is Earnings Yield?
The earnings yield refers to the earnings per share for the most recent 12-month period divided by the current market price per share. The earnings yield (which is the inverse of the P/E ratio) shows the percentage of how much a company earned per share. This yield is used by many investment managers to determine optimal asset allocations and is used by investors to determine which assets seem underpriced or overpriced.
KEY TAKEAWAYS
Earnings yield is 12-month earnings divided by the share price.
Earnings yield is the inverse of the P/E ratio.
Earnings yield is one indication of value, as a low ratio may indicate an overvalued stock or a high value may indicate an undervalued stock.
Growth prospects for a company are critical to consider when using earnings yield, as stocks with high growth potential are typically higher valued and thus may have a low earnings yield even as their stock prices are rising.
163
P/E Ratio vs. EPS vs. Earnings Yield
P/E Ratio vs. EPS vs. Earnings Yield: An Overview
The price/earnings (P/E) ratio, also known as an “earnings multiple,” is one of the most popular valuation measures used by investors and analysts. The basic definition of a P/E ratio is stock price divided by earnings per share (EPS). The ratio construction makes the P/E calculation particularly useful for valuation purposes, but it's tough to use intuitively when evaluating potential returns, especially across different instruments. This is where earnings yield comes in.
KEY TAKEAWAYS
The basic definition of a P/E ratio is stock price divided by earnings per share (EPS).
EPS is the bottom-line measure of a company’s profitability and it's basically defined as net income divided by the number of outstanding shares.
Earnings yield is defined as EPS divided by the stock price (E/P)
164
Dividend Yield
What Is Dividend Yield?
The dividend yield is the ratio of a company's annual dividend compared to its share price. The dividend yield is represented as a percentage and is calculated as follows:
Dividend Yield
=
Annual Dividend
Share Price
165
Dividend
```
What Is a Dividend?
A dividend is the distribution of reward from a portion of the company's earnings and is paid to a class of its shareholders. Dividends are decided and managed by the company’s board of directors, though they must be approved by the shareholders through their voting rights. Dividends can be issued as cash payments, as shares of stock, or other property, though cash dividends are the most common. Along with companies, various mutual funds and exchange traded funds (ETF) also pay dividends.
```
Basics of a Dividend
A dividend is a token reward paid to the shareholders for their investment in a company’s equity, and it usually originates from the company's net profits. While the major portion of the profits is kept within the company as retained earnings, which represent the money to be used for the company’s ongoing and future business activities, the remainder can be allocated to the shareholders as a dividend. However, at times, companies may still make dividend payments even when they don’t make suitable profits. They may do so to maintain their established track record of making regular dividend payments.
166
Retained Earnings
```
What Is Retained Earnings?
Retained earnings (RE) is the amount of net income left over for the business after it has paid out dividends to its shareholders. A business generates earnings that can be positive (profits) or negative (losses).
```
Positive profits give a lot of room to the business owner(s) or the company management to utilize the surplus money earned. Often this profit is paid out to shareholders, but it can also be re-invested back into the company for growth purposes. The money not paid to shareholders counts as retained earnings.
What Retained Earnings Tells You
Whenever a company generates surplus income, a portion of the long-term shareholders may expect some regular income in the form of dividends as a reward for putting their money in the company. Traders who look for short-term gains may also prefer getting dividend payments that offer instant gains.
KEY TAKEAWAYS
Retained earnings (RE) is the amount of net income left over for the business after it has paid out dividends to its shareholders.
The decision to retain the earnings or to distribute it among the shareholders is usually left to the company management.
A growth-focused company may not pay dividends at all or pay very small amounts, as it may prefer to use the retained earnings to finance expansion activities.
Using Retained Earnings
The following options broadly cover all possibilities on how the surplus money can be utilized:
The income money can be distributed (fully or partially) among the business owners (shareholders) in the form of dividends.
It can be invested to expand the existing business operations, like increasing the production capacity of the existing products or hiring more sales representatives.
It can be invested to launch a new product/variant, like a refrigerator maker foraying into producing air conditioners, or a chocolate cookie manufacturer launching orange- or pineapple-flavored variants.
The money can be utilized for any possible merger, acquisition, or partnership that leads to improved business prospects.
It can also be used for share buybacks.
The earnings can be used to repay any outstanding loan (debt) the business may have.
167
Dividend Per Share
What Is Dividend Per Share?
Dividend per share (DPS) is the sum of declared dividends issued by a company for every ordinary share outstanding. The figure is calculated by dividing the total dividends paid out by a business, including interim dividends, over a period of time by the number of outstanding ordinary shares issued. A company's DPS is often derived using the dividend paid in the most recent quarter, which is also used to calculate the dividend yield.
168
Share Capital
Share Capital
Share capital consists of all funds raised by a company in exchange for shares of either common or preferred shares of stock. The amount of share capital or equity financing a company has can change over time. A company that wishes to raise more equity can obtain authorization to issue and sell additional shares, thereby increasing its share capital.
169
Issued Share Capital
Issued Share Capital
Issued share capital is the total value of the shares a company elects to sell. In other words, a company may elect to only issue a portion of the total share capital with the plan of issuing more shares at a later date. Not all these shares may sell right away, and the par value of the issued capital cannot exceed the value of the authorized capital. The total par value of the shares that the company sells is called its paid share capital. This is what most people refer to when speaking about share capital. Issued share capital is simply the monetary value of the portion of shares of stock a company offers for sale to investors.
170
Paid Up Capital
Paid-Up Capital
Paid-up capital is the amount of money a company has been paid from shareholders in exchange for shares of its stock. Paid-up capital is created when a company sells its shares on the primary market, directly to investors. Paid-up capital is important because it's capital that is not borrowed. A company that is fully paid-up has sold all available shares and thus cannot increase its capital unless it borrows money by taking on debt. Paid-up capital can never exceed authorized share capital. In other words, the authorized share capital represents the upward bound on possible paid-up capital.
Characteristics of Paid-Up Capital
Paid-up capital doesn't need to be repaid, which is a major benefit of funding business operations in this manner. Also called paid-in capital, equity capital, or contributed capital, paid-up capital is simply the total amount of money shareholders have paid for shares at the initial issuance. It does not include any amount that investors later pay to purchase shares on the open market.
Paid-up capital may have costs associated with it. In capital budgeting, paid-up capital is most often referred to as equity capital. In the great debate on the relative benefits of debt versus equity, the absence of required repayment is among equity's main advantages. However, shareholders expect a certain amount of return on their investments in the form of capital gains and dividends. While the business is not required to return shareholder investment, the cost of equity capital can still be quite high.
Paid-up capital is listed under stockholder's equity on the balance sheet. This category is further subdivided into the common stock and additional paid-up capital sub-accounts. The price of a share of stock is comprised of two parts: the par value and the additional premium paid that is above the par value. The total par value of all shares sold is entered under common stock, while the remainder is assigned to the additional paid-up capital account.
Paid-up capital can be used in fundamental analysis. Companies that utilize large amounts of equity funding may carry lower amounts of debt than companies that do not. A company with a debt to equity ratio that is lower than the average for its industry may be a good candidate for investing because it indicates prudent financial practices and a decreased debt burden relative to its peers.
Finding Authorized Versus Paid-Up Capital
The amount of authorized share capital must be listed in the company's founding documents. Any time the authorized share capital changes, these changes must be documented and made public.
Paid-up capital can be found or calculated in the company's financial statements. The Securities and Exchange Commission (SEC) requires publicly traded companies to disclose all sources of funding to the public.
171
Stockholders' Equity
What is Stockholders' Equity?
Stockholders' equity, also referred to as shareholders' equity, is the remaining amount of assets available to shareholders after all liabilities have been paid. It is calculated either as a firm's total assets less its total liabilities or alternatively as the sum of share capital and retained earnings less treasury shares. Stockholders' equity might include common stock, paid-in capital, retained earnings and treasury stock.
Understanding Stockholders' Equity
Stockholders' equity is often referred to as the book value of the company and it comes from two main sources. The first source is the money originally and subsequently invested in the company through share offerings. The second source consists of the retained earnings the company accumulates over time through its operations. In most cases, especially when dealing with companies that have been in business for many years, retained earnings is the largest component.
KEY TAKEAWAYS
Stockholders' equity refers to the assets remaining in a business once all liabilities have been settled.
This figure is calculated by subtracting total liabilities from total assets; alternatively, it can be calculated by taking the sum of share capital and retained earnings, less treasury stock.
A negative stockholders' equity may indicate an impending bankruptsey..
172
Paid-In Capital
What Is Paid-In Capital?
Paid-in capital is the amount of capital "paid in" by investors during common or preferred stock issuances, including the par value of the shares themselves plus amounts in excess of par value. Paid-in capital represents the funds raised by the business through selling its equity and not from ongoing business operations.
Paid-in capital also refers to a line item on the company's balance sheet listed under stockholders' equity, often shown alongside the line item for additional paid-in capital.
KEY TAKEAWAYS
Paid-in capital is the full amount of cash or other assets that shareholders have given a company in exchange for stock, par value plus any amount paid in excess.
Additional paid-in capital refers to only the amount in excess of a stock's par value.
Paid-in capital is reported in the shareholder’s equity section of the balance sheet.
It is usually split into two different line items: common stock (par value) and additional paid-in capital.
173
Time Value of Money
The time value of money is the greater benefit of receiving money now rather than an identical sum later. It is founded on time preference.
The time value of money explains why interest is paid or earned: interest, whether it is on a bank deposit or debt, compensates the depositor or lender for the time value of money.
It also underlies investment. Investors are willing to forgo spending their money now only if they expect a favorable return on their investment in the future, such that the increased value to be available later is sufficiently high to offset the preference to have money now
174
Discounted Cash Flow
In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money.
To apply the method, all future cash flows are estimated and discounted by using cost of capital to give their present values (PVs). The sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value of the cash flows in question.
Discounted cash flow analysis is widely used in investment finance, real estate development, corporate financial management and patent valuation. It was used in industry as early as the 1700s or 1800s, widely discussed in financial economics in the 1960s, and became widely used in U.S. courts in the 1980s and 1990s.
————————————
The time value of money is the greater benefit of receiving money now rather than an identical sum later. It is founded on time preference.
The time value of money explains why interest is paid or earned: interest, whether it is on a bank deposit or debt, compensates the depositor or lender for the time value of money.
It also underlies investment. Investors are willing to forgo spending their money now only if they expect a favorable return on their investment in the future, such that the increased value to be available later is sufficiently high to offset the preference to have money now
————————————
PRESENT ASSET VALUE determined by calculating future income from asset sales.
ASSET VALUE
Process and System Efficiencies derived from technologies.
Process and System Efficiencies derived from knowledge architecture.
Services derived from conceptual knowledge. (Consulting Model)
Security and protection of assets and its values. (Property Rights)
Discounted Cash Flow is a method of estimating what an asset is worth today by using projected cash flows. It tells you how much money you can spend on the investment right now in order to get the desired return in the future. Whether you want to calculate the value of another business, a bond, stock, real estate, equipment, or any long-term asset, discounted cash flow calculation can help determine if an investment is worthwhile.
175
Discounting
Discounting is a financial mechanism in which a debtor obtains the right to delay payments to a creditor, for a defined period of time, in exchange for a charge or fee.[1] Essentially, the party that owes money in the present purchases the right to delay the payment until some future date.[2] The discount, or charge, is the difference between the original amount owed in the present and the amount that has to be paid in the future to settle the debt.[1]
The discount is usually associated with a discount rate, which is also called the discount yield.[1][2][3] The discount yield is the proportional share of the initial amount owed (initial liability) that must be paid to delay payment for 1 year.
Discount yield
=
Charge to delay payment for 1 year
debt liability
{\displaystyle {\text{Discount yield}}={\frac {\text{Charge to delay payment for 1 year}}{\text{debt liability}}}}
Since a person can earn a return on money invested over some period of time, most economic and financial models assume the discount yield is the same as the rate of return the person could receive by investing this money elsewhere (in assets of similar risk) over the given period of time covered by the delay in payment.[1][2] The concept is associated with the opportunity cost of not having use of the money for the period of time covered by the delay in payment. The relationship between the discount yield and the rate of return on other financial assets is usually discussed in economic and financial theories involving the inter-relation between various market prices, and the achievement of Pareto optimality through the operations in the capitalistic price mechanism,[2] as well as in the discussion of the efficient (financial) market hypothesis.[1][2][4] The person delaying the payment of the current liability is essentially compensating the person to whom he/she owes money for the lost revenue that could be earned from an investment during the time period covered by the delay in payment.[1] Accordingly, it is the relevant "discount yield" that determines the "discount", and not the other way around.
176
Forward Discount
A currency trades at a forward discount when its forward price is lower than its spot price.
A forward discount is a term that denotes a condition in which the forward or expected future price for a currency is less than the spot price. It is an indication by the market that the current domestic exchange rate is going to decline against another currency.
178
Pareto efficiency or Pareto optimality
Pareto efficiency or Pareto optimality is a state of allocation of resources from which it is impossible to reallocate so as to make any one individual or preference criterion better off without making at least one individual or preference criterion worse off. The concept is named after Vilfredo Pareto (1848–1923), Italian engineer and economist, who used the concept in his studies of economic efficiency and income distribution.
The Pareto frontier is the set of all Pareto efficient allocations, conventionally shown graphically. It also is variously known as the Pareto front or Pareto set.
A Pareto improvement is a change to a different allocation that makes at least one individual or preference criterion better off without making any other individual or preference criterion worse off, given a certain initial allocation of goods among a set of individuals. An allocation is defined as "Pareto efficient" or "Pareto optimal" when no further Pareto improvements can be made, in which case we are assumed to have reached Pareto optimality.
"Pareto efficiency" is considered as a minimal notion of efficiency that does not necessarily result in a socially desirable distribution of resources: it makes no statement about equality, or the overall well-being of a society.[2][3]:46–49 It is simply a statement of impossibility of improving one variable without harming other variables in the subject of multi-objective optimization (also termed Pareto optimization).
179
Productive efficiency
Productive efficiency (or production efficiency) is a situation in which the economy or an economic system (e.g., a firm, a bank, a hospital, an industry, a country, etc.) could not produce any more of one good without sacrificing production of another good and without improving the production technology.[1] In other words, productive efficiency occurs when a good or a service is produced at the lowest possible cost.
180
Allocative efficiency
Allocative efficiency is a state of the economy in which production represents consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing.
In contract theory, allocative efficiency is achieved in a contract in which the skill demanded by the offering party and the skill of the agreeing party are the same.
181
Marginal Costs
A conventional marginal cost is incremented by one unit; that is, it is the cost of producing one more unit of a good.
Example.
To build one automobile requires hiring engineers and staff, building a plant and offices, and buying resources to build the car. So if only “one car” is built, the cost of producing that single car would include everything needed to design and build one car. This is marginal cost as opposed to fixed cost.
But, the cost of building an additional car only includes resources and labor to build an extra car because all other “fixed costs” have already been incurred.
Then, if the plant build 10,000 cars, the fixed and marginal costs would be divided between all cats, reducing the overall cost per car down to its marginal cost plus a 1/10,000 % share of the fixed costs.
182
purchasing power parity
The name "purchasing power parity" comes from the idea that, with the right exchange rate, consumers in every location will have the same purchasing power.
Purchasing power parity (PPP) is a term that measures prices in different areas using a specific good or goods to contrast the absolute purchasing power between different currencies. In many cases, PPP produces an inflation rate that is equal to the price of the basket of goods at one location divided by the price of the basket of goods at a different location. The PPP inflation and exchange rate may differ from the market exchange rate because of poverty, tariffs and other frictions. PPP exchange rates are widely used when comparing the GDP of different countries.[1]
183
Exchange Rate
In finance, an exchange rate is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country's currency in relation to another currency.[1] For example, an interbank exchange rate of 114 Japanese yen to the United States dollar means that ¥114 will be exchanged for each US$1 or that US$1 will be exchanged for each ¥114. In this case it is said that the price of a dollar in relation to yen is ¥114, or equivalently that the price of a yen in relation to dollars is $1/114.The government has the authority to change exchange rate when needed.
184
Forward exchange rate
The forward exchange rate (also referred to as forward rate or forward price) is the exchange rate at which a bank agrees to exchange one currency for another at a future date when it enters into a forward contract with an investor.[1][2][3] Multinational corporations, banks, and other financial institutions enter into forward contracts to take advantage of the forward rate for hedging purposes.[
185
Spot exchange rate
A foreign exchange spot transaction, also known as FX spot, is an agreement between two parties to buy one currency against selling another currency at an agreed price for settlement on the spot date. The exchange rate at which the transaction is done is called the spot exchange rate.
186
Spot date
In finance, the spot date of a transaction is the normal settlement day when the transaction is carried out as soon as practical, i.e. "on the spot".[1] This kind of transaction is called a "spot transaction" or simply "spot", and is often described as such in contrast to a transaction which is not settled immediately, such as a futures contract or a forward contract.
187
Settlement date
The spot settlement date may be different for different types of financial transactions, based on market practice. For example, in the foreign exchange market, spot is normally two banking days forward for the currency pair traded.
Other settlement dates are also possible. Standard settlement dates are calculated from the spot date. For example, a one-month foreign exchange forward settles one month after the spot date—i.e., if today is 1 February, the spot date is 3 February and the one-month date is 3 March, assuming these dates are all business days. For a trade with two dates, such as a foreign exchange swap, the first date is usually taken as the spot date.
188
Purchasing power
Purchasing power is the amount of goods and services that can be purchased with a unit of currency. For example, if one had taken one unit of currency to a store in the 1950s, it would have been possible to buy a greater number of items than would be the case today, indicating that the currency had a greater purchasing power in the 1950s. Currency can be either a commodity money, like gold or silver, or fiat money emitted by government sanctioned agencies.
If one's monetary income stays the same, but the price level increases, the purchasing power of that income falls. Inflation does not always imply falling purchasing power of one's money income since the latter may rise faster than the price level. A higher real income means a higher purchasing power since real income refers to the income adjusted for inflation.
Traditionally, the purchasing power of money depended heavily upon the local value of gold and silver, but was also made subject to the availability and demand of certain goods on the market.[1] Most modern fiat currencies like US dollars are traded against each other and commodity money in the secondary market for the purpose of international transfer of payment for goods and services.
As Adam Smith noted, having money gives one the ability to "command" others' labor, so purchasing power to some extent is power over other people, to the extent that they are willing to trade their labor or goods for money or currency.
189
ROI
Return on investment (ROI) is a ratio between net profit (over a period) and cost of investment (resulting from an investment of some resources at a point in time). A high ROI means the investment's gains compare favorably to its cost. As a performance measure, ROI is used to evaluate the efficiency of an investment or to compare the efficiencies of several different investments.[1] In economic terms, it is one way of relating profits to capital invested.
190
Capital
In economics, capital consists of assets that can enhance one's power to perform economically useful work. For example, in a fundamental sense a stone or an arrow is capital for a hunter-gatherer who can use it as a hunting instrument, while roads are capital for inhabitants of a city.
Adam Smith defines capital as "that part of man's stock which he expects to afford him revenue".
Capital goods, real capital, or capital assets are already-produced, durable goods or any non-financial asset that is used in production of goods or services.[1]
Capital is distinct from land (or non-renewable resources) in that capital can be increased by human labor. At any given moment in time, total physical capital may be referred to as the capital stock (which is not to be confused with the capital stock of a business entity).
Capital is an input in the production function. Homes and personal autos are not usually defined as capital but as durable goods because they are not used in a production of saleable goods and services.
Marxian economics distinguishes between different forms of capital:
constant capital, which refers to capital goods
variable capital, which refers to labor-inputs, where the cost is "variable" based on the amount of wages and salaries are paid throughout the duration of an employee's contract/employment,
fictitious capital, which refers to intangible representations or abstractions of physical capital, such as stocks, bonds and securities (or "tradable paper claims to wealth")
Earlier illustrations often described capital as physical items, such as tools, buildings, and vehicles that are used in the production process. Since at least the 1960s economists have increasingly focused on broader forms of capital. For example, investment in skills and education can be viewed as building up human capital or knowledge capital, and investments in intellectual property can be viewed as building up intellectual capital.
Financial capital, which represents obligations, and is liquidated as money for trade, and owned by legal entities. It is in the form of capital assets, traded in financial markets. Its market value is not based on the historical accumulation of money invested but on the perception by the market of its expected revenues and of the risk entailed.
Natural capital, which is inherent in ecologies and which increases the supply of human wealth
Social capital, which in private enterprise is partly captured as goodwill or brand value, but is a more general concept of inter-relationships between human beings having money-like value that motivates actions in a similar fashion to paid compensation.
Instructional capital, defined originally in academia as that aspect of teaching and knowledge transfer that is not inherent in individuals or social relationships but transferable. Various theories use names like knowledge or intellectual capital to describe similar concepts but these are not strictly defined as in the academic definition and have no widely agreed accounting treatment.
Human capital, a broad term that generally includes social, instructional and individual human talent in combination. It is used in technical economics to define “balanced growth”, which is the goal of improving human capital as much as economic capital.
Public capital is a blanket term that attempts to characterize physical capital that is considered infrastructure and which supports production in unclear or poorly accounted ways. This encompasses the aggregate body of all government-owned assets that are used to promote private industry productivity, including highways, railways, airports, water treatment facilities, telecommunications, electric grids, energy utilities, municipal buildings, public hospitals and schools, police, fire protection, courts and still others. However it is a problematic term insofar as many of these assets can be either publicly or privately owned.
Ecological capital is the world's stock of natural resources, which includes geology, soils, air, water and all living organisms. Some natural capital assets provide people with free goods and services, often called ecosystem services. Two of these (clean water and fertile soil) underpin our economy and society and make human life possible.
Human development theory describes human capital as being composed of distinct social, imitative and creative elements:
Social capital is the value of network trusting relationships between individuals in an economy.
Individual capital, which is inherent in persons, protected by societies, and trades labour for trust or money. Close parallel concepts are "talent", "ingenuity", "leadership", "trained bodies", or "innate skills" that cannot reliably be reproduced by using any combination of any of the others above. In traditional economic analysis individual capital is more usually called labour.
Instructional capital in the academic sense is clearly separate from either individual persons or social bonds between them.
191
Human Capital
```
Human capital infographic
Part of a series on
Economics
Index Outline Category
HistoryBranchesClassification
[show]
ConceptsTheoryTechniques
[show]
By application[show]
Notable economists[show]
Lists[show]
Glossary[show]
Emblem-money.svg Business portal
Bills and coins.svg Money portal
vte
Human capital is the stock of habits, knowledge, social and personality attributes (including creativity) embodied in the ability to perform labour so as to produce economic value.[1]
Human capital is unique and differs from any other capital. It is needed for companies to achieve goals, develop and remain innovative. Companies can invest in human capital for example through education and training enabling improved levels of quality and production.
```
Human capital, the value that the employees of a business provide through the application of skills, know-how and expertise.[15] Human capital is an organization's combined human capability for solving business problems and exploiting its intellectual property. Human capital is inherent in people and cannot be owned by an organization[16]. Therefore, human capital can leave an organization when people leave, and if the management has failed to provide a setting where others can pick up their know-how. Human capital also encompasses how effectively an organization uses its people resources as measured by creativity and Innovation.
192
Knowledge Capital
```
Knowledge management (KM) is the process of creating, sharing, using and managing the knowledge and information of an organization.[1] It refers to a multidisciplinary approach to achieving organisational objectives by making the best use of knowledge.[2]
An established discipline since 1991[citation needed], KM includes courses taught in the fields of business administration, information systems, management, library, and information sciences.[3][4] Other fields may contribute to KM research, including information and media, computer science, public health and public policy.[5] Several universities offer dedicated master's degrees in knowledge management.
Many large companies, public institutions and non-profit organisations have resources dedicated to internal KM efforts, often as a part of their business strategy, IT, or human resource management departments.[6] Several consulting companies provide advice regarding KM to these organizations.[6]
Knowledge management efforts typically focus on organisational objectives such as improved performance, competitive advantage, innovation, the sharing of lessons learned, integration and continuous improvement of the organisation.[7] These efforts overlap with organisational learning and may be distinguished from that by a greater focus on the management of knowledge as a strategic asset and on encouraging the sharing of knowledge.[2][8] KM is an enabler of organizational learning.
```
In order to profit from intellectual capital, knowledge management has become a task for management.[28] Often, intellectual capital, or at least rights to it, are moved off-shore for exploitation, which entails risks that are hard to value.[29] The transfer of rights to intellectual capital to offshore subsidiaries is a major enabler of corporate tax avoidance.
193
Intellectual Capital
Intellectual capital is the intangible value of a business, covering its people (human capital), the value relating to its relationships (relational capital), and everything that is left when the employees go home[1] (structural capital), of which intellectual property (IP) is but one component.[2] It is the sum of everything everybody in a company knows that gives it a competitive edge.[3] The term is used in academia in an attempt to account for the value of intangible assets not listed explicitly on a company's balance sheets.[
194
Structural Capital
Structural capital, the supportive non-physical infrastructure, processes and databases of the organisation that enable human capital to function.[15] Structural capital includes processes, patents, and trademarks, as well as the organization's image, organization, information system, and proprietary software and databases. Because of its diverse components, structural capital can be classified further into organization, process and innovation capital. Organizational capital includes the organization philosophy and systems for leveraging the organization's capability. Process capital includes the techniques, procedures, and programs that implement and enhance the delivery of goods and services. Innovation capital includes intellectual property such as patents, trademarks and copyrights, and intangible assets.[17] Intellectual properties are protected commercial rights such as patents, trade secrets, copyrights and trademarks. Intangible assets are all of the other talents and theory by which an organization is run.
195
Relational Capital
Relational capital, consisting of such elements as customer relationships, supplier relationships, trademarks and trade names (which have value only by virtue of customer relationships) licences, and franchises. The notion that customer capital is separate from human and structural capital indicates its central importance to an organization's worth.[18] The value of the relationships a business maintains with its customers and suppliers is also referred as goodwill, but often poorly booked in corporate accounts, because of accounting rules.
196
Workforce-in-place
A term "Workforce-in-place" can be used as a category when companies with their staff are purchased.[27] Without that category, most of the excess purchase price over the tangible book value would just appear as goodwill.
197
Good Will
The price someone is willing to pay above and beyond the fair market value of tangible and intangible assets of a company minus liabilities.
Logo, customers lists, reputation in the community are all intangible assets.
198
Business Valuation
Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to effect a sale of a business.
199
Valuation (Finance)
```
Part of a series on
Accounting
Early 19th-century German ledger
Historical cost Constant purchasing power Management Tax
Major types[show]
Key concepts[show]
Selected accounts[show]
Accounting standards[show]
Financial statements[show]
Bookkeeping[show]
Auditing[show]
People and organizations[show]
Development[show]
vte
In finance, valuation is the process of determining the present value (PV) of an asset. Valuations can be done on assets (for example, investments in marketable securities such as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., bonds issued by a company). Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability.
```
Common terms for the value of an asset or liability are market value, fair value, and intrinsic value. The meanings of these terms differ. For instance, when an analyst believes a stock's intrinsic value is greater (or less) than its market price, an analyst makes a "buy" (or "sell") recommendation. Moreover, an asset's intrinsic value may be subject to personal opinion and vary among analysts. The International Valuation Standards include definitions for common bases of value and generally accepted practice procedures for valuing assets of all types. Regardless, the valuation itself is done generally using one or more of the following approaches[1]; but see also, Outline of finance #Valuation:
Absolute value models ("Intrinsic valuation") that determine the present value of an asset's expected future cash flows. These models take two general forms: multi-period models such as discounted cash flow models, or single-period models such as the Gordon model (which, in fact, often "telescope" the former). These models rely on mathematics rather than price observation. See #Discounted cash flow valuation.
Relative value models determine value based on the observation of market prices of 'comparable' assets, relative to a common variable like earnings, cashflows, book value or sales. This result will often be used to complement / assess the intrinsic valuation. See #Relative valuation.
Option pricing models, in this context, are used to value specific balance-sheet items, or the asset itself, when these have option-like characteristics. Examples of the first type are warrants, employee stock options, and investments with embedded options such as callable bonds; the second type are usually real options. The most common option pricing models employed here are the Black–Scholes-Merton models and lattice models. This approach is sometimes referred to as contingent claim valuation, in that the value will be contingent on some other asset; see #Contingent claim valuation.
200
Cash Flow
Part of a series on
Accounting
Early 19th-century German ledger
Historical cost Constant purchasing power Management Tax
Major types[show]
Key concepts[show]
Selected accounts[show]
Accounting standards[show]
Financial statements[show]
Bookkeeping[show]
Auditing[show]
People and organizations[show]
Development[show]
vte
A cash flow is a real or virtual movement of money:
a cash flow in its narrow sense is a payment (in a currency), especially from one central bank account to another; the term 'cash flow' is mostly used to describe payments that are expected to happen in the future, are thus uncertain and therefore need to be forecast with cash flows;
a cash flow is determined by its time t, nominal amount N, currency CCY and account A; symbolically CF = CF(t,N,CCY,A).
it is however popular to use cash flow in a less specified sense describing (symbolic) payments into or out of a business, project, or financial product.
Cash flows are often transformed into measures that give information e.g. on a company's value and situation:
to determine a project's rate of return or value. The time of cash flows into and out of projects are used as inputs in financial models such as internal rate of return and net present value.
to determine problems with a business's liquidity. Being profitable does not necessarily mean being liquid. A company can fail because of a shortage of cash even while profitable.
as an alternative measure of a business's profits when it is believed that accrual accounting concepts do not represent economic realities. For instance, a company may be notionally profitable but generating little operational cash (as may be the case for a company that barters its products rather than selling for cash). In such a case, the company may be deriving additional operating cash by issuing shares or raising additional debt finance.
cash flow can be used to evaluate the 'quality' of income generated by accrual accounting. When net income is composed of large non-cash items it is considered low quality.
to evaluate the risks within a financial product, e.g., matching cash requirements, evaluating default risk, re-investment requirements, etc.
201
Accrual
Accrual (accumulation) of something is, in finance, the adding together of interest or different investments over a period of time. It holds specific meanings in accounting, where it can refer to accounts on a balance sheet that represent liabilities and non-cash-based assets used in accrual-based accounting. These types of accounts include, among others, accounts payable, accounts receivable, goodwill, deferred tax liability and future interest expense.
For example, a company delivers a product to a customer who will pay for it 30 days later in the next fiscal year, which starts a week after the delivery. The company recognizes the proceeds as a revenue in its current income statement still for the fiscal year of the delivery, even though it will not get paid until the following accounting period.[2] The proceeds are also an accrued income (asset) on the balance sheet for the delivery fiscal year, but not for the next fiscal year when cash is received.
Similarly, a salesperson, who sold the product, earned a commission at the moment of sale (or delivery). The company will recognize the commission as an expense in its current income statement, even though the salesperson will actually get paid at the end of the following week in the next accounting period. The commission is also an accrued liability on the balance sheet for the delivery period, but not for the next period when the commission (cash) is paid out to the salesperson.
The term accrual is also often used as an abbreviation for the terms accrued expense and accrued revenue that share the common name word, but they have the opposite economic/accounting characteristics.
Accrued revenue: revenue is recognized before cash is received.
Accrued expense: expense is recognized before cash is paid out.
Accrued revenue[edit]
Accrued revenue (or accrued assets) is an asset, such as unpaid proceeds from a delivery of goods or services, when such income is earned and a related revenue item is recognized, while cash is to be received in a later period, when the amount is deducted from accrued revenues.
In the rental industry, there are specialized revenue accruals for rental income which crosses month end boundaries. These are normally utilized by rental companies who charge in arrears, based on an anniversary of a contract date. For example, a rental contract which began on 15 January, being invoiced on a recurring monthly basis will not generate its first invoice until 14 February. Therefore, at the end of the January financial period an accrual must be raised for sixteen days' worth of the monthly charge. This may be a simple pro-rate basis (e.g. 16/31 of the monthly charge) or may be more complex if only week days are being charged or a standardized month is being used (e.g. 28 days, 30 days etc.)
Accrued expense[edit]
Accrued expense is a liability whose timing or amount is uncertain by virtue of the fact that an invoice has not yet been received.[3] The uncertainty of the accrued expense is not significant enough to qualify it as a provision. An example of an accrued expense is a pending obligation to pay for goods or services received from a counterpart, while cash is to be paid out in a later accounting period when the amount is deducted from accrued expenses.
The accrual method records income items when they are earned and records deductions when expenses are incurred.[4] For a business invoicing for an item sold, or work done, the corresponding amount will appear in the books even though no payment has yet been received – and debts owed by the business show as they are incurred, even though they may not be paid until much later.[5]
202
Discount Rate
DISCOUNT RATE AND OPPORTUNITY COST
DISCOUNT RATE AND ALTERNATIVE INVESTMENTS
If one investment is “guaranteed” to result in a 5% return in a year, and another may possibly return 8% in a year with more risk, then the investor must “discount” 5% from 8% to get 3% which is the “additional potential return” for (accepting added risk). The investor must “decide” whether or not the “added risk” is “worth 3%” more on his investment.
This decision space is the nature of the bet.
An investor might be willing to wait a year to earn an extra 5%, but that may not be acceptable for all investors. In this case, the 5% is the discount rate which will vary depending on the investor. If an investor knew they could earn 8% from a relatively safe investment over the next year, they would not be willing to postpone payment for 5%. In this case, the investor’s discount rate is 8%.
A company may determine the discount rate using the expected return of other projects with a similar level of risk or the cost of borrowing money needed to finance the project. For example, a company may avoid a project that is expected to return 10% per year if it costs 12% to finance the project or an alternative project is expected to return 14% per year.
Imagine a company can invest in equipment that will cost $1,000,000 and is expected to generate $25,000 a month in revenue for five years. The company has the capital available for the equipment and could alternatively invest it in the stock market for an expected return of 8% per year. The managers feel that buying the equipment or investing in the stock market are similar risks.
203
Counter Party
COUNTER PARTY
KEY TAKEAWAYS
A counterparty is simply the other side of a trade - a buyer is the counterparty to a seller.
A counterparty can include deals between individuals, businesses, governments, or any other organization.
Counterparty risk is the risk that the other side of the trade will be unable to fulfill their end of the transaction. However, in many financial transactions, the counterparty is unknown and the counterparty risk is mitigated through the use of clearing firms.
What is a Counterparty?
A counterparty is the other party that participates in a financial transaction, and every transaction must have a counterparty in order for the transaction to go through. More specifically, every buyer of an asset must be paired up with a seller who is willing to sell and vice versa. For example, the counterparty to an option buyer would be an option writer. For any complete trade, several counterparties may be involved (for instance a buy of 1,000 shares is filled by ten sellers of 100 shares each).
Explaining Counterparties
The term counterparty can refer to any entity on the other side of a financial transaction. This can include deals between individuals, businesses, governments, or any other organization. Additionally, both parties do not have to be on equal standing in regards to the type of entities involved. This means an individual can be a counterparty to a business and vice versa. In any instances where a general contract is met or an exchange agreement takes place, one party would be considered the counterparty, or the parties are counterparties to each other. This also applies to forward contracts and other contract types.
A counterparty introduces counterparty risk into the equation. This is the risk that the counterparty will be unable to fulfill their end of the transaction. However, in many financial transactions, the counterparty is unknown and the counterparty risk is mitigated through the use of clearing firms. In fact, with typical exchange trading, we do not ever know who our counterparty is on any trade, and often times there will be several counterparties each making up a piece of the trade.
204
Counter party risk
COUNTER PARTY RISK
What Is Counterparty Risk?
Counterparty risk is the likelihood or probability that one of those involved in a transaction might default on its contractual obligation. Counterparty risk can exist in credit, investment, and trading transactions.
KEY TAKEAWAYS
Counterparty risk is the likelihood or probability that one of those involved in a transaction might default on its contractual obligation. Counterparty risk can exist in credit, investment, and trading transactions.
The numerical value of a borrower's credit score reflects the level of counterparty risk to the lender or creditor.
Investors must consider the company that's issuing the bond, stock, or insurance policy to assess whether there's default or counterparty risk
205
Collateralized Debt Obligation
Collateralized Debt Obligation
What Is a Collateralized Debt Obligation (CDO)?
A collateralized debt obligation (CDO) is a complex structured finance product that is backed by a pool of loans and other assets and sold to institutional investors. A CDO is a particular type of derivative because, as its name implies, its value is derived from another underlying asset. These assets become the collateral if the loan defaults.
Understanding Collateralized Debt Obligations
To create a CDO, investment banks gather cash flow-generating assets—such as mortgages, bonds, and other types of debt—and repackage them into discrete classes, or tranches based on the level of credit risk assumed by the investor.
Types of CDOs
These tranches of securities become the final investment products: bonds, whose names can reflect their specific underlying assets. For example, mortgage-backed securities (MBS) are comprised of mortgage loans, and asset-backed securities (ABS) contain corporate debt, auto loans, or credit card debt. CDOs are called "collateralized" because the promised repayments of the underlying assets are the collateral that gives the CDOs their value.
Other types of CDOs include collateralized bond obligations (CBOs)—investment-grade bonds that are backed by a pool of high-yield but lower-rated bonds, and collateralized loan obligations (CLOs)—single securities that are backed by a pool of debt, that often contain corporate loans with a low credit rating.
How Are CDOs Structured?
The tranches of CDOs are named to reflect their risk profiles; for example, senior debt, mezzanine debt, and junior debt—pictured in the sample below along with their Standard and Poor's (S&P) credit ratings. But the actual structure varies depending on the individual product.
206
Credit Default Swap
Credit Default Swap
What is a Credit Default Swap (CDS)?
A credit default swap (CDS) is a financial derivative or contract that allows an investor to "swap" or offset his or her credit risk with that of another investor. For example, if a lender is worried that a borrower is going to default on a loan, the lender could use a CDS to offset or swap that risk. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse the lender in the case the borrower defaults. Most CDS will require an ongoing premium payment to maintain the contract, which is like an insurance policy.
A credit default swap is the most common form of credit derivative and may involve municipal bonds, emerging market bonds, mortgage-backed securities or corporate bonds.
Credit default swaps, or CDS, are credit derivative contracts that enable investors to swap credit risk on a company, country, or other entity with another counterparty.
Credit default swaps are the most common type of OTC credit derivatives and are often used to transfer credit exposure on fixed income products in order to hedge risk.
Credit default swaps are customized between the two counterparties involved, which makes them opaque, illiquid, and hard to track for regulators
207
Mark to Market
Mark to Market
What Are Mark-To-Market Losses?
Mark-to-market losses are losses generated through an accounting entry rather than the actual sale of a security. Mark-to-market losses can occur when financial instruments held are valued at the current market value. If a security was purchased at a certain price and the market price later fell, the holder would have an unrealized loss, and marking the security down to the new market price would result in the mark-to-market loss. Mark-to-market accounting is part of the concept of fair value accounting, which attempts to give investors more transparent and relevant information.
KEY TAKEAWAYS
Mark-to-market losses are losses generated through an accounting entry rather than the actual sale of a security.
Mark-to-market losses can occur when financial instruments held are valued at the current market value.
Assets that experience a price decline from their original cost would be revalued at the new market price leading to a mark-to-market loss.
Understanding Mark-To-Market Losses
Mark-to-market is designed to provide the current market value of a company's assets by comparing the value of the assets to the asset's value under current market conditions. Many assets fluctuate in value, and periodically, corporations must revalue their assets given the changing market conditions. Examples of these assets that have market-based prices include stocks, bonds, residential homes, and commercial real estate.
Mark-to-market helps to show a company's current financial condition within the backdrop of current market conditions. As a result, mark-to-market can often provide a more accurate measurement or valuation of a company's assets and
208
Richard Cantillon
Cantillon Effect
https://www.aier.org/article/cantillon-effects-and-money-neutrality/
The Cantillon Effect refers to the change in relative prices resulting from a change in money supply. The change in relative prices occurs because the change in money supply has a specific injection point and therefore a specific flow path through the economy. The first recipient of the new supply of money is in the convenient position of being able to spend extra dollars before prices have increased. But whoever is last in line receives his share of new dollars after prices have increased. This is why when the Treasury’s deficit is monetized, inflation is referred to as a non-legislated tax. In these cases, the government has seized purchasing power (rather than physical bills) from its citizens without congressional approval.
```
Richard Cantillon (French: [kɑ̃tijɔ̃]; 1680s – May 1734) was an Irish-French economist and author of Essai sur la Nature du Commerce en Général (Essay on the Nature of Trade in General), a book considered by William Stanley Jevons to be the "cradle of political economy".[4] Although little information exists on Cantillon's life, it is known that he became a successful banker and merchant at an early age. His success was largely derived from the political and business connections he made through his family and through an early employer, James Brydges. During the late 1710s and early 1720s, Cantillon speculated in, and later helped fund, John Law's Mississippi Company, from which he acquired great wealth. However, his success came at a cost to his debtors, who pursued him with lawsuits, criminal charges, and even murder plots until his death in 1734.
Essai remains Cantillon's only surviving contribution to economics. It was written around 1730 and circulated widely in manuscript form, but was not published until 1755. His work was translated into Spanish by Gaspar Melchor de Jovellanos, probably in the late 1770s, and considered essential reading for political economy. Despite having much influence on the early development of the physiocrat and classical schools of thought, Essai was largely forgotten until its rediscovery by Jevons in the late 19th century.[5] Cantillon was influenced by his experiences as a banker, and especially by the speculative bubble of John Law's Mississippi Company. He was also heavily influenced by prior economists, especially William Petty.
Essai is considered the first complete treatise on economics, with numerous contributions to the science. These contributions include: his cause and effect methodology, monetary theories, his conception of the entrepreneur as a risk-bearer, and the development of spatial economics. Cantillon's Essai had significant influence on the early development of political economy, including the works of Adam Smith, Anne Turgot, Jean-Baptiste Say, Frédéric Bastiat and François Quesnay.
```
209
Inflationary causes
Inflationary causes
Demand — desire or need to buy a product or service.
Scarcity — of a product or service that is in demand.
Closer to the source of money — Receive money first
It is easier to acquire money than a competitor, so you are willing to part with more of it.
You can buy low, buy first, and then sell high.
