Business Financial Terms - Definitions: Acid Test
Business Financial Terms - Definitions: Acid Test
Business Financial Terms - Definitions: Acid Test
Acid test
A stern measure of a company's ability to pay its short term debts, in that stock is excluded from
asset value. (liquid assets/current liabilities) Also referred to as the Quick Ratio.
Assets
Anything owned by the company having a monetary value; eg, 'fixed' assets like buildings, plant
and machinery, vehicles (these are not assets if rentedand not owned) and potentially including
intangibles like trade marks and brand names, and 'current' assets, such as stock, debtors and
cash.
Asset turnover
Measure of operational efficiency - shows how much revenue is produced per £ of assets
available to the business. (sales revenue/total assets less current liabilities)
Balance sheet
The Balance Sheet is one of the three essential measurement reports for the performance and
health of a company along with the Profit and Loss Account and the Cashflow Statement. The
Balance Sheet is a 'snapshot' in time of who owns what in the company, and what assets and
debts represent the value of the company. (It can only ever be a snapshot because the picture is
always changing.) The Balance Sheet is where to look for information about short-term and
long-term debts, gearing (the ratio of debt to equity), reserves, stock values (materials and
finsished goods), capital assets, cash on hand, along with the value of shareholders' funds. The
term 'balance sheet' is derived from the simple purpose of detailing where the money came from,
and where it is now. The balance sheet equation is fundamentally: (where the money came from)
Capital + Liabilities = Assets (where the money is now). Hence the term 'double entry' - for
every change on one side of the balance sheet, so there must be a corresponding change on the
other side - it must always balance. The Balance Sheet does not show how much profit the
company is making (the P&L does this), although pervious years' retained profits will add to the
company's reserves, which are shown in the balance sheet.
Budget
In a financial planning context the word 'budget' (as a noun) strictly speaking means an amount
of money that is planned to spend on a particular activity or resource. This is typically over a
trading year, although budgets apply to shorter and longer periods, and may refer to costs
allocated to projects of flexible timescales. An overall organizational plan usually contains the
budgets within it for all the different departments and costs held by them. The verb 'to budget'
means to calculate and set a budget, although in a looser context it also means to be careful with
money and find reductions (effectively by setting and maintaining a lower 'budgeted' or reduced
level of expenditure). The word budget is also more loosely used by many people to mean the
whole organizational business or operating financial plan. In this context a budget means the
same as a plan (and a business plan, or an operating plan or trading plan, etc). For example in the
UK the Government's annual plan is called 'The Budget'. A 'forecast' in certain contexts means
the same as a budget - either a planned individual activity/resource cost, or a whole business/
corporate/organizational plan. A 'forecast' more commonly (and precisely in my view) means a
prediction of performance - costs and/or revenues, or other data such as headcount, %
performance, etc., especially when the 'forecast' is made during the trading period, and normally
after the plan or 'budget' has been approved. In simple terms: budget = plan or a cost element
within a plan; forecast = updated budget or plan. The verb forms are also used, meaning the act
of calculating the budget or forecast.
Capital employed
The value of all resources available to the company, typically comprising share capital, retained
profits and reserves, long-term loans and deferred taxation. Viewed from the other side of the
balance sheet, capital employed comprises fixed assets, investments and the net investment in
working capital (current assets less current liabilities). In other words: the total long-term funds
invested in or lent to the business and used by it in carrying out its operations.
Cash flow
The movement of cash in and out of a business from day-to-day direct trading and other non-
trading or indirect effects, such as capital expenditure, tax and dividend payments.
Current assets
Cash and anything that is expected to be converted into cash within twelve months of the balance
sheet date.
Current ratio
The relationship between current assets and current liabilities, indicating the liquidity of a
business, ie its ability to meet its short-term obligations. Also referred to as the Liquidity Ratio.
Current liabilities
Money owed by the business that is generally due for payment within 12 months of balance sheet
date. Examples: creditors, bank overdraft, taxation.
Depreciation
The apportionment of cost of a (usually large) capital item over an agreed period, (based on life
expectancy or obsolescence), for example, a piece of equipment costing £10k having a life of
five years might be depreciated over five years at a cost of £2k per year. (In which case the P&L
would show a depreciation cost of £2k per year; the balance sheet would show an asset value of
£8k at the end of year one, reducing by £2k per year; and the cashflow statement would show all
£10k being used to pay for it in year one.)
Dividend
A dividend is a payment made per share, to a company's shareholders by a company, based on
the profits of the year, but not necessarily all of the profits, arrived at by the directors and voted
at the company's annual general meeting. A company can choose to pay a dividend from reserves
following a loss-making year, and conversely a company can choose to pay no dividend after a
profit-making year, depending on what is believed to be in the best interests of the company.
Keeping shareholders happy and committed to their investment is always an issue in deciding
dividend payments. Along with the increase in value of a stock or share, the annual dividend
provides the shareholder with a return on the shareholding investment.
Earnings before..
There are several 'Earnings Before..' ratios and acronyms: EBT = Earnings Before Taxes; EBIT
= Earnings Before Interest and Taxes; EBIAT = Earnings Before Interest after Taxes; EBITD =
Earnings Before Interest, Taxes and Depreciation; and EBITDA = Earnings Before Interest,
Taxes, Depreciation, and Amortization. (Earnings = operating and non-operating profits (eg
interest, dividends received from other investments). Depreciation is the non-cash charge to the
balance sheet which is made in writing off an asset over a period. Amortisation is the payment of
a loan in instalments.
Fixed assets
Assets held for use by the business rather than for sale or conversion into cash, eg, fixtures and
fittings, equipment, buildings.
Fixed cost
A cost which does not vary with changing sales or production volumes, eg, building lease costs,
permanent staff wages, rates, depreciation of capital items.
Forecast
See 'budget' above.
Gearing
The ratio of debt to equity, usually the relationship between long-term borrowings and
shareholders' funds.
Goodwill
Any surplus money paid to acquire a company that exceeds its net tangible assets value.
Gross profit
Sales less cost of goods or services sold. Also referred to as gross profit margin, or gross profit,
and often abbreviated to simply 'margin'. See also 'net profit'.
Letters of credit
These mechanisms are used by exporters and importers, and usually provided by the importing
company's bank to the exporter to safeguard the contractual expectations and particularly
financial exposure of the exporter of the goods or services. (Also called 'export letters of credit,
and 'import letters of credit'.)
When an exporter agrees to supply a customer in another country, the exporter needs to know
that the goods will be paid for.
The common system, which has been in use for many years, is for the customer's bank to issue a
'letter of credit' at the request of the buyer, to the seller. The letter of credit essentially guarantees
that the bank will pay the seller's invoice (using the customer's money of course) provided the
goods or services are supplied in accordance with the terms stipulated in the letter, which should
obviously reflect the agreement between the seller and buyer. This gives the supplier an
assurance that their invoice will be paid, beyond any other assurances or contracts made with the
customer. Letters of credit are often complex documents that require careful drafting to protect
the interests of buyer and seller. The customer's bank charges a fee to issue a letter of credit, and
the customer pays this cost.
The seller should also approve the wording of the buyer's letter of credit, and often should seek
professional advice and guarantees to this effect from their own financial services provider.
In short, a letter of credit is a guarantee from the issuing bank's to the seller that if compliant
documents are presented by the seller to the buyer's bank, then the buyer's bank will pay the
seller the amount due. The 'compliance' of the seller's documentation covers not only the goods
or services supplied, but also the timescales involved, method for, format of and place at which
the documents are presented. It is common for exporters to experience delays in obtaining
payment against letters of credit because they have either failed to understand the terms within
the letter of credit, failed to meet the terms, or both. It is important therefore for sellers to
understand all aspects of letters of credit and to ensure letters of credit are properly drafted,
checked, approved and their conditions met. It is also important for sellers to use appropriate
professional services to validate the authenticity of any unknown bank issuing a letter of credit.
Letters of guarantee
There are many types of letters of guarantee. These types of letters of guarantee are concerned
with providing safeguards to buyers that suppliers will meet their obligations or vice-versa, and
are issued by the supplier's or customer's bank depending on which party seeks the guarantee.
While a letter of credit essentially guarantees payment to the exporter, a letter of guarantee
provides safeguard that other aspects of the supplier's or customer's obligations will be met. The
supplier's or customer's bank is effectively giving a direct guarantee on behalf of the supplier or
customer that the supplier's or customer's obligations will be met, and in the event of the
supplier's or customer's failure to meet obligations to the other party then the bank undertakes the
responsibility for those obligations.
Typical obligations covered by letters of guarantee are concerned with:
Tender Guarantees (Bid Bonds) - whereby the bank assures the buyer that the supplier
will not refuse a contract if awarded.
Performance Guarantee - This guarantees that the goods or services are delivered in
accordance with contract terms and timescales.
Advance Payment Guarantee - This guarantees that any advance payment received by the
supplier will be used by the supplier in accordance with the terms of contract between seller
and buyer.
There are other types of letters of guarantee, including obligations concerning customs and tax,
etc, and as with letters of credit, these are complex documents with extremely serious
implications. For this reasons suppliers and customers alike must check and obtain necessary
validation of any issued letters of guarantee.
Liabilities
General term for what the business owes. Liabilities are long-term loans of the type used to
finance the business and short-term debts or money owing as a result of trading activities to
date . Long term liabilities, along with Share Capital and Reserves make up one side of the
balance sheet equation showing where the money came from. The other side of the balance sheet
will show Current Liabilities along with various Assets, showing where the money is now.
Liquidity ratio
Indicates the company's ability to pay its short term debts, by measuring the relationship between
current assets (ie those which can be turned into cash) against the short-term debt value. (current
assets/current liabilities) Also referred to as the Current Ratio.
Net profit
Net profit can mean different things so it always needs clarifying. Net strictly means 'after all
deductions' (as opposed to just certain deductions used to arrive at a gross profit or margin). Net
profit normally refers to profit after deduction of all operating expenses, notably after deduction
of fixed costs or fixed overheads. This contrasts with the term 'gross profit' which normally
refers to the difference between sales and direct cost of product or service sold (also referred to
as gross margin or gross profit margin) and certainly before the deduction of operating costs or
overheads. Net profit normally refers to the profit figure before deduction of corporation tax, in
which case the term is often extended to 'net profit before tax' or PBT.
Opening/closing stock
See explanation under Cost of Sales.
4. Divide the price of the stock or share by the earnings per share.
Overhead
An expense that cannot be attributed to any one single part of the company's activities.
Quick ratio
Same as the Acid Test. The relationship between current assets readily convertible into cash
(usually current assets less stock) and current liabilities. A sterner test of liquidity.
Reserves
The accumulated and retained difference between profits and losses year on year since the
company's formation.
Restricted funds
These are funds used by an organisation that are restricted or earmarked by a donor for a specific
purpose, which can be extremely specific or quite broad, eg., endowment or pensions
investment; research (in the case of donations to a charity or research organisation); or a
particular project with agreed terms of reference and outputs such as to meet the criteria or terms
of the donation or award or grant. The source of restricted funds can be from government,
foundations and trusts, grant-awarding bodies, philanthropic organisations, private donations,
bequests from wills, etc. The practical implication is that restricted funds are ring-fenced and
must not be used for any other than their designated purpose, which may also entail specific
reporting and timescales, with which the organisation using the funds must comply. A glaring
example of misuse of restricted funds would be when Maxwell spent Mirror Group pension
funds on Mirror Group development.
Return on capital employed (ROCE)
A fundamental financial performance measure. A percentage figure representing profit before
interest against the money that is invested in the business. (profit before interest and tax, divided
by capital employed, x 100 to produce percentage figure.)
Return on investment
Another fundamental financial and business performance measure. This term means different
things to different people (often depending on perspective and what is actually being judged) so
it's important to clarify understanding if interpretation has serious implications. Many business
managers and owners use the term in a general sense as a means of assessing the merit of an
investment or business decision. 'Return' generally means profit before tax, but clarify this with
the person using the term - profit depends on various circumstances, not least the accounting
conventions used in the business. In this sense most CEO's and business owners regard ROI as
the ultimate measure of any business or any business proposition, after all it's what most business
is aimed at producing - maximum return on investment, otherise you might as well put your
money in a bank savings account. Strictly speaking Return On Investment is defined as:
Profits derived as a proportion of and directly attributable to cost or 'book value' of an asset,
liability or activity, net of depreciation.
In simple terms this the profit made from an investment. The 'investment' could be the value
of a whole business (in which case the value is generally regarded as the company's total assets
minus intangible assets, such as goodwill, trademarks, etc and liabilities, such as debt. N.B. A
company's book value might be higher or lower than its market value); or the investment could
relate to a part of a business, a new product, a new factory, a new piece of plant, or any activity
or asset with a cost attached to it.
The main point is that the term seeks to define the profit made from a business investment or
business decision. Bear in mind that costs and profits can be ongoing and accumulating for
several years, which needs to be taken into account when arriving at the correct figures.
Share capital
The balance sheet nominal value paid into the company by shareholders at the time(s) shares
were issued.
Shareholders' funds
A measure of the shareholders' total interest in the company represented by the total share capital
plus reserves.
Variable cost
A cost which varies with sales or operational volumes, eg materials, fuel, commission payments.
Working capital
Current assets less current liabilities, representing the required investment, continually
circulating, to finance stock, debtors, and work in progress.