UNDERSTANDING

FINANCE
AND
ACCOUNTING
METHODS

Cash Flow Statement

A company's ability to consistently generate positive cash flows from its
daily business operations is highly valued by investors. Operating cash
flow can uncover a company's true profitability. Its one of the purest
measures of cash sources and uses, and is the gateway between other
reported financial statements.
The Cash Flow Statement
Operating cash flow (or cash flow from operations - CFO) can be found in
the cash flow statement, which reports the changes in cash versus its
static counterparts: the income statement, balance
sheet and shareholders equity statement. Specifically, the cash flow
statement reports where cash is used and generated over specific time
periods and ties the static statements together. By taking net income on
the income statement and making adjustments to reflect changes in
the working capital accounts on the balance sheet (receivables,
payables, inventories), the operating cash flow section shows how cash
was generated during the period. It is this translation process
from accrual accounting to cash accounting that makes the operating
cash flow statement so important.
The sources and uses of cash are broken down into categories of
operating, investing, financing and, in some cases, supplemental
activities.
Cash flow from operating activities is a section of the Statement of Cash
Flows that is included in a companys financial statements after the
balance sheet and income statements.
Cash flow from operating activities appears in the first section of the
Statement of Cash Flows. There are a number of different ways to
calculate cash flow from operating activities, but the American Institute of
Certified Public Accounts recommends starting with net income as stated
on the income statement. Net income is then adjusted for working capital

changes and non-cash accruals that have been made throughout the
reporting period. These adjustments include depreciation, amortization,
increases and decreases in receivables, increases and decreases in
payables, changes in inventory levels, and any expense or revenue
accruals.
Cash is the lifeblood of any business. Therefore it is very important for
managers to know how much cash has been generated from operating
activities. Knowing how much cash to expect from ongoing operating
activities helps them plan their cash flow budgeting for things like future
capital investments, hiring and operating expenses. Investors also like to
know how much cash a company generates from its ongoing activities.
Steady cash growth is indicative of an efficient, profitable, well-managed
company and thus a good investment.
What is 'Shareholders' Equity'
Shareholders' equity is equal to a firm's total assets minus its total
liabilities and is one of the most common financial metrics employed
by analysts to determine the financial health of a company. Shareholders'
equity represents the net value of a company, or the amount that would
be returned to shareholders if all the company's assets were liquidated
and all its debts repaid.

Financial Statements
What are 'Financial Statements'
Financial statements for businesses usually include income
statements, balance sheets, statements of retained earnings and cash
flows. It is standard practice for businesses to present financial
statements that adhere to generally accepted accounting principles
(GAAP) to maintain continuity of information and presentation across
international borders. Financial statements are often audited by
government agencies, accountants, firms, etc. to ensure accuracy and
for tax, financing or investing purposes.
BREAKING DOWN 'Financial Statements'
Financial analysts rely on data to analyze the performance of, and make
predictions about, the future direction of a company's stock price. One of
the most important resources of reliable and audited financial data is the
annual report, which contains the firm's financial statements. The three
main financial statements are the income statement, balance sheet and
cash flow statement.
Balance Sheet
The balance sheet provides an overview of assets, liabilities and
stockholders' equity as a snapshot in time. The date at the top of the
balance sheet tells you when the snapshot was taken, which is generally
the end of the fiscal year. The balance sheet equation is assets equals
liabilities plus stockholders' equity, because assets are paid for with
either liabilities, such as debt, or stockholders' equity, such as retained
earnings and additional paid-in capital. Assets are listed on the balance
sheet in order of liquidity. Liabilities are listed in the order in which they
will be paid. Short-term or current liabilities are expected to be paid within

the year, while long-term or noncurrent liabilities are debts expected to be

paid after one year.
Income Statement
Unlike the balance sheet, the income statement covers a range of time,
which is a year for annual financial statements and a quarter for quarterly
financial statements. The income statement provides an overview of
revenues, expenses, net income and earnings per share. It usually
provides two to three years of data for comparison.
Cash Flow Statement
The cash flow statement merges the balance sheet and the income
statement. Due to accounting convention, net income can fall out of
alignment with cash flow. The cash flow statement reconciles the income
statement with the balance sheet in three major business activities.
These activities include operating, investing and financing activities.
Operating activities include cash flows made from regular business
operations. Investing activities include cash flows due to the buying and
selling of assets such as real estate and equipment. Financing activities
include cash flows from debt and equity. This is where analysts can also
find the amount of dividends paid and/or dollar value of shares
repurchased.

Balance Sheet
What is a 'Balance Sheet'
A balance sheet is a financial statement that summarizes a company's
assets, liabilities and shareholders' equity at a specific point in time.
These three balance sheet segments give investors an idea as to what
the company owns and owes, as well as the amount invested by
shareholders.

The balance sheet adheres to the following formula:

Assets = Liabilities + Shareholders' Equity

BREAKING DOWN 'Balance Sheet'

The balance sheets gets its name from the fact that the two sides of the
equation above assets on the one side and liabilities plus shareholders'
equity on the other must balance out. This is intuitive: a company has
to pay for all the things it owns (assets) by either borrowing money
(taking on liabilities) or taking it from investors (issuing shareholders'
equity).

Assets, liabilities and shareholders' equity are each comprised of several

smaller accounts that break down the specifics of a company's finances.
These accounts vary widely by industry, and the same terms can have
different implications depending on the nature of the business. Broadly,
however, there are a few common components investors are likely to
come across.
Assets
Within the assets segment, accounts are listed from top to bottom in
order of their liquidity, that is, the ease with which they can be converted
into cash. They are divided into current assets, those which can be
converted to cash in one year or less; and non-current or long-term
assets, which cannot.
Here is the general order of accounts within current assets:

 Cash and cash equivalents: the most liquid assets, these can
include Treasury bills and short-term certificates of deposit, as well
as hard currency
Marketable securities: equity and debt securities for which there is
a liquid market
Accounts receivable: money which customers owe the company,
perhaps including an allowance for doubtful accounts (an example
of a contra account), since a certain proportion of customers can
be expected not to pay
Inventory: goods available for sale, valued at the lower of the cost
or market price
Prepaid expenses: representing value that has already been paid
for, such as insurance, advertising contracts or rent
Long-term assets include the following:
Long-term investments: securities that will not or cannot be
liquidated in the next year
Fixed assets: these include land, machinery, equipment, buildings
and other durable, generally capital-intensive assets
Intangible assets: these include non-physical, but still valuable,
assets such as intellectual property and goodwill; in general,
intangible assets are only listed on the balance sheet if they are
acquired, rather than developed in-house

The resources owned by a business can be divided into two

categories: current assets and non-current assets. Some assets are
considered liquid, meaning they can be converted into cash relatively
quickly. Other assets either cannot be converted or are not expected to
be converted into cash. Non-current assets can be considered anything
not classified as current. The primary determinant between current and
non-current assets is the anticipated timeline of their use. Current and
non-current assets are listed on the balance sheet. They appear as
separate categories before being summed and reconciled against
liabilities and equities.
Defining an Asset as Current
Current assets are expected to be sold, loaned out, leased, consumed or
otherwise used to create income within one year of the date of
the balance sheet or the operating cycle of the business. These assets
are separated from other resources because a company relies on its
current assets to fund ongoing operations and pay current expenses.
Examples of current assets on a typical balance sheet are
cash, accounts receivable, prepaid expenses, inventory and marketable
securities.
Role of Non-current Assets
The formal definition of a non-current asset is any resource not expected
to be recovered, meaning monetary value is extracted from it or it is no
longer useful, until more than 12 months past the balance sheet date.
There are some differences in the treatment of non-current assets
between U.S. GAAP (generally accepted accounting principles) and
IFRS (international financial reporting standards). Examples of noncurrent assets include land, property, capital equipment,
trademarks, long-term investments and even goodwill. Since these
resources last for a very long time, companies spread their costs over
several years. This helps avoid huge losses during years when capital
expansions take place.

Current vs. Non-Current Assets

In the current assets vs. non-current assets debate and as far as the
operational facet of the company goes, both current and non-current
assets are equally important for the company. While current assets are
involved and used for ready income-generation, non-current assets are
generally involved with profit generation. In most accounting concepts,
both current as well as non-current assets can even be intangible
assets that generate profit for the venture. Both the assets together
account for total revenue generated for a company.
Tangible vs. Intangible Assets
Financial statements are historical documents that show what a company
was worth at one point in time. Changes in markets, currency, and
economic conditions all contribute to discrepancies between book and
market values. The longer an asset is held by a company, the greater the
chance that discrepancies exist.
One factor that affects the market value of an asset is intangibility. An
intangible asset is one that does not have a physical form but provides
value to the firm nevertheless. Examples of intangible assets include
contracts and patents, i.e. assets that cost money to acquire but do not
have easily-accessible markets through which to buy and sell them.
Unlike tangible assets like machinery and automobiles, the lack of
secondary markets increases the risk that the intangible asset can not be
liquidated at a reasonable price.
Assets that are not very liquid, such as plants and proprietary equipment,
have secondary markets in which used assets can be sold. These assets
typically suffer from low liquidity because there are costs, sometimes
high costs, associated with their disposal in secondary markets. Liquidity
is based on the ability to sell an item for cash if the need or desire arises.

Liabilities
Liabilities are the money that a company owes to outside parties, from
bills it has to pay to suppliers to interest on bonds it has issued to
creditors to rent, utilities and salaries. Current liabilities are those that are
due within one year and are listed in order of their due date. Long-term
liabilities are due at any point after one year.
Current liabilities accounts might include:
Current portion of long-term debt
Bank indebtedness
Interest payable
Rent, tax, utilities
Wages payable
Customer prepayments
Dividends payable and others

Long-term liabilities can include:

Long-term debt: interest and principle on bonds issued
Pension fund liability: the money a company is required to pay into
its employees' retirement accounts
Deferred tax liability: taxes that have been accrued but will not be
paid for another year; besides timing, this figure reconciles
differences between requirements for financial reporting and the
way tax is assessed, such as depreciation calculations

Some liabilities are off-balance sheet, meaning that they will not appear
on the balance sheet. Operating leases are an example of this kind of
liability.
How To Interpret a Balance Sheet
The balance sheet is a snapshot, representing the state of a company's
finances at a moment in time. By itself, it cannot give a sense of the
trends that are playing out over a longer period. For this reason, the
balance sheet should be compared with those of previous periods. It
should also be compared with those of other businesses in the same
industry, since different industries have unique approaches to financing.
A number of ratios can be derived from the balance sheet, helping
investors get a sense of how healthy a company is. These include
the debt-to-equity ratio and the acid-test ratio, along with many others.
The income statement and statement of cash flows also provide valuable
context for assessing a company's finances, as do any notes or addenda
in an earnings report that might refer back to the balance sheet.

What is the 'Profit and Loss Statement

(P&L)'
A profit and loss statement (P&L) is a financial statement that
summarizes the revenues, costs and expenses incurred during a specific
period of time, usually a fiscal quarter or year. These records provide
information about a company's ability or lack thereof to generate
profit by increasing revenue, reducing costs, or both. The P&L statement
is also referred to as "statement of profit and loss", "income statement,"
"statement of operations," "statement of financial results," and "income
and expense statement."

BREAKING DOWN 'Profit and Loss Statement (P&L)'

The profit and loss statement, commonly referred to as the income
statement, is one of three financial statements every public company
issues quarterly and annually, along with the balance sheet and the cash
flow statement. The income statement, like the cash flow statement,
shows changes in accounts over a set period of time. The balance sheet,
on the other hand, is a snapshot, showing what is owned and owed at a
single moment. It is important to compare the income statement with the
cash flow statement, since under the accrual method of accounting,
revenues and expenses can be logged before cash actually changes
hands.
The income statement follows a general form as seen in the example
below. It begins with an entry for revenue, known as the "top line," and
subtracts the costs of doing business, including cost of goods
sold, operating expenses, tax expense and interest expense. The
difference, known as the bottom line, is net income, also referred to
as profit or earnings. Many templates for creating a personal or business
profit and loss statement can be found online for free.
It is important to compare income statements from different accounting
periods, as the changes in revenues, operating costs, research and
development spending and net earnings over time are more meaningful
than the numbers themselves. For example, a company's revenues may
be growing, but its expenses might be growing at a faster rate.

Income Statement
An income statement is a financial statement that reports a
company's financial performance over a specific accounting period.
Financial performance is assessed by giving a summary of how the
business incurs its revenues and expenses through both operating and

non-operating activities. It also shows the net profit or loss incurred over
a specific accounting period.
BREAKING DOWN 'Income Statement'

Also known as the profit and loss statement or statement of revenue and
expense, the income statement is the one of three major financial
statements in the annual report and 10-K. All public companies must
submit these legal documents to the Securities and Exchange
Commission (SEC) and investor public. The other two financial
statements are the balance sheet and the statement of cash flows. All
three provide investors with information about the state of the company's
financial affairs, but the income statement is the only one that provides
an overview of company sales and net income.

Income Statement
Unlike the balance sheet, which covers one moment in time, the income
statement provides performance information about a time period. It
begins with sales and works down to net income and earnings per share
(EPS)
The income statement is divided into two parts: operating and nonoperating. The operating portion of the income statement discloses
information about revenues and expenses that are a direct result of
regular business operations. For example, if a business creates sports
equipment, it should make money through the sale and/or production of
sports equipment. The non-operating section discloses revenue and
expense information about activities that are not directly tied to a
company's regular operations. Continuing with the same example, if the

sports company sells real estate and investment securities, the gain from
the sale is listed in the non-operating itemssection.

ASSETS AT FAIR VALUE THROUGH THE INCOME STATEMENT

Assets at fair value through the Profit and Loss are described in these
accounts as assets at fair value through the Income Statement.

Trading securities are purchased without the intention of being held to

maturity. The securities are recorded at fair value based on quoted
market prices. Realised and unrealised gains and losses are recognised
in the Income Statement. Interest on trading securities is included in net
interest income. At acquisition, trading securities are recorded on a
settlement date basis.

Where available, quoted bid prices are used to account for the fair value
of assets. Quoted mid prices are used to account for fair value of assets
where there is an offsetting risk position in a portfolio.

Realised gains and losses on disposal and unrealised fair value

adjustments are included in other income. Interest income on assets at
fair value through the Income Statement is included within interest
income using the effective interest rate method. Dividends continue to be
reflected in other income when earned.

Comparative Statement
A comparative statement is a document that compares a particular
financial statement with prior period statements or with the same financial
report generated by another company. Analyst and business managers
use the income statement, balance sheet and cash flow statement for
comparative purposes. The process reveals trends in the financials and
compares one company's performance with another business.

BREAKING DOWN 'Comparative Statement'

Analysts like comparative statements because the reports show the

effect of business decisions on a company's bottom line. Analysts can
identify trends and evaluate the performance of managers, new lines of
business and new products on one report, instead of having to flip
through individual financial statements. When comparing different
companies, a comparative statement shows how a business reacts to
market conditions affecting an entire industry.
The income statement is based on the revenue minus the expenses, and
analysts often use a percentage of sales presentation to generate
comparative financial statements for the income statement. This report
presents each revenue and expense category as a percentage of sales,
which makes it easier to compare periods and assess company
performance.

Financial Analysis: Solvency Vs. Liquidity Ratios

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Solvency and liquidity are both terms that refer to an enterprises state
of financial health, but with some notable differences. Solvency refers to
an enterprise's capacity to meet its long-term financial commitments.
Liquidity refers to an enterprises ability to pay short-term obligations; the
term also refers to its capability to sell assets quickly to raise cash. A
solvent company is one that owns more than it owes; in other words, it
has a positive net worth and a manageable debt load. On the other hand,
a company with adequate liquidity may have enough cash available to
pay its bills, but it may be heading for financial disaster down the road.
Solvency and liquidity are equally important, and healthy companies are
both solvent and possess adequate liquidity. A number of financial ratios
are used to measure a companys liquidity and solvency, the most
common of which are discussed below.

What is 'Solvency'
Solvency is the ability of a company to meet its long-term financial
obligations. Solvency is essential to staying in business as it asserts a
companys ability to continue operations into the foreseeable future.
While a company also needs liquidity to thrive, liquidity should not be
confused with solvency. A company that is insolvent must often
enter bankruptcy.

What is 'Liquidity'
Liquidity describes the degree to which an asset or security can be
quickly bought or sold in the market without affecting the asset's price.

Market liquidity refers to the extent to which a market, such as a country's

stock market or a city's real estate market, allows assets to be bought
and sold at stable prices. Cash is the most liquid asset, while real estate,
fine art and collectibles are all relatively illiquid.
Accounting liquidity measures the ease with which an individual or
company can meet their financial obligations with the liquid assets
available to them. There are several ratios that express accounting
liquidity.
Solvency Vs. Liquidity
While solvency represents a companys ability to meet long-term
obligations, liquidity represents a company's ability to meet its short-term
obligations. In order for funds to be considered liquid, they must be either
immediately accessible or easily converted into usable funds. Cash is
considered the most liquid payment vehicle. A company that lacks
liquidity can be forced to enter bankruptcy even if it is solvent if it cannot
convert its assets into funds that can be used to meet financial
obligations.

Liquidity Ratios
Current ratio = Current assets / Current liabilities
The current ratio measures a companys ability to pay off its current
liabilities (payable within one year) with its current assets such as
cash, accounts receivable and inventories. The higher the ratio, the
better the companys liquidity position.
Quick ratio = (Current assets Inventories) / Current liabilities

= (Cash and equivalents + Marketable securities + Accounts receivable) /

Current liabilities
The quick ratio measures a companys ability to meet its short-term
obligations with its most liquid assets, and therefore excludes inventories
from its current assets. It is also known as the acid-test ratio.
Days sales outstanding = (Accounts receivable / Total credit sales)
x Number of days in sales
DSO refers to the average number of days it takes a company to collect
payment after it makes a sale. A higher DSO means that a company is
taking unduly long to collect payment and is tying up capital
in receivables. DSOs are generally calculated quarterly or annually.

Solvency Ratios
Debt to equity = Total debt / Total equity
This ratio indicates the degree of financial leverage being used by the
business and includes both short-term and long-term debt. A rising debtto-equity ratio implies higher interest expenses, and beyond a certain
point it may affect a companys credit rating, making it more expensive to
raise more debt.
Debt to assets = Total debt / Total assets

Another leverage measure, this ratio measures the percentage of a

companys assets that have been financed with debt (short-term and
long-term). A higher ratio indicates a greater degree of leverage, and
consequently, financial risk.
Interest coverage ratio = Operating income (or EBIT) / Interest
expense
This ratio measures the companys ability to meet the interest expense
on its debt with its operating income, which is equivalent to its earnings
before interest and taxes (EBIT). The higher the ratio, the better the
companys ability to cover its interest expense.

Efficiency ratios
The efficiency ratio is typically used to analyze how well a company uses
its assets and liabilities internally. An efficiency ratio can calculate
the turnover of receivables, the repayment of liabilities, the quantity and
usage of equity, and the general use of inventory and machinery. This
ratio can also be used to track and analyze the performance of
commercial and investment banks.
BREAKING DOWN 'Efficiency Ratio'

Analysts use efficiency ratios, also known as activity ratios, to measure

the performance of a company's short-term or current performance. All of
these ratios use numbers in a company's current assets or current
liabilities, quantifying the operations of the business.
An efficiency ratio measures a company's ability to use its assets to
generate income. For example, an efficiency ratio often looks at aspects
of the company, such as the time it takes to collect cash from customers
or the amount of time it takes to convert inventory to cash. This makes
efficiency ratios important, because an improvement in the efficiency
ratios usually translates to improved profitability.

Profitability Ratios

Profitability ratios are a class of financial metrics that are used to assess
a business's ability to generate earnings compared to its expenses and
other relevant costs incurred during a specific period of time. For most of
these ratios, having a higher value relative to a competitor's ratio or
relative to the same ratio from a previous period indicates that the
company is doing well.
BREAKING DOWN 'Profitability Ratios'

Some industries experience seasonality in their operations. The retail

industry, for example, typically experiences higher revenues and earnings
for the Christmas season. It would not be useful to compare a retailer's
fourth-quarter profit margin with its first-quarter profit margin. Comparing
a retailer's fourth-quarter profit margin with the profit margin from the
same period a year before would be far more informative.
Some examples of profitability ratios are profit margin, return on
assets (ROA) and return on equity (ROE). Profitability ratios are the most
popular metrics used in financial analysis. Read the short guide
on Profitability Indicator Ratios: Introduction.

Return Ratios
A return is the gain or loss of a security in a particular period. The return
consists of the income and the capital gains relative on an investment,
and it is usually quoted as a percentage. The general rule is that the
more risk you take, the greater the potential for higher returns and losses.
BREAKING DOWN 'Return'
While some investors will settle for principal protection, most investors
are in search of return, specifically alpha returns. Alpha returns are
generated when an investment generates more money than it costs. In
general, there are three different types of return measures: return on
investment, return on equity and return on assets. Each one is essentially
calculated the same way, but the inputs have different labels.
What is 'Return On Equity - ROE'
Return on equity (ROE) is the amount of net income returned as a
percentage of shareholders equity. Return on equity measures a
corporation's profitability by revealing how much profit a company
generates with the money shareholders have invested.

ROE is expressed as a percentage and calculated as:

Return on Equity = Net Income/Shareholder's Equity
Net income is for the full fiscal year (before dividends paid to common
stock holders but after dividends to preferred stock.) Shareholder's equity
does not include preferred shares.

What is the difference between revenue

and sales?
In accounting terms, sales make up one component of a
business's revenue. Sales are the proceeds from the provision of goods
or services to customers, but this doesn't capture all of the sources of
income for most firms. Other revenue streams might include interest,
royalties, fees and donations. Revenue encompasses all these diverse
sources and is a better indication of the total cash flow generated by a
company. Some businesses refer to sales as operating revenue and
revenue as total revenue, but the same distinctions apply.
Sales can be defined as the economic price paid by customers. Revenue
is the total amount of money taken in by a business during a set period of
time. Even though revenue is almost always the larger number, it could
actually be smaller than sales. Consider a business that only sells hats
and has no other sources of income. If its revenue formula deducts any
discounts from sales or returned or damaged hats, then the
company's gross sales could actually exceed its revenue.
Accountants use revenue and sales figures to build financial statements,
and investors use these statements to analyze company fundamentals.
Sales (operation revenue) is useful for determining how efficiently a
company turns a profit on its primary goods and services. It can also be
combined with non-operating revenue for net income calculations and
overall business efficiency measurements.
It's important to distinguish between sales and revenue, since not all
sources of income are equally reliable or repeatable. Investors,
accountants, regulators and those involved with corporate
governance (such as managers and owners) all examine the relationship
between sales and revenue.

Revenue can also be used to describe the money brought into a

government, made up of taxes, fees, fines, transfers and any publicly
operated services. While it is possible for a government agency to sell
goods or services, you rarely see the proceeds referred to as
government sales.

Revenue

Revenue is the amount of money that a company actually receives during

a specific period, including discounts and deductions for returned
merchandise. It is the "top line" or "gross income" figure from which costs
are subtracted to determine net income.
Revenue is calculated by multiplying the price at which goods or services
are sold by the number of units or amount sold.
Revenue is also known as "REVs."
BREAKING DOWN 'Revenue'
Revenue is the amount of money that is brought into a company by its
business activities. Revenue is also known as sales, as in the price-tosales ratio, an alternative to the price-to-earnings ratio that uses revenue
in the denominator.
There are different ways of calculating revenue, depending on the
accounting method a business employs. Accrual accounting will include
sales made on credit as revenue, as long as the goods or services have
been delivered to the customer. It is therefore necessary to check
the cash flow statement to assess how efficiently a company collects the
money it is owed. Cash accounting, on the other hand, will only count
sales as revenue if the payment has been received. When cash is paid to
a company, this is known as a "receipt" to distinguish it from revenue. It is
possible to have receipts without revenue, if the customer paid in

advance for a service that has not been rendered or goods that have not
been delivered.
Revenue is known as the "top line" because it is displayed first on a
company's income statement. Expenses are then deducted from revenue
in order to obtain net income, or profit the "bottom line."

Working Capital
Working capital is a measure of both a company's efficiency and its
short-term financial health. Working capital is calculated as:
Working Capital = Current Assets - Current Liabilities
The working capital ratio (Current Assets/Current Liabilities) indicates
whether a company has enough short term assets to cover its short term
debt. Anything below 1 indicates negative W/C (working capital). While
anything over 2 means that the company is not investing excess assets.
Most believe that a ratio between 1.2 and 2.0 is sufficient. Also known as
"net working capital".
BREAKING DOWN 'Working Capital'
If a company's current assets do not exceed its current liabilities, then it
may run into trouble paying back creditors in the short term. The worstcase scenario is bankruptcy. A declining working capital ratio over a
longer time period could also be a red flag that warrants further analysis.
For example, it could be that the company's sales volumes are
decreasing and, as a result, its accounts receivables number continues
to get smaller and smaller.Working capital also gives investors an idea of
the company's underlying operational efficiency. Money that is tied up in
inventory or money that customers still owe to the company cannot be
used to pay off any of the company's obligations. So, if a company is not
operating in the most efficient manner (slow collection), it will show up as
an increase in the working capital. This can be seen by comparing the
working capital from one period to another; slow collection may signal an
underlying problem in the company's operations.
Things to Remember
If the ratio is less than one then they have negative working capital.

 A high working capital ratio isn't always a good thing, it could

indicate that they have too much inventory or they are not investing
their excess cash

Discounted Cash Flow (DCF)

What is a 'Discounted Cash Flow (DCF)'
A discounted cash flow (DCF) is a valuation method used to estimate the
attractiveness of an investment opportunity. DCF analysis uses future
free cash flow projections and discounts them to arrive at a present
value estimate, which is used to evaluate the potential for investment. If
the value arrived at through DCF analysis is higher than the current cost
of the investment, the opportunity may be a good one.

BREAKING DOWN 'Discounted Cash Flow

(DCF)'
There are several variations when it comes to assigning values to cash
flows and the discount rate in a DCF analysis. But while the calculations
involved are complex, the purpose of DCF analysis is simply to estimate
the money an investor would receive from an investment, adjusted for
the time value of money.
The time value of money is the assumption that a dollar today is worth
more than a dollar tomorrow. For example, assuming 5% annual interest,
$1.00 in a savings account will be worth $1.05 in a year. Due to the
symmetric property (if a=b, then b=a), we must consider $1.05 a year
from now to be worth $1.00 today. When it comes to assessing the future
value of investments, it is common to use the weighted average cost of
capital (WACC) as the discount rate.
For a hypothetical Company X, we would apply DCF analysis by first
estimating the firm's future cash flow growth. We would start by
determining the company's trailing twelve month (ttm) free cash flow

(FCF), equal to that period's operating cash flow minus capital

expenditures. Say that Company X's ttm FCF is $50 m. We would
compare this figure to previous years' cash flows in order to estimate a
rate of growth. It is also important to consider the source of this growth.
Are sales increasing? Are costs declining? These factors will inform
assessments of the growth rate's sustainability.
Say that you estimate that Company X's cash flow will grow by 10% in
the first two years, then 5% in the following three. After a few years, you
may apply a long-term cash flow growth rate, representing an assumption
of annual growth from that point on. This value should probably not
exceed the long-term growth prospects of the overall economy by too
much; we will say that Company X's is 3%. You will then calculate a
WACC; say it comes out to 8%. The terminal value, or long-term
valuation the company's growth approaches, is calculated using
the Gordon Growth Model:
Terminal value = projected cash flow for final year (1 + long-term growth
rate) / (discount rate - long-term growth rate)

What is 'Free Cash Flow - FCF'

Free cash flow (FCF) is a measure of a company's financial
performance, calculated as operating cash flow minus capital
expenditures. FCF represents the cash that a company is able to
generate after spending the money required to maintain or expand
its asset base. FCF is important because it allows a company to pursue
opportunities that enhance shareholder value.
BREAKING DOWN 'Free Cash Flow - FCF'

FCF is an assessment of the amount of cash a company generates after

accounting for all capital expenditures, such as buildings or property,

plant and equipment. The excess cash is used to expand production,

develop new products, make acquisitions, pay dividends and reduce
debt. Specifically, FCF is calculated as:
EBIT (1-tax rate) + (depreciation) + (amortization) - (change in
net working capital) - (capital expenditure).
FCF in Company Analysis
However, it is important to note that negative free cash flow is not bad in
itself. If free cash flow is negative, it could be a sign that a company is
making large investments. If these investments earn a high return, the
strategy has the potential to pay off in the long run.

Weighted Average Cost Of Capital WACC

Weighted average cost of capital (WACC) is a calculation of a firm's cost
of capital in which each category of capital is proportionately weighted.
All sources of capital, including common stock, preferred
stock, bonds and any other long-term debt, are included in a WACC
calculation. A firms WACC increases as the beta and rate of
return on equity increase, as an increase in WACC denotes a decrease
in valuation and an increase in risk.
To calculate WACC, multiply the cost of each capital component by its
proportional weight and take the sum of the results.
BREAKING DOWN 'Weighted Average Cost Of Capital - WACC'
In a broad sense, a company finances its assets either through debt or
with equity. WACC is the average of the costs of these types of financing,

each of which is weighted by its proportionate use in a given situation. By

taking a weighted average in this way, we can determine how much
interest a company owes for each dollar it finances.
Debt and equity are the two components that constitute a companys
capital funding. Lenders and equity holders will expect to receive certain
returns on the funds or capital they have provided. Since cost of capital is
the return that equity owners (or shareholders) and debt holders will
expect, so WACC indicates the return that both kinds
of stakeholders (equity owners and lenders) can expect to receive. Put
another way, WACC is an investors opportunity cost of taking on the risk
of investing money in a company.
A firm's WACC is the overall required return for a firm. Because of this,
company directors will often use WACC internally in order to make
decisions, like determining the economic feasibility of mergers and other
expansionary opportunities. WACC is the discount rate that should be
used for cash flows with risk that is similar to that of the overall firm.

Return On Invested Capital ROIC

A calculation used to assess a company's efficiency at allocating
the capital under its control to profitable investments. Return on invested
capital gives a sense of how well a company is using its money to
generate returns. Comparing a company's return on capital (ROIC) with
its weighted average cost of capital (WACC) reveals whether invested
capital is being used effectively.
One way to calculate ROIC is:

BREAKING DOWN 'Return On Invested Capital - ROIC'

Invested capital, the value in the denominator, is the sum of a company's
debt and equity. There are a number of ways to calculate this value. One
is to subtract cash and non-interest bearing current liabilities
(NIBCL) including tax liabilities and accounts payable, as long as these
are not subject to interest or fees from total assets.
Another method of calculating invested capital is to add the book value of
a company's equity to the book value of its debt, then subtract nonoperating assets, including cash and cash equivalents, marketable
securities and assets of discontinued operations.
Yet another way to calculate invested capital is to obtain working
capital by subtracting current liabilities from current assets. Next you
obtain non-cash working capital by subtracting cash from the working
capital value you just calculated. Finally non-cash working capital is
added to a company's fixed assets, also known as long-term or noncurrent assets.
The value in the numerator can also be calculated in a number of ways.
The most straightforward way is to subtract dividends from a company's
net income.
On the other hand, because a company may have benefited from a onetime source of income unrelated to its core business a windfall from
foreign exchange rate fluctuations, for example it is often preferable to
look at net operating profit after taxes (NOPAT). NOPAT is calculated by
adjusting the operating profit for taxes: (operating profit) * (1 - effective
tax rate). Many companies will report their effective tax rates for the
quarter or fiscal year in their earnings releases, but not all. Operating
profit is also referred to as earnings before interest and tax (EBIT).

ROIC is always calculated as a percentage and is usually expressed as

an annualized or trailing twelve month value. It should be compared to a
company's cost of capital to determine whether the company is creating
value. If ROIC is greater than the weighted average cost of capital
(WACC), the most common cost of capital metric, value is being created.
If it is not, value is being destroyed. For this reason ROIC is one of the
most important valuation metrics to calculate.

Beta
Beta is a measure of the volatility, or systematic risk, of a security or
a portfolio in comparison to the market as a whole. Beta is used in
the capital asset pricing model (CAPM), which calculates the expected
return of an asset based on its beta and expected market returns. Beta is
also known as the beta coefficient.
BREAKING DOWN 'Beta'

Beta is calculated using regression analysis. Beta represents the

tendency of a security's returns to respond to swings (a fluctuation in the
value of an asset) in the market. A security's beta is calculated by dividing
the covariance the security's returns and the benchmark's returns by the
variance of the benchmark's returns over a specified period.

Beta: Know The Risk

Beta is a measure of a stock's volatility in relation to the market. By
definition, the market has a beta of 1.0, and individual stocks are ranked
according to how much they deviate from the market. A stock that swings
more than the market over time has a beta above 1.0. If a stock moves
less than the market, the stock's beta is less than 1.0. High-beta stocks
are supposed to be riskier but provide a potential for higher returns; lowbeta stocks pose less risk but also lower returns.
Beta is a key component for the capital asset pricing model (CAPM),
which is used to calculate cost of equity. Recall that the cost of
capital represents the discount rate used to arrive at the present value of
a company's future cash flows. All things being equal, the higher a
company's beta is, the higher its cost of capital discount rate. The higher
the discount rate, the lower the present value placed on the company's
future cash flows. In short, beta can impact a company's share valuation.
The Bottom Line
It's important for investors to make the distinction between short-term risk
- where beta and price volatility are useful - and longer-term, fundamental
risk, where big-picture risk factors are more telling. High betas may mean
price volatility over the near term, but they don't always rule out long-term
opportunities.

Leveraged Buyout LBO

A leveraged buyout (LBO) is the acquisition of another company using a
significant amount of borrowed money to meet the cost of acquisition.
The assets of the company being acquired are often used
as collateral for the loans, along with the assets of the acquiring
company. The purpose of leveraged buyouts is to allow companies to
make large acquisitions without having to commit a lot of capital.
BREAKING DOWN 'Leveraged Buyout - LBO'

In an LBO, there is usually a ratio of 90% debt to 10% equity. Because of

this high debt/equity ratio, the bonds issued in the buyout are usually are
not investment grade and are referred to as junk bonds. Further, many
people regard LBOs as an especially ruthless, predatory tactic. This is
because it isn't usually sanctioned by the target company. Further, it's
seen as ironic in that a company's success, in terms of assets on the
balance sheet, can be used against it as collateral by a hostile company.

Reasons for LBOs

LBOs are conducted for three main reasons. The first is to take a public
company private; the second is to spin-off a portion of an existing
business by selling it; and the third is to transfer private property, as is the
case with a change in small business ownership. However, it is usually a
requirement that the acquired company or entity, in each scenario, is
profitable and growing.

Equity Method
The equity method is an accounting technique used by firms to assess
the profits earned by their investments in other companies. The firm
reports the income earned on the investment on its income statement,
and the reported value is based on the firm's share of the company
assets. The reported profit is proportional to the size of
the equity investment.
BREAKING DOWN 'Equity Method'
The equity method is the standard technique used when one company
has significant influence over another. When a company holds
approximately 20 to 25% or more of another company's stock, it is
considered to have significant control, which signifies the power one
company can exert over another company. This power includes
representation on the board of directors, partaking in company policy
development and the interchanging of managerial personnel. If a firm
owns 25% of a company with a $1 million net income, the firm reports
earnings of $250,000.
Investment Adjustment by Earnings
The equity method used to account for a company's investment in
another company acknowledges the substantive economic relationship
between the two entities. When a company, the investor, has a significant
influence on the operating and financial results of another company, the
investee, it can directly impact the value of the investor's investment. With
an investment holding above 20%, the investor usually records its share
of the investee's earnings as revenue from investment, which increases
the carrying value of the investment.
Investment Adjustment by Losses
When the investee company reports a net loss, the investor company
records its share of the loss as loss on investment, which decreases the

carrying value of the investment. Using the equity method, a company

reports the carrying value of its investment independent of any fair value
change in the market. With a significant influence over another
company's operating and financial policies, the investor is basing its
investment value on changes in the value of that company's net assets
from operating and financial activities and the resulting performances,
including earnings and losses.

Investment Adjustment by Dividends

When the investee company pays a cash dividend, it decreases the value
of its net assets. Using the equity method, the investor company
receiving the dividend records an increase to its cash balance but,
meanwhile, reports a decrease to the carrying value of its investment.
Other financial activities that affect the value of the investee's net assets
should have the same impact on the value of the investor's share of
investment. The equity method ensures proper reporting on the business
situations for the investor and the investee, given the substantive
economic relationship they have.

Earnings Per Share EPS

Earnings per share (EPS) is the portion of a company's profit allocated to
each outstanding share of common stock. Earnings per share serves as
an indicator of a company's profitability.
Calculated as:

When calculating, it is more accurate to use a weighted average number

of shares outstanding over the reporting term, because the number of

shares outstanding can change over time. However, data sources

sometimes simplify the calculation by using the number of shares
outstanding at the end of the period.
BREAKING DOWN 'Earnings Per Share - EPS'
Earnings per share is generally considered to be the single most
important variable in determining a share's price. It is also a major
component used to calculate the price-to-earnings valuation ratio.
For example, assume that a company has a net income of $25 million. If
the company pays out $1 million in preferred dividends and has 10
million shares for half of the year and 15 million shares for the other half,
the EPS would be $1.92 (24/12.5). First, the $1 million is deducted from
the net income to get $24 million, then a weighted average is taken to
find the number of shares outstanding (0.5 x 10M+ 0.5 x 15M = 12.5M).
An important aspect of EPS that's often ignored is the capital that is
required to generate the earnings (net income) in the calculation. Two
companies could generate the same EPS number, but one could do so
with less equity (investment) - that company would be more efficient at
using its capital to generate income and, all other things being equal,
would be a "better" company. Investors also need to be aware of
earnings manipulation that will affect the quality of the earnings number.
It is important not to rely on any one financial measure, but to use it in
conjunction with statement analysis and other measures.
What are 'Fully Diluted Shares'
Fully diluted shares are the total number of shares that would be
outstanding if all possible sources of conversion, such as convertible
bonds and stock options, are exercised. This number of shares is
important for a companys earnings per share (EPS) calculation, because
using fully diluted shares increases the number of shares used in the
EPS calculation and reduces the dollars earned per share of common
stock.

BREAKING DOWN 'Fully Diluted Shares'

EPS is a calculation of the dollar amount of earnings a firm generates per
share of common stock outstanding, and analysts consider this ratio to
be a key indicator of company value.

Differences Between Fully Diluted Shares and Basic Outstanding Shares

Basic outstanding shares are the total amount of stock currently held by
all of a company's shareholders. Outstanding shares are the company's
stock that have been authorized and issued and represent ownership of
the company by investors or institutions holding the shares.
Unlike basic outstanding shares, fully diluted shares include all possible
sources of conversion to outstanding shares, such as convertible
bonds, stock options, stock warrants and convertible preferred stock or
debt, assuming these securities were exercised.
Investors should consider the amount of fully diluted shares because it
could cause a large discrepancy between fundamental figures, such as a
company's earnings per share, or EPS.

Hedge Fund

What is a 'Hedge Fund'

Hedge funds are alternative investments using pooled funds that may
use a number of different strategies in order to earn active return,
or alpha, for their investors. Hedge funds may be aggressively managed
or make use of derivatives and leverage in both domestic and
international markets with the goal of generating high returns (either in an
absolute sense or over a specified market benchmark). Because hedge
funds may have low correlations with a

traditional portfolio of stocks and bonds, allocating an exposure to hedge

funds can be a good diversifier.

Hedge Accounting
Hedge accounting is a method of accounting where entries for the
ownership of a security and the opposing hedge are treated as one.
Hedge accounting attempts to reduce the volatility created by the
repeated adjustment of a financial instrument's value, known as marking
to market. This reduced volatility is done by combining the instrument
and the hedge as one entry, which offsets the opposing movements.
BREAKING DOWN 'Hedge Accounting'

The point of hedging a position is to reduce the volatility of the overall

portfolio. Hedge accounting has the same effect except that it's used
on financial statements. For example, when accounting for complex
financial instruments, such as derivatives, the value is adjusted by
marking to market; this creates large swings in the profit and loss
account. Hedge accounting treats the reciprocal hedge and
the derivative as one entry so that large swings are balanced out.
Hedge accounting is used in corporate bookkeeping as it relates to
derivatives. In order to lessen overall risk, hedging is often used to offset
the risks associated with the derivatives. Hedge accounting uses the
information from the derivative and the associated hedge as a single
item, lessening the appearance of volatility when compared to reporting
each individually.
Reporting With Hedge Accounting
Hedge accounting is an alternative for recording gains and losses. When
treating the items individually, such as a derivative and its associated

hedge fund, the gains or losses of each would be displayed individually.

Since the purpose of the hedge fund is to offset the risks associated with
the derivative, hedge accounting treats the two line items as one. Instead
of listing one transaction of a gain and one of a loss, the two are
examined to determine if there was an overall gain or loss between the
two and just that amount if recorded.
This approach can make financial statements simpler, as they will have
fewer line items, but some potential for deception exists since the details
are not recorded individually.

Using a Hedge Fund

A hedge fund is used in order to lower the risk of overall losses by
assuming an offsetting position in relation to a particular security or
derivative. The purpose of the account is not to generate profit
specifically but instead to lessen the impact of associated derivative
losses, especially those attributed to interest rate, exchange rate or
commodity risk. This helps lower the perceived volatility associated with
an investment by compensating for changes that are not purely reflective
of an investment's performance.
A Cash Flow Hedge is used when an entity is looking to eliminate or
reduce the exposure that arises from changes in the cash flows of a
financial asset or liability (or other eligible exposure) due to changes in a
particular risk, such as interest rate risk on a floating rate debt
instrument.
A Fair Value Hedge is a hedge of the exposure to changes in fair
value of a recognized asset or liability or unrecognized firm commitment,
or a component of any such item, that is attributable to a particular risk
and could affect profit or loss.

A Net Investment Hedge in foreign operations is a derivative used

to hedge future changes in currency exposure of a net investment in a
foreign operation. For derivative financial instruments.

What is a 'Short Hedge'

A short hedge is an investment strategy that is focused on mitigating a
risk that has already been taken. The "short" portion of the term refers to
the act of shorting a security, usually a derivatives contract, that hedges
against potential losses in an investment that is held long.
If a short hedge is executed well, gains from the long position will be
offset by losses in the derivatives position, and vice versa.

Non-Controlling Interest
A non-controlling interest (NCI) is an ownership stake in a corporation,
with the investors owning a minority interest and having less influence
over how the company is managed. The majority of investor positions are
deemed to be NCI, because the ownership stake is so insignificant
relative to the total number of outstanding shares. For smaller
companies, any ownership position that holds less than 50% of the
outstanding voting shares is deemed to be an NCI.
BREAKING DOWN 'Non-Controlling Interest'

Most shareholders are granted a set of rights when they purchase

common stock, including the right to a cash dividend if the company has
sufficient earnings and declares a dividend. Shareholders may also have
the right to vote on major corporate decisions, such as a merger or
company sale, and a corporation can issue different classes of stock,
each with different shareholder rights.
Factoring in Consolidations
A consolidation is a set of financial statements that combines the
accounting records of several entities into one set of financials. These
typically include a parent company, as the majority owner; a subsidiary,
or purchased firm; and an NCI company. The consolidated financials
allows investors, creditors and company managers to view the three
separate entities as if all three firms are one company. A consolidation
assumes that a parent and an NCI company jointly purchase the equity
of a subsidiary company. Any transactions between the parent and the
subsidiary company, or between the parent and the NCI firm, are
eliminated before the consolidated financial statements are created.
What is 'Consolidation'

Consolidation is used in technical analysis to describe the movement of a

stock's price within a well-defined pattern of trading levels. Consolidation
is generally regarded as a period of indecision, which ends when the
price of the asset moves above or below the prices in the trading pattern.
Consolidation is also defined as a set of financial statements that
presents a parent and a subsidiary company as one company.
BREAKING DOWN 'Consolidation'

Periods of consolidation can be found in price charts for any time

interval, and these periods can last for days or months. Technical traders
look for support and resistance levels in price charts, and traders use
those levels to make buy and sell decisions.

The Differences Between Support and Resistance

The upper and lower bounds of the stock's price create the levels of
resistance and support within the consolidation. A resistance level is the
top end of the price pattern, while the support level is the lower end of the
pattern. Once the price of the stock breaks through the identified areas of
support or resistance, volatility quickly increases, and so does the
opportunity for short-term traders to generate a profit. Technical traders
believe that a breakout above the resistance price means that stock price
is increasing further, so the trader buys the stock. On the other hand, a
breakout below the support level indicates that the stock price is moving
even lower, and the trader sells the stock.
How Consolidations Work in Accounting
Analysts and other stakeholders use consolidated financial statements,
which present a parent and a subsidiary company as one combined
company. A parent company buys a majority ownership percentage of a

subsidiary company, and a non-controlling interest (NCI) purchases the

remainder of the firm. In some cases, the parent buys the entire
subsidiary company, which means that no other firm has ownership.
To create consolidated financial statements, the assets and liabilities of
the subsidiary are adjusted to fair market value, and those values are
used in the combined financial statements. If the parent and NCI pay
more than the fair market value of the net assets (assets less liabilities),
the excess amount is posted a goodwill asset account, and goodwill is
moved into an expense account over time. A consolidation eliminates any
transactions between the parent and subsidiary, or between the
subsidiary and the NCI. The consolidated financials only includes
transactions with third parties, and each of the companies continues to
produce separate financial statements.

Consolidated Financial Statements

Consolidated financial statements are the combined financial
statements of a parent company and its subsidiaries. Because
consolidated financial statements present an aggregated look at the
financial position of a parent and its subsidiaries, they let you gauge the
overall health of an entire group of companies as opposed to one
company's standalone position.
BREAKING DOWN 'Consolidated Financial Statements'
Consolidated financial statements report the aggregate of separate legal
entities. A parent company can operate as a separate corporation apart
from its subsidiary companies. Each of these entities reports its own
financial statements and operates its own business. However, because
the subsidiaries are considered to form one economic entity, investors,
regulators, and customers find consolidated financial statements more
beneficial to gauge the overall position of the entity.

Consolidated Statement of Income

The consolidated financial statements only report income and expense
activity from outside of the economic entity. Any revenue earned by the
parent that is an expense of a subsidiary is omitted from the financial
statements. This is because the net change in the financial statements is
$0. The revenue generated from one legal entity is offset by the
expenses in another legal entity. To avoid overinflating revenues, all
internal revenues are omitted.
Consolidated Balance Sheet
Certain account receivable balances and account payable balances are
eliminated from the consolidated balance sheet. These eliminated
amounts relate to the amounts owed to or from parent or subsidiary
entities. Similar to the income statement, this is to simply reduce the
balances reported as the net effect is $0. All cash, receivables, and other
assets are reported on the consolidated as well as all liabilities owed to
external parties.

Pension Plan
A pension plan is a retirement plan that requires an employer to make
contributions into a pool of funds set aside for a worker's future benefit.
The pool of funds is invested on the employee's behalf, and the earnings
on the investments generate income to the worker upon retirement.
In addition to an employer's required contributions, some pension plans
have a voluntary investment component. A pension plan may allow a
worker to contribute part of his current income from wages into an
investment plan to help fund retirement. The employer may also match a

portion of the workers annual contributions, up to a specific percentage

or dollar amount.

BREAKING DOWN 'Pension Plan'

There are two main types of pension plans.
In a defined-benefit plan, the employer guarantees that the employee
receives a definite amount of benefit upon retirement, regardless of the
performance of the underlying investment pool. The employer is liable for
a specific flow of pension payments to the retiree (the dollar amount is
determined by a formula, usually based on earnings and years of
service), and if the assets in the pension plan are not sufficient to pay the
benefits, the company is liable for the remainder of the payment.
American employer-sponsored pension plans date from the 1870s, and
at their height, in the 1980s, they covered nearly half of all private
sector workers. About 90% of public employees, and roughly 10% of
private employees, in the U.S are covered by a defined-benefit plan
today.
In a defined-contribution plan, the employer makes specific plan
contributions for the worker, usually matching to varying degrees the
contributions made by the employees. The final benefit received by the
employee depends on the plan's investment performance: The
companys liability to pay a specific benefit ends when the contributions
are made.

What is a Pension Fund?

When a defined-benefit plan is made up of pooled contributions from

employers, unions or other organizations, it is commonly referred to as a
pension fund. Run by a financial intermediary and managed by
professional fund managers on behalf of a company and its employees,
pension funds control relatively large amounts of capital and represent
the largest institutional investors in many nations; their actions can
dominate the stock markets in which they are invested. Pension funds
are typically exempt from capital gains tax. Earnings on their investment
portfolios are tax deferred or tax exempt.
Advantages and Disadvantages of a Pension Fund
A pension fund provides a fixed, preset benefit for employees upon
retirement, helping workers plan their future spending. The employer
makes the most contributions and cannot retroactively decrease pension
fund benefits. Voluntary employee contributions may be allowed as well.
Since benefits do not depend on asset returns, benefits remain stable in
a changing economic climate. Businesses can contribute more money to
a pension fund and deduct more from their taxes than with a definedcontribution plan. A pension fund helps subsidize early retirement for
promoting specific business strategies. However, a pension plan is more
complex and costly to establish and maintain than other retirement plans.
Employees have no control over investment decisions. In addition,
an excise tax applies if the minimum contribution requirement is not
satisfied or if excess contributions are made to the plan.

Payment-In-Kind Bonds
A type of bond that pays interest in additional bonds rather than in cash.
The bond issuer incurs additional debt to create the new bonds for the
interest payments. Payment-in-kind bonds are considered a type of
deferred coupon bond since there are no cash interest payments during
the bond's term.
BREAKING DOWN 'Payment-In-Kind Bonds'
The types of companies that issue these bonds may be financially
distressed and their bonds may have low ratings but pay interest at a
higher rate. Because payment-in-kind bonds are an unusual and highrisk product, they appeal mainly to sophisticated investors such as hedge
funds. Investors seeking cash flow should not purchase payment-in-kind
bonds.

What is a 'Convertible Bond'

A convertible bond is a type of debt security that can be converted into a

predetermined amount of the underlying company's equity at certain
times during the bond's life, usually at the discretion of the bondholder.
Convertible bonds are a flexible financing option for companies and are
particularly useful for companies with high risk/reward profiles.

GAAP vs. Non-GAAP

GAAP

GAAP was developed by the Financial Accounting and Standards

Board to standardize financial reporting, providing a uniform set of rules
and formats to facilitate analysis by investors and creditors. The GAAP
created guidelines for item recognition, measurement, presentation and
disclosure. Bringing uniformity and objectivity to accounting improves the
credibility and stability of corporate financial reporting, factors that are
deemed necessary for optimally functioning capital markets. Companies
can be compared against one another; results can be verified by
reputable auditors, and investors can be assured that the reports are
reflective of fundamental well-being. These principles were established
and adapted largely to protect investors from misleading or dubious
reporting.
Non-GAAP
There are instances in which GAAP reporting fails to accurately portray
the operations of a business. Companies are allowed to display their own
accounting figures, as long as they are disclosed as non-GAAP and
provide reconciliation between the adjusted and regular results. NonGAAP figures usually exclude irregular or noncash expenses, such as
those related to acquisitions, restructuring or one-time balance sheet
adjustments. This smooths out high earnings volatility that can result
from temporary conditions, providing a clearer picture of the ongoing
business. Forward-looking statements are important because valuations
are largely based on anticipated cash flows. However, non-GAAP figures
are developed by the reporting company, so they may be subject to
situations in which the incentives of shareholders and corporate
management are not aligned.

Deferred Tax Asset

Deferred tax asset is an accounting term that refers to a situation where
a business has overpaid taxes or taxes paid in advance on its balance

sheet. These taxes are eventually returned to the business in the form of
tax relief, and the over-payment is, therefore, an asset for the company. A
deferred tax asset can conceptually be compared to rent paid in advance
or refundable insurance premiums; while the business no longer has
cash on hand, it does have comparable value, and this must be reflected
in its financial statements.
BREAKING DOWN 'Deferred Tax Asset'

Deferred tax assets are often created due to taxes paid or carried
forward but not yet recognized in the income statement. For example,
deferred tax assets can be created due to the tax authorities recognizing
revenue or expenses at different times than that of an accounting
standard. This asset helps in reducing the companys future tax liability. It
is important to note that a deferred tax asset is recognized only when the
difference between the loss-value or depreciation of the asset is
expected to offset future profit.

How Deferred Tax Assets Arise

The simplest example of a deferred tax asset is the carry-over of losses.
If a business incurs a loss in a financial year, it usually is entitled to use
that loss in order to lower its taxable income in following years. In that
sense, the loss is an asset.

Deferred Tax Liability

A deferred tax liability is an account on a company's balance sheet that is
a result of temporary differences between the company's accounting and
tax carrying values, the anticipated and enacted income tax rate,
and estimated taxes payable for the current year. This liability may be
realized during any given year, which makes the deferred status
appropriate.

Because there are differences between what a company can deduct for
tax and accounting purposes, there is a difference between a
company's taxable income and income before tax. A deferred tax
liability records the fact the company will, in the future, pay more income
tax because of a transaction that took place during the current period,
such as an installment salereceivable.

BREAKING DOWN 'Deferred Tax Liability'

Because U.S. tax laws and accounting rules differ, a company's earnings
before taxes on the income statement can be greater than its taxable
income on a tax return, giving rise to a deferred tax liability on the
company's balance sheet . The deferred tax liability represents a future
tax payment a company is expected to make to appropriate tax
authorities in the future, and it is calculated as the company's anticipated
tax rate times the difference between its taxable income and accounting
earnings before taxes.