Common Financial Terms

Financial Accounting

Financial accounting is the process of recording, summarizing, and reporting the transactions that result from a business's operations over time. These transactions are reflected in summary reports called financial statements. 

Financial Statements

Financial statements summarize a business's financial activity, reflecting its overall performance. To ensure accuracy, financial statements are often audited by government agencies, accounting firms, etc. Financial statements are also audited for tax, financing, or investing purposes. 

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Basic financial statements are comprised of three parts:

1. Balance Sheet

2. Income Statement

3. Statement of Cash Flows

Balance Sheet

The balance sheet reports a company's assets, liabilities, and shareholders’ equity at a specific point in time. This statement provides a snapshot of what a company owns and owes, as well as the amount of investment by shareholders. ​

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Balance sheets employ the accounting equation:​

Assets = Liabilities + Shareholders' Equity

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Comparing the balance sheet from a specific point in time with those from previous dates yields a sense of general trends over a longer period of time.

Income Statement

The income statement, also known as the profit and loss statement, reflects a company's revenues and expenses during a particular period. Whereas a balance sheet can be compared  to a snapshot of a company's financial situation at a specific date, a company's income statement reflects performance over a particular period of time.

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Four key items are included on an income statement:  

1. Revenue

2. Expenses

3. Gains

4. Losses

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Net Income = (Total Revenue + Gains) - (Total Expenses + Losses)

Statement of Cash Flows

The statement of cash flows provides information about how money moves in and out of a business, acting as a bridge between the income statement and the balance sheet. There are three classifications of cash flow: Operating Cash Flow, Investing Cash Flow, & Financing Cash Flow.

These are divided into three sections on the statement of cash flows:

1. Operating Activities

2. Investing Activities

3. Financing Activities

Assets

An asset is any resource with economic value that is  owned or controlled by an individual, corporation, or other entity. An asset is  bought or created with the expectation that it will yield future benefits, such as:

• Generation of cash flow

• Reduction of expenses

• Improved sales

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Assets are reported on a company’s balance sheet.

Tangible Assets

Tangible assets have a physical form and can be recorded as either current (short-term) assets or non-current (long-term) assets.

Examples of tangible assets include:

• Cash

• Accounts receivable

• Land

• Vehicles

• Equipment

• Furniture

• Machinery

• Inventory

Intangible Assets

Intangible assets are non-physical assets created or acquired by businesses.

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Examples of intangible assets include:

• Brands

• Trademarks

• Copyrights

Current Assets

A company’s current assets include all of its assets that are expected to be realized within a year. These include the following:

• Cash

• Cash equivalents

• Accounts receivable

• Inventory

• Marketable securities

• Prepaid expenses

• Other liquid assets

Long-Term Assets

A company’s long-term assets are not expected to be converted to cash within a year.

Types of long-term assets include the following:

• Land

• Facilities

• Equipment

• Copyrights

• Other illiquid investments

Capital Assets

A capital asset meets the following criteria:

• It is a tangible asset.

• The asset has a useful life longer than a year.

• The asset is not intended for sale in the regular course of the business’s operations.

For example, a computer that is bought for the company’s own use is considered a capital asset, whereas it would be considered inventory if the company purchased the computer with the intention of selling it.

Depreciation

Depreciation reflects the expense associated with the loss in useful life of a tangible asset. This accounting convention allows a company to deduct costs associated with tangible assets over time. Considered a non-cash transaction, depreciation reflects how much of an asset’s value a business has used over a given period.

Amortization

The accounting convention of amortization is similar to depreciation, with an important distinction; rather than dealing with tangible assets, amortization spreads out capital expenses associated with intangible assets over time.

Liabilities

A company’s liabilities include its legal financial debts or obligations, which are recorded on the balance sheet. Liabilities are settled over time through the transfer of money, goods, or services.

Types of liabilities include:

• Loans

• Accounts payable

• Mortgages

• Deferred revenues

• Accrued expenses

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There are two main categories of liabilities:

• Current Liabilities

• Long-Term (Non-Current) Liabilities

Current Liabilities

Current liabilities include all of a company’s debts or obligations that are due within one year or one operating cycle.

Types of current liabilities include:

• Short-term debt

• Accounts payable

• Accrued liabilities

• Other similar debts

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Current liabilities can be settled in the following ways:

• Through the use of a current asset, such as cash or a cash equivalent

• By creating a new current liability

• By converting a current liability to a long-term liability

Long-Term Liabilities

Also known as non-current liabilities, long-term liabilities represent debts payable over a period longer than one year.

Examples of long-term liabilities include the following:

• Bonds payable

• Long-term loans

• Pension liabilities

• Post-retirement healthcare liabilities

• Deferred compensation

• Deferred revenues

• Deferred income taxes

• Customer deposits

Working Capital

Calculating a company’s working capital provides insight into its short-term financial health. This amount is calculated by subtracting a company’s current liabilities from its current assets:

Working Capital = Current Assets - Current Liabilities

Capital Gains & Losses

A capital gain occurs when a capital asset’s value surpasses its purchase price. Conversely, a capital loss is incurred when a capital asset decreases in value compared to its purchase price.

A capital gain or loss is not realized until an asset is sold. Short-term capital gains or losses are realized within one year of an asset’s purchase; long-term capital gains or losses are realized after one year.

Rate of Return

The rate of return (RoR), also known as the return on investment (ROI), represents an investment’s net gain or loss over a period of time.

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Rate of Return = [(Current Value - Initial Value) ÷ Initial Value] * 100

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The rate of return serves many purposes. It is commonly used by companies to measure growth between distinct periods and evaluate overall investment growth.

Shareholders’ Equity 

Shareholders’ equity illustrates a company’s financial health by subtracting its total liabilities from its total assets. This amount reflects the amount of money that would be returned to shareholders if all of the company’s assets were liquidated and its debt was paid off.

Shareholders’ Equity (SE) = Total Assets - Total Liabilities

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Shareholders’ Equity is also referred to as “Stockholders’ Equity,” “Share Capital,” and “Net Worth.”

Capital Structure

A company's capital structure determines how it finances its overall operations and growth through various sources of funds, including its long-term and short-term debts as well as its equity. This term is often used to refer to a firm's debt-to-equity (D/E) ratio, which reflects how risky a company is to investors.

Debt-to-Equity Ratio

The debt-to-equity (D/E) ratio is used to determine a company’s financial leverage, or the degree to which it is financing its operations through debt versus equity.​

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Debt/Equity = Total Liabilities ÷ Total Shareholders’ Equity

Gross Revenue

A company’s gross revenue reflects the total amount of sales for a given period without accounting for any expenses. This amount indicates the business’s ability to sell goods and services.

Because gross revenue does not take into account the cost of goods sold, sales discounts, sales returns, etc., it does not reflect the company’s ability to make a profit.

Net Revenue

A company’s net revenue is calculated by subtracting the cost of goods sold from its gross revenue.

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Net Revenue = Gross Revenue - Cost of Goods Sold

Operating Expense

Operating expenses are incurred by a business through its normal business operations.

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Operating expenses include the following:

• Rent

• Wages not classified as costs of goods sold

• Equipment

• Inventory costs

• Marketing

• Insurance

• Funds allocated for research and development

Capital Expense

Capital expenses include any purchases that a company makes as a form of investment. These include costs related to the acquisition of tangible and intangible assets, as well as costs associated with upgrading such assets.

Non-Operating Expense

Incurred expenses that are unrelated to a business’s normal operations are considered non-operating expenses.
 

The most common types of non-operating expenses include:

• Depreciation

• Amortization

• Other costs of borrowing

Revenue v. Receipts

Two terms that are often confused are “revenue” and “receipts.”

A company’s revenue is the amount that it has earned as a result of its business activities, such as selling merchandise or performing services. Revenues are reported on the income statement for the period in which they are earned, even if payment has not yet been received.

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A company’s receipts include any cash that the company receives. Receipts can come from a number of sources including but not limited to the following:

• Payments from customers

• Borrowing cash from a bank

• Receiving cash in exchange for a company vehicle

Although revenues and receipts are distinct financial concepts, they are not mutually exclusive; for example, a cash sale represents an earned revenue as well as a receipt.

​Income from Operations 

Income from operations, or operating income, is the profit from a business's primary operations. Analyzing a company's income from operations can help to predict its future profitability.

Operating income includes revenue and expenses involved in a business's day-to-day operations, excluding income from other sources such as investments or the sale of company assets.

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Operating income is determined using the following formula:

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Income from Operations (IFO) = Revenue from Operations - Cost of Goods Sold - Other Operating Expenses

Cost of Goods Sold

Also known as the cost of sales, a company’s cost of sales reflects the direct costs incurred through the company’s production of goods or services. These include:

• Cost of materials used to produce a good

• Labor costs incurred during production of goods sold

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Indirect expenses, such as distribution costs or sales force costs, are excluded from a company’s cost of goods sold.

Operating Margin

Operating Margin

A company’s operating margin reflects how much profit it makes per dollar of sales, accounting for costs of sales as well as operating expenses. Calculating a company’s operating margin provides insight into its profitability.

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Operating Margin = Operating Earnings ÷ Revenue

Interest Income

Interest income is the amount of interest earned over a specified period of time. Interest income can refer to the revenue earned by lenders or investors.

Lenders earn interest income in exchange for the use of their funds (such as the loan interest charged by banks). Investors earn interest income from investments that pay interest, such as certificates of deposit (CD) or savings accounts.

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Interest income is a separate concept from dividends, which represent distributions of a company’s retained earnings, not earned interest,

Interest Expense

Interest expense is a type of non-operating expense. It represents the interest payable on any borrowings, such as bonds, loans, convertible debt, or lines of credit.

The following formula is used to calculate a company’s interest expense:

Interest Expense = Principal x Interest Rate x Time period

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Note that the interest expense amount listed on a company’s income statement represents interest accrued during the specified period, regardless of whether that interest has yet been paid.

Dividends

Dividends are distributions paid by a company to owners of its stock, also known as its shareholders. Dividends are paid from retained earnings, which represent profits that have not yet been distributed. Because these profits have already accounted for expenses, dividends are not considered an expense.

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Dividends can take a few different forms:

Cash payments

Additional shares of stock

Property.

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Shareholders receive a dividend per share of stock owned; for example, if an individual owns 40 shares of a company's stock and the company pays $4 in annual dividends, that shareholder will receive $160 in dividends annually.

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Cash dividends are the most common type of dividend, followed by stock dividends. Some companies offer dividend reinvestment programs (DRIPS), through which shareholders can reinvest their dividends into additional shares of the company's stock.

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Companies in the United States typically pay dividends quarterly, though some choose to distribute them monthly or semi-annually.

Retained Earnings 

The term "retained earnings" refers to a business's accumulated net income after it has paid out dividends to its shareholders. Positive retained earnings reflect profits; negative retained earnings reflect losses.

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Retained Earnings (RE) = Beginning Period RE + Net Income (or Loss) - Cash Dividends - Stock Dividends

Price-to-Earnings Ratio

The price-to-earnings ratio (P/E ratio) measures a company’s current share price relative to its per-share earnings. If a company has a high P/E ratio, its investors likely anticipate higher earnings in the future.

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Price-to-Earnings Ratio = Market Value Per Share ÷ Earnings Per Share

Capital Gains Distributions

A capital gains distribution is a type of payment made by a mutual fund or an exchange-traded fund (EFT) to its investors. This payment consists of a portion of the proceeds from the fund’s sales of stocks or other assets.

In other words, a capital gains distribution represents an investor’s share of a fund’s proceeds from various transactions. Investors can choose to receive capital gains distributions as payments or to reinvest them back into the fund in the form of additional shares of stock.

Earnings Per Share (EPS)

A company’s earnings per share (EPS) reflects how much money it makes for each share of its stock, indicating the company’s profitability. This amount is calculated by dividing a company’s net income by the number of outstanding shares of its common stock.

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Earnings Per Share = (Net Income - Preferred Dividends) ÷ End-of-Period Common Shares Outstanding

Inventory Turnover Ratio

By calculating how many times average inventory is sold and replaced during a given period, a company can determine how efficiently its inventory is managed. This ratio is calculated by calculated by dividing a company’s sales by its average inventory.

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In order to use the inventory turnover ratio, the company's average inventory must first be calculated:

Average Inventory = (Beginning Inventory - Ending Inventory) ÷ 2

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After determining its average inventory, the company can calculate its inventory turnover:

Inventory Turnover = Sales ÷ Average Inventory

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Cash Balance

A company’s cash balance includes its cash on hand as well as its demand deposits.

Cash Equivalents

Cash equivalents include the following:

• Cash held as bank deposits

• Short-term investments

• Easily cash-convertible assets

Cash Flow

“Cash flow” refers to inflows and outflows of cash and cash equivalents. Cash flows come from operating activities, investing activities, and financing activities.

Operating Cash Flows

Cash flow from operating activities represents the main revenue-generating activities of a company, as well as other activities that are not investing or financing.

Cash flows from operations are typically associated with the following:

• Sales

• Purchases

• Other expenses

Investing Cash Flows

Cash flow from investing activities includes the acquisition and disposal of long-term assets and other investments not included in cash equivalents.

Investing cash flow is typically associated with the buying or selling of the following:

• Property, plant, and equipment (PP&E)

• Other non-current assets

• Other financial assets

Financing Cash Flows

Cash flow from financing activities results from changes in size and composition of a company’s equity capital or borrowings.

Financing cash flows are typically associated with the following:

• Borrowing and repaying bank loans

• Issuing and buying back shares

• Payments of dividends

Liquidity

Liquidity reflects how quickly an asset can be converted into cash. Liquidity exists along a spectrum. Cash is the most liquid asset. Tangible assets, such as real estate or collectibles, are considered less liquid because they take longer to liquidate. Most stocks and bonds, which are easily converted into cash, are considered liquid assets. Investment assets that take longer to convert into cash (such as restricted shares of stock) are considered less liquid.

Liquidity Ratios

The following ratios are commonly used to measure a company’s liquidity:

• Current Ratio

• Quick Ratio

• Operating Cash Flow Ratio

Current Ratio

The current ratio measures the liquidity of a company by dividing its current assets by its current liabilities.​

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Current Ratio = Current Assets ÷ Current Liabilities

Quick Ratio

Also known as the “acid test ratio,” the quick ratio excludes a company’s inventories from its current assets, measuring the company’s ability to meet its short-term obligations using only its most liquid (near-cash) assets.​

Quick Ratio = (Current Assets - Inventory - Prepaid Expenses) ÷ Current Liabilities

Operating Cash Flow Ratio

This ratio measures how well a company’s current liabilities are covered by the cash flows generated from its operating activities. This helps gauge a company’s short-term liquidity.

Operating Cash Flow Ratio = Operating Cash Flow ÷ Current Liabilities