Gearing Ratio

Gearing Ratio

Gearing focuses on the capital structure of the business. The gearing ratio is the proportion of a company's debt to its equity. A high gearing ratio represents a high proportion of debt to equity, and a low gearing ratio represents a low proportion of debt to equity. Gearing also known as "leverage" measures the proportion of assets invested in a business that are financed by long-term borrowing.

A high gearing ratio is indicative of a great deal of leverage, where a company is using debt to pay for its continuing operations. The higher the level of borrowing (gearing) the higher are the risks to a business. However, gearing can be a financially sound part of a business's capital structure particularly if the business has strong, predictable cash flows.

A company with high gearing is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are. A high gearing ratio is less of a concern where a business is in a monopoly situation and its regulators are likely to approve rate increases that will guarantee its continued survival.

A low gearing ratio is indicative of conservative financial management. It may also mean that a company is located in a highly cyclical industry, and so cannot afford to become overextended in the face of a downturn in sales and profits.

The formula for calculating gearing is:

Long-term debt + Short-term debt + Bank overdrafts
Shareholders' equity

 

National Debt

National Debt

National debt is the total amount owed by central government which has accumulated over time. It is the total amount of borrowing accumulated by the government that is still outstanding. It is the total amount that the government owes to individuals and institutions.

Debt swap

Debt swap is a set of transactions in which a firm buys a country's dollar bank debt at a discount and swaps this debt with the central bank for local currency that it can use to acquire local equity.  

A company can undergo some financial restructuring for long term success. One possible way to achieve this goal is to issue a debt/equity or an equity/debt swap. In the case of an equity/debt swap, all specified shareholders are given the right to exchange their stock for a predetermined amount of debt (i.e. bonds) in the same company. A debt/equity swap works the opposite way: debt is exchanged for a predetermined amount of equity (or stock). The value of the swap is determined usually at current market rates, but management may offer higher exchange values to entice share and debt holders to participate in the swap. After the swap takes place, the preceding asset class is cancelled for the newly acquired asset class.

Variable-rate mortgage

A variable-rate mortgage or adjustable-rate mortgage (ARM) is a mortgage loan with the interest rate on the note periodically adjusted based on an index which reflects the cost to the lender of borrowing on the credit markets. The loan may be offered at the lender's standard variable rate/base rate. There may be a direct and legally defined link to the underlying index, but where the lender offers no specific link to the underlying market of index they can choose to increase or decrease at their discretion. The term "variable-rate mortgage" is most common outside the United States, whilst in the United States, "adjustable-rate mortgage" is most common, and implies a mortgage regulated by the Federal government,  with limitations on charges ("caps"). In many countries, adjustable rate mortgages are the norm, and in such places, may simply be referred to as mortgages.

Adjustable rate mortgage is a mortgage that features predetermined adjustments of the loan interest rate at regular intervals based on an established index. The interest rate is adjusted at each interval to a rate equivalent to the index value plus a predetermined spread, or margin, over the index, usually subject to per-interval and to life-of-loan interest rate and/or payment rate caps.

Decile rank

Decile rank is a rating of performance over time. It is rated on a scale of 1-10, where 1 is best and 10 is worst. For performance of mutual funds, 1 indicates that a mutual fund's return was in the top 10% of funds being compared, while 3 means the return was in the top 30%.

General ledger

The general ledger is where financial information from all aspects of your business is consolidated.  Each General Ledger is divided into debits and credits sections. The general ledger is a collection of the group of accounts that supports the value items shown in the major financial statements. It is built up by posting transactions recorded in the sales daybook, purchases daybook, cash book and general journals daybook. The general ledger can be supported by one or more subsidiary ledgers that provide details for accounts in the general ledger. For instance, an accounts receivable subsidiary ledger would contain a separate account for each credit customer, tracking that customer's balance separately. This subsidiary ledger would then be totaled and compared with its controlling account (in this case, Accounts Receivable) to ensure accuracy as part of the process of preparing a trial balance.

There basic categories in which all accounts are grouped are:

1. Assets
2. Liability
3. Owner's equity
4. Revenue
5. Expense
6. (Gains)
7. (Loss)

The balance sheet and the income statement are both derived from the general ledger.

Earnings per share

Earnings per share (EPS) is calculated by dividing company’s profit by its number of outstanding shares. If a company earned $2 million in one year had 2 million shares of stock outstanding, its EPS would be $1 per share.

The portion of a company's profit allocated to each outstanding share of common stock. Earnings per share serve as an indicator of a company's profitability.

The company often uses a weighted average of shares outstanding over the reporting term. 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.

Hell or high water contract

A contract that obligates a purchaser of a project's output to make cash payments to the project in all events, even if no product is offered for sale. It is a non-cancellable contract whereby the purchaser must make the specified payments to the seller, regardless of any difficulties they may encounter. 

It is a contract including a clause stating that payments must be made regardless of what happens. Specifically, a hell or high water contract requires one party to continue to receive payments even if an act of God prevents the contract from being completed. For example, suppose two parties sign a contract renting an apartment. The contract may contain a hell or high water clause saying that the renter must pay rent every month even if the apartment floods or burns down. It is also called a promise to pay contract.

Growing equity mortgages

Growing equity mortgages are the mortgages in which annual increases in monthly payments are used to reduce outstanding principal and to shorten the term of the loan. 

It is a fixed rate mortgage on which the monthly payments increase over time according to a set schedule. The interest rate on the loan does not change, and there is never any negative amortization. In other words, the first payment is a fully amortizing payment. As the payments increase, the additional amount above and beyond what would be a fully amortizing payment is applied directly to the remaining balance of the mortgage, shortening the life of the mortgage and increasing interest savings.

Working Capital

Working capital is defined as those funds a business has available to meet its day-to-day financial obligations. A sustainable business must have sufficient funds available at all times to meet its financial obligations as they become due. Working capital can be expressed in a layman's formula: 

Working Capital = Available funds - day to day financial obligations 

In accounting terms,

Working Capital = Current Assets – Current Liabilities

Current assets are items of economic value that can be converted into cash quite quickly in the accounting period (usually 1-3 months). These items typically include cash, inventory, accounts receivable (i.e. what customers owe to the business).

Current liabilities are monies that a business owes to external parties (not owners) and are due for payment within the current accounting period (usually within the next 12 months). These items are typically accounts payable (i.e. what the business owes to suppliers) plus other payables like income tax or council rates.

Operating Cycle

The Operating Cycle of a business is the length of time between the cash outflow on purchased material and cash inflow from the sale of goods. The Operating Cycle determines the amount of working capital that a business requires to operate on a day-to-day basis. The shorter the Operating Cycle the lower the amount of working capital required for the business and the greater opportunity for investments in other value-adding activities.

The Operating Cycle for a manufacturing based business can involve many stages, namely:

1. Purchase - the receipt of raw materials from suppliers on account.
2. Conversion - the conversion of these raw materials into finished goods
3. Inventory - the holding and storage of raw materials, Work-In-Progress (WIP) and Finished Goods.
4. Payment - the payment of the supplier's account for the raw materials received earlier.
5. Sale - the sale of finished goods to customers on account
6. Collection - the collection of money from these customers in payment of their account

Cash flow matching

Cash flow matching is the practice of matching returns on a portfolio to future capital outlays. It involves investing in certain securities with a certain expected return so that the investor will be able to pay for future liabilities. Pension funds and annuities perform the most cash flow matching, as they have future liabilities that are both large and relatively easy to estimate. Portfolios that perform cash flow matching usually invest in low-risk, investment-grade securities. The practice is also called portfolio dedication, matching, or the structured portfolio strategy.

Clearing House Interbank Payments System (CHIPS)

The Clearing House Interbank Payments System (CHIPS) is the main privately held clearing house for large-value transactions in the United States, settling well over US$1 trillion a day in around 250,000 interbank payments. Together with the Fedwire Funds Service CHIPS forms the primary U.S. network for large-value domestic and international USD payments (where it has a market share of around 96%).

CHIPS is owned by financial institutions. According to the Federal Financial Institutions Examination Council (FFIEC), an interagency office of the United States government, "any banking organization with a regulated U.S. presence may become an owner and participate in the network." CHIPS participants may be commercial banks, Edge Act corporations or investment companies.

Banks typically prefer to make payments of higher value and of a less time-sensitive nature by CHIPS instead of Fedwire, as CHIPS is less expensive (both by charges and by funds required).

CHIPS differ from the Fedwire payment system in three key ways. First, it is privately owned, whereas the Fed is part of a regulatory body. Second, it has 47 member participants (with some merged banks constituting separate participants), compared with 9,289 banking institutions (as of March 19, 2009) eligible to make and receive funds via Fedwire. Third, it is a netting engine (and hence, not real-time).

A netting engine consolidates all of the pending payments into fewer single transactions. For example, if Bank of America is to pay American Express US$1.2 million, and American Express is to pay Bank of America $800,000, the CHIPS system aggregates this to a single payment of $400,000 from Bank of America to American Express — only 20% of the $2 million to be transferred actually changes hands. The Fedwire system would require two separate payments for the full amounts ($1.2 million to American Express and $800,000 to Bank of America).

Only the largest banks dealing in U.S. dollars participate in CHIPS; about 70% of these are non-U.S. banks. Smaller banks have not found it cost effective to participate in CHIPS but many have accounts at CHIPS-participating banks to send and receive payments.

Reasonableness test

Reasonableness test is a procedure to examine the logic of accounting information. It is where the expected value is determined by reference to data partly or wholly independent of the accounting information system, and for that reason, evidence obtained through the application of such a test may be more reliable than evidence gathered using other analytical procedures.

For example, the trend in promotion and entertainment expense for a company can be compared to that of prior years of the same company or to competitive companies, or to industry norms. If the promotion and entertainment expense is relatively high, it will require investigation because it does not appear reasonable.

Balloon Maturity

Balloon Maturity means a repayment schedule for a bond issue where a large number of the bonds come due at a one time, usually at the final maturity date. Balloon maturity occurs only in bonds without a sinking fund provision; rather than retiring part of the principal at different times, balloon maturity returns most or the entire principal on a single date. Issuers of bonds with balloon maturities can have difficulty in repayment if they have not set aside a sufficient amount of money.

A final loan payment that is considerably higher than prior payments is also known as a "balloon payment."

Debt service parity approach

Debt service parity approach is an analysis wherein the payment alternatives under consideration will provide the firm with the exact same schedule of after-tax debt payments (including both interest and principal).

Historical cost vs. market (fair) value

According to GAAP, assets and liabilities have been recording through historical cost accounting: a system where assets and liabilities are recorded and presented at the monetary amount paid or the consideration given at the time of their acquisition. But it possess some strong flaws in context of the contemporary business environment which have made accounting bodies, especially FASB & IASB, to search for a number of alternative accounting methods. One of these alternatives is market or fair value accounting that has been thinking as the best alternative to the historical cost accounting. The market value of an asset (liability) is the amount at which that asset (liability) could be bought or sold (incurred or settled) in a current transaction between willing parties.

As historical cost accounting is based on actual transactions, the recorded amounts are reliable and verifiable and free from management bias. Historical cost accounting leads to absolute certainty and it fits in perfectly with the cash flow statement. It tells exactly what has been paid or received and therefore there is no doubt about balance sheet amounts.

Historical cost helps the managers to forecast future operational cost based on past data. Without knowing the original cost, future projections are almost hampered. Under historical cost accounting, there is no scope for manipulation, because the data is supported by sufficient evidences such as: invoices, receipts etc.

However historical costs do have their own limitations. The strongest argument against historical cost accounting is it does not provide information that is relevant to investors. Intangible assets acquired outside of business combination (internally generated) are not reported in historical financial statements. Reliable forecast of the future income effects of a financial instrument is unlikely to be possible from the simple extrapolation of past gain and losses based on historical cost.

Proponents of market value accounting argues that this measurement is more relevant than historical cost as it provides up-to-date information consistent with market and as it takes into account the inflationary adjustment to the acquired cost. Critics have argued that this method increases volatility and thus reduces stock price. But its proponents contend that market value reveals economic realities that are hidden by historical cost accounting. The patrons of market value accounting have been continuing their supports to it for its following advantages:

Market value measurement is more relevant to investors and creditors as it reflects the current market price of an asset or liability. It provides more transparency to users. Measurement of financial assets and liabilities at market value in the balance sheet should better capture an entity’s exposure to risk and increase its visibility in the balance sheet.

The market value dissenters argue that the information provided by market value financial statements is unreliable; because it is not based on arm’s length transactions & there is a huge possibility for management to manipulate the bottom line. They contend that if the information is unreliable, it should not be used to make financial decisions.

Some critics are concerned that the precipitous adoption of market value accounting will have adverse effect on both banks and the financial system as a whole. These critics believe that earnings based on market values for investment securities are likely to be more volatile than those based on historical cost.

Market values are basically based on unverifiable subjective estimates of managers. When quoted market price for an asset or liability is not available, market value is measured based on an estimate by using the best information and techniques available in the circumstances.

Although historical cost accounting has some distinguishing features for which its patrons think it better method for measuring assets and liabilities, it can’t provide relevant information to investors. Market value accounting can able to eliminate this limitation by providing current and inflation adjusted information to investors. Therefore, market value is the best alternative to historical cost. But there are also several significant problems within market value accounting in its current application which make more users reluctant to use market value in measuring assets and liabilities.

As investors are the major users of financial statements, priority should be given to their wants, that is, which measurement they prefer- historical cost or market value. Empirical evidences show that investors want both measurements. They want reliable and transparent market value information to determine the actual value of their investment. They also want historical cost information that helps them to determine whether management has discharged the stewardship entrusted to them. Therefore, assets and liabilities should be measured and reported at market value and these measurements must be reliable, verifiable &transparent and these measurements should not be at the cost of abandoning historical cost information.

Payback Period

The amount of time it takes to recover the cost of an investment. In capital budgeting the payback period refers to the specific time period needed by the firm in order to recoup the initial plus and subsequent costs of the capital investment. The payback period includes all initial investment to the annual predicted cash inflows for the recovery time period. The major problem of this ratio is that it does not take into account cash flows which the firm receives after the payback period has been met and thus cannot be considered a measure of the profitability of any particular investment. undertaking.

It is calculated as:

Cost of Project/Annual Cash Inflows

For example, if a project costs $150,000 and is expected to return $30,000 annually, the payback period will be $150,000 / $30,000, or five years.

Accrued interest

The accumulated coupon interest earned but not yet paid to the seller of a bond by the buyer (unless the bond is in default).

Acid-test ratio

It is also called the quick ratio, the ratio of current assets minus inventories, accruals, and prepaid items to current liabilities.