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

 

Balanced Scorecard

Balanced Scorecard

Balanced scorecard (BSC) is an approach to performance measurement.  It is a strategy performance management tool.  A balanced scorecard is a set of performance measures constructed for four dimensions of performance. The four dimensions are:

• Financial: encourages the identification of a few relevant high-level financial measures. In particular, designers were encouraged to choose measures that helped inform the answer to the question "How do we look to shareholders?"
• Customer: encourages the identification of measures that answer the question "How do customers see us?"
• Internal business processes: encourages the identification of measures that answer the question "What must we excel at?"
• Learning and growth: encourages the identification of measures that answer the question "How can we continue to improve, create value and innovate?"

The balanced scorecard is ultimately about choosing measures and targets. The various design methods proposed are intended to help in the identification of these measures and targets, usually by a process of abstraction that narrows the search space for a measure.

Derivative instruments

A derivative is a financial instrument whose value depends on underlying variables. The most common derivatives are futures, options, and swaps but may also include other tradable assets such as a stock or commodity. A derivative is essentially a contract whose payoff depends on the behavior of a benchmark.

Derivatives are broadly categorized by the relationship between the underlying asset and the derivative (e.g., forward, option, swap); the type of underlying asset (e.g., equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives or credit derivatives); the market in which they trade (e.g., exchange-traded or over-the-counter); and their pay-off profile.

Derivatives can be used for speculating purposes ("bets") or to hedge ("insurance"). Very commonly, companies buy currency forwards in order to limit losses due to fluctuations in the exchange rate of two currencies.

Arms index

The Arms Index, also known as TRIN, an acronym for TRading INdex, was developed in 1967 by Richard Arms. It is a volume-based indicator, which determines market strength and breadth by analysing the relationship between advancing and declining issues and their respective volume; it is used to measure intra-day market supply and demand, and it can be applied over short or longer time periods.

The index is calculated using the following formula:

Arms index or TRIN= (number of advancing issues)/ (number of declining issues) (Total up volume)/ (total down volume).

An index value of 1.0 indicates that the ratio of up volume to down volume is equal to the ratio of advancing issues to the declining issues. The market is said to be in a neutral state when the index equals 1.0 since the up volume is evenly distributed over the advancing issues and the down volume is evenly distributed over the declining issues.

Market conversion price

Market conversion price is the price that an investor effectively pays for common stock by purchasing a convertible security and then exercising the conversion option. This price is equal to the market price of the convertible security divided by the conversion ratio.

Conversion ratio is the number of shares of common stock one receives by exercising the conversion option. In order for the exercise of the option to be worthwhile, the market conversion price must be lower than the market price of common stock. It is also called the conversion parity price and the conversion value.

Information coefficient

Information coefficient is the correlation between predicted and actual stock returns, sometimes used to measure the value of a financial analyst. It is a measure of the correlation between expected and actual returns. The IC is used internally within a firm to judge the performance of individual financial forecasters. The IC is measured on a scale between 0 to 1, with 1 indicating no difference between expected and actual returns. An IC of 1.0 indicates a perfect linear relationship between predicted and actual returns, while an IC of 0.0 indicates no linear relationship.

Omnibus account

Omnibus account is an account carried by one futures commission merchant with another futures commission merchant in which the transactions of two or more persons are combined and carried in the name of the originating broker, rather than designated separately. It is an account between two futures merchants (brokers). It involves the transaction of individual accounts which are combined in this type of account, allowing for easier management by the futures merchant.

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.

Holding period return

Holding period return (HPR) is the total return on an asset or portfolio over the period during which it was held. It is one of the simplest measures of investment performance.

HPR is the percentage by which the value of a portfolio (or asset) has grown for a particular period. It is the sum of income and capital gains divided by the initial period value (asset value at the beginning of the period).

HPR = ((Present Value, or face Value, End-Of-Period Value) + (Any Intermediate Gains eg. Dividends) - (Initial Value)) /(Initial Value)

HPR_n = Income + (P_n+1 – P_n)/ P_n

Annualized holding period return is the annual rate of return that when compounded t times, would have given the same t-period holding return as actually occurred from period 1 to period t.

Quality spread

Quality spread is, the spread between Treasury securities and non-Treasury securities that are identical in all respects except for quality rating. For instance, the difference between yields on Treasuries and those on single A-rated industrial bonds. It is also called credit spread. 

In an interest rate swap quality spread differential is the difference between the interest rates of debt obligations offered by two parties of different creditworthiness that engage in the swap. A swap transaction is considered beneficial to both parties only when the QSD is positive.

J-curve

The term J-curve is used in several different fields to refer to a variety of unrelated J-shaped diagrams where a curve initially falls, but then rises to higher than the starting point.

In private equity, the J curve is used to illustrate the historical tendency of private equity funds to deliver negative returns in early years and investment gains in the outlying years as the portfolios of companies mature.

In economics, the 'J curve' refers to the trend of a country’s trade balance following a devaluation or depreciation under a certain set of assumptions. A devalued currency means imports are more expensive, and on the assumption that the volume of imports and exports change little immediately, this causes a depreciation of the current account (a bigger deficit or smaller surplus). After some time, though, the volume of exports may start to rise because of their lower more competitive prices to foreign buyers, and domestic consumers may buy fewer of the costlier imports. Eventually, if this happens, the trade balance may improve on what it was before the devaluation. If there is a currency revaluation or appreciation the same reasoning leads to an inverted J-curve.

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%.

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.

Naïve diversification

Naïve diversification is a strategy whereby an investor simply invests in a number of different assets and hopes that the variance of the expected return on the portfolio is lowered. It is a diversification of a portfolio without regard, for the mathematical formulas in the capital asset pricing model. Naive diversification rests on the assumption that simply investing in enough unrelated assets will reduce risk sufficiently to make a profit. Alternately, one may diversify naively by applying the capital asset pricing model incorrectly and finding the wrong efficient portfolio frontier. Such diversification does not necessarily decrease risk at a given expected return, and may in fact increase risk.

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.

Market model

This relationship is sometimes called the single-index model. The market model says that the return on a security depends on the return on the market portfolio and the extent of the security's responsiveness as measured, by beta. In addition, the return will also depend on conditions that are unique to the firm. Graphically, the market model can be depicted as a line fitted to a plot of asset returns against returns on the market portfolio.

 Mathematically it is expressed as:

where:

r_it is return to stock i in period t

r_f is the risk free rate (i.e. the interest rate on treasury bills)

r_mt is the return to the market portfolio in period t

α_i is the stock's alpha, or abnormal return

β_i is the stocks's beta, or responsiveness to the market return

Note that r_it − r_f is called the excess return on the stock, r_mt − r_f the excess return on the market

ε_it is the residual (random) return, which is assumed normally distributed with mean zero and standard deviation σ_i

These equations show that the stock return is influenced by the market (beta), has a firm specific expected value (alpha) and firm-specific unexpected component (residual). Each stock's performance is in relation to the performance of a market index.

Program (or Project) Evaluation and Review Technique

The Program (or Project) Evaluation and Review Technique (PERT), is a model for project management designed to analyze and represent the tasks involved in completing a given project. It is commonly used in conjunction with the critical path method or CPM.

PERT is a method to analyze the involved tasks in completing a given project, especially the time needed to complete each task, and identifying the minimum time needed to complete the total project.

PERT was developed primarily to simplify the planning and scheduling of large and complex projects. It was developed for the U.S. Navy Special Projects Office in 1957 to support the U.S. Navy's Polaris nuclear submarine project. It was able to incorporate uncertainty by making it possible to schedule a project while not knowing precisely the details and durations of all the activities. It is more of an event-oriented technique rather than start- and completion-oriented, and is used more in projects where time, rather than cost, is the major factor. It is applied to very large-scale, one-time, complex, non-routine infrastructure and Research and Development projects.

A PERT chart is a tool that facilitates decision making. The first draft of a PERT chart will number its events sequentially in 10s (10, 20, 30, etc.) to allow the later insertion of additional events. Two consecutive events in a PERT chart are linked by activities, which are conventionally represented as arrows. The events are presented in a logical sequence and no activity can commence until its immediately preceding event is completed. The planner decides which milestones should be PERT events and also decides their “proper” sequence. A PERT chart may have multiple pages with many sub-tasks.

PERT is valuable to manage where multiple tasks are occurring simultaneously to reduce redundancy.

Passive portfolio strategy

Passive portfolio strategy is a strategy that involves minimal expectational input, and instead relies on diversification to match the performance of some market index. A passive strategy assumes that the marketplace will reflect all available information in the price paid for securities, and therefore, does not attempt to find mispriced securities. 

It is a strategy in which an investor (or a fund manager) invests in accordance with a pre-determined strategy that doesn't entail any forecasting (e.g., any use of market timing or stock picking would not qualify as passive management). The idea is to minimize investing fees and to avoid the adverse consequences of failing to correctly anticipate the future. The most popular method is to mimic the performance of an externally specified index. Retail investors typically do this by buying one or more 'index funds'. By tracking an index, an investment portfolio typically gets good diversification, low turnover (good for keeping down internal transaction costs), and extremely low management fees. With low management fees, an investor in such a fund would have higher returns than a similar fund with similar investments but higher management fees and/or turnover/transaction costs.