Finance for Managers

Reference Guide

Contents

Financial Statements
Pages 3 12

Key Ratios
Pages 13 22

Glossary of Accounting Terms

Pages 23 31

This booklet has been produced as a

reference guide for participants of the
Ashridge Finance for Managers programme

Financial
Statements

Financial Statements
Balance Sheet, Profit and Loss, Cash Flow
Financial statements are the six elements of finance in
a business assembled into three reports:
Liabilities
Assets

form the Balance Sheet

Sales
Costs/Expenses

form the Profit and Loss Statement

Cash In
Cash Out

form the Cash Flow Statement

These are used to measure the performance

of the business.

The Balance Sheet

Liabilities (including Shareholders Equity) = Assets

LIABILITIES AND EQUITY

A companys funds come from two sources:
EQUITY (SHARE CAPITAL)
LIABILITIES

ASSETS
A company uses its funds to buy assets.
There are two types of assets:
FIXED ASSETS things a company means to keep.
CURRENT ASSETS things a company does not
intend to keep.

EQUITY (SHARE CAPITAL)

Gross Profit Margin

Gross Profit
This is the main mechanism for
bringing owners capital
Sales
Shares

into the business. There are many types of shares that a

company can issue. Different types of shares carry different
risks. The two most commonly known shares are:

Expenses
Ordinary shares (Common StockOperating
in the US)
The holders of ordinary shares are entitled to
all
Sales
remaining profits of the company after all costs, interest
and preference dividends have been paid. There are
two values associated with shares the value that is
shown on the Balance Sheet (nominal, or par value),
and the value on the market (market value). The latter
changes constantly and is not reported in the financial
statements. As the ordinary shareholders are the
investors taking the largest risk, they expect the greatest
average percentage returns in the long term.

Sales
Fixed Assets

Preference shares
The holders of preference shares areSales
entitled to a fixed
Sales
rate of dividend before any ordinary share dividends
Land
&
Buildings
Plant
&
Machinery
have been paid. When there are low profits, or when a
company goes into liquidation, preference shareholders
get paid before ordinary shareholders. As the preference
shareholders take less risk than ordinary shareholders but
are still less protected than lenders, their annual returns
tend to fall in the range between the two.
Retained profits/earnings (sometimes known as
Reserves or Retained Earnings)
Retained profits shows the total accumulated profit after
dividends have been distributed. This does not mean a
Cost
of put
Salesto one side,
Trade
x 365
sum of money has literally
been
but Debtors
that
historically the company hasStocks
made profits profits thatSales
may already have been used in some way, usually to
grow the company.

The shareholders equity or shareholders funds

represents the investment by shareholders in the
company. It is made up of:
shares
retained profits /earnings (sometimes called reserves).

Trad

LIABILITIES

ASSETS

Liabilities are split according to their repayment date into:

Long-term liabilities
Current liabilities

Fixed assets
Fixed assets are long term assets. They are grouped under
three headings:

Long-term liabilities
Long-term liabilities are amounts owed by the business
falling due in more than one year including:

Loans

Tangible fixed assets

These are the long-lasting, physical items required for
use in operating the business land and buildings,
plant and equipment, vehicles, office equipment, etc.

A loan is borrowings raised directly from a financial institution.

Intangibles
Bonds
A bond is a written promise to pay the holder a sum of
money at a certain time at a stated annual rate of interest.
It can be traded and doesnt have to come from a bank.

These are assets that do not have a physical presence,

such as patents, licenses, and goodwill. The largest figure
in intangibles is usually goodwill.

Long-term investments
Debentures
A debenture is a written acknowledgement of a debt
owing by a company. The debt carries a fixed rate of
annual interest and is repayable within a fixed term of
years. It may be secured on certain of the companys
assets, or it may be unsecured.

This will often include shares in associated companies

and trade investments.
Fixed asset investments tend to be long term, strategic
stakes in businesses.

Current assets
Current liabilities
Current liabilities include everything which must be
repaid within one year, such as:

Current assets are short-term assets, which change

continually in the normal course of business.
They are grouped under four headings:

Stock
Creditors/Accounts payable
This represents the invoices of suppliers that have been
received but not yet been paid, and any other expenses
which have been incurred but not yet paid for the
telephone, for example.

Also known as inventories, stock includes all raw materials

used in the operating cycle, all work-in-progress and
finished goods.

Debtors

Taxation payable

Also called accounts receivable, debtors are customers

from whom money is due.

Taxes that are due for payment within the next

12 months, but which have not yet been paid.

Cash

Dividends payable

This includes all cash equivalents such as short-term

bank deposits.

Dividends that have been declared, but not yet been paid.

Short term investments

Short-term borrowing
Overdrafts and other short-term borrowing from banks
and institutions.

Any short-term investments are usually held only for trading

or as a temporary home for spare cash.

The Profit and Loss Statement

Format/Construction of the Profit and Loss Statement
The Profit and Loss Statement records the operating
performance of a business over a period by matching the
businesss sales to its costs to calculate the difference
which is profit. Neither sales nor costs necessarily
consist of immediate cash transactions, therefore some
of the cash effects may be felt in a different period.
The categories well see listed on a P&L statement are:

Sales/turnover/revenue/income
(latter means profit in the US)
The first figure on the P&L statement shows the total
value of products or services delivered during the period.
As many businesses choose to allow some form of credit
and payment for these goods or services may not yet
have been received from customers (debtors), this sales
figure is unlikely to represent immediate cash flow.
Also some businesses, such as publishers and travel
businesses, receive the money before they deliver the
service/products.

Cost of sales
This figure also sometimes known as cost of goods
sold shows the costs incurred in buying or manufacturing
the products sold, or in providing a service to a customer.
Cost of sales for a retail company will be based on the
price at which the goods were acquired. Cost of sales
for a manufacturing company will match all the
production/manufacturing costs to the products
sold ie cost of raw materials, direct labour, and
manufacturing overhead costs. Cost of sales for a services
company is often impossible to specify, as they are usually
not selling anything except the complete service.

Gross profit
The gross profit is the difference between sales and
cost of sales.

Operating expenses
Operating expenses are all the costs not directly associated
with the goods sold, but which are incurred in the daily
running of the company, such as administration expenses
and marketing costs. They are sometimes called overheads,
or indirect expenses. In the USA they are called Selling,
General and Admin. (SG and A).

Operating profit (PBIT)

The Operating Profit is what is left after deducting
operating expenses from the gross profit. It is the profit
that the business is generating the Profit Before Interest
and Taxes, or PBIT. This profit now has to be distributed
and the sequence of sharing it out is very important.

Interest
First, a slice of profit is paid to lenders for Interest owing
on debt. This leaves Profit Before Tax (PBT).

Tax
Next a slice of profit goes in tax to the government.
This leaves Profit After Tax (or Net Profit).
Profit after tax is often called Earnings. It represents the
amount available either for payment of dividends to
shareholders, or for reinvestment in the company.

Dividends
Next its the turn of the shareholders to receive payment
of some profit in the form of a dividend. All the Profit
after Tax (or net profit) belongs to the shareholders and
could be paid to them. In practice most companies retain
some of these profits to fund expansion. It is the Boards
responsibility to judge how much should be distributed in
dividend and how much be retained subject to approval
by shareholders at the AGM. For businesses in the
Introductory or Growth phases of their sectors development
it is common not to pay dividends at all until they reach a
level of market maturity.

Retained profit
This is the amount remaining after dividends have been paid
to shareholders, which a company keeps in the business.
It is not necessarily represented in cash, but represents
the wealth generated by the business during the period.
The cumulative retained profits are shown on the balance
sheet and provide the link between the two statements.

The matching concept

One of the most important accounting principles rules
that revenues and expenses are recognised in the
Profit and Loss Statement at the time they are earned or
incurred not at the time they materialise into a real cash
flow. This is known as the accrual accounting principle.

Capitalising expenses
When expenses are capitalised, it means that the costs
are not charged directly to the P&L account and are instead
shown on the balance sheet as an asset. This can happen
in some circumstances to research and development
expense, to the writing/buying of computer software,
or commonly the improvement made to land and
buildings, where a cost is incurred one year, but where
the company is confident the benefit is going to last over
the years ahead.

NOTES TO THE ACCOUNTS

The Notes to the Accounts are an important part of all
financial statements, as they define they ways in which
the accounts have been drawn up. They will include
information about many important aspects which affect
the P&L, two of which are:
Depreciation of fixed assets
Stock value

Depreciation of fixed assets

The Profit and Loss Account is a scorecard for how a
company is doing, and it would distort this performance
measure if a huge loss were to occur every time a major
asset was replaced. The purpose of depreciation is to put
a fair charge into the P&L statement for the use of a resource
or an asset during an accounting period, so spreading the
cost of fixed assets over their expected useful life.
The cost of fixed assets does not, therefore, appear in full
on the P&L, but in the form of one years depreciation.
This is an important part of the costs of any business with
a high figure for fixed assets in an airline, for example,
whose principal fixed assets are the planes which can
have significant capital values.
The most common method of depreciation is:

The straight line method of depreciation

Straight Line Depreciation allocates an equal percentage of
the cost of an asset to a depreciation charge each period.
The reducing balance method of depreciation is sometimes
also seen. Reducing Balance Depreciation takes a fixed
percentage of the balance of expenditure remaining.
The fixed assets are shown on the Balance Sheet at cost
less accumulated depreciation. In this way, the Balance

10

Sheet does not reflect the market value of the company

or the individual assets nor does it pretend to.
The purpose of depreciation is to measure the impact
on the profit statement, not the balance sheet.

Stock or Inventory value

Stock valuation can have an effect on cost of goods sold.
The opening and closing stocks for the period have to
be counted and valued in order to calculate the material
costs of sales. The normal convention is to value stocks at
their historical cost i.e. the cost when they were originally
bought. Any stock which is obsolete should be written
down, as should any which will fail to recoup their cost.

The Cash Flow Statement

Introduction
The Profit and Loss Account and the Balance Sheet may
show a profit, but they may also be hiding a cash flow
problem, as they give us no direct information on the
movement of cash. Without cash flowing through the
business, a company will be unable to pay its debts as they
fall due many profitable companies have gone out of
business because they have failed to manage cash properly.
This statement tracks the flow of cash through the company.
It summarises the receipts and payments made during the
accounting period, identifying where money has come from
and how it is has been used, and critically revealing whether
money cash is flowing in or out.

Format/construction of the
cash flow statement
The cash flow statement aims to answer the questions
most generally asked about cash flow:
What is the company generating from its operations?
What is the company doing in terms of investments
or sale of investments?
And the net result is: does the company need to borrow
or raise finance from shareholders?
Here, groupings are usually according to the nature of
the item, regardless of whether it is money in or money
out. Groupings are listed under three main headings:
Operating Cash Flow
Investment
Financing.

11

Operating Cash Flow

This is money from operations.
It is the cash equivalent of Operating Profit as adjusted
for non cash items such as depreciation, accruals and
provisions etc. It also allows for the changes in working
capital (stocks/debtors/creditors).
In this way Operating Cash Flow accounts for the main
inflow of cash, usually from customers, less the main
operating cash outflows (payments to suppliers of raw
materials and services and payments of staff
wages/salaries and all other operating expenses.)
Interest and tax are deducted next the logic is that these
have to be paid before you consider the following items:

Investment
Investments comprise the buying and selling of any
fixed assets, the buying and selling of any companies,
and long term investments.
This leaves the amount of money a company has
available after meeting its investment needs. The higher
this figure is, the more freedom and flexibility it gives
the company to build its long-term strategy without the
need for external finance.

Financing
The financing section of the cash flow statement
summarises new finance in and old finance paid
off in simple terms, whether the company has repaid
borrowings or taken out loans, issued new shares or
repaid shares, or paid dividends.
The final balance is the difference between the cash
the firm started the year with and the amount shown
at the end of the year.

12

Key Ratios

Analysing Company Performance

Users of Financial Statements

Ratios can be considered in three groups:

There are many different users of financial statements.

The factors in which they are interested vary:

a) Performance Ratios: These attempt to give an

indication of how well the business is being run

a) Management will be primarily concerned with the

companys profitability. They will also be interested in
the ability of the company to remain in business, and
therefore will monitor the liquidity position.
b) Trade creditors will be interested in the ability of the
company to pay its debts as they fall due. They will,
therefore, be primarily concerned with liquidity.
c) Loan creditors will be interested in the companys ability
to continue in business (and therefore repay long-term
loans). They will be concerned with future profitability
and cash flow and the level of risk involved.
d) Investors will be interested in the return on their
investment. This will take the form of dividends
together with capital growth (an increase in the
share price). They will, therefore, be concerned with
profitability, liquidity and dividend policy.
Thus users of financial statements will be interested
in the following factors:Profitability
Liquidity and Solvency
Future Potential.

Ratio Analysis
Ratio analysis is probably the single most important
technique of financial analysis. However, a ratio is
unlikely to provide any useful information about a
company in isolation. A ratio must be used as a means
of comparison. This can be done by comparing the
trend of a ratio for a particular company over time, and
by comparing with the corresponding figure for other
companies. This is particularly useful when the comparison
is made with other companies in the same sector.

14

b) Financial Status Ratios: These indicate the financial

position of the company. Solvency ratios measure the
ability of the company to meet its long-term obligations.
Liquidity ratios measure the ability of the company to
meet its short-term obligations.

c) Investor Ratios: These relate to the financial results

and to the number and price of the companys shares.

Performance Ratios
a) Return on Capital Employed (ROCE)
(expressed as a percentage)

ROCE = Profit before interest and tax (PBIT)

Capital employed
Capital employed can be defined in a number of ways.
One definition is the total of shareholders funds plus
borrowings (the total invested into the business by
stakeholders who expect a return). It can also be
expressed as fixed assets plus working capital
(inventories plus receivables less trade payables), and
therefore represents the net operating assets being
used by the management in running the business.
The ratio compares the profit which has been earned to
the net assets. Strictly speaking, the figure for capital
employed should be the average for the year. However,
in order to simplify the computation, it is normally
sufficient to use year-end capital employed.
This measure of performance is independent of the
method of financing of the company. A change in the
capital structure (or gearing) of a company has no effect
on the ROCE.
It is important to note that in calculating profit before
interest and tax, care should be taken to ensure that the
figure is before the deduction of interest charges on all
loans which are treated as long-term borrowings.

15

b) Profit margin on sales (Margin)

(expressed as a percentage)

Margin = PBIT
Sales
This ratio gives the profit which is earned as a
proportion of sales. Thus, if the margin is 10%,
10 pence of each 1 of sales represents, on average,
profit. The margin will vary from sector to sector.
A manufacturing company might have a margin of 20%,
whereas a food retailer might have a margin of 5%.
Further analysis showing each cost as a percentage of
sales helps to identify trends within the business and to
highlight areas for management attention. Care is needed
in comparing different companies as their classification of,
for example, distribution costs may differ.

e) Stock turnover = Cost of Sales

(inventory ratio)

Stocks

This gives the number of times, on average, that the

stock stockholding has been sold during the year.
Cost of sales (and not sales) is the more correct figure
to use since the stock value is based on cost. If the figure
is too low, the company is incurring unnecessary costs
associated with holding stock. If the figure is too high,
the company may lose sales as a result of not having a
particular item in stock when it is ordered.
This analysis can be done internally for different lines,
and targets can be set for optimum performance.

f) Debtor days: Average collection period

expressed in days (receivables ratio)

c) Asset turnover =

Average collection period = Trade Debtors x 365

This ratio compare the level of sales a company can

generate from a given level of capital employed.
Capital intensive industries (eg. heavy engineering)
will tend to have low figures of asset turnover.

Sales
This gives the average amount of time customers are
taking to pay. Practice varies in different industries and
in different countries, but comparison with direct
competitors can be very relevant and, as with stock,
performance targets can be set and monitored against.

Sales
Capital employed

The asset turnover can be improved either by generating

a higher level of sales from a given asset base or by
disposing of assets which are not productive.

d) Relationship between ROCE,

margin and asset turnover
ROCE =

PBIT
Capital Employed

ROCE = PBIT
Sales

ROCE =

Sales
Capital Employed

g) Creditor Days: Average payment period

expressed in days (payables ratio)

Average payment period = Trade Creditors x 365

Cost of Sales
This gives an indication of the amount of time we are
taking to pay our suppliers. However, if Cost of Sales
includes considerable staffing and depreciation costs
(which have no impact on trade creditors), the ratio will
only help us to identify trends rather than absolute values.

Margin x Asset Turnover

Thus a change in return on capital employed can be

analysed into a change in margin and/or a change
in asset turnover.

16

17

Financial Status Ratios Liquidity

h) Pyramid of ratios: Measuring performance

PBIT
Capital Employed

Margin

Asset Turnover

PBIT
Sales

Sales
Capital Employed

Gross Profit Margin

For some industries the current ratio is a useful indicator.

It is particularly significant if there is a sharp deterioration
in the liquidity position.
It should be noted that while too low a current ratio may
be worrying on the grounds of liquidity, too high a current
ratio may be worrying on the grounds of profitability.
Funds inefficiently invested in working capital could
perhaps be earning a higher return if invested elsewhere.

b) Acid test (or quick) ratio = Current assets stock

Current liabilities

Gross Profit
Sales

Current Assets
Current Liabilities

This ratio indicates the extent to which short-term assets

are adequate to settle short-term liabilities. The norm for
a manufacturing company is a current ratio of at least
1.5. In some industries, eg. food retailing, this does not
apply: debtors are zero, stock is held for only a few days
but trade creditors are typically paid after 30 to 40 days,
so current liabilities exceed current assets the cash to
pay the trade creditors comes from later sales.

ROCE

a) Current (or liquidity) ratio =

The idea behind this ratio is the same as that behind the
current ratio. However, in this case the stock figure is
excluded from the funds available to meet current liabilities
on the grounds that stock may take several months to
turn into cash, especially when times are bad. An acid
test ratio of 0.8 is normal for a manufacturing company.

Operating Expenses
Sales

Financial Status Ratios Solvency

Sales
Fixed Assets

Sales
Land & Buildings

a) Debt/equity =

Sales
Plant & Machinery
Sales
Working Capital

Total borrowing
Shareholders funds

A company with a low debt-equity ratio is described as

having low gearing, whereas a highly-geared company
is one which relies on borrowing for a significant
proportion of its capital. This is all right when business
is good, but puts the company under strain to meet
interest and loan repayments if profits fall. A debt/equity
ratio of 50% is regarded as quite normal with concern
being expressed as it approaches or exceeds 100%.
The debt/equity ratio is often referred to in the financial
press as gearing. Strictly speaking:

Gearing =
Cost of Sales
Stocks

18

Trade Debtors x 365

Sales

Trade Creditors x 365

Cost of Sales

Total borrowing
Shareholders funds + total borrowing

And so can never exceed 100%.

19

b) Interest cover =

PBIT
Interest

This ratio means the number of times profit before

interest covers the interest charge. It gives an indication
of the relative safety of the loan interest. An interest cover
of 3x is generally regarded as satisfactory.

Investor Ratios
a) Return on Equity
ROE = Profit after tax (or earnings)
Shareholders funds

Summary
a) Performance ratios:
Return on capital employed =
Profit before interest and tax
Capital employed
Does the business generate an adequate return on its assets?

Profit margin on sales = Profit before interest and tax

Sales
To what extend do prices exceed costs? Measure of added value.

This ratio gives an indication of what return the

shareholders are earning.

Asset turnover =

b) Earnings per share (EPS)

To what extent do the assets generate revenue?

Measure of utilisation.

EPS =

Profit after tax

Number of ordinary shares in issue

The EPS figure is widely used, especially in measuring

changes from year to year.

c) Price/earnings ratio (P/E ratio)

P/E ratio =

Market price per share

EPS

This ratio gives an indication of the markets view of the

companys growth potential, business risks involved and
dividend policy. In general, the higher the P/E ratio, the
more highly rated is the company by the market.

Sales
Capital employed

Fixed assets turnover = Sales

Fixed assets
To what extent do the fixed assets, specifically, generate revenue?
Measure of fixed asset utilisation.

Stock turnover = Cost of sales

(inventory ratio)

Stocks

or, expressed in days = Stocks x 365

Cost of sales
How well are inventories managed?

Average collection period = Trade Debtors x 365

Sales

d) Dividend yield = Dividend per share

Market price per share
This ratio indicates the current income yield provided
for an investor in relation to the present market price
of the share.

e) Dividend cover =

EPS
Dividend per share

This ratio measures the number of times the dividend for

the year could have been paid out of the years earnings.
It is a measure of the safety of the dividend. However, it
should be noted that profit is not the only constraint on the
ability of a company to pay a dividend. If the company does
not have sufficient cash, then a dividend is not possible.
Also the maximum distribution which can legally be made
is based not on profits for the year, but on the cumulative
amount of retained profits.

20

How quickly are debtors/receivables collected?

Average payment period = Trade Creditors x 365

Cost of sales
How quickly are suppliers paid?

b) Financial status ratios:

Current ratio = Current assets
Current liabilities
Do our more liquid assets cover our more immediate liabilities?

Acid test ratio = Current assets stock

Current liabilities
Do our liquid assets, excluding stocks, cover our more
immediate liabilities?

21

Debt/equity ratio =

Total borrowing
Shareholders funds

What is the mix of funds constituting Capital Employed?

Interest cover = Profit before interest and tax

Interest
How easily is our interest afforded?

c) Investor ratios:
Return on equity = Profit after tax
Shareholders funds
Do the shareholders earn an adequate return
on their investment?

Earnings per share = Profit after tax

Number of ordinary
shares in issue

EPS growth = Percentage increases in EPS per year

Are the shareholders experiencing growth in the annual
profits per share?

Price/earnings ratio = Market price per share

Earnings per share
What multiple of earnings are investors willing to pay to buy the
share? The higher, the more the earnings are projected to grow
in the future.

Dividend yield = Dividend per share

Market price per share
What is the percentage return shareholders receive in the
form of dividends? It does not reflect the capital gains made
from increases in the share price.

Dividend cover = Earnings per share

Dividend per share
How easily is the dividend payment covered by earnings.
If the ratio is inverted it shows a payout percentage (eg. a cover
of 2.0 means 50% of earnings are pa0id out in dividends.)

22

Glossary of
Accounting Terms

Glossary

Accounts payable

Capital employed

See Creditor.

The investment used by a firm comprising share capital,

reserves, and borrowings. Within many businesses the definition
is taken from the other side of the balance sheet as Fixed Assets
plus Working Capital.

Accounts receivable
See Debtor.

Absorption costing
A system of costing where cost units (products) absorb
a share of indirect costs in addition to their direct costs.

Accrual
Outstanding expenses for an accounting period for which
the invoice has not been received and therefore not paid.

Accruals concept
See Realisation.

See Reserves.

Cash flow
The definition depends on the context in which the term is
used but is generally regarded as the operating profit after
adding back the depreciation charge for the period.

Cash flow statement

Acid test ratio

A financial statement showing the internal and external

sources and uses of cash during a period.

A measure of liquidity obtained by dividing debtors,

cash and short-term investments by current liabilities
(short-term creditors).

Common stock

Activity-based costing (ABC)

Consolidated accounts

See Ordinary shares.

The identification of activities as a basis for charging

overhead costs to cost units (products).

A combined profit and loss account and a combined

balance sheet for a holding company and its subsidiaries.

Asset

Contribution

Any possession or claim on others which is of value

to a firm. See also Fixed Assets and Current Assets.

The difference between Sales less variable costs.

Asset turnover
See Turnover of capital.

Starts its life as a conventional loan but gives the holder the right to
transfer into a specified number of ordinary shares at a later date.

Associated company

Cost centre

A company in which another company owns a substantial

shareholding exceeding 20 per cent but not more than
50 per cent of the total.

A physical location within an organisation, for example a department

or section, where costs are accumulated.

B
Balance sheet
A statement of the financial position of a firm at a particular
date showing the assets owned and the sources of finance.

Benchmarking
A comparison with best practice in order to help to gain
superior performance.

Convertible loan

Cost code
A numbering system used to describe the type, source, and
purpose of all costs and revenues.

Cost direct or indirect

A direct cost is one which can be specifically allocated to a
product, as in the case of materials used and labour expended.
An indirect cost cannot be directly related to any particular product
but is more general in nature. Indirect costs are alternatively called
overheads and direct costs are sometimes referred to as prime costs.

Cost unit

Book value

Any product or service to which costs can be charged.

The original or historical cost of an asset less

accumulated depreciation.

Cost variable or fixed

Break-even point

A variable cost varies in total to the volume of production. A fixed

costs stays the same total sum over a range of output levels.

The level of output or sales value at which total

costs equal total revenues.

Creditor

Budgetary control
Financial plans to meet objectives in the accounting
year against which actual results are compared.

24

Capital reserves

Any party to whom the business owes money, separated into

amounts payable within and after one year, and usually analysed
into borrowings and other creditors (including trade creditors).

25

Current assets
Cash and other short-term assets in the process of being
turned back into cash, for example stocks and debtors.

Current cost accounting

A procedure for adjusting items in a company profit and
loss account and balance sheet for the effects of inflation.

Current liabilities
Creditors payable within one year, for example trade
creditors, bank overdrafts, dividends, and tax provisions.

Current ratio
A measure of liquidity obtained by dividing current
assets by current liabilities.

D
Debtor
A credit customer (trade debtor) or other party who
owe money to the firm. Also Accounts Receivable.

Deferred tax
Tax liability arising from differences between profits for
reporting purposes and those for taxation purposes.

E
Earnings per share
Profit after tax earned for shareholders divided by the
number of ordinary shares issued.

Earnings yield
The earnings per share expressed as a percentage
of the current market price of an ordinary share.

Equity
See Shareholders funds.

F
Factoring
The receipt of cash from a specialist company against the
security of sales invoices which that company collects.

Fixed assets
Assets used by the firm itself and not sold in the normal course
of business. For example, buildings and plant and machinery.

Flexible budget
A budget which is constructed to change in accordance
with the actual level of activity achieved.

Depreciation
A proportion of the cost of a fixed asset charged as an
expense in a company profit and loss account.

Differential costing
The costs and/or revenues of alternative courses of action
which are compared to identify the differences between them.

Discounted cash flow (DCF)

A method used to calculate the present value of cash flows,
taking into account the time value of money.

Dividend
A periodic distribution to shareholders in proportion
to the number of shares held.

Gearing
The relationship of borrowings to shareholders funds.
Also known as Leverage.

Goodwill
When another business is acquired, goodwill is the difference
between the purchase price and the value of the net assets acquired.

Gross profit
The difference between the sales and the cost of goods
sold before charging general overhead expenses.

Gross profit margin

Dividend cover

Gross profit expressed as a percentage of sales.

A measure of the security of the dividend payment obtained

by dividing the profit after tax by the total dividend.

Group accounts

Dividend yield
The income obtained from the gross dividend as a
percentage of the current market price of a share.

Double entry bookkeeping

The method of recording financial transactions
whereby every item is entered as a debit in one account
and a corresponding credit in another.

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See Consolidated Accounts.

H
Historical cost accounting
The recording of transactions at the actual cost incurred at
the time of purchase, irrespective of the items current value.

Holding company
The parent company which owns a controlling
interest in one or more subsidiaries.

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Income

Ordinary shares

In US terminology this means profit.

Intangible assets

The class of capital entitling the holders to all remaining

profits after all costs, interest and preference dividends
have been paid. They are also entitled to all residual assets
once other claimants have been repaid on liquidation.
Known as Common Stock in US.

Assets of a non-physical nature including goodwill,

patents, trade marks, brands and royalty agreements.

Outsourcing

Inflation accounting
See Current cost accounting.

Internal rate of return (IRR)

A measure of the true rate of return expected on a project.
It represents the maximum rate of interest which could be
paid on the diminishing capital balance of an investment.

Investment centre
A type of responsibility centre where the manager is responsible
for revenues, costs, profit and investment, culminating in either a
residual profit or return on capital objective.

The buying-in of services, components or manufactured goods.

Overtrading
A liquidity problem caused by insufficient working
capital to support the level of sales.

P
Payback period
The number of years taken to recover the original sum invested.

L
Leverage
See Gearing.

M
Marginal costing
A system of costing used for decision making which is based
on the analysis of costs into fixed and variable categories.

Market capitalisation
The total market value of all a quoted companys
ordinary shares.

Minority interests
The proportion of a subsidiary company which is owned by
outside shareholders as opposed to the parent or holding
company. Cannot apply to wholly owned subsidiaries.

N
Net present value (NPV)
The sum of all the negative and positive present values
of the cash flows in an investment appraisal, indicating
that projects viability when they are positive.

Net profit before taxation

The profit after all costs (including interest) have been
deducted, but before tax and dividends.

Net profit after taxation

The profit after all costs, interest and taxation have
been deducted, but before dividends.

Post-completion audit
A comparison of the original estimates and premises on
which they were based with the actual outcomes of an
investment project.

Preference shares
The class of capital entitling the holders to a fixed rate
of dividend prior to any ordinary share dividend.
On liquidation, holders are also entitled to the repayment of
their capital before ordinary shareholders are repaid.

Present value
The equivalent value now of a sum of money receivable
in a later year.

Price/earnings ratio
A ratio used for comparing market prices of different
companies ordinary shares. It is calculated by dividing
the market price of the share by the earnings per share.

Profit and loss account

(or Income Statement). It summarises the revenue and
expenditure of a company to arrive at the net profit
or loss for the period.

Profit centre
A type of responsibility centre where the manager is
responsible for costs and revenues and therefore profit,
but without authority for the level of investment.

Profit margin
A ratio used to measure performance, calculated by expressing
gross or net profit as a percentage of sales value.

Net profit margin

Net profit before interest, tax and dividends expressed
as a percentage of sales.

28

29

R
Ratio
Two figures usually extracted from the profit and loss
account and/or balance sheet and related together
as a percentage, ratio or function.

Realisation
An accounting concept which states that profit is earned
when a sale takes place and not when cash from that sale
is received. It is also referred to as the accruals concept.

Reserves
Revenue reserves are retained profits. Capital reserves
occur when fixed assets are revalued or sold at a profit
and when a company sells new shares at a premium.
Revenue reserves (but not capital reserves) may be
distributed in the form of dividends.

Return on capital (ROC)

Profit before tax and interest charges expressed as a
percentage of capital employed. Also known as
Return on Investment, Return on Net Assets, etc.

Revenue centre
A type of responsibility centre where the manager is
responsible for the revenue generated from sales.

Rights issue
An invitation to existing shareholders to subscribe for
new shares when a company requires further capital.

S
Scrip issue
A free or bonus issue of new shares to existing shareholders
in proportion to their existing holding. No new capital is
received by the company which translates existing reserves
into share capital.

Sensitivity analysis
Used in investment appraisal as a risk technique,
where any component in the net cash flows can be
examined for its effect on the NPV or IRR, when its
value is varied from the original estimate.

Share capital
Money subscribed by shareholders in a limited company
for ordinary or preference shares. Issued share capital is
the amount of capital actually received, while authorised capital
is the total amount the directors are empowered to issue.

Shareholders funds or net worth

The total amount of shareholders investment in the
company, comprising issued share capital, retained profits,
and all other reserves. It equals the value of all the companys
assets after deducting all debts owing to outside parties.
Other terms with the same meaning include share capital
and reserves, shareholders equity or net assets.

Standard costing
A system of costing whereby predetermined product
costs are compared with actual costs to highlight
significant variances which are then investigated.

Subsidiary
A company which is controlled by another company,
which owns more than 50 per cent of the voting shares.

T
Trading profit
Same as operating profit.

Trial balance
The list of debit and credit balances on individual accounts from
which a profit and loss account and balance sheet are prepared.

Turnover
An alternative word for sales or revenue.

Turnover of capital
The relationship of sales to capital employed, stating the
number of times each 1 of capital has generated 1 of sales
in one year. A financial measure of utilisation.

V
Value added statement
A financial statement showing the wealth created by a
company in a period of time and how it was distributed
to the interested parties.

Variance
The difference between a budget or standard and the
actual amount.

W
Working capital
The standard definition is current assets less
current liabilities. Some simplify this to stock plus
work in progress plus trade debtors, less trade creditors.

Share premium account

The additional paid-in capital received by a company
when it sells shares for more than their par value.
It is a capital reserve and must be distinguished from
the issued share capital in the balance sheet.

30

Z
Zero based budget
A budget compiled without reference to the prior years budget.

31

The Ashridge Finance for

Managers programme helps

you to understand the financial
aspects of your job and the
impact of your decisions,
enabling you to work effectively
alongside financial specialists

Ashridge
Berkhamsted
Hertfordshire HP4 1NS
United Kingdom
Tel: +44 (0)1442 841026
Fax: +44 (0)1442 841036
Email: steve.watson@ashridge.org.uk
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