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Level I Knowledge Base Terms
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Level II Knowledge Base Terms
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10-K Annual filing made by public companies with the SEC (Securities and Exchange Commission). Provides income statement, Balance Sheet and cash flow statement and related footnotes for the year, together with management's discussion and analysis of these results.
The 10-K is filed no more than 90 days after the end of the fiscal year. So for companies whose fiscal year ends December 31, you can expect to be able to find 10-K reports beginning March 31. The SEC archive can be accessed at http://www.sec.gov/cgi-bin/srch-edgar 10-Q Quarterly filing made by public companies with the SEC (Securities and Exchange Commission). Provides income statement, Balance Sheet and cash flow statement and related footnotes for the quarter, together with management's discussion and analysis of these results. The first 10-Q of the year (e.g. March 31 for a calendar year reporting company) is straightforward. It includes a three month income statement and cash flow statement. Subsequent quarters not only include results for the quarter (3 months) but also for the year to date. Be careful when deciding which schedule to focus on! The 10-Q is filed no more than 45 days after the end of the quarter. The SEC archive can be accessed at http://www.sec.gov/cgi-bin/srch-edgar |
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Accounts Payable Amounts that the company owes to its suppliers. A Current Working Capital Liability.
See also: Working Capital Accounts Receivable Amounts that customers owe the company. A Current Working Capital Asset. See also: Accrual Accounting, Working Capital Accrual Accounting Accountants' record of revenues and expenses does not always match the actual cash inflows and outflows. Accountants follow a number of rules that govern when revenue or expenses hit an income statement. Here are a couple of the most significant examples: Revenue Recognition - Suppose Ajax Corp. ships out a widget to a customer, along with a $100 invoice. At that moment Ajax' accountant would recognize revenue of $100 (under most circumstances) - even though Ajax has not received the $100 in cash yet. Ajax records a receivable on its Balance Sheet for the $100. Ninety days later, when the check arrives, Ajax records an entry to remove the receivable and increase its cash balance. Note that this leads to a delay between the cash impact and the (accrual) accounting impact. Inventory Accounting - Suppose Ajax spends the entire month of January making a widget at a direct cost of $50 (e.g. the apportioned salaries of the people working on it plus the cost of raw materials). The widget sits in the warehouse for three months and is finally sold for $70 on April 30. What if Ajax used a cash accounting method, recognizing revenues and expenses when the cash actually moves? It would have a $50 loss in the first quarter and a $70 profit in the second quarter. Instead, accountants use principles that match the revenues with the expenses. The $50 of costs are capitalized - they increase the value of the inventory on Ajax' balance sheet. So instead of attributing the $50 of costs to an expense on the income statement, the cost is temporarily capitalized to the balance sheet. Later, when the widget is sold, $70 of revenue and $50 expense are recognized ($20 profit) and the inventory disappears. Depreciation - Suppose Ajax spends $1,000 on a new machine. The machine is expected to last for 10 years. The accountant does not show a gigantic $1,000 expense on the income statement this year. Instead, the $1,000 is capitalized - increasing the property, plant and equipment (PP&E) line item on the balance sheet. The expense is recognized over the period of time that the benefits of the machine are received. A depreciation expense of $100 per year for the next 10 years would be a very typical treatment. An annual $100 expense is recognized on the income statement. The cash picture is different. $1,000 is spent today and none for the next 10 years. Accumulated Depreciation Accumulated Depreciation represents the cumulative depreciation related to the property, plant and equipment owned (an allowance for the PP&E getting used up). Acquisition The purchase of a business or collection of Assets. Amortization Amortization: When a business or collection of Assets is acquired under Purchase Accounting, Intangible assets are created on the Balance Sheet as certain assets get written up to fair value. Amortization expense is recognized on the income statement each year to gradually write-down this amount. Amortization is a non-cash expense that functions very similarly to Depreciation for modeling purposes. The simplest way to think of amortization is that it is the process of writing off the cost of an asset. In the example of a piece of machinery, the word used is depreciation, which is simply a type of amortization, where the cost of the machinery is gradually written off over a number of years. In the case of a bank loan, the bank will typically charge the lender a fee for taken out a loan. This fee is usually written off, or amortized, over the life of the loan. The use of amortization allows the accounting profession to match the cost of an asset with the benefit it produces. In the example of the bank loan, obviously, a company gains some benefit from the loan over the life of the loan, otherwise they would simply repay it. By amortizing the fee that the bank charged, the company recognizes the cost of that loan over the same period of time that the company benefits from it. To better understand how to model amortization, see GoodWill or Depreciation. Amortization of Capitalized Financing Costs See Financing Costs Amortization Amortization Schedule Schedule that sets forth the minimum required principal retirements for certains types of debt. Analyst The most junior level of investment banker, typically focused on Excel-based analytics, valuation and modeling work. Or, in equity research, the individuals who analyze a company's prospects and publish their opinions to investors. Assets "Stuff" that a company owns or has a claim on that has value. Examples include Cash, Accounts Receivable, Inventory and PP&E. At the Money When an Option can be exercised by paying a Strike Price that is equal to the Market Value of the underlying stock, the Option is said to be At the Money. Average Interest A financial model that calculates Interest Expense (or Interest Income) based on the average of the beginning and ending Debt balances for that period is said to be running "Average Interest". Average Interest causes a circular reference in Excel (the only acceptable circular reference in corporate finance modeling, by the way). So it's a good practice to calculate Interest Expense/Income using the beginning of period balance (non-circular) until it's time to print. |
Accretion The increase in value or dollar amount of a particular measure.
For example, an EPS accretion/dilution analysis looks at the impact on Earnings per Share as a result of a transaction. As another example, when interest expense is not paid in cash, the balance amount owed increases, so the non-cash interest expense is sometimes termed "accretion". Adjusted EBITDA The EBITDA of a business as reported (or pro forma for a deal), plus adjustments to exclude any non-recurring items. Adjusted EBITDA is meant to give a better picture of the go-forward cash generation potential of the business. After-Market Trading in a stock or bond issue that happens after it is first sold to the market. In the after-market, the issuing company does not receive any proceeds, since the trades are between two investors. However, the issuer is keenly interested in how well its securities trade in the after-market, since a rising price will make it easier to sell subsequent issues. Agent Someone acting on behalf of another. Investment Bankers usually act in an agency capacity, representing their client's interests. An Agent is the opposite of a Principal, which is someone acting on their own behalf. AHYDO AHYDO stands for "Applicable High Yield Discount Obligation", the set of IRS rules governing deductibility of Accretion of OID. When bonds pay interest in the form of Accretion rather than cash, not all of the interest expense is tax deductible, as set forth by the AHYDO rules. Asset Purchase A form of acquisition where specified assets and liabilities of the target are purchased, as opposed to buying all of the stock of the target. In an asset purchase, the target company continues on as a business entity, and it receives cash in exchange for the net assets sold. The selling company must pay a tax equal to the difference between the value paid for the net assets and the Tax Basis of those assets. The buyer enjoys the benefit of inheriting assets with a "Stepped-Up Basis". Asset Sale An Asset Purchase, as seen from the point of view of the seller. Associate The entry level position in an investment bank for business school graduates, one level above an investment banking Analyst. Attached Warrants Warrants sold together with a Bond or Mezzanine security. The Warrants serve to increase the overall returns that the investor can expect, since they earn a return on the equity warrant as well as the other security. Auction Book A book sponsors receive from M&A bankers inviting them to participate in the sale of a business. Audited Audited financial statements are signed by an independent accounting firm, affirming that the accountant has reviewed the detailed financial records of the company and believes them to be accurate in all material respects (staking its reputation on the claim). |
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Balance Sheet A snapshot of a company's Assets ("stuff" that has value) and the claims on those assets. A company's assets are either owed to others (liabilities) or are left over as a residual claim of the equity holders. The equity holders get whatever's left over after the liabilities.
Core Principle: Assets = Liabilities + Equity Bank Debt See Revolver, Term Loan Beta Analysts use a statistical measure known as Beta to measure the degree of Systematic Risk of a given security. Beta is calculated by measuring the statistical correlation between the returns on a given security and the broader market. Securities with a Beta of 0 have no Systematic Risk. The market as a whole has a Beta of 1. So securities with Betas greater than 1 have a higher Risk level than the rest of the market. Beta can even be negative. The market and the economy often move together (though not always). For that reason, stocks that are heavily correlated to the economy - cyclicals such as autos and manufacturers - often have high Betas (greater than 1). Non-cyclicals such as beverage companies tend to have low Betas (less than 1). Bonds See Bullet Note Book Taxes The Income Tax Expense shown on the company's financial statements. See also: Deferred Taxes Book Value The amount shown on a Balance Sheet for one or more Assets or liabilities, net. The book value of an asset, liability or equity account does not necessarily equate to the market value, and in fact usually differs substantially. Be careful when looking at a balance sheet and making inferences about the value of the assets. Be VERY careful when looking at the Equity line item of the balance sheet and inferring that that is what the company's stock is worth. Buildup See Operating Buildup Bullet Note A Bullet Note (or bond) is another form of long-term debt capital. These Notes are typically Unsecured. This type of debt will have the longest maturity and will not have an Amortization schedule. In other words, the entire amount of the loan is due at maturity (in one "bullet" payment) and there are typically restrictions on prepayment prior to maturity. Bullet Notes are considered to be a more permanent piece of a company's capital structure. In most instances, a company does not really expect to repay these loans at maturity. Usually the company will refinance the debt with a new security. These securities will usually have a fixed interest rate. |
Bank Book A book published by the Lead Bank in a bank debt deal that contains detailed information about the issuing company (borrower), credit highlights and risks, historical and (in most cases) projected financials, and the terms of the deal (e.g. the maintenance covenants). Other banks decide whether to buy (lend) a piece of the bank debt based on the information contained in this book.
Base Case In financial modeling, the starting case set of operating assumptions for a financial model. Usually a fairly conservative set of assumptions that the investor group is comfortable with based on their due diligence. Basis Basis is the carrying value of an asset on a set of financial statements. The Book Basis is the value shown on a set of GAAP financial statements and the Tax Basis is the value shown on the set of books maintained for the IRS or other taxing authority. Basis Points A Basis Point is 1/100th of a percentage point Blended Returns The combined returns of different assets. For example, if an investor pays $100 for a Unit comprised of a bond plus an attached warrant, the Blended Returns would be based on the cash received for the bond (principal + interest), plus the value of the warrant; and this would be compared with the $100 investment. Block Holder Refers to an individual or institution holding a large block of stock. Bolt on A small acquisition Bond A financial instrument issued by governments, municipalities, and corporations that pays either fixed or variables rates of interest. Typical market bonds pay interest "coupons" in cash semi-annually (twice per year), with repayment of principal in 10 years -- though bonds can have different structures as well. Book Basis Basis is the carrying value of an asset on a set of financial statements. So the Book Basis is the value shown on a set of GAAP financial statements. Book Income Taxes The income tax expense shown on the company's reported (GAAP) income statement. Book purposes For the preparation of the GAAP financial statements (as opposed to the financial statements reported to the IRS or other taxing authority). BPS Abbreviation for basis points Breached Violated a material term of an agreement. Breakup Fee Once an acquisition is agreed to by the acquiror and the target, if either backs out of the deal it may owe the other party a cash payment called a "breakup fee". Bridge Loan The investment bank may provide the sponsor with a bridge loan commitment to finance the middle portion of the capital structure, as a "backstop" in case the bond issue cannot be raised. Buy Side A segment of the financial services industry consiting of firms and individuals that invest in stocks and bonds, such as hedge funds, pensions and mutual funds. Meanwhile, the "sell%20side" consists of investment bankers and brokers who are focused on selling securities to institutions and individuals. Buy-In Price In an LBO, the valuation at which an investment is made. |
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CADR See Cash Available for Debt Repayment
CAGR See Compound Average Growth Rate Call Option See Option Capex See Capital Expenditures Capital Expenditures Investments made in the long term Assets of the company; primarily represents additions to Property, Plant and Equiptment (PP&E). Capital Spending See Capital Expenditures Capital Structure Also known as Capitalization, the capital structure of a firm is the amount and type of each class of Debt and Equity. For example, suppose a company is worth $350 million altogether. If the company borrows $100 million of bank debt, its remaining equity value is $250 million. Alternatively, the company could change its capital structure by issuing $50 million of additional stock (e.g. through an IPO) and using the proceeds to repay $50 million of the debt (ignoring fees). That would leave it capitalized with $50 million of debt and $300 million of equity. Most "deals" have an impact on the capital structure of the company. There is a tradeoff that firms need to analyze when setting their Capital Structure (i.e. when deciding whether to raise money by borrowing (Debt) or issuing shares of stock (Equity). Debt is paid back with a fixed amount of Interest expense - and the Interest is tax deductible. That limits the amount that the company needs to pay out, but also signs up the company to a fixed obligation that could cause trouble if cash gets tight. When Equity is issued, the company is giving up a percentage of its ownership. That leaves the new shareholders with a lot of upside potential - far beyond the typical return they would have earned by lending the company money at a fixed rate of interest. See also: Financial Leverage Capitalization See Capital Structure Capitalize When money is spent, accountants either record it as an expense in that period capitalize the expenditure and recognize it as an expense at a later date. When money is spent for advertising, for example, an expense is recognized immediately. On the other hand, if money is spent to buy a machine that will be used for the next 10 years, the income statement sees no impact now. Instead, the cost of the machine is capitalized - increasing the PP&E balance on the Balance Sheet. Over the next 10 years the expense is recognized through an annual Depreciation expense on the income statement. Capitalized Financing Costs The Balance Sheet account for Capitalized Financing Costs represents the fees incurred raising debt financing. Cash Accounting Opposite of accrual accounting. Cash Accounting records revenues at the time cash is received by the business and expenses at the time cash is spent. Review Accrual Accounting to understand how this differs from standard accounting practices. Cash Available for Debt Repayment Cash generated during the year that is available to pay down debt or increase the cash balance - or, if negative, it is the shortfall that the company must borrow or come up with from available funds. Cash COGS Cost of Goods Sold minus Depreciation expense, to adjust for this non-cash expense. Cash Flow Statement An Income Statement provides a bottom line profit number called Net Income. However, Net Income does not tell us how much cash the company earned during the year. Some of the revenues and expenses on the Income Statement do not match up with the actual cash inflows and outflows of the business (see accrual accounting). The Cash Flow Statement provides a reconciliation between the Net Income number and the actual change in the company's cash balance. Cash for Working Capital See Minimum Cash Balance. Cash Gross Profit Gross Profit plus Depreciation expense, to adjust for this non-cash expense. COGS See Cost of Goods Sold Common Stock One of two types of Equity. Common Stock holders have the right to vote and elect directors. Most shares of stock traded on exchanges are Common Stock. Companies may also issue Preferred Stock. See also: Preferred Stock Comp See Comparable Company Analysis Comparable Company Analysis Comparable Company Analysis entails valuing a Security based on a relative comparison with comparable Securities ("Comps"). It is a comparison of companies in the same industry, subject to the same economic trends, to evaluate valuation metrics, profit levels, Beta and other factors. The concept is that if two companies are similar, these metrics should be similar. Compound Average Growth Rate A Compound Average Growth Rate (CAGR) is defined as: (Future Value / Present Value) (1 / Number of Periods) - 1 For example, if revenues grow from $100 in 2000 to $150 in 2003, the 3 year CAGR is (150/100)1/3 - 1, or 14.5%. Now, it's possible that revenues were $100 in 2000, then $130 in 2001, $132 in 2002, and $150 in 2003 (i.e. not necessarily smooth growth each year), but an average growth rate of 14.5% can be found using the CAGR formula. Note: To raise a portion of a formula to a power in Excel, use the "^" symbol. An example of a CAGR formula in Excel would therefore be "=(F4/C4)^(1/3)-1". Consolidated The Consolidated financial results of the company (e.g. Revenue) are the overall combined results across all business segments (adjusting for inter-company and certain other items). Continuing Operations When a company sells a business mid-year (a divestiture), the financial results of the remaining business are known as "continuing operations". The results of the business sold, by contrast, are recorded separately on the Income Statement and Balance Sheet under the heading "Discontinued Operations". Cost of Capital The Cost of Capital is the expected return that you require on an investment to compensate you for its level of risk. It is the appropriate rate to use when Discounting cash flows to find the Present Value of a Security. Cost of Goods Sold The cost involved in manufacturing the goods that were sold - in other words, the direct cost associated with the sales generated. These direct costs include the labor and materials related to making the product, as well as manufacturing overhead such as Depreciation. Service companies do not have this line item. Also called COGS or Cost of Sales. Cost of Goods sold is the cost associated with the products sold to generate Revenue. In the case of Anheuser-Busch, the cost of goods sold is the cost of making the can of beer that is sold. Included in this cost is not simply the cost of the ingredients for the beer and the can, but also some allocated costs from the plant that manufactures the can of beer. Even some costs that are not directly attributed to a certain can of beer are included, for example the cost of the electricity that keeps the lights on in the plant that made the can of beer. Cost of goods sold is also known as Cost of Sales or shortened as COGS. An important aspect of cost of goods sold is the importance of recognizing costs in the same period that the revenues from those sales are recognized. In other words, in order to analyze the performance of a company, one must be able to subtract the cost of goods sold from the revenues generated by those COGS. In modeling cost of goods sold, it is very common to assume a certain percentage of sales will predict the cost of goods sold. For example, when Microsoft forecasts their income statement, they have a very good grasp on what percentage of their sales will be spent on manufacturing the products that they sell. Another common method of forecasting cost of goods sold is to "back" into it. In this case, you will start with Sales and an assumption of gross profit. From this you can determine what the cost of goods sold is by subtracting gross profit from revenues, since gross profit = revenues - cost of goods sold. Another frequent way to model cost of goods sold is to exclude depreciation from the calculation. As mentioned above, the calculation of the cost of goods sold number often includes and allocation of overhead costs (i.e. the cost of the manufacturing plant), part of this is usually some depreciation from those overhead costs. By separating this number from the COGS, it is possible to more accurately model the relationship between the cost of goods sold and the revenues of the company as well as the relationship between depreciation and the cost of the asset base. See also: Accrual Accounting Cost of Sales See Cost of Goods Sold Coupon Rate of interest paid to a lender. A $1000 bond paying a 10% Coupon semi-annually pays $50 to the holder each 6 months. Current Due and payable within one year Cyclical Increasing and decreasing |
Call A feature of either a bond or option referring to the issuer's ability to force the return of the underlying asset at some predetermined price called the strke price. For example, a call option might give the owner of the option the right (but not the obligation) to buy 100 shares of stock at a predetermined price. This contrasts with a "Put" option, which is the right (but not the obligation) to sell at a predetermined strike price.
Call Premium If an issuer wants to pay off a bond issue early, it may be able to do so, but generally only by paying an amount over and above the principal amount owed. This excess amount is called the "call premium". For example, five years from the original issue date, an issuer (borrower) can typicall redeem (repay) a 12% bond, but only by paying 106 cents for every dollar of principal owed. The call premium typically starts at half the coupon in year five and declines ratably to par (no call premium) in year eight. Prior to year five, a typical bond is not callable at all. Capital Asset Pricing Model CAPM is a fundamental tenet of modern finance. This relates the expected return of some asset to the risk free rate, expected market return, and risk of the asset being evaluated, where risk is defined as beta. The actual formula is: Re = Rf + B*(Rm-Rf), where Rf is the risk free rate and (Rm-Rf) is referred to as the "market risk premium" -- the excess return on equities relative to risk-free securities. If a security has "no risk" (like a short term US government security), it is defined to have a Beta (B) of zero, so its expected returns should equal the "risk free rate" (e.g. 3 month US treasury yields). If it is just as risky as "the market", it is defined as having a Beta of one (1), so its returns should equal those of the market as a whole. Capital Gains Tax Gains assesed on individuals for the sale of profitable captial market transactions. Equity, Option, Bonds, Futures, are all taxed the same way--by the length of time held. There are two types of capital gains, short term and long term and they have differing tax rates with short term capital gains being highest. Capital Markets Refers to the markets in which securities are bought and sold. The capital markets group of an investment bank matches investors and issuers in this market. Capital Stock This represents the original investment by capital contributors. It is the sum of common stock and preferred stock. Capitalized When a cost is incurred, it can either be "expensed" as an expense on the income statement or "capitalized" by creating an asset that will later be expensed over time. For example, capital expenditures result in creation of an asset (PP&E) that is later expensed over time (as depreciation). Expensing a capitalized asset is often referred to as "amortization" of that asset. CAPM See Capital Asset Pricing Model Carried Interest The primary source of compensation for the partners of a merchant bank comes from the carried interest. A 20% carried interest, which is typical, means that the partners share 20% of the value increase of the invested capital (after paying the management fee). Carrying Value See "book value" Carry-Over Basis A situation, as in a stock purchase transaction, where the basis in the assets remains unchanged (for tax purposes). For example, if TargetCo had a tax basis of $100k on a piece of equipment, depreciated at the rate of $10k/year, and if TargetCo is sold in a stock purchase, the acquiror will also show $100k of tax bais and $10k/year of tax depreciation. This differs from "stepped-up basis". Cash-less Exercise In an acquisition it is typical for option holders to simply receive a check for the net difference between the stock price of the deal and the strike price of the options ("cash less exercise"), rather than going to the trouble of coming up with cash to pay the strike and receiving shares only to have them cashed out an instant later. Cash-Pay Bonds that require cash interest payments. CEO Chief Executive Officer Change of Control Transactions M&A deals - i.e. transactions where a controlling stake in a business (e.g. more than 50%) is sold to another investor group Chinese Wall The division between trading and investment banking mandated by the investment act of 1940. The Chinese Wall restricts information flow between the investment bankers who want to sell securities at a high price to satisfy their corporate clients, and the traders who want institutional investors to buy securities at low prices. The capital markets group sits "on the wall" to mediate these conflicts and keep the best interests of all parties and the bank in mind. Closing The completion of a deal, at which securities and cash change hands. Co-Investment In order to provide a more tax-advantaged equity incentive, some sponsors will allow senior management to "co-invest", buying stock alongside them as part of the deal (sometimes financed, in part, by a mix of recourse and non-recourse loans from the company in a "leveraged co-investment"). Commercial Bank A bank that offers a broad range of deposit accounts, including checking, savings and time deposits and extends loans to individuals and businesses. Commitment Fee A fee paid to a lender or investor in exchange for a binding commitment to make a loan or purchase securities. Commitment Letter The letter provided by a lender or investor evidencing a binding commitment to make a loan or purchase securities. Common Stock Comparison See Comparable Company Analysis Comparables Companies that are similar to the one being analyzed, especially in terms of industry sector, but also based on business risk, operating leverage, and other factors affecting valuation. Consideration Something of value provided by one party to another in a contract. Consolidation Creating combined financials of a parent and one or more subsidiaries by summing the results of their operations and then eliminating out any revenue or asset of one entity which is an expense or liability of another. Convertible A security is convertible if it can be changed into a different security. Some debt is convertible into equity, certain preferred is convertible into common stock. The terms of the security specify how many units of the new security are received per unit of the original security. Corporate Finance The segment of finance dealing with the investment decisions and financing decisions of businesses, from the firm's point of view. Corporate Marginal Tax Rate The tax rate which a corporation applies to a pretax income number to arrive at the taxes owed on that income. In the U.S., 40% is a typical number to use for estimating the combined marginal tax rate for federal and state tax purposes. Note that the more advantageous "capital gains" tax rate only applies to individuals and is not available to corporations that sell long term assets. Covenants Covenants are restrictions placed on managers of companies or issuers of bonds that protect the investor. Coverage Ratio The number of times that financial obligations (for interest, principal payments, preferred stock dividends, and rental payments) are covered by EBITDA or other cash flow measures. For example, EBITDA / Cash Interest Expense is a measure indicating whether EBITDA exceeds the cash portion of interest expense, and if so by what multiple. Credit Facility Banks typically provide loans as a package of a Revolver plus a Term Loan, which together represent the total Credit Facility. Credit Risk A type of risk that describes the possibility that a company may not be able to meet all of its obligations. Companies with higher credit risk need to pay a higher premium or interest rate to receive loans or issue bonds. Credit Statistics Credit ratios, leverage ratios, and other measures used to assess credit risk |
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D&A See Depreciation and Amortization
DCF See Discounted Cash Flow Analysis Deal See Transaction Debt An interest bearing liability - recognized when a company borrows money and owes interest on that money. Debt Schedule The supplemental schedule built into a financial model to decide how changes in net debt get allocated between debt paydown/borrowing and changes in cash. This helps the modeler then complete the Financing Activities section of the model. Deferred Financing Costs See Capitalized Financing Costs Deferred Taxes Companies keep a separate set of books for tax purposes that typically differs from the accounting records. This is because generally accepted accounting principles call for different methods of recognizing revenue and expenses than the IRS. For example, when a company Depreciates $1,000 of PP&E, it may recognize $100 per year of Depreciation on its P&L each year for 10 years. Meanwhile, the IRS offers an accelerated depreciation schedule that enables companies to recognize a higher proportion of the expense in the early years. For the first few years, this reduces the taxable income on the IRS books relative to the company's P&L. So the company pays less tax in cash than it shows on its P&L as an income tax expense. The difference needs to be accounted for and is shown as a deferred tax expense. Depreciation When a plant asset (e.g., a piece of machinery or a new manufacturing plant) is purchased, the cost of that asset is not expensed immediately in the year it was purchased. The reason is that the asset will benefit the purchaser for years to come, not just in the year it was purchased. Therefore, the accounting profession has created what is called "depreciation," where part of the cost of the equipment or manufacturing plant is expensed in each year the asset is useful. For example if General Mills purchases a machine that makes cereal boxes for $100 and it is expected that the machine will be equally useful in each of the next 10 years, each year the depreciation will be $10. Related topics are amortization and depletion. Depreciation is a way to match the cost of an asset with the benefit that the asset bestows upon its owner. If the cost of General Mills' new machine was entirely expensed in the first year, but was used for the next ten years, the income in none of those years would accurately reflect the decision that General Mills made. They decided that the $100 cost of the machine was worthwhile, because they would be able to produce salable cereal boxes with it for the next ten years. In the first year, there would be a huge expense of $100 and in subsequent years, there would be no cost of the machine reflected in the financial statements. From a modeling perspective, depreciation is reflected on all three financial statements. Before we discuss this, however, it is important to understand how to build in depreciation into a financial model. Typically there are three ways to incorporate depreciation into a model:
See also: Accrual Accounting Depreciation and Amortization Depreciation and Amortization are very closely related concepts. They recognize a non-cash expense that reduces the carrying value of a capitalized asset. See also: Accrual Accounting, Depreciation, Amortization Discontinued Operations When a company sells a business mid-year, the results of the business sold are recorded separately as a Discontinued Operation, allowing you to separately analyze the results of the remaining business (the "Continuing Operations"). Discount To calculate the Present Value of future cash flows. Discount Rate The appropriate rate at which to Discount future cash flows in order to arrive at a Present Value. This Discount Rate represents the annual return that could be earned on an alternative investment with comparable risk. Discounted Cash Flow Analysis A firm's future cash flows are (i) projected, (ii) expressed in Present Value terms (i.e. "today dollar equivalents") and (iii) summed together to determine the firm's value. Divestiture The sale of a business or collection of Assets. Driver In a spreadsheet, any cell that is used as an input to another cell is said to be a Driver. For example, a row for "# of units sold" would be a key driver of "total revenue". Due Diligence Investigation of a company's business, strategy, finances, operations and management as part of a transaction. Due diligence is a critical step in understanding whether the assumptions laid out in a financial model are appropriate and to gauge how actual results might differ from a base case forecast. |
Dartboard Theory If you throw darts at the Wall St. Journal stock pages to pick stocks, your returns are likely to be similar to those of a professional stock-picker. After all, incredible values are likely to be spotted by other stock-pickers first (among the millions of investors out there), thereby raising their prices, and over-priced stocks are likely to be shorted by other investors, driving their prices down.
Deal Flow Describes the volume of possible acquisition, investment or financing opportunities. If deal flow volume is high, there are more chances to spot attractive opportunities. Proprietary contacts and relationships can help improve the quality of deal flow, giving rise to opportunities without as much competition. Debt Capacity Describes the level of debt that a company can sustain. For example, if a company generates strong, steady, growing cash flow, investors will be willing to lend a lot of money to the business. If the company borrows as much as it can at any reasonable rate, it has no more debt capacity until it pays down some of that debt or increases its cash flow. Debt Cost of Capital The debt portion of weighted cost of capital that describes the aggregrate rate of interest that the company is paying on all outstanding debt Default The condition under which a company cannot pay its interest obligations, or otherwise triggers a provision that enables the debt holders to seek remedy. Deleveraged The act of reducing outstanding debt. Description of Notes The Description of Notes sets forth the terms and covenants of the securities being issued to investors. Dilution Reduction in ownership percentage (ownership dilution) or in value per share (value dilution). Dilution Protection Rights held by existing equity investors that help keep their ownership percentages from declining precipitously if subsequent equity is raised at a lower price per share. This is accomplished by giving the protected investor additional shares. This has a compounded effect on the original investor, who not only suffers from the newest round being at a low valuation, but also suffers dilution from giving additional shares to the protected class. If an investor has "full ratchet" dilution protection, their ownership percentage will never decrease because if future deals are done at a lower price per share then the protected investor gets treated as if they also bought in at this low price. If the investor has "weighted average" dilution protection, they receive additional shares in an amount that makes it as if they bought in at the weighted average of the two valuation levels (theirs and the new deal's). Discount Note If the coupon rate on a bond (amount paid in cash) is not enough to entice investors to lend money, the bond price will fall and it will trade at a "discount" to par value. In the extreme example of a true "discount note", no cash coupon is paid so the bond can only be issued at a steep discount to its par (face) value. The bond "accretes" toward par over time. For example, if a five year Discount Note is priced to yield 14% per annum (compounded semi-annually), it will be issued at 50.8 cents on the dollar (price of 50.8). Note that 50.8 compounded at 7% per period for 10 semi-annual periods equals 100 (par value). Dividend A payment, either in stock or cash, to existing company shareholders. Divisions Corporate delineations that are not based on separate legal business entities Double Dip Preferred See "participating preferred" Drag Along Rights Rights to compel minority shareholders to participate in a transfer of stock pro rata along with a controlling holder, under certain circumstances. For example, if a majority holder has drag-along rights and a is selling a portion of its stake, it can compel minority holders to participate in the transfer under the same terms. Each holder would sell shares representing the same proportion of their total ownership. Drawdown Funding of an investment by a party that has made a commitment to do so DTA Deferred Tax Asset (see Deferred Taxes) DTL Deferred Tax Liability (see Deferred Taxes) |
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Earnings per Share Calculated as (i) the net income available to common equity divided by (ii) the number of shares of common stock.
In practice, there are two EPS calculations: Basic EPS uses Shares Outstanding as a denominator without regard to stock options and warrants. Diluted EPS uses a larger denominator that accounts for dilutive options and warrants (which lowers the EPS figure). EBIT Earnings Before Interest and Taxes. Also called Operating Profit. As the name suggests, this important profit subtotal is calculated after subtracting expenses that are directly related to the operations of the business, but before subtracting Interest expense and Income Taxes. As with the other profit metrics, a Margin is typically calculated to compare profitability; EBIT Margin is simply EBIT divided by Revenue. Non-Operating expenses, namely Interest expense, do not impact Operating Profit. That is very important because it allows for a consistent measure of profit no matter what type of transaction is analyzed. (Remember that most transactions have an impact on Interest expense because of borrowing or repaying debt). As the name suggests, EBIT is calculated by starting with Net Income (Earnings) and adding back Interest and Taxes. Or take Revenue and subtract total Operating Expenses (COGS and SG&A). Earnings Before Interest, and Taxes. To calculate EBITDA, simply start with revenues, then subtract cost of goods sold (including depreciation and amortization), selling, general and administrative, and what is left is EBIT. Alternatively, you may start with Net Income and add back, interest, and taxes. EBIT is often used synonymously with operating income or operating profit. EBIT is one of the most important operating statistics. What EBIT refers to is the profits that a company is making from its core businesses, without regard to its capital structure (in other words before making interest payments or paying taxes). As a result EBIT margin (or EBIT divided by Revenues) is often used to compare the results of companies in the same industry to show how relative efficiencies. Although in some models, the Income Statement is driven off of revenue and EBIT, this is rare. It is far more common for EBIT to be a line item on the Income Statement that is generated by a formula. EBITA Earnings Before Interest, Taxes and Amortization. This formula starts with EBITDA and subtracts Depreciation. Although Depreciation is a non-cash expense, some Analysts subtract Depreciation from EBITDA to build in a charge for the cost of PP&E investment. These analysts argue that Capex is too volatile to be an appropriate PP&E charge and prefer to subtract Depreciation. EBITA is also an important line item to calculate when calculating Unlevered Free Cash Flows. Amortization expense is usually not tax deductible, so the cash taxes related to Operating Profit are often calculated based on EBIT + Amortization (i.e. EBITA) * TaxRate. Note that calculating Cash Taxes on EBIT can be more complicated if Tax and Book Depreciation are not equal or if NOLs are involved. EBITDA Earnings Before Interest, Taxes, Depreciation and Amortization. There are three main ways to calculate EBITDA: Take Net Income (Earnings) and add back Interest, Tax, Depreciation and Amortization expenses. Start with EBIT and just add back Depreciation and Amortization. (iii) Start with Revenue and subtract only the Cash COGS (excluding the non-cash Depreciation component) and Cash SG&A (excluding the non-cash Amortization component) EBITDA is also often called Operating Cash Flow. EBITDA is a KEY financial measure since it represents a cash flow measure (depreciation & amortization are added back), is an Operating measure, meaning it is calculated before subtracting interest expense. Since EBITDA is before interest expense, the Capitalization of a company does not impact this measure. An Analyst can separately assess the impact of a Transaction on a company without having to change EBITDA. Click Here for More Details Enterprise Value The total value of a firm. Enterprise Value = Multiple * EBITDA Enterprise Value = Common Equity Value + Preferred + Debt - Cash Equity Stock. When a firm needs to raise money it can either (i) borrow money by incurring Debt, in which case it owes a fixed amount plus interest or (ii) sell equity in the company (shares of stock), which entitle the shareholders to a percentage ownership of the company. See also: Capital Structure Equity Market Capitalization The total value of a firm's equity. EPS See Earnings per Share Excess Cash Cash on the Balance Sheet in excess of the minimum level required for operations. This excess amount can be freely used to repay debt, reinvest in the business or pay out in dividends. See also: Minimum Cash Balance Excess Cash Flow Typically calculated as Cash Available for Debt Repayment minus Required Debt Retirements. This term is usually used to describe cash that can be used to pay down bank debt. The exact definition usually depends on the Terms of the Bank Debt. Exercise Price The holder of an Option can pay a fixed Exercise Price to obtain a share of stock (or other underlying security). See also: Option Expiration The last day on which a stock option can be exercised. See also: Option |
Equity Comp Analysis of the valuation multiples of comparable publicly traded companies
Equity Cost of Capital The expected rate of return that equity holders demand on an investment. Assuming a liquid market, if the stock is not priced to provide an adequate return, the price of the stock will drop until it does; and vice versa. Equity Cushion Enterprise value in excess of the amount of debt owed by the company. Equity Sweetener Providing an equity component to the returns of a debt or mezzanine investor through attached warrants or a conversion feature. Excess to Allocate In an acquisition, the excess of the equity purchase price (plus fees) as compared to the book value of the target. This amount in excess of book value is allocated to tangible and intangible assets under purchase accounting. Exit The point at which investors are cashed out of the their investment Exit Multiple The valuation multiple at which a business is sold at exit. Expensed Financing Costs Financing costs associated with raising equity capital are expensed at the time of the deal. |
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Financial Asset An investment that has value
Financial Leverage A firm with a high proportion of Debt relative to Equity is said to have high Financial Leverage. As the value of the firm increases, the company still only has to repay a fixed amount of debt. The residual value belongs to the Equity. Levered firm example: If the total value of the firm grows from $100 to $120 (20% increase) and the firm has $80 million of Debt, the Equity value grows from $20 million to $40 million, a 100% increase! Unfortunately, the converse is also true. If the total firm value declines by 20% to $80 million, the equity is wiped out. Financing In a debt or equity financing, a company issues (sells) securities to raise cash for the firm. For example, in a $100 million initial public offering (IPO), a firm sells shares of common stock and might use the money to repay debt obligations. Financing Activities The portion of a Cash Flow Statement that deals with changes in the company's Capital Structure. Financing Costs Amortization The Balance Sheet account for Capitalized Financing Costs represents the fees incurred raising debt financing. These fees are not expensed immediately, but instead are Amortized over the term of the Debt (similar concept to Depreciation). Fixed Costs Costs that do not depend on the level of revenue Fixed Rate Describes debt pieces where the Interest rate is a fixed percentage that does not vary with an index. Interesting note on Fixed Rate Debt: Bonds rarely allow optional prepayments without a penalty. The bondholders lend money at a fixed rate, and they know the company is likely to prepay them at all the wrong times - e.g. when interest rates decline and the bondholder is stuck with cash that he cannot invest at the same rate. See also: Floating Rate Floating Rate Describes debt pieces where the Interest rate varies up and down with an index such as LIBOR. Interest note on Floating Rate Debt: Unlike Bonds, Bank Debt often requires that a portion of Excess Flow go to principal repayment. Bank Debt is lent at floating rates, minimizing the risk of having to reinvest at lower rates. See also: Fixed Rate Formulas Any time you want to perform a calculation in Excel, it starts off with the equal sign ("="). Formulas are generally formatted as black cells. See also: Inputs Future Value The value in the future of cash that you invest today. For example, if you invest $100 at 10% for two years, the Future Value at the end of year 2 would be $121. |
Face Value Historically, the name derived from the amount that was printed on the front of a bond. Represents the amount returned to holders at the bonds maturity.
Fairness Opinion An opinion letter provided by the investment bank advising the Board of a target company, indicating whether they believe the price being offered represents fair value from the seller's standpoint. The investment banker will typically look at valuation benchmarks including a discounted cash flow analysis ("DCF"), analysis of multiples of public comparable companies, analysis of valuation multiples paid in other M&A transactions, and (in the case of a public target) a comparison of the stock price being paid relative to the highest closing price for the stock in the past 52 weeks. Fiduciary Duty The legal responsibility held by a company's directors and officers to make decisions that are in the best interests of the company and its stockholders. Financial Buyer If the acquiring company in an M&A deal is nothing more than an empty shell corporation, set up for the sole purpose of raising capital from investors to acquire the target business, the acquiror (together with the investor group capitalizing it) is termed a financial buyer. This differs from a strategic buyer, which is an acquirer that has its own business operations. Financial Distress Situation where a company is close to insolvent and may go bankrupt. Flow of Funds This is a detailed set of instructions and steps indicating exactly which entity needs to wire or transfer funds from one bank account to another upon closing of a transaction. Friendly Deal A deal in which the target company's board agrees to the acquisition (as opposed to a "hostile" deal). Full Ratchet If an investor has "full ratchet" dilution protection, their ownership percentage will never decrease because if future deals are done at a lower price per share then the protected investor gets treated as if they also bought in at this low price. Funds Flow This is a detailed set of instructions and steps indicating exactly which entity needs to wire or transfer funds from one bank account to another upon closing of a transaction. |
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GAAP Generally accepted accounting principals. The rules that accountants follow to prepare financial statements.
Goodwill Goodwill is an Intangible asset that is created when a company is Purchased. It is Amortized over a period of 15-40 years. See also: Amortization Gross Margin Gross Profit as a percentage of Sales. Divide Gross Profit by Revenue. Gross PP&E The company's cumulative investment in property, plant and equipment. Gross Profit Revenue minus Cost of Goods Sold (COGS). For manufacturing companies, gross profit provides a useful measure of the profit generated after direct costs (COGS) have been deducted. Gross Profit is often expressed as a percentage of Sales, Gross Margin, which is a useful profitability metric. Service companies do not have this line item. Gross profit is a way to measure a company's performance. It shows how much profit a company is making from producing products or services and selling them. The analysis excludes all overhead and other expenses. For example, for a pencil manufacturer, gross profit would be the amount of revenue that the company received from the sale of pencils less the amount the company spent to produce the pencils that it sold. As mentioned previously, typically, gross profit is modeled as revenue less cost of goods sold (including depreciation). It is possible to reverse this however, and start with gross margin and revenues and back into cost of goods sold. For example, models usually begin with revenues are x, for illustrative purposes, let us say $100. Cost of goods sold is also assumed, in this case assume $60. Therefore gross profit is $40 and gross margin is 40%. However, it is also possible to assume a 30% gross margin and $200 in sales. In this case, it is possible to conclude that gross profit is therefore $60 and cost of goods sold is then $140. |
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High Yield Also called "junk bonds", high yield is a risky form of debt. Unlike investment grade debt, the issuer (borrower) of high yield typically has a great deal of debt outstanding relative to its ability to generate cash flow.
See also: Financial Leverage |
Highly Confident Letter A technique used by LBO sponsors in the late 1980s, by which an investment bank such as Drexel Burnham Lambert would state that it was "highly confident" in its ability to raise the financing. Although it wasn't a firm commitment like a bridge loan, it was typically enough in those days (on Drexel's strength and reputation) to convince the target's Board to sign the deal with the sponsor even though the financing wasn't actually in hand.
Holding Company If the ultimate parent company does not conduct business operations, it is referred to as a holding company. Hostile Deal A buyout that does not have the backing of the target company's board of directors. Hurdle Rate A minimum threshold rate of return. Investors in an LBO fund may decide to limit the carry of the general partners to return above some pre-defined rate. This "hurdle rate" helps ensure that the general partners are only compensated for meaningful levels of return. |
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In the Money When an Option can be exercised by paying a Strike Price that is less than the Market Value of the underlying stock, the Option is said to be In the Money. See also: Option Income Statement Also called a profit and loss statement, or P&L, the Income Statement records the revenues, expenses and profits of the business over a period of time. These figures are not necessarily equal to the cash generated by the firm. The bottom line profit number of an Income Statement is called Net Income. Income Taxes Typically, companies pay 35-40% of their Pretax Income to the government. Some non-deductible expenses and other factors can affect the percentage paid out. Also, the Income Statement records can differ from the amount actually paid to the IRS. This isn?t a scam ? it?s a topic called Deferred Taxes. Initial Public Offering A company's shares are made available to the public for the first time. Inputs Any time you enter text or a number directly into a cell without linking to other cells, it is referred to as an Input and is formatted blue. See also: Formulas Intangibles Intangible Assets include |