16 Business Terms Any Finance Professional Should Be Aware Of

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16 Business Terms Any Finance Professional Should Be Aware Of

10K Report

It’s a statement to be submitted each year according to U.S. SEC regulations. It needs to be submitted within 90 days of the end of the fiscal year. This statement/form is a detailed account of all the information related to the company, which submitted it. The 10K report usually contains information related to business and financial profile of the organization. In addition, you will find also corporate governance information and managers’ compensations. This is the main report, which the analyst will consult to extract financial information to perform an analysis. (learn how to read a 10k reports from Fundamental Analysis – Simplified Manual: Simplified Manual to Understanding Fundamental Analysis)

Accrual Method

Accounting method for which sales and expenses must be recorded when occurred. This means that each time a customer buys an item, even though on credit, the sale must be recorded. Therefore, independently from cash disbursement the transaction will be recorded on the accounting books. This method is mandatory for company, following the SEC regulations. On the other hand, some companies are allowed to use the cash method as well. (learn more about financial accounting through Financial Accounting Simplified Manual)

Assets

Any organization has resources at its disposal that can be used for operational purposes. Those resources are called assets. In finance lingo, assets are displayed on the balance sheet. They can be classified in current and non current. The former are the ones, which will be converted into cash within one year. The latter are the ones, which will be on the balance sheet for few years. In addition, current asset are usually listed on the balance sheet according to their degree of liquidity. Therefore, we will find on the balance sheet the following items: cash, cash equivalents, short-term marketable securities, account receivable, inventory and prepaid expenses. The non-current assets (also called fixed assets) can be tangible or intangible. The former are physical things, such as plant and equipment. The latter are intangible things, like licenses or patents, which will have a life of few years as well. While, tangible assets are depreciated, non-tangible assets are amortized.(learn more about financial accounting through Financial Accounting Simplified Manual)

Backward Integration

In the business world the supply chain is the set of processes a product has to go through before and after it is sold. For instance, a tomato sauce before it gets sold in the supermarket needs to be packaged. Before packaging comes production. Before production comes growing and farming the product. All these steps are crucial to make the product available to customers. When a company controls all the processes (like in our example), from farming to end customers, this is called vertical integration. When a company decides to move backward in the supply chain, this is called backward integration. For instance, Starbucks, which is a coffee chain, sells its products directly to its end customers. On the other hand, Starbucks also bought some farms were the coffee is produced; therefore Starbucks used backward integration to reduce its costs related to purchasing; but also to guarantee an higher quality of the final product.

Bear Market

Financial markets are in an eternal fight to reach the point of equilibrium. In short, each time demand and offer agree on the value to be given to a certain asset or stock, that is when a price forms. Therefore, in the market there are buyers and sellers. The former have an optimistic outlook, and the latter a negative or pessimistic outlook. When sellers dominate, a bear market forms.

Beta

In corporate finance, understanding risk is crucial. But how can we define risk? This can be defined as the amount of reward to expect for each level of risk undertaken. In other words, if I take on more risk I also expect a higher return and vice-versa. The objective of corporate finance is to quantify the risk and also the expected return. How to measure it? Thru CAPM (Capital Asset Pricing Model) the main measure of risk is Beta. Beta tells you the specific risk of a company stock in comparison to the market portfolio. In short, the Beta tells you of how many units will a particular stock move in comparison to the market portfolio. For instance, a Beta of 2 means that the stock is more volatile compared to the market portfolio. In other words, a swing of the market portfolio would result in a much greater swing of the stock with a high Beta. The Beta is the main component of the CAPM, which helps us in assessing the cost of equity (expected return for a certain investment). This means that a higher Beta will also result in a higher cost of equity. Of course this works in theory. Although Beta is one of the most used measures of risk this is based on historical value of the stocks. We learned in the last years that future cannot be predicted based on the assumptions of the past. Therefore, this measure may work in “normal times” but be useless during “abnormal times.” (Learn more about corporate finance through Corporate Finance – The Toolbox for The Financial Manager)

Black Swan Event

Before the first black swan was discovered, in Australia, it was believed that black swans did not exist. This means that a single event (a black swan) can swipe out all the empirical evidences found until a certain point in time. This leads up to the thanksgiving turkey problem. The turkey, which was fed for 1000 days, made a reliable assumption based on a fair number of observations that it would have always worked in that way. Until, Thanksgiving Day comes and the turkey is slaughtered and eaten. Nicolas Nassim Taleb brings up these two examples, which in his book “The Black Swan” opened up the road to better understand randomness and the limits of empiricism.

Blue Ocean Strategy

How does a blue ocean look like? Imagine first a red ocean; plenty of sharks, which try to compete for each single fish in that water; blindly fighting against each other for a small piece of food. In such a scenario, many sharks will die, and few will survive. Imagine, instead an open blue ocean unexplored by other sharks. The shark, which has the courage and ability to find that new ocean, will enjoy unlimited resources. What is the most successful example of Blue Ocean Strategy? Only few years ago, I-Phone and I-Pad did not exist in the mind of consumers. Apple came out with these products. Therefore, Apple was successful in convincing consumers that those new products would have filled a real need they had. Although that need didn’t exist few months before. This is one of the most sublime examples of Blue Ocean Strategy.

Bull Market

Call Option

An option is a financial instrument that gives the right to its holder to buy or sell a stock or asset at a determined price. The option’s holder has the right and not obligation to buy or sell that stock. When the option’s holder bought the right to buy the stock after a certain date, then he bought a call option. For instance, you can buy 10 call options at $1 each for a stock worth $10. Therefore you spent $10 total. In one month this stock rises at $12. You exercise your right to buy 10 stocks, worth $12 but you will pay just $10. This means that you will own now 10 stocks worth $120, but you paid $100 $10 = $110. In conclusion you made $10 profit ($120 – $110). (Learn more about financial options through Option Basics: Simplified Manual for Understanding Financial Options)

CAM in Real Estate

In commercial real estate, CAM or common area maintenance are expenses incurred by the landlord on common areas (such as landscaping, parking lot, utilities and so on). Those will eventually be reimbursed by the tenant based on its pro-rata share of square meters in comparison to the overall commercial building. For instance, a tenant, who occupies 1,000SF on a commercial area of 10,000SF, will pay 10% of the total common area maintenance; if stated in its lease, otherwise the tenant will be not responsible for that. Why is this so important? CAM is crucial for both tenant and landlord. For the former it is important to understand the hidden expenses resulting from a lease. For the landlord, it is important to quantify common area expenses, to determine the amount to ask as reimbursement to the tenant. For instance, there are two main categories or leases: Gross and Net. According to the lease stipulated the CAM expenses could change a great deal for the tenant. In turn, the CAM reimbursement will grow substantially for the landlord if contracted one lease or the other. (Learn more about commercial real estate through Fast Tenant’s Guide to Understanding Commercial Lease Agreements)

Carry Trade

Before we get to the meaning of this exotic term let me answer the following questions: what is a central bank? What does it do? And what are the tools available to it? First, the central bank is an institution, which objective is to “stabilize” the economy and therefore financial markets. How? Central banks have different tools to achieve this objective. The two most powerful instruments are interest rates and money printing. For the sake of understanding carry trade, we are going to focus on the former, “interest rates.” In fact, when the economy slows down, usually central banks tend to lower interest rates, to allow the economy to recover and stabilize. Instead, when there is too much “exuberance,” prices of assets and commodities tend to rush, by creating what economists call “inflation.” To avoid such scenario central bankers tend to increase interest rates. Not all central banks have the same approach and not all central banks face the same economical scenario. Therefore, you will have countries in which the interest rate is 5% and other countries where the interest rates are between 1-2%. Speculators take advantage of such arbitrage opportunities. How? Thru carry trade. In fact, they borrow money in countries where interest rates are lower and invest in countries where interest rates are higher. For instance, in Japan interest rates are close to zero. Therefore, you will borrow money in yen (Japanese currency) and invest in euro, where interest rates are higher.

Cash Flow Statement

Benjamin Franklin used to say, “Cash is king.” This holds true in business and finance. For such reason, while balance sheet and income statements give a certain profile of the business; the cash flow statement tells whether a business is making enough cash to survive and thrive. In fact, the cash flow statement can be obtained by adjusting the income statement to reflect all the non-cash items that are included into it. Therefore, this statement, which has three sections: operating, investing, and financing are going to tell us where the cash is coming from. Therefore, if you are a manager you will focus more on cash flow from operations. If you are an investor you will focus more on cash flow from investing. And if you are a banker you will focus more on cash flow from financing.(learn more about financial accounting through Financial Accounting Simplified Manual)

FED Bank

The Federal Reserve Bank is the U.S. central bank. The central bank main role is to stabilize the economy through three main tools: discount rate, open-market operations, and by controlling the reserve requirements of institutions. The FED uses discount rates to affect the economy. For instance, lower interest rates imply a less positive outlook for the economy, while higher interest rate will be used to slow down inflation, when the economy is in good health. In the open-market operations the FED indirectly controls interest rates. In fact, by buying U.S. bonds, the FED will influence the price and interest of these securities, and this de facto influences the economy. In the third case, the FED makes sure that banks and financial institutions hold reserves, or funds. For instance, although banks receive billion of dollars in deposits, if they could they would lend 100% of this money, to maximize their profits and also avoid costs associated with keeping money into their vaults. Therefore, the FED determines the % amount of deposited funds to keep as reserves, for emergency situations.(Learn more about corporate finance through Corporate Finance – The Toolbox for The Financial Manager)

Pareto Principle

Wilfred Pareto was an Italian economist (he actually was a polymath) that lived across the 19th and 20th century. At the end of the 19th century Pareto found out that most of the wealth of the population was in the hands of few. This observation became the 80/20 principle, which states that 80% of the effects is given by 20% of the causes. The 80/20 is just indicative and there are phenomena, which go beyond the 80/20. For instance, new observations show that 0.1% of U.S. population owns 22% of the household income. The Pareto principle can be extended to any other field, and why not, also personal life. What is that 20% of your daily activities that gives you the 80% of joy and happiness?

Pecking Order

The pecking order theory was first formulated outside finance and it related to the social hierarchy existing in the animal world. This theory was reformulated to fit the finance world. In short, the pecking order states that a company can finance itself through three main sources, internal funds, debt issuance and new equity issuance. Managers based on the necessity of the organization pick those three. In normal conditions, the firm will finance itself through internal funds or debt. As last resort the company would use equity. The reason stands in the fact that there is asymmetry of information. Managers know more about the company, that external investors do. Therefore, if managers “pick” new equity as finance option, it means that they believe the stock to be overpriced. Instead, when the management is positive about the value of the firm, they will issue debt or use internal funds.

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