Equivalent to accounts receivable, but on the liabilities side of the balance sheet, A/P are the consequence of terms of payment, i.e. the time lag between the moment the company received the goods (or services) and the moment it actually paid the supplier. It is a current liability, which is included in the working capital requirement.

Accounts receivable is the consequence of terms of payment (see accounts payable). Customers often pay with a delay, which may go up to 30, 60 or even 90 days. Thus, the company records a revenue in the P&L, but waits for the cash in-flow. A/R is a current asset in the balance sheet and is included in the working capital requirement.

When raw materials are consumed in the operating process, they are expensed in the income statement. What characterizes a fixed asset is that it is used during a number of consecutive periods. Amortization (intangible fixed asset) and depreciation (tangible fixed asset) are the operating expenses, which are accounted in the P&L as a consequence of the asset progressive “consumption”. As an example, if a machine is bought for $20,000 and is used during 5 years, the company will depreciate it by $4,000 per year and, thus, evenly allocate the investment cost over the products manufactured by the machine during these years of operation. It would obviously be absurd to entirely expense the $20,000 when the machine is acquired, which would unfairly increase the production cost of the goods produced during that year. As opposed to other costs, depreciation and amortization is not generating any cash outlay: the unique out-flow is the investment itself, depreciation and amortization are only its “memory” in the P&L.

Constant amount of money paid, for example, by a company to redeem its financial debt, or generated by an investment. Financial tables give the present value of a constant annuity at x% during n years.

An asset is everything a company needs to run and develop its business, i.e. produce and sell products and services. An asset may be fixed or current. Assets appear in the balance sheet under the column named “Assets”.

This ratio measures the ability of the company to generate sales from capital invested in the business operations. It is calculated dividing sales by capital employed (or invested capital). The ratio is lower than one in capital intensive businesses (real estate investment, shipping, cement) and very high in sectors, which consume relatively low resources (retail distribution, software).

The balance sheet is the financial statement, which describes the assets owned by the company and the way they are financed. The resources appear on the Equity and Liabilities side of the document. The statement actually balances, as there must be a balance between uses and sources of funds.

The company can finance its operations with, basically, two financial resources: shareholders contribute through equity and financial creditors provide financial debt. Banks provide interest-bearing debt funding to corporations. The company pays an interest, which is a kind of a rent paid against the right to use funds during a contractual period of time.

The ß measures the systematic risk of the asset, i.e. its relative sensitivity to non-diversifiable risk, basically the favourable or unfavourable evolution of the economy. A model helps quantifying the coefficient, the CAPM, which stands for Capital Asset Pricing Model. The statistical formula of the ß is: ßi = cov (Ri ; Rm) / Var (Rm). The two limitations of the formula are: one the one hand, the result is very sensitive to statistical characteristics (period, frequency), on the other hand it looks at the past (historical data), when only the future is relevant for the investor.

A bond is a contract, which binds an issuer and a subscriber. The last puts, at the disposal of the issuer, an amount of money against periodical remuneration (the coupon) and with contractual redemption dates. The main characteristics of a bond are its nominal, its maturity and the interest paid to the bondholder. Some bonds may have additional characteristics, such as the convertibility into shares (see Convertible bonds).

The bondholder is the investor who holds the bond, exactly like the shareholder who holds the share.

When a company sells goods or services, it generates a contribution margin per unit, which is the difference between the selling price and the variable cost per unit. The breakeven is reached when the company has sold enough goods so that the accumulated contribution margin entirely pays the fixed costs. It is calculated dividing total fixed costs by the contribution margin per unit.

Capital represents all the existing shares progressively issued by the company. Shareholders contributed to corporate financing by investing in issued shares and possibly paying a premium on top of the nominal of the share.

Capital employed represents the accumulated funds invested by the company in its operations. It is calculated as the sum of fixed assets and working capital requirement, net of non-current operating liabilities. The Net financial resources finance the capital employed.

CAPM (Capital Assets Pricing Model)

CAPM is a model, which helps calculate the risk-premium required by shareholders. The model differentiates specific and systematic risks (market risk, non diversifiable). Specific risk disappears with portfolio diversification. What remains is the systematic, which should be remunerated. The systematic risk coefficient, ß, measures the relative sensitivity of the financial profitability of the company to the evolution of the economy. As it is almost impossible to calculate this coefficient, the model suggests to replace the economy by the stock market and the financial profitability of the company by its stock market return.

This represents all liquid assets, which can be immediately used by the company to pay it creditors. It consists in cash at bank or cash invested in, say, short-term Treasury Bills.

The cash flow measures the funds potentially generated by operating cycles. Calculating the cash flow as the sum of net earnings and depreciation & amortization is the same as re-computing the income statement and withdrawing the unique operating expense, which will never generate any cash outlay, depreciation& amortization. The cash flow will become actual cash in the bank account after having deducted the change in working capital requirement, which gives the operating cash flow described in the cash flow statement.

The balance sheet provides a periodical picture of the company. The P&L expresses the ability of the company to sell above or under the total cost. Still, the company must produce a third document, the cash flow statement, which describes the evolution of the cash position as a consequence of its investment policy and the respective contribution of funds internally generated (operating cash flow) or raised from outside (shareholders and debt-holders). It consists in three parts: the operating cash flow (funds from operations), the funds devoted to investment and acquisitions, and the funds from financing (paid dividends, shares issue or shares buyback, increase vs. decrease in financial debt, change in the net cash position).

A charge is any consumption or usage (raw materials, labour, fixed asset,…) of the period, which is generated by products manufactured (production cost) and / or sold (cost of goods sold). Charges generate, in most cases, cash outlays with the exception of depreciation and amortization.

The comparables methods helps evaluating a company, comparing it with other corporations operating in the same sector. First, ratios are calculated, which confront stock market values (market capitalization or enterprise value) with accounting figures (net earnings, EBIT, EBITDA, sales, capital employed, equity). Then, the analyst tries to determine which ratio looks more “relevant” to he sector and applies these ratios to the evaluated company. The comparables method helps evaluating the market opinion and must, obviously, be supplemented by other methods, including the calculation of a fundamental value coming from discounted free cash flows or dividends.

A convertible bond can be converted into a certain number of shares. The conversion rate is the number of shares obtained by the investor when the conversion right is exercised.

A bond is qualified as convertible when the bondholder has the right, and not the obligation, to convert the bond into shares during or at the end of the life of the bond. The conversion right is an option. The convertible bond is, then, a hybrid financing instrument, which combines a straight bond and an embedded option. The option premium is the negative difference between the coupon actually paid by the convertible bond and the market coupon paid on a straight bond. The bond can be convertible into new shares or exchangeable into existing shares. Some convertibles are, even, issued with warrants. Basically, the convertible bond is a very flexible financing instrument, widely used in financial engineering.

The corporate financial policy gathers all decision taken by the company and relative to its financing, including: issuance or repurchase of shares, selection of the supposed optimal financial leverage, use of hybrid financing instruments, dividend policy.

This tax is paid when operating and financial revenues exceed operating and financial charges. The income tax rate considerably varies from one country to the other. When a company generates losses, it may carry them forward to offset future profits in the tax calculation. Some legislations allow the carry back, which generates tax repayments, matching the loss generated today and the profit generated yesterday.

The cost of capital is the weighted average cost of the financial resources. It is calculated from the respective expected returns and funds invested by shareholders and debt holders. A company is profitable if the return generated by its business operations exceeds the cost of financing them (see economic profit). An investment is profitable if its intrinsic profitability (internal rate of return) exceeds the cost of capital. The value of a corporation lies in its ability to generate funds flows discounted at the cost of capital. The WACC, therefore, plays a key role in corporate finance.

Among the operating charges, a distinction is made between production costs and other expenses (R&D, administration, …). The cost of sales is the production (manufacturing) cost of the goods sold during the period.

The coupon is the interest paid to bondholders. The same word is used for the interest rate of the bond. It comes from years ago, when the coupon was physically attached to the bond as a piece of paper.

A company is penalized by a credibility gap when there is a significant difference between where it actually stands and how the market perceives it. It happens when, among other reasons, the company experiences a strategic shift (sector, positioning) or is just getting out of a restructuring period. Under such conditions, the market rather stays in a “wait and see” position and simply observes the company during some time. Once it feels reassured by the sustainability of its performance, the market adjusts its valuation to the fundamental value of the firm. As long as the company stays in a credibility gap, its ability to raise funds is negatively affected, for example if it wants to issue sophisticated hybrid instruments like convertible bonds.

A current asset is renewed at the rate of the operating cycle: it is used during one unique operating cycle. Inventories are current assets, as they consist in raw materials progressively transformed into finished goods before they are shipped to the customers. Accounts receivable is a current asset, too, as it represents the part of the sales which is not yet cashed in. Other current assets are predominantly prepaid expenses, such as advance payments to suppliers. Cash and cash equivalents is, also, a current asset, as it permanently affected by the operating cycle. Current is, often, assimilated to “short term”, as opposed to fixed assets, which represent the permanent activity of the company in a long term perspective (“non current” or “fixed” assets).

A current liability is, basically, a short term liability, be it operating or financial. The current liabilities of the balance sheet gather, altogether, bank overdraft, accounts payable, sales tax or social security expenses payable. The operating part of the current liabilities is used in the calculation of the working capital requirement.

There are two different meanings for this word. In the balance sheet, “current” means “short term”. The opposite, “non current”, obviously means “long term”. In the P&L, “current” means everything, which is not “exceptional”.

This generic word describes everything, which is due by the company. What is due and not yet paid is a resource. Therefore, debt and liabilities appear on the Equity & liabilities side of the balance sheet.

Consequence of its activity, the company takes contractual commitments, especially with financial creditors. The default risk comes from the potential inability of the company to meet these commitments; in the case of the financial debt, the firm cannot pay the interest and / or redeem the capital when due. Often evoked about the financial debt, the default risak actually applies to all stakeholders, with whom the company is in a contractual relationship.

The default risk is the probability that the company is not able to meet its contractual requirements (see Default).

New shares issued by a company are, with few exceptions, proposed to the existing shareholders pro rata their participation so that, if they exercise their subscription right, they keep a constant percentage of the total outstanding shares. A shareholder is diluted when his / her participation drops in percentage, even if he / she doesn’t sell any share. When shareholders are asked to abandon their subscription right in order to welcome a new significant shareholder, they are imposed a dilution.

A discount rate is used to calculate the financial equivalent today of a funds flow, which is to be generated in the future. The discount rate , thus, helps calculating the present value of future cash flows. The rate represents the cost of financing the asset, which generates the flows. As an example, the WACC is used to discount the cash flows generated by an investment, as it represents its financing cost.

The meaning, here, is different from strategic diversification. Financial diversification consists in creating a portfolio whose risk is reduced without affecting the profitability. Basically, a portfolio made of two assets, whose anticipated return is 10%, is supposed to generate itself a 10% return. But, the variability of its return will be all the more reduced as the respective returns of the assets move in opposite directions. Still, the most sophisticated diversification is unable to drive the risk down the zero.

The dividend is the part of the net earnings (group) that shareholders decide to distribute to themselves, based on a board’s proposal. Basically, the dividend is a cash outlay for the company and a symmetric cash inflow for the shareholder, the stock price exactly dropping by the amount of the dividend amount the day it is distributed. It is a wealth transfer and no wealth creation, the total shareholder’s wealth being unchanged. Obviously, a fast growing company will tend to minimize the distribution (see sustainable growth) and a mature company will increase its payout ratio. The dividend is a revenue for the shareholder, who will be more or less fiscally penalized depending, in particular, on his / her age. Last, the evolution of the dividend is a signal sent by the company to the financial community consistent with its financial communication. The financial theory extensively studied the relationship between dividend policy and value creation without developing a consensus on a model, which maximizes shareholders’ wealth.

The net earnings generated by a company belong to its shareholders, who will decide, during the ordinary shareholders’ meeting and on proposal of the board, which part of it will be back into their pocket. The dividend as a percentage of group net earnings is named “payout ratio”; As an example, a company will distribute half of its profits. The rest of the earnings will be reinvested in the corporation and increment the retained earnings. The payout is the direct consequence of the corporate financial policy of the firm and considerably depends on its growth rate.

The last “earnings” line before the bottom line in the income statement. The last expense to be deducted is the income tax when the company is, hopefully, profitable, i.e. when the EBT is positive.

EPS is calculated by dividing the group net earnings by the number of outstanding shares. Earnings per share are used, in particular, to calculate the ost well-known market ratio, the PER or Price / Earnings (P/E).

EBITDA is the difference between sales and the only operating expenses, which are generating a cash outlay. Thus, depreciation and amortization are excluded from the calculation. The acronym is self-explanatory: Earnings Before Interest, Taxes, Depreciation & Amortization means that EBITDA is a monetary operating profit calculated before remunerating the financial debt and paying the income tax. EBITDA is key in any valuation process, as the value of an asset lies in its ability to generate actual cash flows, as opposed to book earnings. EBITDA is a kind of “promise” for future flows, then a source of value. It is used in the calculation of the cash flows, which are discounted in the investment appraisal process.

A company is profitable if the profit generated by its business operations exceeds the cost of financing them. Operations generate the operating profit, out of which income tax is deducted. The financing cost is given by the cost of capital (WACC). The economic profit is, thus, the difference between the net operating profit after tax (NOPAT) and the total financing cost, result of the multiplication of the capital employed by the WACC. It can, also, be calculated per unit of capital employed. Then, it is the difference between the ROCE after tax and the cost of capital. The same figure is obtained by subtracting from the net earnings the cost of equity obtained multiplying the shareholders’ investment (equity) par their expected return ( E(ROE) ). A positive economic profit means that shareholders received more from their investment than the minimum, which pays for time and risk. Then, the company is profitable and the economic profit is a very robust indicator to measure, in the long run, the performance of a firm or a business. But, when it is used to evaluate the performance of managers, there is a danger that they privilege the short run at the detriment of long term investment and value creation.

The first step to calculate the value of equity and the share value is, often, to calculate the value of the business operations. The company invested its funds in the operations (capital employed). The value of the shareholders’ equity is the difference between the enterprise value, i.e. the value of the capital employed, and the value of the net financial debt, which finances the company together with the shareholders.

The EMRP is the average risk-premium required by shareholders who invest in a diversified portfolio of shares. The historical figure varies from one market to another. It is widely accepted that it ranges, for mature markets, between 4% and 7%.

The option holder has the right to buy or sell an asset at a price named exercise or strike price, which is agreed on when the option contract is concluded.

As any investor, the shareholder requires a return out of his / her investment. The figure is the sum of the risk-free rate of return (government bond rate) and a risk-premium, which is calculated multiplying the equity market risk-premium by a coefficient (see systematic risk and beta). The beta expresses the non diversifiable risk carried by the asset.

Financial creditors, bankers and bondholders, require a remuneration for their service, which consists in putting funds at the disposal of the company for a limited period of time. This remuneration is calculated by multiplying the amount of debt by an interest rate (time + risk): the financial charges are a fixed cost in the income statement and contribute to the financial risk of the company.

There is an information asymmetry between the company and its shareholders and stakeholders. Thus, the company must communicate and keep a permanent link with capital markets. The financial communication activity was born and the early ‘80s and its importance never stopped increasing since then. It goes far beyond simple legal information and consists in complete economic information, which must be permanent, as there is nothing worse than communicating to the markets only when the firm needs them.

A financial debt is a contract between the company and a financial creditor, i.e. any person or company requiring a rent (interest expense, coupon) against putting funds at the disposal of the company during a limited period of time. Financial debt increases the financial risk of the corporation, as financial charges are a fixed cost in the P&L. When the debt level reaches a critical point, the company carries a significant default risk. Financial charges are accrued in the P&L. Debt increase or redemption is accounted in the cash flow statement.

Different items are qualified as financial fixed assets. A minority equity stake is a financial fixed asset, which may be consolidated according to the equity method if the stake is significant. Long term sales financing, also, appears in the balance sheet as a financial fixed asset (cars, computers, aircrafts,…).

A business shows a positive financial performance if it is able to remunerate the investors who invested funds in its activity. Concretely, it happens when the profit generated by the business operations is greater than the cost of financing them, the cost of capital or WACC (see economic profit).

This is the difference between interest income and expense. Interest income is generated by the financial assets. Interest expense are the consequence of the interest-bearing financial debt.

When a company decides to finance its operations with financial debt, it introduces interest expense, a fixed cost in the P&L. The interest expense is the source of the financial risk, which, added to the operating risk, makes the total risk of the company. The financial risk has the differentiated impact depending on the investor. One the one hand, the interest expense increases the probability of default of the company and, beyond a certain level of debt, the interest rate. On the other hand, shareholders’ return and systematic risk are affected by the very first dollar of debt introduced in the balance sheet. Thus, the beta increases with the level of debt with the Hamada formula, which gives the ß of a leveraged firm (ßl) as a fonction of the ß of the same company, but entirely financed by equity, i.e. un-leveraged (ßu). The formula is: ßl = ßu * ( 1 + (1-CTR) * D / EQ), where CTR is the corporate (or income) tax rate, D represents the net financial debt and EQ the shareholders’ equity.

Financial tables are helpful to evaluate assets using discounted cash flows. They provide the present value of one dollar generated in N years and discounted at x%. They, also, give the present value of a constant annuity of one dollar generated during N years and discounted at x%.

This cost is linked with the financing of the firm. There are two financing costs: the interest expense paid to the financial creditors (banks, bondholders, …) and the cost of equity, i.e. the remuneration required by the shareholders. The interest expense appears in the income statement, the cost of equity in the calculation of the economic profit.

Fixed assets, as opposed to current assets, are not renewed at the rate of the operating cycle, but are used during a number of consecutive operating cycles. There are, essentially, three different types of fixed assets: tangible, intangible and financial fixed assets.

A company is flexible if it is in a position of grasping potential opportunities. Flexibility is all the more valuable as future is uncertain and it is, sometimes, very profitable for a firm to invest, today, in flexibility in order to be able, tomorrow, to be proactive, improve its competitive situation and appropriate incremental value. As an example, being under-leveraged creates some flexibility and helps the company exercise a growth option (industrial investment, acquisition) without being blocked by lack of financial resources. Flexibility is the same as an option, a so-called “real” option, whose evaluation is always difficult and rarely reliable.

The FCF is the net cash flow generated by an asset or a business. This flow is discounted at the cost of capital to take into account investors’ remuneration and obtain the present financial value of the asset. It is calculated subtracting investment out-flows (industrial investment together with net change in the working capital requirement) from operating in-flows (after-tax EBITDA and tax savings from depreciation and amortization). The formula itself leads to an interesting conclusion: a very capital-intensive business (huge investment) must generate very significant profits (EBITDA). If not, the FCF is negative and the value of the company, too…

There are, basically, two differentiated approaches in company valuation. One consists in considering that the value of any asset is nothing else than the price somebody accepts to pay for it: the methods developed on this approach are based on multiples and comparables. The other one looks at the fundamental value of the firm, which lies in its ability to generate funds flows. Then, the fundamental enterprise value (value of the capital employed) comes from discounted free cash flows. The two methods derived from the fundamental value approach are the free cash flows method and the dividend discounted model.

The gearing is the most frequently used ratio to characterize the financial structure of the company. It is calculated dividing the net financial debt by the book equity (book gearing) or by the market capitalization (market gearing). The ratio is used in the calculation of the cost of capital and in the evaluation of the leverage effect.

A goodwill appears in the balance sheet when the mother company fully integrates a controlled company in its consolidated statements as a result, say, of an acquisition. It represents the part of the acquisition price, which can be allocated neither to existing assets, nor to assets created by the subsidiary but which are not accounted (a brand or a market share internally developed). Starting in 2005, the new IFRS do not require any systematic amortization of this intangible fixed asset, but do require a periodical impairement.

Gross margin reflects the profitability generated by the industrial activity of the company. It is calculated subtracting from sales the cost of goods sold. It is measured in absolute terms or as a percentage to sales (gross margin rate).

Growth plays a dual role in finance. On the one hand, it “accelerates” the performance of the company, boosting value creation or destruction. On the other hand, it consumes financial resources. The key to value creation is profitability, growth merely amplifying the economic profit. As a consequence, growth cannot be envisaged as a primary strategic objective, but as a way to amplify the performance and / or a way to improve it, say, through economies of scale.

Some financing instruments are qualified as hybrids if their characteristics make them look like partly equity, partly financial debt. The best illustration is the convertible bond. When it is issued, it is a bond, but it will hopefully be converted later into one or several shares; then, it moves from debt status to equity status.

At least once a year (potentially any time the company produces audited accounts), companies must, through the impairment test, confront the financial value of their assets with their book value and adjust them downwards if the book value is lower. In the accounts, the consequence is, then, an asset write-off.

P&L is one of the three basic accounting statements periodically produced by the firms, together with the balance sheet and the cash flow statement. It confronts total revenues (sales, top line) and total costs. The bottom line (net earnings) is positive if the company, on the average, has been able to sell at a price above its costs during the period. It has, then, been able to meet all its contractual requirements and remunerate the stakeholders. The net earnings belong to the shareholders who will decide which part of it is distributed, the rest incrementing the retained earnings in the balance sheet. A company is profitable if the net earnings are high enough to remunerate the immobilization of funds and the risk taken by shareholders (see economic profit).

When revenues exceed operating and financial charges, the company pays an income tax, whose rate substantially varies from one country to the other. When a firm generates losses, it is allowed to carry them forward in a kind of inter-period profit consolidation process. Some legislations even allow to carry losses back, which generates an income tax repayment to the benefit of the company.

Being the owner of the corporation, the shareholder supposedly knows what is going on in there. But, for obvious confidentiality reasons and according to the legislation, the company will restrict its communication to everything, which may be revealed without prejudicing its own future. It will very much limit its communication on future developments (products, R&D, markets, acquisitions). Still, its value comes from its ability to perform in the future. As a consequence, the investor receives a very small part of the information, which would help the investment decision process. In the meantime, the managers use this information on a daily basis: they are insiders. Therefore, there is a significant asymmetry between those who own the company and these who run it. This phenomenon is recorded anytime there is a transaction in which the buyer knows much less about the product than the seller. Information asymmetry is one of the most promising research areas of contemporary microeconomics.

In order to improve its financial structure, to create liquidity for its investors, to welcome new shareholders and / or to maximize shareholders’ wealth, a company will decide to go public and raise public money. This operation is complex and risky, and very much impacts the financial communication as well as the investor relationship. Financial communication, then, plays a critical role, not only when the company goes public, but in the long run in order to keep a trustworthy relationship with markets, especially if it intends to raise additional funds in the future.

Intangible fixed assets are essentially immaterial, as opposed to tangible: patent, license, market share, trademark, intellectual property right, software, goodwill. The new IFRS implemented in 2005 require the implementation of an impairment process, which replaced the traditional amortization (previously, some intangibles were amortized, some others not, like brands).

The interest rate represents a cost paid per unit of money and per period. The debt interest rate is the rent paid by the borrower to the lender during a given period: day, week, month, quarter or year. The coupon paid by the company or the State to the bondholder remunerates the immobilization of the funds and a potential risk.

Mathematically, the IRR is the discount rate, which makes the net present value of an investment go down to zero. Financially, it is the intrinsic operating profitability of the investment. If the IRR is greater than the cost of capital, the project is profitable, as it generates a return, which exceeds its financing cost. The opposite situation leads to negative performance and value destruction. The IRR is a powerful communication instrument, but it has some drawbacks: multiple IRR for some projects and the underlying assumption that intermediary cash flows are reinvested at the IRR.

The value of an option is the sum of two figures. The first figure, the intrinsic value, is the potential profit, which might be generated by the immediate exercise of the option (example: a call option in which the underlying asset price is greater than the exercise price). When the intrinsic value is strictly positive, the option is said “in the money”. When asset price and exercise price are matching, the option is said “at the money”. If there is no price matching and if the exercise of the option just generates losses, the option is “out of the money”. The second figure is the time value of the option. It is much more difficult to quantify and comes from the fact that, between the moment the option is evaluated and the moment it expires, there is some uncertainty on its final status: exercised or not. Obviously, uncertainty drops when the maturity gets closer and the time value is zero at maturity. Furthermore, the uncertainty is at its maximum when asset and exercise prices are equal. As a consequence, the time value is highest when the option is “at the money”.

In its production process, the company holds inventories of raw materials, work-in progress, semi-finished goods and finished goods in order to be able to serve the customer when needed. Inventories are accounted in the balance sheet at their historical production cost and appear among the current assets. Their reduction is a permanent challenge and helps improve the financial performance of the firms.

An investment is an immediate expense, which will generate benefits in the future. This time lag, between the moment the company invests and the moment it gets the benefits, characterizes the investment. Thus, R&D project, education process, acquisition of an efficient equipment, communication campaign and company acquisition are investment. Some investment appear in the cash flow statement (acquisition of tangible and intangible fixed assets) and are accounted as fixed assets. Some others are expensed in the income statement. An investment is profitable if its value is greater than its cost. The net present value criterion characterizes this value creation. Companies often calculate the intrinsic profitability of the investment, named internal rate of return. The mission statement of the financial controller includes measuring and controlling the risk of the investment and identify the potential opportunities it generates through the sensitivity analysis. Is, also, named “investment” the decision taken by a shareholder or a financial creditor to invest his / her money in a company against a required return.

A leverage buy-out consists in financing an acquisition with a significant amount of debt. This debt is more or less risky, depending on the guarantees granted to each level of financing. The “target” (acquired company) must generate high and recurrent funds flows so that creditors are repaid, capital plus interest. The financial engineering of an LBO is highly sophisticated.

The financial structure of a company may have a positive or negative impact on its financial profitability (see ROE). The leverage effect measures this impact and is calculated as the difference between the actual financial profitability of the firm and the ROE it would generate if entirely financed by equity. In this case, the financial profitability would exactly be the return on capital employed (see ROCE) after corporate tax: the economic profitability would be directly attributed to the shareholders, as there is no financial creditor to remunerate. It is easy to demonstrate that the leverage is positive (the higher the gearing, the higher the ROE) if the ROCE exceeds the interest rate of the financial debt.

When a company signs a financial debt contract, it commits itself to pay capital and interest at contractual dates. The liquidity risk is the potential inability of the company to face its contractual requirements, i.e. to repay the debt or, at least, to renew it. It is obviously correlated with the net financial debt of the company, its net cash position and its working capital.

Long term resources consist in all the non current resources of the company, financial as well as operating. These resources do not generate any immediate liquidity risk on the company. Net fixed assets, which are not liquid but of utmost importance for the firm, must be entirely financed by long term resources, whose consequence is a positive working capital.

This is the market value of shareholders’ equity, calculated multiplying the stock price (last, average) by the number of outstanding shares. If the market capitalization is greater (respectively lower) than its book equity, the company is a goodwill (respectively badwill) situation, it has created (respectively destroyed) value to its shareholders.

In corporate finance, market values are often preferred to book values when considering balance sheet items. For example, to calculate the cost of capital, it is recommended to use the market value of equity instead of its book value, as it represents the actual shareholders’ investment and not the historical one. If the company decides to buyback its shares, it will propose a price, which is attractive to shareholders, then higher than the market value of the stock, whatever its book value. When the market value is greater than the book value, there is a value creation: the acquisition goodwill is the difference between the price paid for assets and their historical cost.

French: market value-added

The MVA is the difference between the enterprise value and the book value of capital employed. It is demonstrated that the MVA is the sum of all the economic profits generated by the company, which leads to the fundamental conclusion: value creation comes from sustainable profitable growth. A positive MVA is equivalent to a MTB greater than one.

The MTB is calculated dividing the market capitalization by the book value of shareholders’ equity. It must be greater than one. Indeed, equity represents the accumulated shareholders’ investment. If the value of the investment is greater than its cost, some value is potentially created, the MTB is greater than one and the market value-added is positive.

According to the debt contract, the company must repay the funds on contractual dates. The debt maturity is the period running between the moment it is measured and the redemption date. When the debt is progressively repaid, the calculation is more complex. Then, the average maturity, named duration is obtained from an actuarial calculation.

The activity consists in getting the control of companies, through mergers or acquisition; the companies may be listed or not and will be possibly acquired through takeover (cash or shares).

Very often, cash and cash equivalents, on the asset side of the balance sheet, are confronted with the short term financial on the liabilities side. The difference between these two figures is named the net cash position of the firm. When it is negative, the company is, potentially, in a liquidity risk situation.

The net financial debt is calculated subtracting cash and cash equivalents from the financial debt (short term and long term).

To finance its operations, the company mobilizes two categories of investors, shareholders and financial creditors. Net financial resources are the sum of equity and financial debt net of cash and cash equivalents. The investors share a common objective: getting a fair return on their respective investment.

The net present value (NPV) measures the value created by the investment in today’s dollars (today: the day of the investment cash outlay). Net future value, also, measures a value created, but at the end of the investment life, when the last cash flow is generated. Net present value can be deducted from the NFV simply discounting it at the cost of capital, i.e. dividing it by 1 plus the WACC to the n-th power, n representing the lifespan of the investment.

The net present value measures the potential value created by the investment. To calculate it, the cost of the investment is deducted from its value. The value is obtained by discounting the cash flows generated by the investment at the cost of capital (value comes from cash). The net present value is, also sometimes, named goodwill and represents a value creation when it is positive.

The New York Stock Exchange, based on Wall Street, is the largest stock market of the United States. Founded shortly after the independence at the end of the eighteenth century, it merged with Euronext in 2007.

When a company is created, it issues property rights (shares) sold to the founding shareholders at a price named the nominal (or par). As an example, if a company needs $100,000 to start its activity, it may issue 1,000 shares at a par value of $100 per share (or 10,000 shares at $10, or …). Each share represents a property right, which confers to its holder a right on the corporate value (a right on the company’s net worth to be rigorous on a legal and accounting point of view!). Maybe, two years later, the company needs to raise additional shareholders’ funding, say, to finance its growth. Needed funds are evaluated at $300,000. The firm will propose new shares through a capital increase. But, in the meantime, the value of the company increased: its business model is, now, credible, the first customers are convinced and the company has, maybe, already generated its first profit. Let’s suppose that the value is, now a million dollars. Then, each share is worth $1,000, 1/1,000^th of the total company’s value. Each new share will be issue at this value (or close to it), because the existing shareholders will never accept to sell off their wealth. Indeed, each new share has the same rights as the old ones (there are exceptions …) and, thus the same value and the same purchasing price. Then, the company will issue 300 new shares at the unit price of $1,000 and collect the needed $300,000. In the balance sheet, this amount will increment the shareholders’ equity, as it is the consequence of an incremental shareholders’ investment. But, the amount will not increment the “capital” line. Indeed, the new shares are issued at the same nominal value as the old ones, because they have the same rights. Then, capital will increase by $30,000 (300 shares times $100 of nominal value). But, the newcomers had to pay a higher price to get the same rights, they paid a premium, which will appear in the equity, next to capital. The balance sheet will be incremented, on the asset side, by the cash collected by the company ($300,000) and, on the equity and liabilities side, by the same amount in the equity as the sum of incremental capital ($30,000) plus premiums ($270,000, i.e. he difference between the price paid for a new share -$1,000- and the par value of the share -$100- multiplied by the number of shares issued -300-). Each and every new shares issue will follow the same process. It could, then be concluded that the par remains unchanged over the life of the corporation. In fact, the figure may change, as the company itself changes. Let us suppose, for example, that the stock price gets to a “too high” level. This will significantly reduce the liquidity of the share’s market (the stock becomes inaccessible to the small shareholder). The company can, then, decide to divide the nominal, say by 10. Let us go back to our example: 10 shares with a nominal of $10 will replace one share, whose par is $100. The value of the firm did not change at all, but the number of shares is multiplied 10 times: the value of each share is mechanically divided by 10, which makes the stock more accessible and the market more liquid. This long paragraph was devoted to the nominal of a share. The same word is used to mention the initial and / or reference price at which a bond or any financial asset is sold.

The cash flow statement describes how the company did finance its investment. The operating cash flow represents the funds flow generated by business operations and operating cycles. It is calculated subtracting the net change in the working capital requirement from the gross cash flow. The gross cash represents the cash potentially generated by the operations. The change in WCR is the consequence of the time lag between the generation of profit and its cash collection. The operating cash flow should be positive. Otherwise, the company must raise external financial resources (equity and financial debt) before it even invested its first dollar.

The operating cycle starts the moment the company receives raw materials from its suppliers and ends when it has completed the cash collection from the customers. In the meantime, it must finance the operating cycle, that is to say its inventories and accounts receivable with the help, among others, of accounts payable. The funds, which are necessary to finance the operating cycle, are named working capital requirement.

Liabilities are of different natures, depending of their origins. An operating debt is generated in the operating activity of the company and has nothing to do with its financing. To make it simple, any liability is operating, when it is not of financial nature, i.e. if not contractually interest-bearing.

Among all costs, there is distinction between those which are linked with the firm’s activity and business, and the financing costs (interest expense) or the income tax. An operating expense is, then, a consumption linked with the capital employed.

The operating profit expresses the ability of the company to sell its product above their industrial cost before it pays the interest due to the debt holders and the income tax, and, last but not least, it remunerates its shareholders. The figure is of utmost importance and will be divided by the capital employed to calculate the ROCE and the economic profit, indicator of the actual performance of the firm.

As any risk, it is the consequence of variability. The operating risk is the expression of EBIT variability. The higher the operating, the lower the ability of the company to introduce interest expense in the P&L, thus financial debt in the balance sheet. High operating risk means low debt capacity.

An option in a financial asset is a contract, which confers to the buyer the right to buy (call option) or sell (put option) this asset from or to the seller against a strike (or exercise) price initially agreed, during (American option) or at the end (European option) of a given period. It is a right and not an obligation. The value of the contract depends, among others, on its lifespan, the strike price and the future variability of the asset return. The option is widely used in financial engineering, for example in the convertible bonds or the warrants. The first sophisticated valuation models of financial options date back to the early ‘70s. The most well-known model bears the name of its authors, Black & Scholes.

Organic growth comes from “inside” the organization and external growth is driven by acquisitions. In the long run, organic growth should be financed by the operating cash flow. The free cash flow of a company may be negative when it aggressively buys businesses, but the company will, then face financing problems if the actual growth exceeds its sustainable growth.

Shareholders may decide to reduce their investment through a share buyback. Shares are, then, purchased by the company, which holds its own property rights. The shares, which are not held by the company, are named outstanding shares. Only outstanding shares dispose of ordinary rights: information, vote and dividend.

An investment is characterized by a time lag between the moment the money is spent and the moment the company gets the benefits of the investment. A cash outlay is followed by a succession of cash inflows. These cash inflows will progressively remunerate and repay the financial resources, which initially financed the investment. The payback is the minimum number of years the investment should be operated, so that financial resources are repaid by its cash flows.

According to the theory, the company does not randomly select its financial resources when financing its growth. Indeed, the selection does not take into account their relative financing cost, but the easiness of access. The gross cash flow is, first, consumed because there is no need for convincing any banker or shareholder. Then, bank debt is used because it is easier to meet bankers’ than shareholders’ requirements. The shareholder will be the very last mobilized financial resource, as his / her requirement is the highest. Between bank debt and shareholders’ equity, there is some room for hybrid financing instruments. Then, according to pecking order theory, the company will, successively, mobilize its gross cash flow, then “pure” financial debt, then quasi equity and, last, straight equity. Empirical studies, observing actual corporate behaviour, neither validate nor invalidate the theory.

It is the amount of money an investor must pay for a new stock on top of the nominal when the company issues shares.

This is the most “classical” multiple. It is obtained by dividing the stock price by the earnings per outstanding share. As net earnings represent the shareholders’ remuneration, the P/E expresses a kind of payback period.

Like Price / EBIT, Price / EBITDA helps calculating the value of capital employed, but from the “cash” operating profit before depreciation and amortization, which do not generate any cash outlay.

This multiple calculates the value of capital employed from its ability to generate a cash flow net of investment, the free cash flow. There are different ways to calculate the FCF. It is, often, calculated as the difference between EBITDA and industrial investment (tangible and intangible) plus the net change in the working capital requirement. It may, also, be calculated after deduction of income tax, as it is used in the classical FCF evaluation method.

This multiple calculates the value of capital employed from sales.

A company generates a profit (respectively a loss), when it sells a product, a service or an asset at a price, which is above (respectively under) its cost, as it appears in the balance sheet.

Project finance is a technique, which consists in putting an asset in a dedicated legal structure. The asset generates cash flows, which are affected to the different financing instruments according to a precise contractual process. Project finance deals with highly sophisticated legal and financial engineering, support by complex modelling. It is particularly developed in public-private partnership.

When a company, at the end of the year, closes its accounts, it should take into account revenues and costs, which are identified but for which no invoice has been issued or received. Indeed, it must produce its best estimate of the revenue or the cost, which will the be accrued in the P&L.

These are independent organizations, whose mission statement is to give their best estimate of default risk on financial debt issued by a company, as a function of the amount and the maturity. Their opinion is public. The three largest agencies are Standard & Poor’s, Moody’s and Fitch IBCA. As an example, S&P will give rate AAA a long term debt, whose probability of default is very close to zero.

We have described the option on a financial asset. But, the scope of the option may be much larger, it is the ability to defer a decision, which is applicable to plenty of management situations. Everything, which created some flexibility or introduces some reversibility in any resource allocation process, can be identified as an option. For example, being under-leveraged is an option, as it gives the company the ability to raise massive funds in order to grasp a growth opportunity. R&D projects can, also, be assimilated to option creation processes. A company may decide to invest in manufacturing flexibility, in order to be able to produce different products on the same assembly line: this is a typical option-like investment. These options do not deal with financial assets; they are named “real options” as opposed to “financial options”. Their pricing is very delicate, with the notable exception of those dealing with assets, whose behaviour make them look like financial assets: construction rights, natural resources, among others. But, the concept itself is very fruitful and helps building models, which are very useful in decision-making.

The net earnings are calculated as the difference between sales and costs, which represent the respective remuneration of all stakeholders. Thus, it expresses the book remuneration of he shareholders, who decide, following or not the board’s proposal, which part of it gets back to themselves (dividend), the rest being re-invested in the company to finance growth and / or reduce debt. These re-invested funds constitute an incremental annual shareholders’ investment. Thus, they appear in he balance sheet item, which gathers the accumulated shareholders’ investment, i.e. equity. Retained earnings are, then, the link between the profitability of the company and its ability to self-finance its growth (see sustainable growth).

This ratio is key in corporate finance, as it measures the profitability generated by each dollar invested in business operations. It is calculated dividing EBIT by capital employed. The ROCE should be high enough to remunerate investors, shareholders and financial creditors. To calculate the economic profit, the cost of capital is subtracted from the ROCE. To evaluate the leverage effect, the ROCE is confronted with the interest rate of the financial debt.

This ratio measures the book return on shareholders’ investment. It is calculated dividing net earnings attributable to shareholders by their total investment, shareholders’ equity.

This concept is quite general is diversely interpreted. It is, often, used as a complement of the ROCE to evaluate the performance of a business division, regardless of its acquisition price. The ROI is calculated like the ROCE with the exception of the intangible fixed assets (denominator, capital employed) accounted, when the business was acquired, including the goodwill. The ROCE, then, measure the return generated as a consequence of the acquisition and the ROI measures the industrial performance of the division itself, again regardless of the acquisition price.

This ratio measures the profit generated by each dollar of sales. At the denominator’s level, sales obviously appear. The numerator expresses the different levels of profit generation in the P&L. The profitability generated by the production activity is measured with the gross margin, the operating profitability with EBIT (or EBITDA to focus on cash) and the shareholders’ profitability uses the net earnings (bottom line divided by top line).

The company generates revenues when it sells goods or services (sales, operating revenues), when it invests its cash in financial assets (interest income or dividends received, financial revenue) and when it sells fixed assets (exceptional items). These revenues are, potentially, taxed, depending on the profit they actually generate.

Risk is a key word in finance. An asset is risky if the return it actually generates potentially differs form what was initially anticipated. Risk is, thus, about asset return variability. To quantify the risk, a statistical indicator is traditionally used, which combines the probability of getting a return, which differs from what was expected, and the difference, when there is any, between actual and expected returns. The name of the indicator is the standard deviation. Risk aversion means that investors are ready to take a risk, but they require a return proportional to the risk they have taken. The cost of capital takes into account the respective risk premiums required by both shareholders and bankers. As the value of any asset lies in its ability to generate cash flow discounted at the cost of capital, it is clear that the value of an asset is negatively correlated with its risk. Still, there is an instrument, whose value is positively correlated with uncertainty, the option. Option’s value is positively correlated with the risk carried by the underlying asset, as the right to exercise or not the option gives the investor the ability to grasp opportunities without being penalized by downside potential.

Any investor, banker or shareholder, requires a return, which remunerates the immobilization the funds during a, long or short, period of time, to which should be added a premium, which remunerates the risk of the investment. The risk comes from a potential gap between actual and expected return.

This managerial process consists in identifying all the parameters of a valuation process (investment or enterprise), which might substantially alter the calculated value. The process leads to an interaction between finance and operations and helps identifying, not only, risks but, also, opportunities, and is critical in value creation. The parameters identified as “sensitive” are the key indicators careful followed up by the investment project or post-acquisition control system.

The share is the ownership right issued by the company to finance its activity. It is held by the shareholder. Several types of shares can be issued by the same company, for example ordinary together with preferred shares without voting rights. The number of shares increases any time the company increases its capital. When it buys back its shares, the number of outstanding shares drops. Once repurchased, these shares can be cancelled, which reduces the number of existing shares.

Under different circumstances depending on the country, companies may have the right to buy back their own shares, then keep or cancel them. They must publicize this action, make it accepted by a majority of two-thirds of the shareholders, launch a takeover and produce a prospectus. There might different reasons for a buyback. One is increase the financial leverage of the firm, change the shareholders’ structure, give back funds in excess and send a signal to capital markets when the shares are not cancelled, their purchasing price is deducted from the equity (treasury stocks), as they represent a shareholders’ divestment. Under this status, they obviously lose any right (dividend and voting right).

The shareholder is the owner of the company, as he / she holds the ownership rights, i.e. the shares. The shareholder invests in the company, both, buying newly created shares and accepting the re-investment of all or part of the net earnings in the business. This re-investment appears in the retained earnings of the balance sheet. The shareholder has a right on the earnings, together with an information right (restricted by confidentiality, see information asymmetry) and a voting right (ordinary shares), which is key for the approval of the accounts and the appointment of directors.

Shareholders’ equity represents the accumulated investment decided by the shareholders throughout the life of the corporation. Shareholders invested in newly created shares (see capital and premiums) and approving to reinvest all of part of the net earnings (see retained earnings). They divested selling their shares, when the company makes a buyback. Equity is, thus, made of capital, premiums and retained earnings, net of treasury stocks.

Shareholders’ equity and liabilities gather all financial and operating resource, which together contribute to the financing of the business operations.; There are financial resources (shareholders’ equity and financial debt) and operating resources, like accounts payable. These items can, also, be ranked by maturity: long term resources vs. current liabilities.

The company has neither the right, nor the will to give confidential information to the market. It will, for example, not disclose detailed information on R&D projects and say anything about acquisition targets. This phenomenon is known as information asymmetry. Still, the company must keep a permanent contact with capital markets, role attributed, among others, to the investor relation department. Corporate financial policy, also, contributes to communication, as some decisions are quite meaningful and scrutinized by the market. A very strong signal is the evolution of the dividend, especially its growth rate, which gives information about potential earnings growth. Shares buyback is a strong signal, too, but which may be differently interpreted depending on the observer: some will interpret that action as the board conviction that the stock price is under-evaluated, some others will conclude that the company has anticipated no significant profitable project for the future. Similarly, when a company acquires a company and issues shares, it may be positively perceived as creating new aggressive financial flexibility, or negatively as board concerns about the price paid for the target and the easiness of integration.

The total risk (variability of the return) of the company basically consists in two different risks, specific and systematic. Specific risk may affect the company’s profitability, but disappears with diversification. As an example, R&D is a huge, but specific, risk for a pharmaceutical company, which will be spread by the asset manager who invests in different companys of the sector at the same time. Good and bad news form laboratories will, supposedly, compensate each other. This risk is, also, named, “diversifiable” and, as rational investors spread it, no remuneration will be required. This conclusion is fundamental in the CAPM, which calculates the expected return on equity.

Stakeholders are actors more or less participating to company’s activity. Employees, suppliers and bankers are key stakeholders. There is a distinction between shareholders and stakeholders, as their respective roles are quite different, even though they are, sometimes, assimilated in corporate financial communication.

In statistics, standard deviation measures the average distance between a random variable and its mean. For example, an asset, whose return is evenly distributed 10% / 30%, generates an average return of 20% with a standard deviation of 10%. Standard deviation is the traditional indicator used to evaluated the risk of the asset, which is, in most cases, quite relevant. But, complex assets require more sophisticated approaches for risk evaluation.

The strike price is the price at which the holder of an option has the right to buy or sell the underlying asset. This price is agreed on, when the option contract is concluded.

This is the maximum growth rate a company can afford without increasing its financial leverage and without issuing shares. If actual growth is greater than sustainable, then the company must issue shares (dilution), raise financial debt (increase in the financial risk at the expense of strategic flexibility) or reduce its dividend (negative signal). Confronting actual and sustainable growth, therefore, gives precious information about future funding needs or excesses.

As opposed to specific risk, systematic risk cannot be spread. Economic evolution is, by essence, the systematic risk. When the economy is prosperous, companies will benefit of the situation, but to different extents. In the case of an economic downturn, all business sectors will be negatively affected, but, again, to different extents. Systematic risk, for a company, is the relative sensitivity of its profitability to what happens in the economy. This risk cannot be diversified, as it is impossible to identify a business, which “profits” from a crisis or a sector penalized by economic prosperity. The systematic risk coefficient is named the beta (ß).

A tangible fixed asset is, by nature, material: land, building, and equipment. It is complemented by intangible fixed assets, which are immaterial. Land is not depreciated, all other tangible fixed assets are depreciated over their anticipated lifespan.

Companies paid all kinds of taxes. Finance differentiates taxes linked with operations (real estate taxes, for example), which are dealt as operating expenses, and income tax, consequence of the profits generated by the company.

The word means the end of an asset’s or a contract’s life. The term of a liability is when it should be paid or redeemed. Short term means “less than one year” and, of course, long term is used beyond one year.

An option is the right to buy (call) or sell (put) an asset, named “underlying asset”. It may be a financial asset (share, future, index, …). The underlying asset of a real option is more difficult to identify, as it may be a process, a R&D project or a flexible assembly line.

Volatility is the foundation of risk. A government bond generates a non-volatile return, it is, therefore, not risky. Each and every other not-government guaranteed asset is risky, because its return will be potentially affected by the evolution of the environment. Volatility is the variability in the return, which is the essence of risk. A classical volatility inicator is the standard deviation, which, in statistics, quantifies the average difference between the values of a random variable and its average value (mean).

The working capital represents the long-term resources in excess of the net fixed assets. It should be positive, in most cases. If not, part of the fixed assets is financed by short-term debt, which creates a very high liquidity risk on assets, which are not liquid themselves. The exception is the case of companies, whose working capital requirement is so negative that the net cash position is significantly and steadily positive. The working capital was, formerly, calculated as the difference between current assets and current liabilities. The mathematical result was the same, but the rationality was different (no focus on the fixed assets) and, above all, it used to introduce confusion with the working capital requirement.

The working capital requirement represents the funds, which are invested and “sleeping” in the operating cycle. The main items are inventories, accounts receivable and accounts payable. It may be positive, when customers are paying immediately (retail distribution). These immobilized funds generate financing costs, operating expenses, even exceptional expenses, without generating any value. In addition, the funds would generate real value creation, if they were invested in fixed assets. Therefore, the objective of any finance department is to reduce it.

When an investor buys bonds, he / she may sell them before maturity or keep them until redemption. The yield-to-maturity is the internal rate of return generated by a bond held by the investor over its lifespan.