Glossary of Financial Terms
Profit and Loss Statement Terms

**Cost of Goods Sold (CGS) or Cost of Sales** is the costs that go into creating the products that a company sells; the only costs included in this measure are those that are directly tied to the production of the product.

**Operating Expenses** are the day-to-day expense such as sales, accounting, administration, or research & development.

**Operating Profit** is a measure of a company?s earning power from ongoing operations, equal to earnings before the deduction of interest payments and income taxes.

**Other Income** is typically defined as interest income or gains from the sale of assets.

**Other Expenses** are income tax payments, interest expenses or the loss on the disposal of assets.

**Net income** is equal to the income that a firm has after subtracting costs and expenses from the total revenue.

Financial Ratios

**Liquidity Ratios** measures the company's ability to turn short-term assets into cash to cover debts is of the utmost importance when creditors are seeking payment. Bankruptcy analysts and mortgage originators frequently use the liquidity ratios to determine whether a company will be able to continue as a going concern.

**Types of Liquidity Ratios** are:

**Current Ratio** is a ratio that measures a company?s ability to pay it?s obligations over the next twelve months. Current Assets such as Cash, Accounts Receivable and Inventory are divided by Current Liabilities which includes Accounts Payables. The higher the current ratio, the more capable the company is of paying its obligations.

**Quick Ratio** measures a company?s ability to quickly meet its short-term obligations with its most liquid assets (Cash and Receivables).

**Liquidity** is an asset that can be sold rapidly and with minimal loss of value. This ratio is sometimes referred to as the cash ratio.

**Solvency Ratios** is one of many ratios used to measure a company's ability to meet long-term obligations. Acceptable solvency ratios will vary from industry to industry, but as a general rule of thumb, a solvency ratio of greater than 20% is considered financially healthy. Generally speaking, the lower a company's solvency ratio, the greater the probability that the company will default on its debt obligations.

**Types of Solvency Ratios** are:

**Current Liability/Equity** measures the relative proportion of equity and debt used to finance a company's assets. Highly leveraged companies use a great deal of debt versus capital investment which increases their risk.

**Debt Ratio** shows the proportion of a company's assets which are financed through debt. If the ratio is less than one, most of the company's assets are financed through equity. If the ratio is greater than one, most of the company's assets are financed through debt. Companies with high debt/asset ratios are said to be "highly leveraged," not highly liquid as stated above. A Company with a high debt ratio (highly leveraged) could be in danger if creditors start to demand repayment of debt.

**Leverage Ratio** looks at the long term risk burden of debt as a percentage of the business.

Turnover

**Activity ratios** measure how quickly a firm converts non-cash assets to cash assets

**Types of Turnover Ratios** are:

**Days Sales Outstanding (DSO)** looks at your average collection period. DSO, is calculated as: Total Outstanding Receivables at the end of the period analyzed divided by Total Sales for the period analyzed (typically 90 or 365 days), times the number of days in the period analyzed. Higher DSO can also be an indication of poor follow up on delinquencies, or higher DSO might be the result of inadequate analysis of applicants for open account credit terms. An increase in DSO can result in cash flow problems.

**Days Payable Outstanding (DPO)** is similar to the DSO but looks at how fast the companies pay their bills. A company with a low DPO ratio is likely paying their bills too quickly which could create a cash shortage. However, certain industries require quick payment terms.

**Days Working Capital** compares the DSO and DPO calculation to evaluate cash management. Company paying their bills faster than they collect would have negative working capital days.

**Asset Turnover** is a financial ratio that measures the efficiency of a company's use of its assets in generating sales revenue or sales income to the company.

Productivity Ratios

**Headcount ratios** are primarily used to evaluate the impact staff has on sales growth and profitability.

**Debt Coverage**

Ability to produce enough revenue to cover its monthly debt payments. The higher this ratio is, the easier it is to borrow money for the business.

Profitability

**Return on Assets** indicates what return a company is generating on the firm's investments/assets. This is an important ratio for companies deciding whether or not to initiate a new project. The basis of this ratio is that if a company is going to start a project they expect to earn a return on it, ROA is the return they would receive. Simply put, if ROA is above the rate that the company borrows at then the project should be accepted, if not then it is rejected.

**Return on Equity** measures the rate of return on the ownership interest. ROE is viewed as one of the most important financial ratios. It measures a firm's efficiency at generating profits from every dollar of net assets (assets minus liabilities), and shows how well a company uses investment dollars to generate earnings growth. ROE is best used to compare companies in the same industry since comparing a ROE of a consulting firm versus a ROE of a manufacturer will prove no value given the up front investment required of a manufacturer.

The DuPont Formula

**The DuPont formula**, also known as the strategic profit model, is a common way to break down ROE into three important components. Essentially, ROE will equal net margin multiplied by asset turnover multiplied by financial leverage. Splitting return on equity into three parts makes it easier to understand changes in ROE over time. For example, if the net margin increases, every sale brings in more money, resulting in a higher overall ROE. Similarly, if the asset turnover increases, the firm generates more sales for every dollar of assets owned, again resulting in a higher overall ROE. Finally, increasing financial leverage means that the firm uses more debt financing relative to equity financing. Thus, a higher proportion of debt in the firm's capital structure leads to higher ROE. Financial leverage benefits diminish as the risk of defaulting on interest payments increases. So if the firm takes on too much debt, the cost of debt rises as creditors demand a higher risk premium, and ROE decreases. Increased debt will make a positive contribution to a firm's ROE only if the firm's Return on assets (ROA) exceeds the interest rate on the debt.