Essential Terms
Present value: The basis of all multi-period financial decision-making. Financial analysis has to recognize that dollar amounts occurring in different time periods are not comparable. That is, a dollar received ten years from today is not the same as a dollar received today. The present value, or value today, of the future dollar amount is the relevant number to use when making a financial decision today. The present value calculation is the common denominator that allows us to compare dollars of different time periods.
Financial statements, income statements, balance sheets: Use the accounting terms and definitions to give us the information from which we make our financial decisions. Therefore, we in the world of finance are incredibly concerned that those financial statements be fair and accurate, not fraudulent, not deceptive, not telling us something that isn’t true.
Risk and return: The foundation concept of financial decision-making. You must recognize you can’t look at one without looking at the other to make a decision when you’re choosing among alternative investments.
Capital budgeting: One of the most important applications of the present value concept. In making decisions to allocate capital among competing uses, it helps you do so in a manner that will give you the best return possible relative to the use of that capital.
Cash flow: As we say in finance, cash is king. Understanding what causes your cash flow, understanding what your cash flow is, and understanding how to use that information are essential parts of financial decision-making.
Accounting methods: They have become so complex and so confusing that the average person reading a financial statement can’t understand in many cases what’s going on. As an example, at the far extreme, unless you were a PhD and an accounting professor, you would have had no clue what Enron’s financial statements were telling you, they were so complex. The accounting profession must do some things to simplify the financial information so the average investor, or any average individual looking at those financial statements, whatever the purpose may be, doesn’t have to have a PhD in accounting to understand what that information is telling us.
Capital structure: An important concept that financial research has looked at for years and years and years, and ultimately it seems to come down to weighing many factors that make it almost an individual decision for each firm. The capital structure decision involves the choices of financing sources. What should the liabilities and shareholders’ equity part of the balance sheet look like? How much debt financing should be used? What types of debt – bank loans, bonds, privately placed debt? What should be the mix between short-term and long-term debt? How much equity should be used? What types of equity – common stock, preferred stock, retained earnings? There are so many factors involved, so many complexities in that decision, many of which are unique to an individual firm, that we’ve been unable to generalize and come up with a universal answer as to what the optimal capital structure should be. We know the things that are important, and we know what the firms’ managers should look at, but ultimately it becomes a mixture of many, many factors that make that decision a very complex one.
Market efficiency: The theory sounds believable, but when you look at the actual efficiency across the financial markets, they are less efficient than the theory would suggest. Market efficiency, as popularly defined, implies that all public information is quickly and completely assimilated in a common stock’s price. Not all relevant public information reaches all investors at the same time or in the same way. Thus, there is still an opportunity for some market participants to trade profitability when they obtain new information. In addition, there is nothing to lead us to believe that all investors have to derive the same conclusions about a stock’s value, even if they all had the same information at the same time.
Dividends: Another timely issue. Dividends are becoming increasingly important to investors because they’re discovering that some of the promises of capital gains that we saw, especially in the late 1990s, may disappear as quickly as they appeared. If you receive a cash dividend, then that was a tangible return that you received from an investment in stock, so we might see a little more pressure on firms to pay dividends to shareholders.
M&A: An activity that, on many occasions, generates such enthusiasm for the deal that a lot of the basics we teach and talk about in finance about valuation get forgotten. For example, it is very hard to justify the prices that are paid for many firms without making some huge assumptions about the size of the synergistic benefits. Those synergistic benefits would have to be outlandishly large to justify the prices that are paid, and we’ve seen on many occasions that those synergies just don’t happen. But people were so excited about the deal that they just assumed either greater values for the synergies that were going to come about or greater probabilities of synergies even happening.
Options pricing: Where the finance world starts to get away from the basics of day-to-day. Options pricing starts to get pretty sophisticated pretty quickly, and it goes beyond the average individual’s understanding of the basics of finance. Everybody should know a bit about some of these things, but we’re getting to some quite specialized information when we look at options pricing models.
International finance: An area people need to know more about. Business finance is becoming increasingly global, so an understanding of the interactions of the financial markets and an understanding of the financial implications of doing business internationally are becoming more and more important as the world becomes financially smaller and more intertwined.
Valuation approaches: Various methodologies for valuing an asset or a firm. There are no rules as to which approach you have to use; you can go to a negotiating table having used any methodology you want. Theoretically, we would argue in the world of finance that the best approach is a free cash-flow model where we look at the cash flows that will be generated and discount those back to the present using an appropriate discount rate; however, there are other approaches, some of which have more academic validity than others, and some of which have no academic validity. What makes the whole valuation process and the negotiation process involving buying or selling firms or assets interesting is that there are no rules.
Working capital: A terrible name because it’s confusing. In the world of economics, for example, when we talk about capital, the connotation is that it is plant equipment, machinery, and things like that. Working capital, in the world of accounting and finance, is defined as your current assets. It’s your cash and the dollars invested in accounts receivable and inventory, so it’s your short-term dollars, not dollars invested in long-term assets. You have to understand the management of things like cash, accounts receivable, and inventory – the things that change every day for a firm. Another important concept that sometimes gets lost is that even though our income statement may say we’ve generated a large profit, that profit will never turn into cash unless we collect our receivables, and just because the accountant has told us we’ve earned a profit doesn’t mean we have any cash. Cash won’t happen unless we collect the receivables, and sometimes there is not enough effort spent on the collection of receivables.