CISI Training Review: Understanding Key Financial Terms and Statements
Relevant to the following CISI qualifications: ICWIM, ICAWM, Securities
Publicly traded companies are under an obligation to deliver regular trading updates to the market, ensuring that at all times they present a reasonable reflection of their actual trading performance. However, the terms commonly used in trading statements range from the readily understood, such as “sales” to the more complex and obscure such as “EBITA.” While audited accounts are intended to ensure that the company’s interim and full-year trading statements provide a truthful assessment as to how the company has fared during the specified trading period,
investors frequently pay particular attention to the “outlook” or “prospects” section of a company review, on the basis that stock valuations are heavily geared to perceptions of future earnings. Given that many stocks typically trade on multiples of 10 or more of earnings, stocks are, therefore, highly sensitive to the perception of how future earnings could vary from existing market forecasts. How a company’s results compare to the market’s consensus expectations is usually the major driver for the stock’s direction following a trading update. For example, should a company announce record results, the stock is actually likely to decline should even these results fail to match the market’s even more optimistic expectations.
When reporting their performance, companies present four kinds of financial statements:
1 balance sheet—a breakdown of the company’s assets and its liabilities at a fixed date;
2 income statement—details of how much money the company earned and what it spent during the period;
3 cash flow statement—how cash moved in and out of the company during the period;
4 stockholders’ equity statement—a statement summarizing the opening balance, additions to and deductions
from, and the closing balance of the stockholders’ equity account, over a stated period.
While the purpose of each of these statements is relatively easy to understand, some of the terminology contained in company reports can be confusing without some accountancy knowledge. The following paragraphs present a small selection of examples of commonly misunderstood terms used by companies in their trading updates:
• EPS—Earnings per stock. The figure represents the company’s total net income during the period, minus dividends
to be paid to preferred stockholders (i.e. guaranteed dividends), divided by the number of stocks in issue. As the latter can change during the review period, many companies use a weighted average stock count figure for
the review period as a whole.
• EBIT—Earnings before interest and tax. This figure represents the total income from all sources before interest payments and taxes are taken into account.
• Working capital—Trading current assets less trading current liabilities.
• Retained earnings—This figure refers to the total of net earnings—revenues after all expenses, taxes, and interest deductions— that the company has built up.
• Return on capital employed—Also known as ROCE, this is a measure of the returns that a business is achieving from
the capital employed, usually expressed in percentage terms. Typically used as a guide as to how efficiently a company is using the money invested in it, ROCE can be expressed as the ratio of operating profits achieved to the total amount of operating capital invested (i.e. both equity and debt) in the business.
• Understanding financial terms and statements helps investors to make more informed decisions.
• During extended periods of volatility in financial markets, investment news becomes mainstream news, so an understanding of the terms used becomes even more beneficial.
- Some of the terminology used in finance and investment can be complex.
- Detailed analysis of statements and company-specific financial number crunching requires knowledge and considerable resources, so it is best left to expert analysts. Also important to note is that a company may have trouble sustaining earnings growth if free cash flow is poor, and it may be forced to increase its debt. In the worst-case scenario, insufficient free cash flow could tip a company into a situation of illiquidity.
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