Financial Terms Glossary

C

Candlestick

A candlestick is a feature of a price chart which shows the open, close, low and high for an asset over a given time period. They are usually red if the asset closed lower than it opened, and green if it rose over the time period. Other popular color combinations are white / black, and red / blue.

Candlesticks are one of the most frequently used tools in chart analysis for showing trends and volatility.

Capital

Capital is a vague term which can refer to one of two things:

  • Factories, machinery, equipment etc. owned by a company
  • The value of financial assets such as cash, short-term securities etc.

In an economic context, capital usually refers to the former whereas in banking and finance, capital is the value of the financial assets. All financial institutions have a level of capital reserve which they must meet, which usually corresponds to risk-weighted assets.

For example, if a company owns $1 billion of a AAA rated asset, and after risk-weighting this is deemed to be $200 million worth of 'risk' and the company is required to hold 8% of capital for risk-weighted assets, the company would need $16 million in capital to own this $1 billion in assets.

Problems can occur when the company has investments using leverage or invests using margin, where a small fall in asset prices can require more collateral to be posted (i.e. capital) but due to leverage the company has no spare collateral to post, and therefore has to sell off some of its assets.

Cash Flow

The Cash Flow Statement is one of the three financial statements that are used to value a company and it shows actual inflows and outflows of cash.

The Cash Flow Statement is constructed using the Balance Sheet and Income Statement and other relevant data. It usually starts with Net Income and adjusts that value to find Cash & Cash Equivalents. Net Income needs to be adjusted in the Cash Flow Statement because it includes factors which either have not been paid / received yet (such as Accrued Expenses and Accounts Receivable) or which are not actually measured in cash (Depreciation, Amortization etc).

The process of creating the Cash Flow Statement is to go through every entry in the Balance Sheet and Income Statement and adjust for anything that is recorded as having value, but has a different effect on cash. The reason for removing non-cash entries is that whilst the Balance Sheet and Income Statement may tell you what a company owns or is worth, they do not actually show whether the company is losing or gaining money. Some examples are listed below:

  • Depreciation - this is removed as although the asset has lost value, no actual cash has been spent or lost.
  • Purchases of Securities - in terms of assets this is an increase in value, but cash is being spent to acquire them so this would reduce cash on the Cash Flow Statement.
  • Accounts Receivable - although the company has sold products and is owed money which adds value to the firm, this cash has not actually been received and therefore has to be reduced on the Cash Flow Statement.

The Cash Flow Statement is split into 3 sections: Operating Activities, Investing Activities and Financing Activities:

  • Operating Activities - refers to general costs of running the business such as Inventory, Accrued Expenses, Research & Development.
  • Investing Activities - refers to the purchase, sale and maturity of investments as well as any Capital Expenditures. Essentially this includes anything that is used to enhance the business without being directly related to product sales.
  • Financing Activities - refers to raising and paying off of debt as well as share actions (dividends, share buy-backs etc).
Close

Close refers to the price at which a security ended a period of trading, as well as the end of a period of trading for an overall market. Two examples of how the word close would be used are:

  • Goldman Sach's closed at $95
  • The S&P500 was down 3% by market close
Collateral

Collateral is any asset which is used as backing for debt. In the event of a default on the debt, the collateral is seized to cover the losses. The most common example of collateral is in a mortgage, where the bank uses your home as collateral and in the event that you do not meet your mortgage payments, they have the legal right to seize your home.

One of the problems associated with collateral (which was prevalent in the 2007-2008 subprime mortgage crisis) is that if the collateral asset falls in value below that of the debt, then there is little incentive to pay off the debt. You are better off to default, keep the loan and give up the collateral asset.

Commodity

A commodity is any good that is identical (or very similar) from any producer, i.e. producers have to compete on price. They are usually used in production of other goods or services.

The most common types of commodity traded on financial markets are:

  • Oil
  • Wheat
  • Copper
  • Iron

Commodities are very susceptible to speculation and therefore are frequently volatile. The quantity of a commodity traded is standardized by the Chicago Board of Trade through contract amounts (i.e. one wheat contract is 5,000 bushels).

Contagion

Contagion is the term used in economics to describe the situation where financial instability in one sector or economy can spread to a different sector or economy. The term comes from the study of contagious diseases.

The reasoning behind contagion is that as the world has developed and become more financially interlinked, economies have become more intertwined and therefore any risk to one of them is likely to have knock-on effects to others.

Two famous examples of contagion are:

  • Eurozone Debt Crisis - what began as a poor budget deficit in countries such as Greece, Portugal and Ireland spread across Europe to affect France, Italy, Spain and others.
  • Asian Crisis - In the late 90s there was a banking crisis in Thailand which quickly spread across Southeast Asia and then to Latin America.
Covenant

A covenant is a term used in loan documents (for example in an LBO) and any other kind of bond issuance and it dictates any terms of a corporate takeover or acquisition or bond repayment. The covenant is simply any specified agreement, the most common one being the Debt / EBITDA ratio and the Loan to Value ratio in real estate.

This is important because when calculating the amount available for debt repayments or the total amount able to be borrowed to finance a transaction, covenants will determine the amount of money that can be borrowed, the value of bonds that can be issued, the total free cash flow which can be used to pay debt, etc.

The purpose of a covenant is to give the lender and the target company security that certain activities will not be carried out and that the company will not be run unsustainably. If the terms of a covenant are violated, there will be a penalty incurred. This penalty could vary from simply repairing a technical default to losing control of the company under a payment default or acceleration of the funds due.

Breaking a covenant is often referred to as a default, and this can be a technical default (the company is still paying its debts) or an actual default (the company misses a payment).

If a covenant is breached, the borrower typically has to put up equity or pay extra money and if it is unable to do this, then the entire amount of the loan is due and there could even be a firesale at massively reduced asset prices.

Some of the most commonly used covenants are:

  • Debt / EBITDA
  • Debt to Assets
  • Debt to Equity
  • EBIT / Interest
  • Loan to Value

Covenants can be often be waived at the discretion of the lender. For example, in a situation of exceptional circumstances whilst the company in question is still sound and stable. Enforcing or abiding by covenants can actually have negative consequences for both parties as the restrictions may lead to reduced efficiencies and lower profits than would otherwise be experienced.

Credit Rating

The credit rating of an individual refers to the likelihood that that individual will be able to repay any debt. The credit rating is usually given in the form of a FICO score, which is based upon borrowing and repayment history as well as income, assets etc.

Individuals with a poor credit rating typically find it harder to borrow money and have to pay higher interest rates on their debt to compensate the lender for the additional risk.

D

Day Trading

Day trading is a trading strategy which revolves around opening and closing positions within a single day. Day trading usually requires large amounts of leverage and uses very short term strategies to profit off small movements in asset prices.

2 of the most common forms of day trading are:

  • Spread betting
  • Forex trading

Day traders usually follow one of 4 strategies:

Scalping - massive leverage on tiny fluctuations, very frequently

Range Trading - determining what levels an asset trades between, and selling at the top and buying at the bottom

Trend Following - buy when the market is going up, sell when the market is going down

Event Driven - trading based upon global events which drive markets

Default

Default is the technical definition of when any borrower fails to make a payment on their debt. This can be failure to pay interest or principal, and can be any amount.

Default is usually a sign of financial difficulty and the lender losing money. The lender often asks for collateral on the loan so in the event of default, they can claim the collateral to cover their losses.

A default can be classified as a technical default (when the terms of a loan agreement are broken but the payments are still made) or actual default (when payments are not made).

Depreciation

Depreciation is when any asset is deemed to have reduced in value. No tangible asset can last indefinitely and therefore at some point, the asset will no longer be usable and will have to be recorded as a loss on the income statement. Depreciation allows a firm to allocate a percentage of that loss to different periods.

One of the reasons for using depreciation is so that when a very expensive asset such as a factory is no longer useful and is worthless, the company does not have to record a massive loss in a single period which would drastically affect performance. Depreciation allows this large loss to be allocated to lots of different periods in small amounts.

A business example of depreciation is if a company was to buy a new factory for $10 million and the useful life of that factory was 25 years, each year the factory would have effectively depreciated by $400,000 ($10,000,000 / 25) and this would be recorded as a loss each year rather than having no change in value and then a $10 million loss in year 25.

The typical real-world example of depreciation is whenever you buy a new car, it is deemed to have depreciated by up to 50% as soon as you drive it away from the dealer. Even though the car has not changed, it is worth less.

Derivative

A derivative is a financial product whose value is derived from another asset (also known as the underlying asset). Derivatives are frequently used for speculation and hedging of risk and the most common forms of derivatives are:

  • Futures
  • Options
  • Swaps

The derivatives market is vast and extremely liquid, but also very hard to quantify as many are sold OTC (Over-the-Counter) and therefore not regulated. It is estimated that in late 2011 the derivatives market may be worth over $700 trillion, compared to a global GDP of ~$60 trillion.

Diversification

Diversification is the act of spreading investments amongst different assets, companies and sectors. The idea behind this is to reduce risk. If one investment fails, the investor will only lose a proportion of their money rather than all of it if they had invested solely in that asset.

Diversification is used for many different investing theories, one of the main ones being investing in large amounts of higher risk assets, with the intention that the high payoff from those which succeed will outweigh the losses from those which fail.

A good investment portfolio should always be diversified as it reduces risk (diversifiable risk) and allows the investor to gain exposure to multiple sectors.

Dividend

A dividend is a payment by a company to its shareholders representing a portion of earnings. The board of directors of the firm determines the amount paid in a dividend.

In order to calculate a dividend, you take away Retained Earnings from Net Income and then divide by Shares Outstanding. For example, if a company has Net Income of $1 billion, Retained Earnings of $200 million and Shares Outstanding of 400 million, the dividends paid are:

  • ($1,000,000,000 - $200,000,000) / 400,000,000 = $2 per share

Usually, dividends are quoted in amount per share, for example a company may pay $1 dollar per share back to shareholders.

Dividends can be paid in different forms such as cash, stock and property but the most common form is cash.

Downgrade

A downgrade is when an asset, company or government has it's rating lowered. Typically this will represent either a lowering of the quality of the asset, or the increased likelihood of default on a corporate or government bond.

Equity downgrades are usually done by equity researchers, whilst bond ratings are done by the main rating agencies.

Due Diligence

Due diligence is the act of investigating any potential investment, usually through an auditor or an audit process. Due diligence is essential to any financial process, and the purpose of it is to ensure that all facts presented (financial statements, solvency, management structure etc.) are accurate and true.

Due diligence is usually carried out by an audit firm, or by some of the junior employees in the firms involved. Despite not being very prestigious or well thought of, due diligence is vital to ensure safety and peace of mind for parties involved in a transaction.