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Glossary of Important Financial Terms You Should Understand

Advance

Advance usually refers to money a borrower receives as a portion of a pre-approved line of credit or loan.

Annual Percentage Rate (APR)

The annual interest rate that is charged for borrowing, expressed as a percentage that represents the actual yearly cost of funds over the term of a loan. This includes any fees or additional costs associated with a transaction. The Federal Truth in Lending law requires many companies to list the APR of their loans when they advertise an interest rate.

Amortization

Amortization refers to the reduction of a loan by regular payments consisting of interest and a portion of the principal made over a specified time period upon the expiration of which the entire debt is repaid. The length of time is referred to as the amortization period. An amortization schedule usually refers to a printed document that displays how much principal and interest is paid with each payment for the life of the loan.

Appraisal

An appraisal is a professional estimate of the fair market value of property. Lenders often require property used as security for a loan to be appraised so that they are comfortable that in an event of default the property can be sold and their loans repaid. The value they assign to property is usually conservative, which means that it is often the lowest reasonable price a third party might pay for the property. Lenders are conservative because if they have to take and sell property it is usually done under undesirable circumstances which lowers the price, has additional sale and administration costs, and is sold as quickly as possible without holding out for the highest price to minimize accrued interest and holding costs.

Asset

An asset is something of value owned by a business. It includes cash, accounts receivable, inventory, notes, supplies, vehicles, equipment, real estate, goodwill, patents, trademarks, customer lists, etc.

Balloon Note/Loan

A balloon note is a loan that requires a single payment of the principal at loan maturity. Sometimes ballon loans have no periodic payments between the time the loan is issued and the time it matures. Some ballon loans have low periodic payments (e.g. monthly) with one much larger payment at loan maturity.

Basis Points

A basis point is 1/100th of a percent. 100 basis points is equal to 1%.

Bridge Loan

A bridge loan is a type of short-term financing which extends a line of credit to a borrower for a short period of time (several weeks to several years), typically at a very high rate of interest. As the name suggests, a bridge loan bridges the gap between more permanent methods of financing; these loans are sometimes used in the real estate industry, by venture capitalists, and by some investors. This type of loan is not available at all banks, since it tends to be more risky than long-term lending options.The advantage of a bridge loan is that it provides an immediate flow of capital which can be extremely useful. For example, a real estate speculator might get a bridge loan in order to buy a piece of property which is being offered at an extremely good price, with the intention of getting a loan with better terms later. Bridge loans are also used to make up various other temporary funding shortfalls.

Call

Call refers to a lenders right to demand repayment of a loan earlier than its scheduled maturity. Usually a call is contingent upon borrower default, but can also be based on events that are beyond a borrowers control (e.g. market interest rates, changes in laws, changes in lender circumstances, changes in market conditions, etc.)

Capital

"Capital" has several different but similar meanings; they all refer to wealth in the form of money and other assets owned by an individual or business. Often the word "capital" is considered to be synonymous with "money". It also refers to funds provided by lenders and investors to businesses, and sometime refers to the net assets or equity in a business. Capital also refers to the physical assets of a business that are used in the production of goods and services (this is considered to be "real" capital).

Collateral

Collateral is property you promise give to a lender to repay your loan if you default. Property can include collectables, personal items, real estate, vehicles, equipment, securities, financial assets, etc. Upon default the lender has the authority to take the property and sell it so they are repaid in full.

Cognovit Note

A lender may ask a borrower to sign a cognovit note when credit is extended. If the borrower defaults the creditor can obtain a legal judgment against the borrower and guarantors without notification to the borrower. The borrower acknowledges, in advance, the claims asserted by a lender against him in a complaint are valid and waives all defenses. It is usually given to a lender to avoid the expenses of protracted litigation. Laws relating to cognovit notes vary by jurisdiction, and are disallowed in some jurisdictions. There is usually little the borrower can do to reverse the judgment when it is discovered. The Supreme Court has held that cognovit notes are not illegal but most states have outlawed their use in consumer transactions.

Confession of Judgement

"Confession of judgment" is an agreement by a party to a lease or promissory note that in the event of a default, the other party, usually a landlord or lender, may proceed to the county courthouse, obtain a legal judgment. The defaulting party does not receive the benefit of a trial. This is similar to a cognovit note, except that this is used in variety of agreements in addition to loans. Such contracts are controversial and may be invalidated as a violation of due process by courts, since the obligor is essentially contracting away his right to raise any legitimate defenses.

Commitment Letter

A written document in which a lender promises, for a certain period, to make a loan to a borrower on agreed terms with generally few conditions to closing.Usually, the borrower must accept the letter by a specified time or else the commitment expires. Once the borrower has signed the letter, the commitment will expire at a specified time (usually about 30 days). If a commitment letter has been issued and the parties are negotiating the documents beyond that period, the borrower should make sure that the commitment is extended. Sometime the borrower is required to pay a non-refundable fee when the letter is signed.

Covenants

A condition that the borrower must comply with in order to adhere to the terms in the loan agreement. If the borrower does not act in accordance with the covenants, the loan can be considered in default and the lender has the right to demand payment (usually in full). Examples of covenants include requirements for insurance, production of financials statements, borrowing from other sources, financial performance, etc.

Current Ratio

The current ratio is a measure of liquidity that is calculated by dividing current assets by current liabilities. It is used to give an idea of a business's ability to repay its short term liabilities (loans and accounts payable) with short term assets (cash, inventory, accounts receivable).The higher the current ratio, the more capable the company may be of paying its obligations. A ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that point. However, the current ratio can be a weak indicator of true liquidity because not all current liability balances will actually be repaid within the foreseeable future, and not all current assets can be quickly turned into cash at their stated value.

Default

A loans is considered to be in default when any promise or commitment of the borrower to the lender is not kept. When a loan is in default a lender may take action against the borrower and guarantors to collect the balance due, change terms of the loan, or require additional collateral.

Deferral

This refers to a period of time that a lender will suspend the normal requirements for repayment. For example, a lender may let a borrower wait for a several months or more before regular month loan repayments must be made to enhance borrower cash flows. Sometime a lender will allow regular scheduled payments to be skipped for a predetermined period of time to help the borrow overcome unexpected challenges.

Due Diligence

Due diligence refers to the process of making sure that someone is what they say they are, did what they say they did, can do what they claim, and are telling the truth about their circumstances.

EBIT

This is an acronym for earnings before interest and taxes. EBIT is a measure of a company's profitability. This number is used to make it easier to compare or benchmark performance against other similar businesses because it eliminates interest expense which is based on discretionary decisions within each business about how the capital structure is designed. Taxes are also eliminated because many businesses are structured to not directly pay income taxes and taxes can significantly vary based on discretionary business design decisions.

EBITDA

This is is similar to the EBIT calculation except that depreciation and amortization are also removed from business profit. EBITDA makes it somewhat easier to understand true cash flow because non-cash expenses like depreciation are excluded in the profit calculation, thus it is used to indicate a business's ability to repay debt. However, it is also a weak indicator of true cash flow because it does not consider existing debt repayment obligations, new capital expenditure requirements, and changes in current assets and liabilities.

Effective Annual Interest Rate

The interest rate on a debt or debt security that takes into account the effects of compounding. For example, if one has a fixed-income investment such as certificate of deposit that pays 3% in interest each month, the effective interest rate is more than 3% (it is actually 3.04%) because compounding the interest results in a (slightly) greater principal each month on which the interest rate is calculated.

Encumbrance

This means that an asset has legal constraint on how whoever possesses it can use it or dispose of it. Assets can include vehicles, equipment, real estate, financial asets, etc.)

Equity

"Equity" has several similar interpretations. It can be the amount of money invested in a business by owners, the amount of non-borrowed money a business contributes toward the purchase of an asset, the amount of profits retained by the business and not distributed to owners, and/or the dollar amount by which the fair market value of business assets exceeds the business debts. The business is not obligated to repay equity to owners or pay interest as is done with loans. The more equity a business has the less it has to pay to others which improves its cash flows and lowers the impact of adverse events. Lenders often require borrowers to have specific minimum acceptable levels of total equity in their business, and equity contributions to purchase specific assets. For example, most lenders require 20% to 30% equity (also referred to as a down payment) for the purchase of real estate.

Fixed Interest Rate

This means the that interest rate will not change during the scheduled the life of a loan. Borrowers like fixed interest rates because it aids in their cash flow planning and reduces risk of profit reductions and cash flow problems if interest rates substantially increase. In exchange for these borrower benefits and the extra interest rate risk the lender must assume, lenders charge an interest rate that is higher than that for a variable rate loan that is the same in all other aspects. Some commercial lenders will not provide fixed interest rates for some types of loans. Fixed interest rates are usually higher for longer term loans than shorter term loans.

Free Cash Flow (FCF)

This is a measure of financial performance calculated by adding non-cash expenses like depreciation to net income, subtracting new capital expenditures, and adding or subtracting changes in working capital. Some believe that Wall Street focuses myopically on earnings while ignoring the "real" cash that a firm generates. Earnings can often be clouded by accounting gimmicks, but it's tougher to fake cash flow. For this reason, some investors believe that FCF gives a much clearer view of the ability to generate cash (and thus profits). A negative cash flow is not necessarily bad; it can vary based on seasonal and economic cycles as well as businesses making major investments to spur new growth and profits.

GAAP

GAAP is an acronym for "Generally Accepted Accounting Principals." GAAP is a collection of methods used to process, prepare, and present public accounting information. Generally accepted accounting principles (GAAP) are varied but based on a few basic principles that must be upheld by all GAAP rules. These principles include consistency, relevance, reliability, and comparability. Most lenders require businesses to prepare financial statements that adhere to GAAP guidelines.

Gap Financing

"Gap financing" has several similar interpretations. It often refers temporary borrowing to provide needed funds between the termination of one loan and the beginning of permanent financing. For example, a developer might obtain gap financing to provide funds for the period between the end of a construction loan and when permanent financing becomes available. Sometimes it is used to refer to loans given to fill the funding gap between what a borrower needs and what can be obtained from conventional commercial lenders.

Grace Period

A grace period is a period of time in which a borrower is late with a payment, but penalties are not incurred.

Guarantor

A guarantor is someone who promises, in writing, that a loan or other type of debt will be paid. Usually a guarantor agrees to fulfill another person's responsibilities should that person fail to do so. Lenders usually require a guarantor if the borrower has a limited credit history upon they can be evaluated or there is substantial risk that the borrower cannot fulfill their repayment obligation.

Interest Rate Swap

In an interest rate swap, two parties (referred to as counterparties) exchange sets of interest payments on a given amount of capital. Generally, one party will have a fixed interest payment, while the other will have a variable rate. Its purpose is usually to allow one party to remove an exposure to a variable interest rate for which they pay a premium on the fixed rate. The variable rate interest is often based on LIBOR. The swap arrangement can be for any period of time and can terminate any time prior to loan maturity. In swap arrangements, if market interest rates fall after the swap is established the borrower must pay a penalty to repay the loan prior to swap maturity. Some commercial lenders will not offer fixed rate loans but will coordinate swap arrangement so borrowers can get a fixed rate loan. However, because the lender is not a counterparty to the swap, the lender does not have the ability to easily modify terms of the loan to accomodate borrower changes.

Letter of Intent

A letter of intent is a document provided by a lender that outlines loan terms between the lender and borrower before lender loan commitments are made and binding loan agreements are finalized. Letters of intent are non-binding and set forth key terms of the proposed deal to aid in reaching final agreements.

Level Payment Term Loan

A level payment term loan has each schedule payment the same. The interest portion of the payment and principal portion both vary with each payment but the total amount of the payment is the same. These types of loans are often used with fixed rate loans. Relative to level principal payment loans, level payment loans have lower scheduled payments during the first portion of the loan time period, but higher payments toward the latter half of the loan maturity. Level payment loans are best for businesses that are new, have much uncertainty in cash flows, and/or will not realize the financial benefits of the loan for a period of time after the loan is received. Variable rate loans can also be established as a level payments loan, but the payment is adjusted from time to time as interest rate change so that the loan matures in the specified time period.

Level Principal Payment Term Loan

A level principal payment term loan has each schedule principal payment the same, but the interest portion varies from payment to payment. Relative to a level payment term loan, the payment is much higher during the early time periods but eventual is lower in the latter r half of the loan. These types of loans are often used with variable rate loans because it is easy for the lender to vary the interest charged as the variable interest rate changes.

Liability

Liability is a term primarily used to refer to debt obligations of a business. Liabilities include accounts payable, loans, prepayments for goods and services not yet delivered, future expenses that must be paid but the exact dollar amount is not yet certain, and amounts owed to employees, tax authorities, and suppliers even though a bill/demand for payment has not yet been presented.

LIBOR

LIBOR, the London Interbank Offered Rate, is the most active interest rate market in the world. It is determined by rates that banks participating in the London money market offer each other for short-term deposits. LIBOR is determined every morning at 11:00am London time. A department of the British Bankers Association averages the inter-bank interest rates being offered by its membership. LIBOR is calculated for periods as short as overnight and as long as one year. While the rates banks offer each other vary continuously throughout the day, LIBOR is fixed for the 24 hour period. LIBOR is used to guide banks in setting rates for adjustable-rate loans.

Lien

A lien is a legal claim or a "hold" on some type of property, making it collateral against money or services owed to another person or entity. It may keep the borrower from selling the property and/or transferring title to the property.

Line of Credit

A arrangement where a lender makes a specific amount of money available to a borrower. The borrower can withdraw amounts and repay amounts at their discretion. Interest is only paid on the actual amount owed. The interest rate is usually variable and changes on a daily or monthly basis. Most business credit lines have to be renewed at intervals of a year or less. Credit lines are typically used to finance seasonal and extraordinary temporary cash needs. Often business credit lines are specifically secured by trade accounts receivable and inventory and as such the balance owed cannot exceed 60% to 80% of their value. Good financial management practices usually indicate that a business should be able to reduce the balance of a credit line to zero at least one time or more each year. If it cannot then it may be financing long term cash needs with a short term source of capital. Commercial lenders are usually prompt to cancel or demand repayment of credit lines when a business experiences financial difficulties.

Liquidity

Liquidity refers to a firm's ability to obtain cash to take advantage of new opportunities and meet financial obligations. It has two dimensions: how quickly cash can be obtained, and certainty of value. Certainty of value refers to how sure one is of getting an expected amount of cash from lenders/investors at a future time, and/or the likelihood that the expected fair market value of an asset can be obtained when it is sold.

Loan Agreement

A loan agreement is a document setting forth the details of a loan. It includes information about the terms of the loan and also the representations, warranties, and covenants of the borrower. A loan agreement sometimes includes a promissory note. A loan agreement covers many of the same points as a promissory note, but is a lengthier and more complicated document to cover a more complicated transaction.

Loan-To-Value Ratio (LTV)

The loan-to-value ratio is used to estimate the amount of equity you have in a property. It is calculated by dividing the amount of the loan by the market value of the asset that the loan is used to purchase. For example, if a real estate parcel is worth $100,000 and a loan is procured for $80,000, the loan to value ratio is 80%. The lower the loan-to-value ratio, the greater the property owner's equity and the less likely they are to default on the loan. Thus, there is less risk to the lender which allows the lender to lower the interest rate and more easily approve a loan request.

Maturity

Maturity refers to the date by a loan must be repaid in full to a lender. Lines of credit usually mature once each year and must be repaid unless the lender agrees to renew the line of credit for another year.

Mortgage Loan

A mortgage loan is a loan secured by land or buildings. Mortgage loans are usually obtained to buy real estate, but a mortgage loan can be obtained on existing property you own to obtain money for any purpose. Most lenders will not loan more than the property is worth, and usually restrict the loan to 60% to 90% of the appraised value or price paid, whatever is less.

Net Income

Net income (which is also referred to as "profit") in a business is calculated by adding total revenue and gains and subtracting all expenses (including depreciation and other non-cash expenses) and losses for a reporting period. Net income can be distributed among owners or held by the firm as an addition to retained earnings. This is one of the most important measures that lenders and investors use to evaluate performance and their interest in participating. Negative net income may be an indicator that the business is in financial trouble and may not survive. However, it is common for new businesses have negative net income for the first several years. Net income is not a good indicator of true cash flows. A business may display a negative net income but have positive cash flows and achieve success, and vice versa, a business with a positive net income can have negative cash flows and quickly fail.

Point

One point has the same meaning as one percent. Sometimes the word "points" refers to the amount of fees (expressed as a percentage of the principal amount) a lender will charge to extend a loan

Prepayment

Prepayment refers to the action of repaying more principal on a loan than required by the lender, or completely repaying a loan before maturity. Loan prepayment can create additional administrative costs for lenders. Thus, some lenders charge borrowers a penalty if they prepay because of this, and also to discourage them from changing lenders to get a lower interest rate.

Prime Rate

The prime rate or prime lending rate is a term used in many countries to a reference interest rate used by banks. The term originally indicated the rate of interest at which banks lent to favored customers, i.e., those with high financial strength, though this is no longer always the case. Large financially strong borrowers are provided with rates lower than prime.Many variable interest rates loans have their interest rate expressed as a percentage above or below prime rate.The prime rate varies little among banks, and adjustments are generally made by banks at the same time. In the US, the prime rate runs approximately 300 basis points (or 3 percentage points) above the federal funds rate, the interest rate that banks charge to each other for overnight loans made to fulfill reserve funding requirements. The prime rate tends to rise promptly as the federal funds rate rises, but is "sticky" when deferral funds rate fall, which means that is not as responsive to interest rate declines. It is also

Principal

The amount of money that is originally borrowed is referred to as the principal. For terms loans a portion of each payment is usually allocated toward the repayment of some of the principal, and the balance of the payment is interest and fees.

Promissory Note

A promissory note is a document that is part of a business loan package. The promissory note details the terms of repayment, including principal and interest, the length of the loan, late fees, and whether there is a prepayment penalty. It also describes the circumstances under which the borrower may be in default, and what happens in the event of default.

Retained Earnings

When a business generates a profit, management has one of two choices: they can either distribute it to owners, or retain the earnings and reinvest them in the business. Retained earnings are displayed on the balance sheet under owners equity. Businesses cannot simply distribute retained earnings in cash to owners because it is represents ownership in all business assets, many of which cannot be easily turned into cash, and many of which have debt obligations that must be repaid before the assets can be sold. In addition, many lenders and good business financial management require retained earnings and equity to be retained at specific levels to enhance opportunities for success.

Solvency

Solvency refers to a firm's ability to meet cash payments as they fall due in the ordinary course of business, and/or having sufficient assets to pay all debts if the firm was closed.

Subordinate Lien

The first lien is held by the lender who is earliest on record at the registry wherever liens are recorded in your local or state jurisdiction. All subsequent liens are subordinate to the first lien (unless the first lien is subordinated to them in a special agreement). The first lienholder gets paid first if the property is foreclosed; subordinate lienholders generally follow in order of the recording of their liens. First and subordinate liens may be held by the same lender.

Term Loan

A term loan is a monetary loan that is repaid in regular payments over a set period of time. Payments are often made each month, but can be quarterly, semiannually, or once each year. The interest rate can be fixed for the life of the loan or change daily, weekly, monthly, annually, or any period. Term loans can be repaid over any period of time. When term loans are used to purchase specific assets, and those assets are used as collateral to guarantee repayment of the term loan, most lenders do not want the balance owed on the loan to exceed the value of the assets. For example most business equipment and vehicle loans are five years or less, most loans for purchase of real estate are thirty years or less (commercial real estate is often twenty years or less).

Term Sheet

Before loan documents are signed the parties will often have a term sheet (which is generally prepared by the lender) that identifies the primary business terms for the proposed loan. It is usually prepared in an outline form, non-binding, a precursor to completion of due diligence efforts, and is the starting point for lawyers to prepare the loan documents.

UCC

Created in 1952, the Uniform Commercial Code (UCC) consists of uniform rules coordinating the sale of goods and other commercial transactions throughout the 50 United States. Lenders file a UCC financing statement (a lien) with the Secretary of State which lists the borrower as the debtor and assets that are collateral. Before the borrower can sell the assets, the UCC filing will show the prospective purchaser that the original lender has the first right to recover its loan from the sale. Before the borrower can borrow more money using that same assets as collateral, the filing will show the new lender that the asset is pledged to another lender. When a borrower pays off the loan, the lender files a UCC release and the property is free and clear.

Unsecured Loan

An unsecured loan is a loan obtained without collateral. A person obtaining an unsecured loan agrees to pay back the loan within a set term and signs documents attesting to such. This type of loan can also be called a signature loan. Most credit cards are unsecured loans. Unsecured loans tend to be smaller and have higher interest rates than loans with collateral because there is more risk to a lender.

Variable Interest rate

This means the that the lender may change the interest rate during the scheduled life of a loan. Variable interest rates are almost always lower than comparable fixed interest rate loans because the vendor has less interest rate risk. Lenders have interest rate risk when interest rates rise for money they borrow to make loans but they are unable to raise the interest rates on loans they extend which are used to repay their money sources. Borrowers prefer variable interest rates when they are confident interest rates are unlikely to significant increase and the difference between the fixed rate and variable interest rate options is significant.

Working Capital

Working capital represents operating liquidity available to a business. "Working capital" is sometimes used to refer to current assets (cash, accounts receivable, inventory), but it is also defined as a number calculated by subtracting current liabilities from current assets. Current assets and current liabilities are expected to be turned into cash within the next twelve months. A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be converted into cash. Positive working capital may indicate that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing debts and upcoming operational expenses. Some lender loan agreements specify minimum levels of working capital that must be maintained.

How To Prepare A Business Plan to Obtain Money

This page displays definitions for many terms that are commonly used by lenders and investors during discussions and in legal documents. You are encouraged to read and understand these items to help others feel comfortable with your business acumen and help you make informed decisions.

Glossary of Important Financial Terms

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