Finance Terminology- Amortization,Negative Goodwill,Capital Reserve,Net Asset Value (NAV)

Amortization:

The gradual elimination of a liability, such as a mortgage, in regular payments over a specified period of time. Such payments must be sufficient to cover both principal and interest.

Charges made against the interest received on a debt in order to offset a premium paid for the debt. Thus, with each periodic payment, a debtor is not only paying back interest, but also part of his or her premium. This leads to higher periodic payments than in the case when only interest is paid out. However, a payment schedule which includes premium amortization makes debt management easier, especially if the principal is large. While paying just the interest each period will lead to a low outflow of cash each month, the debtor might not save enough to pay the principal.

Thus, amortizing the premium each period also reduces the credit risk of the debt, since the creditor gets some part of the principal each time period, as opposed to allowing a debtor to forfeit on all of it at the maturity of the loan. Amortization of premium is a common feature in cases when a person or company takes on a large amount of debt at one time, such as a mortgage

Depreciation:

A noncash expense that reduces the value of an asset as a result of wear and tear, age, or obsolescence. Most assets lose their value over time (in other words, they depreciate), and must be replaced once the end of their useful life is reached. There are several accounting methods that are used in order to write off an asset's depreciation cost over the period of its useful life. Because it is a non-cash expense, depreciation lowers the company's reported earnings while increasing free cash flow. Depreciation is used in accounting to try to match the expense of an asset to the income that the asset helps the company earn.

Example:

For example, if a company buys a piece of equipment for $1 million and expects it to have a useful life of 10 years, it will be depreciated over 10 years. Every accounting year, the company will expense $100,000 (assuming straight-line depreciation), which will be matched with the money that the equipment helps to make each year.

Contingency Reserve:

A reserve set aside for unforeseen events or damages. The term contingency reserve refers primarily to the amount of quantity of funds or other financial resources that is required to be allocated at and above the previously designated estimate amount to reduce the risk of overruns to an acceptable level for the financially responsible organization. However, contingency reserve need not refer exclusively to monetary terms. It can also refer to as specific quantity of time in man hours that must be allocated above and beyond the previously determined quantity of hours required to assure that any overtime or other unexpected hours of work required can be properly compensated for.

Typically the contingency reserves, in terms of both finance and time, are determined at the outset of a project. However, as a project is ongoing, if it appears that the project will require additional funds or time allocation to complete, contingency reserves can be instituted or modified at any time to better prepare the organization for the possibility of their usage at some point in a projects life.

Capital Reserve:

Capital reserve is a reserve created by a company with a view to face contingencies like inflation, instability etc.  in times of rising price. Normally, capital reserves are the reserves raised through non-trading activities and relates to company. For example, to boost investors’ confidence during inflation time, the book value of the company can be increased using revaluation of assets reserve. In the same way, the company can allocate certain portion of their profit for capital redemption reserves for purchasing their own company shares when the share market is in downtrend thus keeping the value of the share in check protecting the shareholders interest which is called buy back of shares. Also any profit on purchase of business, forfeiture of shares, gain on reissue of forfeited shares and debenture premium may be put under capital reserves under different heads. These capital reserves can be used to write off fictitious assets subject to certain conditions.

General Reserve:
At the end of an accounting period the company may decide to transfer part of the profits to a reserve and retain the balance in the profit and loss account. The reserve created out of profits transferred from profit and loss account is called general reserve. The balance in the profit and loss account is called a surplus and will be shown under this head in the balance sheet.

The company can use the general reserve for various purposes including issue of bonus shares to shareholders and payment of dividend when profits are insufficient.

Impairment Charges:

The term impairment refers to assets that are no longer of the same value as in a prior period. An impairment charge is used and the asset is revalued downward and a "charge" is made to net assets. An Impairment Charge is incurred when the fair value of a company's goodwill is less than the recorded value. If the fair value of goodwill is less than the recorded value, a company's goodwill is said to be "impaired" and the difference (between the fair value and recorded value) must be charged off as an expense.

Example:

Goodwill Asset  Value (Year 0) $4,000,000

Impairment Test Results Value (Year 1) $3,000,000

Income Statement Impact/ Impairment Charge $1,000,000

Negative goodwill, also called a bargain-purchase amount, occurs when a company buys an asset for less than its fair market value. Negative goodwill is the opposite of goodwill.

Negative Goodwill:

Negative goodwill is based on the concept of goodwill, an intangible asset that represents the worth of a company's brand name, patents, customer base and other items that are difficult to price but that help to make a company valuable. Most of the time, a company will be purchased for more than the value of its tangible assets, and the difference is attributed to goodwill. When the price paid is less than the actual value of the company's net assets, you have negative goodwill

Example:

let's assume Company XYZ purchases the assets of Company ABC for $20,000,000. The assets are actually worth $35,000,000, but Company XYZ gets a deal because Company ABC needs cash immediately and Company XYZ was the only buyer willing to pay cash. The difference between the purchase price and the fair market value is $15,000,000. 

Company XYZ records this as negative goodwill on its income statement, however it does not record the whole $15,000,000 at once. XYZ records the negative goodwill over the remaining weighted-average estimated useful life of the acquired assets. The remainder stays on the balance sheet as a contra asset that eventually dwindles down to zero as the assets age.

After the acquisition is complete, Company XYZ must test the fair value of the assets for impairment. In cases where a company is acquiring future losses and expenses, the negative goodwill is deferred and recognized on the income statement as those future losses or expenses occur.

A strategy used by corporations to discourage hostile takeovers. With a poison pill, the target company attempts to make its stock less attractive to the acquirer. One example is the issuance of preferred stock that gives shareholders the right to redeem their shares at a premium after the takeover.

Poison Pill:

There are two types of poison pills:

1. A "flip-in" allows existing shareholders (except the acquirer) to buy more shares at a discount. By purchasing more shares cheaply (flip-in), investors get instant profits and, more importantly, they dilute the shares held by the acquirer. This makes the takeover attempt more difficult and more expensive.

2. A "flip-over" allows stockholders to buy the acquirer's shares at a discounted price after the merger.

An example of a flip-over is when shareholders gain the right to purchase the stock of the acquirer on a two-for-one basis in any subsequent merger

A company which makes a hostile takeover bid on a target company. The acquisition of one company (called the target company) by another (called the acquirer) that is accomplished not by coming to an agreement with the target company's management, but by going directly to the company’s shareholders or fighting to replace management in order to get the acquisition approved. A hostile takeover can be accomplished through either a tender offer or a proxy fight.

A golden parachute has been defined as an agreement between a company and an Executive specifying that the employee will receive certain significant benefits if employment is terminated. In other words, benefits given to top executives in the event that a company is taken over by another firm, resulting in the loss of their job. Benefits include items such as stock options, bonuses, severance pay, etc.

A process that increases the current net value of business or shareholder capital gains, with the objective of bringing in the highest possible return. The wealth maximization strategy generally involves making sound financial investment decisions which take into consideration any risk factors that would compromise or outweigh the anticipated benefits.

Any project which generates positive net present value creates wealth to the company. When a company creates wealth from a course of action it has initiated the share holders benefit because such a course of action will increase the market value of the company’s share.

For Example in taking an investing decision management should choose that project for investment, which will give maximum return to the share holders.

Similarly in other financial Decision and for that matter any decision should be taken to with the objectives of maximization of wealth of the shareholders.

A capital gain realized by the sale or exchange of a capital asset that has been held for exactly one year or less. Short-term gains are taxed at the taxpayer's top marginal tax rate. A short-term gain can only be reduced by a short-term loss

Short-term gains and losses are netted against each other. For example, assume a taxpayer purchased and sold two different securities during the tax year: Security A and Security B. If he/she earned a gain on Security A of $5,000 and a loss on Security B of $3,000, then the net short-term gain is $2,000 ($5,000 - $3,000).

It is a term used to describe the value of an entity's assets less the value of its liabilities. The term is most commonly used in relation to open-ended or mutual funds because shares of such funds registered with the U.S. Securities and Exchange Commission are redeemed at their net asset value. Net asset value may represent the value of the total equity, or it may be divided by the number of shares outstanding held by investors and, thereby, represent the net asset value per share.[1]

It is calculated by totaling the value of all the fund's holdings plus money awaiting investment, subtracting operating expenses, and dividing by the number of outstanding shares.

A fund's NAV changes regularly, though day-to-day variations are usually small.

The NAV is the price per share an open-end mutual fund pays when you redeem, or sell back, your shares. With no-load mutual funds, the NAV and the offering price, or what you pay to buy a share, are the same. With front-load funds, the offering price is the sum of the NAV and the sales charge per share and is sometimes known as the maximum offering price (MOP).

The NAV of an exchange traded fund (ETF) or a closed-end mutual fund may be higher or lower than the market price of a share of the fund. With an ETF, though, the difference is usually quite small because of a unique mechanism that allows institutional investors to buy or redeem large blocks of shares at the NAV with in-kind baskets of the fund's stocks.

Working capital is the capital available for conducting day-to-day operations of the business and consists of current assets and current liabilities. In other words, working capital is needed by the business to:

Pay suppliers and other creditors,

Pay employees

Pay for stocks

Allow for customers who are allowed to buy now, but pay later (so-called “trade debtors”)

Working capital is the difference between current assets and current liabilities: 

Current Assets means Inventory, Trade Receivables, Cash, Short term investments, Sundry Debtors etc.

Current liabilities means Trade payables, Bank Overdraft, Sundry Creditors etc.

Effective management of working capital ensures the organization  is maximizing the benefits from net current assets by having  an optimal level to meet working capital demands.

The Working Capital Cycle measures the time between paying for goods supplied to you and the final receipt of cash to you from their sale. It is desirable to keep the cycle as short as possible as it increase the effectiveness of working capital.

Working Capital Cycle:

Net Asset Value (NAV):

Short Term Capital Gain:

Wealth Maximization:

Golden Parachute:

Black Knight: