A sunk cost is a cost that cannot be recovered or changed and is independent of any future costs a business may incur. Since decision-making only affects the future course of business, sunk costs should be irrelevant in the decision-making process. Instead, a decision maker should base her strategy on how to proceed with business or investment activities on future costs.

For example, suppose a business executive of a finance consulting company is hired to build a financial analytics application and will receive $10 million at the end of the project. The business executive determines it will cost $7 million in total to finish the project and take one year. The company will profit $3 million for completing this project.

However, in the ninth month of operation, her team runs into problems with the main framework of the application. The firm already spent $5.25 million on this project, and the business executive must decide whether to continue with the project or cancel it. She estimates that this major setback will cost an extra $1 million. However, the company can still profit $2 million from the project.

Whether the business executive decides to continue with the project or cancel it, the costs spent for the nine months of operation cannot be retrieved. This should be irrelevant to her decision because only future costs and potential revenues should be considered. If she cancels the project, the company would incur a $5.25 million loss and have revenues of $0. If she continues with the project, the future revenue for the company is $10 million, and future costs are only $2.75 million.

She decides to continue with the project because it is a 3.64 return on investment, ignoring sunk costs. The consulting company delivers its application to the hirer and receives revenues of $10 million and has a profit of $2 million.

A company performs a reverse stock split to boost its stock price by decreasing the number of shares outstanding, which typically leads to an increase in the price per share.

How a Reverse Split Works

When a company does a reverse split, it cancels its current outstanding stock and distributes new shares to its shareholders in proportion to how many shares they owned before the reverse split. For example, in a one-for-10 reverse split, shareholders would receive 1 share of the company’s new stock for every 10 shares that they owned. If a shareholder owned 1,000 shares before the split, the shareholder would own 100 shares after the reverse stock split.

Why Would A Company Perform A Reverse Split

A reverse split would most likely be performed to prevent a company’s stock from being delisted from an exchange. If a stock price falls below $1, the stock is at risk of being delisted from stock exchanges that have minimum share price rules. Reverse stock splits can increase share prices to avoid delisting, and being listed on a major exchange is important for attracting equity investors.

A split might also be done to boost the company’s image if the stock has fallen dramatically. If the stock is trading in the single digits, it’ll likely be seen as a risky investment particularly if the price is near $1 or considered a penny stock by investors. A reverse split might be engineered by a company to protect it’s brand’s image by trying to prevent the penny stock label. There is a negative stigma typically attached to penny stocks traded only over the counter.

A reverse split sending the stock higher might draw more attention from analysts. Higher-priced stocks attract more attention from market analysts, and if analysts have a favorable view of a company and its stock, it’s great marketing for the company. 

The Effect of a Reverse Stock Split

A reverse stock split has no inherent effect on the company’s value, so the company’s total market capitalization is the same after the reverse split. The company has fewer outstanding shares, but the share price increases in direct proportion to the reverse stock split. The total value of the shares an investor holds remains the same as well. If an investor owned 1,000 shares worth $1 each prior to a one-for-10 reverse stock split, after the split the investor would own 100 shares worth $10 each. The total value of the shares is still $1,000 for the investor. 

Implications of a Reverse Split

Reverse stock splits can carry a negative connotation. As stated earlier, a company is more likely to undergo a reverse stock split because its share price has fallen so low that it’s in danger of being delisted. As a result, investors might believe the company is struggling and that the reverse split is nothing more than an accounting gimmick.

However, a reverse split can be beneficial to a company by boosting its stock price to a level that enables it to transition from being a penny stock traded over the counter to being listed on a major exchange, thereby attracting the interest of more investors.

Financial analysts give their opinions of the future performance of a security. They can give performance ratings of underweight, overweight and market perform to a security. If analysts give a stock an overweight rating, they expect the stock to outperform its industry in the market. Analysts may give a stock an overweight recommendation due to a steady stream of positive news, good earnings and raised guidance.

Analysts will give a stock an overweight recommendation if they feel that the stock’s expected return will be greater than the average return of the industry or market over a given time period. Analysts may also provide a price target when they give a stock an overweight rating.

For example, assume company ABC is in the biotech sector, has a drug for lung cancer and is currently trading at $100. Suppose the company releases positive data and receives FDA approval, and the stock increases by 25%. Analysts may give their opinion based on this news and rate the stock overweight with a price target of $175 for the fiscal year.

Analysts may also give a stock an overweight rating due to positive earnings and raised guidance. For example, assume company DEF, a technology company, releases its quarterly earnings results and beats its EPS and revenue estimates. In addition, the company raises its full-year EPS and revenue guidance by 25%.

The stock increases by 10%, after its earnings release, from $80 to $88 per share. Suppose the sector has been underperforming the market and its stock price decreases by 20% year-to-date while company DEF’s stock price increases 25% year-to-date.

Analysts may give the stock an outperform rating with a price target of $150, because they expect returns to outperform the industry since the stock is appreciating while the sector is depreciating.

A student loan deferral lets you postpone making payments on your student loan for a period of time. Your lender may approve your deferral request under a number of circumstances, including but not limited to temporary total disability, public service (e.g., the Peace Corps or the Armed Forces), parental leave (e.g., pregnancy or caring for a newly adopted or newborn child), medical school residency, full-time graduate fellowship, teaching in a designated teacher shortage area, unemployment, and full-time or at least half-time enrollment at an eligible school.

Your credit score reflects whether you are meeting your obligations to your creditors. You might think that since you aren’t making any loan payments during a deferral period, you’re hurting your credit score. This is not the case. Since your lender has chosen to let you not make loan payments, you are holding up your end of the agreement with your lender and deferral will not hurt your credit score.

There are a couple of ways that deferral can indirectly hurt your credit score, however:

By waiting too long to request a deferral Don’t wait until you’ve fallen behind on your payments to request a deferral. As soon as you fall behind by more than 30 days, your lender can report your late payment to the credit bureaus, which can lower your credit score.

By not paying down your loan balance during the deferral period, your credit score might be slightly lower than it otherwise would be since the total amount you owe compared with the amount you originally borrowed affects your credit score, and the less you owe, the better. In addition, if you have an unsubsidized loan, interest will continue to accrue during the deferral period, and this increase in your loan balance could ding your credit score. If your credit score is lower than it otherwise might be because you owe such a large balance on your student loans, it should start creeping up once you start repaying your loan.

In summary, a student loan deferral does not affect your credit score. However, there are situations where your credit score would be better off if you would actually opt to not take a deferral. Everybody’s situation is different and opting for taking a student loan deferral might be an optimal strategy for some but not for others. 

Companies will use reverse/forward stock splits mainly in an attempt to save future administrative costs. A reverse/forward stock split involves two corporate actions: first, the company will perform a reverse stock split, and will immediately follow with a forward stock split. The purpose of doing this is to cash out any investors who have a small amount of shares. If the reverse split was done at one for 100, then any shareholders with less than 100 shares would be cashed out by the company. After cashing out the smaller shareholders, the company performs the forward stock split to bring the shares back to their original position.

The administrative cost savings come mainly in the form of mailings. In particular, money is saved by not having to print and mail proxies and other documents to smaller shareholders. For smaller companies, this can be a cost-effective strategy that can help trim expenses. The downside of doing this type of split is the message the company is projecting to small shareholders – that they don’t matter. This can sometimes be detrimental to brand loyalty and result in negative public relations.

Another major area of potential cost savings from doing a reverse/forward stock split split comes from reduced regulation requirements, should the company have less than 300 shareholders. Sarbanes-Oxley regulations require companies with over 300 shareholders to comply with the increased regulations under the act. If the company is small enough, a reverse/forward stock split could reduce the number of shareholders enough to save the company a significant amount of money. (For additional reading, check out Understanding Stock Splits.)

This question was answered by Joseph Nguyen

Shareholders need financial statements to evaluate their equity investments and help them make informed decisions as to how to vote on corporate matters. When evaluating investments, shareholders are able to glean meaningful data found on financial statements. There are a number of tools shareholders can use to make equity evaluations, and it is important for them to analyze their stocks using a variety of measurements. Available evaluation metrics include profitability ratios, liquidity ratios, debt ratios, efficiency ratios and price ratios.

Profitability ratios are a group of financial metrics utilized to gauge how well a company generates earnings. Return on equity, or ROE, reflects the percentage of shareholders’ equity returned as net income. This tool acts as a metric for profitability by showing the amount of profit companies generate with a shareholder’s investment. Operating profit margin is an important metric for evaluating the efficiency of a company’s financial management.

Price ratios focus specifically on a company’s stock price and its perceived value in the market. The price/earnings, or P/E, ratio is an evaluation metric comparing current share price of a company’s stock with its per-share earnings. Higher P/E values indicate investors expect continued future growth in earnings. The P/E ratio is most helpful when compared to historical P/E values of the same company, those of companies in the same industry or to the market in general. The dividend yield ratio shows the amount in dividends a company pays out yearly in relation to its share price. Essentially, the dividend yield ratio is a measurement for the amount of cash flow received for each dollar invested in an equity.

These and other evaluation measurements can be calculated using the figures on a company’s financial statements. Investors and market analysts depend on financial statements for equity evaluation. Evaluations are done using different measures because there is no single indicator that adequately assesses a company’s financial position and potential growth.

The reason that margin accounts and only margin accounts can be used to short sell stocks has to do with Regulation T, a rule instituted by the Federal Reserve Board. This rule is motivated by the nature of the short sale transaction itself and the potential risks that come with short selling.

Under Regulation T, it is mandatory for short trades that 150% of the value of the position at the time the short is created be held in a margin account. This 150% is comprised of the full value of the short (100%), plus an additional margin requirement of 50% or half the value of the position. (The margin requirement for a long position is also 50%.) For example, if you were to short a stock and the position had a value of $20,000, you would be required to have the $20,000 that came from the short sale plus an additional $10,000, for a total of $30,000, in the account to meet the requirements of Regulation T.

The reason you need to open a margin account to short sell stocks is that shorting is basically selling something you do not own. As the short investor, you are borrowing shares from another investor or a brokerage firm and selling it in the market. This involves risk, as you are required to return the shares at some point in the future, which creates a liability or a debt for you. It is important for you to bear in mind that it’s possible for you to end up owing more money than you initially received in the short sale if the shorted security moves up by a large amount. In such a situation, you may not be financially able to return the shares. Therefore, margin requirements are essentially a form of collateral, which backs the position and reasonably ensures that the shares will be returned in the future.

A margin account also allows your brokerage firm to liquidate your position if the likelihood that you will return what you’ve borrowed diminishes. This is part of the agreement that is signed when the margin account is created. From the broker’s perspective, this increases the likelihood that you will return the shares before losses become too large and you become unable to return the shares. Cash accounts are not allowed to be liquidated – if short trading were allowed in these accounts, it would add even more risk to the short selling transaction for the lender of the shares. For further reading, see our Short Selling Tutorialand our Margin Trading Tutorial.

Accumulated depreciation is increased with a credit entry, although it is shown on the asset side of the balance sheet. Following the accounting equation, which is the basis for a balance sheet, assets must always be equal to liabilities plus equity.

Assets, on the left side of the equation, are increased with debits and decreased with credits. Liabilities and equity accounts are increased with credits and decreased with debits. However, accumulated depreciation is a special account on the asset side of the balance sheet, which is increased with a credit and decreased with a debit. This is because the accumulated depreciation account is essentially a substitute for decreasing the cost of assets as they lose value over time. In other words, instead of crediting the equipment account directly for depreciation, the depreciable assets account is maintained at the asset’s original cost, and depreciation to the asset is recorded by increasing credit balance of the accumulated depreciation account.

Accumulated depreciation is maintained in a separate account rather than being recorded to the asset account directly. This separates changes in the asset value due to depreciation from changes in the asset account value, which in turn are due to actually disposing assets. For example, if a company had $1 million of fully depreciated machinery, the net asset value would be $0. Rather than show on the balance sheet that the company had $0 of machinery on hand, use of the accumulated depreciation account allows the financial statement to show that the company has a significant amount of machinery on hand, and that the machinery is fully depreciated.

This is informative to financial statement users, because they will now understand that this is a business that might be dependent on this equipment, and they can also guess that this equipment might be reaching the end of its useful life. This is much more informative than simply showing no equipment on the balance sheet once it is fully depreciated.

An average collection period shows the average number of days necessary to convert business receivables into cash. The degree to which this is useful for a business depends on the business’s relative reliance on credit sales to generate revenue; a high balance in accounts receivable can be a major liability.

In terms of business management, the average collection period is an extension of operating efficiency. Much like the receivables turnover ratio, the average collection period can be used in conjunction with liquidity ratios to highlight problems in cash flow or solvency.

Calculating the Average Collection Period

The standard formula for calculating average collection period is the number of working days divided by the debtor receivables turnover ratio. For an annual average collection period, the number of working days is set to 365.

Clearly, the receivables turnover ratio is a major determinant of collection period efficiency. The following formula can be used to find receivables turnover: (annual credit sales) / ((balance of starting receivables + balance of ending receivables) / 2)

Properly Using the Average Collection Period

Accounting ratios only rearrange business data; they are mostly insignificant by themselves. The interpretations and uses of the average collection period vary between businesses and industries.

For example, suppose it takes a company an average of 25 days to turn receivables into cash. Whether this is good or bad depends on the credit terms, cash flow, relative industry standards and a host of other factors.

What time period should be examined for an average collection period? A company that sells and rents expensive skiing equipment might be best suited by adjusting its analysis for seasonal factors. Good proxies for effective time intervals should be apparent by reviewing industry standards.

It is common for a company to aim for an average collection period that is at least one-third lower than the expressed credit terms. If a credit agreement stipulates that the borrower has 45 days to pay, this would mean that the seller wants to collect within 30 days.

There could be meaningful differences within a single company. The data must be collected, arranged and presented in a way that tells a useful story.

Significance and Interpretation

Effective accounts receivable management practices lead to timely customer collection. Tight credit policies have spill-over effects for the rest of a company’s operations. For example, improved cash flow numbers or liquidity ratios can make it easier for the company to obtain a low-interest commercial loan or attract new investors.

On the other hand, credit policies that are too tight tend to limit sales. A car dealer cannot have unreasonable credit terms, or else customers will choose competitors with more reasonable expectations.

Most companies aim for an average collection period that is lower than a marketable credit policy. They want to be able to offer accommodating terms to attract customers, and they want to be able to collect efficiently as well.

Deferred revenue, which is also referred to as unearned revenue, is listed as a liability on the balance sheet, because under accrual accounting, the revenue recognition process has not been completed, and the company’s product or service is still due to the buyer. When a company uses the accrual accounting method, revenue is only recognized as earned when money is received from a buyer and the goods or services are delivered to the buyer. When a company accrues deferred revenue, it is because a buyer or customer paid in advance for a good or service that is to be delivered at some future date.

Cash received in this manner is considered a liability because there is still a chance the good or service will not be delivered, or the buyer may cancel his order. If either case occurs, a company has to repay the customer, unless other payment terms were explicitly stated in a signed contract.

An example of deferred revenue is when a magazine company accepts payments in the form of yearly subscription services, which are paid annually. If the magazine company delivers a monthly magazine, only one-twelfth of the collected money can be recognized per month, because the full 12 magazines have not yet been delivered.

If a customer decides to cancel his subscription, or the magazine company decides to discontinue the subscribed magazine, the company is obligated to return the unearned money to the customer unless previously stated otherwise. This is exactly why it is considered a liability until earned.