Financial jargon de-mystified

Annuity

Annuity is a sum of money paid to someone, typically for the rest of his / her life. Annuities are provided by life insurance companies.

The sum of money provided may be fixed (e.g. Rs. 10,000 per month) or increasing at a fixed rate of interest. For example, the annuity may be Rs. 10,000 per month in the first year, increasing at 3% (simple) p.a., thus becoming Rs.10,300 per month in the second year, Rs.10,600 per month in the third year etc.

There are also annuity products that combine this regular payment during one’s lifetime, with a lump-sum payment made upon death of the individual.

Besides, there are other types of annuity products offered, such as –

• Joint life annuities – wherein the regular annuity payments are made for as long as the husband and wife are both alive, and the payments may also continue at the same / reduced rate to a surviving spouse during his / her lifetime

• Guaranteed for a certain period – wherein the annuity payments are made for life, but are also guaranteed for a certain period (e.g. 5 years / 10 years etc.) irrespective of whether one survives until the end of that period

Annuities are a good way to provide for guaranteed income during retirement.

Assets

Assets are what you own that may be of value. For example, the cash in your wallet, the bank fixed deposits, the property that you own, the gold that you have are all your assets.

Most assets would increase with interest over time. However, some (e.g. cash in your wallet) would not increase over time.

Cash-flows

Cash-flows are indeed what the term indicates – i.e. flow of cash (or the amount in your bank account). Cash-flows may be positive (i.e. cash inflows) or negative (i.e. cash outflows).

For example, salary income received by you, or interest received on your fixed deposits, or money received in your bank account through the sale of property owned by you are all positive cash-flows. Similarly, monthly expenditure incurred by you on grocery, utilities, travelling etc., amount donated by you to the local charity, money paid by you to buy jewellery etc. are all negative cash-flows.

Net cash-flow during a period is the difference between positive cash-flows and negative cash-flows during that period. This net cash-flow may be negative, meaning that you do not have sufficient cash to meet all your cash-outgo requirements and may be required to sell off some of your investments and / or borrow temporarily (e.g. through a bank loan or through your credit card etc.)

Consumer price inflation (CPI)

Consumer price inflation (CPI), also known as retail price inflation (RPI), is the rate of inflation applicable to the goods and services commonly utilised by consumers.

Governments / Central Banks (e.g. in India, the Reserve Bank of India) publish the CPI / RPI during a given period based on a representative basket of goods and services commonly used by consumers in a given country.

Credit rating

Credit rating is an estimate, provided by independent credit rating agencies (e.g. CRISIL, S&P, Moody’s etc.) on the ability of a borrower (e.g. a company) to meet its financial obligations, based on its historical financial dealings and current financial position.

Credit ratings are also issued for individual borrows. For example, CIBIL in India provides credit scores for individuals, based on his / her loan servicing / repayment history.

A higher credit rating / credit score represents comparatively lower risk for the lender than a lower credit rating / credit score. Hence, a high rating / credit score would mean that one would be able to take loan / borrow at a lower rate of interest. Conversely, a low rating / credit score would mean that one would need to pay a higher rate of interest on his / her loans / borrowings.

Debentures

Debentures are long-term (e.g. 5 years) instruments issued by companies for an investor to invest in and provide a fixed rate of interest on the amounts invested.

A high credit rating of the company issuing the debentures would mean that the rate of interest offered on the debentures would be low, as the risk of non-payment of interest / re-payment of principal amount is also low.

On the other hand, a low credit rating of the company issuing the debentures would mean that the rate of interest offered on the debentures would be high, as the risk of non-payment of interest / re-payment of principal amount is also high.

Dividend

Dividend is the amount paid by a company to the holders of equity shares out of the profits made by the company over given period (typically a year).

Dividend yield

Dividend yield is the ratio of annual dividend paid to the market value of the equity shares. For example, if the annual dividend per equity share of a nominal value of Rs.10, the market value of which is Rs.100, is Rs. 1.50, then the dividend yield is 1.5 / 100 = 1.5%.

It may be noted that dividend yield is always derived with respect to the market value of the equity shares (in the above example, Rs.100) and not with respect to the nominal value of the equity shares (in the above example, Rs. 10).

Typically, over a period of time, one would expect some increase in the market value of the equity shares (although the market values may decrease as well). Such an increase in the market value is referred to as capital appreciation. The overall investment return on investment in equity shares is, therefore, equal to dividend yield plus capital appreciation.

Endowment insurance

Endowment insurance is a form of life insurance product that provides an amount upon death of the insured person or upon the end of the term of the policy (i.e. upon maturity of the policy), if the insured person survives the term.

For example, a guaranteed endowment policy for 15 years for a sum assured of Rs.10 lakhs may provide a death benefit of Rs.10 lakhs if the insured dies during the 15 years tenure, or a survival benefit of Rs.10 lakhs at the end of 15 years.

There may be variation of endowment insurance, wherein the survival benefit is paid prior to the maturity date. Such products are called ‘anticipated endowments’ (or ‘money back’, in India).

Equated monthly instalments (EMI)

An equated monthly instalment (EMI) is a fixed sum of money, paid monthly, by the borrower to the lender, for the fixed tenure of the loan.

EMIs include the interest portion (towards the interest on the outstanding loan amount at the beginning of the month) and a portion for repayment of the principal amount. Thus, in the initial period, when the principal amount (i.e. loan outstanding) is high, the interest portion is high and the portion for repayment of principal amount is low. As one repays the loan, the interest portion comes down and the principal component of the EMI increase.

A change in the interest rate during the tenure of the loan (e.g. if the amount borrowed is at a flexible interest rate) would either necessitate a change in EMI for the remaining period or a change in the period of the outstanding loan. In such a situation, the lender would typically leave the EMI unchanged, and thus adjusting the period of the outstanding loan.

Equity shares

An equity share (also referred to as a ‘stock’) is a certificate that documents proportional ownership of a company that issues the equity shares. The person holding the equity shares is called a shareholder.

Although these certificates can be issued in physical form, most of the investors prefer holding them in a de-materialised (DMAT) form – i.e. the investor receives only a statement from his / her depository participant (i.e. typically a bank) stating the number of equity shares owned by him / her in a company, instead of him / her receiving the certificate itself.

The shareholder would ‘own’ the company of which he holds the equity shares, based on the proportion of equity shares owned by him to the total equity shares issued by the company.

An investor in an equity share would get a share in the profits of the company, in the form of dividends declared by the company. However, should the company make a loss, the investor is not required to invest additional amount in the company (e.g. by buying more equity shares) and thus, the investors liabilities are limited.

For a company that is listed on stock markets, its equity shares are bought and sold between willing buyers and willing sellers. Thus, an investor in equity shares may be able to sell his / her shares on the stock market for a price. The price of a share is decided by the market forces themselves (i.e. demand and supply for the given equity share) and may fluctuate on a minute-by-minute basis.

The equity shares issued by a company has a set nominal value (typically Rs. 1 per share, Rs. 10 per share etc.). In contrast, if the equity shares are listed on stock markets, they may also have a market value (typically much higher than the nominal value, especially for a profitable company).

Employee Provident Fund (EPF)

EPF is a form of saving / investment for the retirement of an individual.

Typically, those employees in organised sector (i.e. working in companies / organisations subjected to certain applicable laws) contribute a certain percentage (typically 12%) of their basic salary into EPF. The employer also contributes the same amount for the employee concerned.

The amount contributed into EPF grows with interest, which is declared annually by the Employees Provident Fund Organisation (EPFO). Upon retirement of the employee, the accumulated amount in his / her EPF is paid out to him as a lump-sum.

Fixed deposits

Fixed deposits (or term deposits) are products offered by banks for the benefit of savers. They are for a fixed tenure (e.g. 3 months, 1 year, 2 years, 3 years etc.) and attract a guaranteed rate of interest, as decided by the bank at the time of effecting the deposit.

The interest may be paid out (e.g. typically on a quarterly basis) or may be accumulated and paid out only at the end of the fixed tenure, along with the original amount of the deposit.

Future value

Future value is the projected value of an amount due today. Given that any amount invested / borrowed would attract an interest, the future value is calculated at a given rate of interest.

For example, at an interest rate of 10% p.a., the future value in a year’s time, of Rs.100 invested today, is 100 * 1.1 = Rs. 110.

Similarly, at an interest rate of 8% p.a., the future value at the end of 10 years, of Rs.500 borrowed today is 500 * (1.08^10) = Rs. 1,079.46.

Inflation

Inflation during a given period (e.g. over one year) is the change in price of a commodity (e.g. vegetables, fruits, clothes, television, car, rental on property etc.) or of a service (e.g. domestic helper, car servicing etc.) over that period.

For example, if the price milk was Rs. 50 per litre on 1 January 2020 and if it is Rs.52 per litre on 1 January 2021, then the rate of inflation applicable to milk prices during the year 2020 would be (52-50) / 50 = 4%.

Although in normal circumstances, the rate of inflation would be positive, it may also become negative at times (i.e. prices may come down over a given period).

Different goods and services may experience different levels of inflation.

Given that the prices of goods and services would increase in the future due to inflation, one needs to have investments that would provide a return that would be higher than the inflation likely to be experienced. If not, the purchasing power of your investments may erode over a period of time.

Interest

Interest is the amount of money paid / (received) on the amount of money borrowed / (lent) by any individual or a company.

Interest is required to be paid / (received) given that the borrower / (lender) is utilising the money of the lender / (borrower), who is required to be compensated for the same.

Internal rate of return (IRR)

IRR is the interest rate per annum, that equates the present value of net cash-flows to zero. IRR is typically used to evaluate alternative investment strategies – a strategy that has a higher IRR is preferred over the strategy that has a lower IRR.

For example, if an investment has the following cash-flow profile, the resulting present value and the IRRs are as set out below:

Investment return

The term ‘investment return’ or ‘return on investment’ on a portfolio of investments is the internal rate of return (IRR) on the cash-flows underlying the investment portfolio.

For example, if you bought an investment at Rs. 10,000 and you earn an annual interest of Rs.200 along with a maturity amount of Rs.15,000 at the end of five years, the investment return you would earn on this investment is 10.2% p.a. as illustrated below:

Liabilities

Liabilities are the amount of money you owe. For example, the housing loan availed by you which is to be repaid to the lender is your liability. Similarly, the outstanding balance on your credit card is your liability.

Most liabilities would increase with interest over time. However, some (e.g. amount lent to you by your parents or friend without interest) may not increase over time.

Liquidity

An asset / investment is considered to be ‘liquid’ if you are able to sell off the asset / investment easily without any penalty. For example, cash in your wallet is liquid. Similarly, amount in your savings bank account is liquid. The mutual fund holdings may also be liquid, unless they are for a fixed tenure.

However, the fixed deposit in a bank may be less liquid, as premature withdrawal may attract some penalty in the form of lower interest rate than originally agreed. Similarly, an endowment insurance policy may be less liquid, as premature surrender of the policy may attract heave penalty.

It is important for an individual to ensure that he / she has sufficient amount of investments held in liquid categories, so that in case of emergencies, he / she can liquidate these investments and raise the funds necessary to meet the fund requirements.

Mutual funds

A mutual fund is financial vehicle through which an investor can invest in different types of investment categories (e.g. equity shares, debentures etc.) A mutual fund pools the investments of several investors and invests the funds in the stated investment categories.

An investor gets ‘units’ for the amount he / she invests in the mutual fund. The number of units allotted depend on the net asset value (NAV), the price per unit. For example, if the NAV is 15 and amount invested is Rs.15,000, the investor would get 1,000 units (=15,000 / 15).

The NAV would change on a daily basis, based on the market value of the investments made by the mutual fund from the pooled monies invested.

The investor in a mutual fund may be able to sell (i.e. redeem) his / her units at the NAV applicable at the time of such sale. For example, if the NAV of the given mutual fund has increased from 15 at the time of investment, to 20 at the time of redemption, the investor who was allotted 1,000 units will get Rs.20,000 (=1,000*20).

A mutual fund employs professional fund managers, who are skilled in analysing performance of various companies / industries in which the funds are invested. Considering that an individual investor may not have the skills or the time to carry out such a detailed analysis before deciding on the right company to invest in, a mutual fund offers a convenient way for the individual investor to invest in different investment categories.

Net worth

Net worth is the difference between assets and liabilities of any person or a company.

A positive net-worth of an individual implies that he / she has assets more than his / her liabilities.

However, a negative net-worth implies that he / she may not have sufficient assets to meet all his / her liabilities is, therefore, expected to be ‘insolvent’.

One should be aiming to increase the positive net worth over the long term, as this would, truly, represent the ‘wealth’ of the person.

Present value

Present value is the opposite of future value.

Present value is today’s value of a given amount that is due in the future. Given that any amount invested / borrowed would attract an interest, the present value is calculated at a given rate of interest.

For example, at an interest rate of 10% p.a., the present value of Rs.100 due in a year’s time is 100 / 1.1 = Rs. 90.91. In other words, if one invests Rs.90.91 today, at an interest rate of 10% p.a., at the end of one year, the amount available to him / her would be Rs. 100 (=90.91*1.1).

Similarly, at an interest rate of 8% p.a., the present value of Rs.500 due in 10 years’ time is 500 / (1.08^10) = Rs. 231.60. In other words, if one invests Rs.231.60 today at an interest rate of 8% p.a., in 10 years, the amount available to him / her would be Rs. 500 (=231.60*(1.08^10)).

Public Provident Fund (PPF)

PPF is a form of investment for the long term. The initial period of investment is 15 years, which can be extended in blocks of 5 years thereafter.

The PPF works like a savings bank account. One deposits money into the PPF account and at the end of the year, the Government of India credits interest on the account balance. The rate of interest is decided on an annual basis.

At the end of the tenure of the PPF, one can withdraw the amounts as a lump-sum.

Purchasing power

Purchasing power of money (say a currency such as Rupee) refers to the amount of goods and services a unit of that money can buy at a given point in time.

Inflation erodes the purchasing power of the currency.

For example, let’s say as at 1 January 2000, one could buy a set lunch at a famous restaurant in Mumbai for Rs.100. Assuming that the overall inflation experienced (e.g. increase in workers’ wages, rentals, electricity, cost of vegetables etc.) by the restaurant owner from 1 January 2000 to 1 January 2021 is such that the same set lunch costs Rs.300 as at 1 January 2021, this means that the purchasing power of Rupee has eroded over the past 21 years.

Rental yield

Rental yield is the ratio of annual rental income from (or outgo for) a property to the market value of the property. For example, if the annual rental of an investment property in Andheri, Mumbai that one had bought for Rs.75 lakhs, but the market value of which is Rs.1.5 Crore, is Rs. 6 lakhs, then the rental yield is 4% (=6,00,000/1,50,00,000).

It may be noted that rental yield is always derived with respect to the market value of the property (in the above example, Rs.1.5 Crore) and not with respect to the cost of the property (in the above example, Rs. 75 lakhs).

Typically, over a period of time, one would expect some increase in the market value of the property itself (although property values may decrease as well). Such an increase in the property value is referred to as capital appreciation. The overall investment return on property investment is, therefore, equal to rental yield plus capital appreciation.

Solvency

A person / company is considered to be ‘solvent’ when the assets are more than the liabilities, i.e. there is a positive net-worth.

On the other hand, if the liabilities are more than the assets (i.e. a negative net-worth), the person / company is considered to be ‘insolvent’.

It should be noted that insolvency is different from facing cash-flow issues. For example, one may have enough assets to pay all the liabilities (and therefore is solvent), but if all his / her assets are in illiquid categories (e.g. property) and all his / her liabilities are liquid and due immediately (e.g. credit card dues), he / she may face cash-flow issues.

Stock market

Stoch market or share market is a place where equity shares (and other types of financial instruments) are bought and sold.

When a shareholder wants to sell his / her equity shares, he / she would need to find a buyer on the stock market, who is willing to buy the equity shares at the desired price. Naturally, if there are no willing buyers, the seller may be required to lower his / her price expectation.

Thus, the price at which the equity shares are traded really depend on the demand for (from buyers) and supply of (from sellers) the equity shares. These prices fluctuate on a minute-by-minute basis.

Term insurance

Term insurance is a form of life insurance product that provides an amount upon death of the insured person, if it happens during the term of the policy.

For example, a term policy for 15 years for a sum assured of Rs.10 lakhs may provide a death benefit of Rs.10 lakhs if the insured dies during the 15 years tenure. No other benefits are payable.

Term insurance is the cheapest form of insurance product, as it does not provide any amount upon survival.

However, there may be other forms of term insurance products, which also provide a return of premiums paid, if the policyholder survives the term of the policy.

Tax

Tax is a form of levy imposed by the governments on the citizens and businesses, in order to meet their own expenses (e.g. salaries to government employees) as well as for funding social welfare schemes (e.g. free medical facility to the needy) and for funding infrastructure projects (e.g. building roads).

Tax is levied in various forms – e.g. income tax, Goods and Services Tax, import duties etc.

For personal financial planning, one should always consider the post-tax (i.e. net of tax) investment return as certain investment categories provide tax-free returns, whereas others require the investor to bear the tax on the returns available.

For example, the death / maturity proceeds from a life insurance policy (subject to certain conditions), the interest / maturity proceeds on PPF are currently tax free, whereas the interest on most bank fixed deposits are taxable.

Thus, a person who pays tax at 30% and earns an interest of 5.5% p.a. on the bank fixed deposit would actually earn a net interest of only 3.85% p.a. (=5.5%*(1-30%)). Whereas, the same person who earns an interest of 7% p.a. on his / her PPF account would earn a net interest of 7% p.a.

Unit-linked insurance plan (ULIP)

ULIP is a form of life insurance product that combines benefits of term insurance with those of mutual funds.

Whole life insurance

Whole life insurance is a form of term insurance product that provides death benefit for whole life (e.g. until age 100) of the insured. Some whole life policies may also pay a maturity benefit, should the insured survive until that age.

For example, a guaranteed whole life policy for a sum assured of Rs.10 lakhs may provide a death benefit of Rs.10 lakhs, whenever the insured dies.

There may be variation of whole life insurance, wherein some survival benefit is paid prior to expiry of the policy.