Financial Analysis Terms

Beta

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the entire market or a benchmark. Beta is used in the capital asset pricing model (CAPM), which calculates the expected return of an asset based on its beta and expected market returns. Beta is also known as the beta coefficient. Calculating Beta: Beta reflects the tendency of a security's returns to respond to swings in the market. A security's beta is calculated by dividing the product of the covariance of the security's returns and the benchmark's returns by the product of the variance of the benchmark's returns over a specified period.

Capital Expenditure (CAPEX)

Capital expenditure, or CapEx, are funds used by a company to acquire, upgrade, and maintain physical assets such as property, industrial buildings, or equipment. CapEx is often used to undertake new projects or investments by the firm. This type of financial outlay is also made by companies to maintain or increase the scope of their operations. Capital expenditures can include everything from repairing a roof to building, to purchasing a piece of equipment, or building a brand new factory.

Weighted Average Cost of Capital (WACC)

Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds and any other long-term debt, are included in a WACC calculation. A firm's WACC increases as the beta and rate of return on equity increase, because an increase in WACC denotes a decrease in valuation and an increase in risk. To calculate WACC, multiply the cost of each capital component by its proportional weight and take the sum of the results.

Free Cash Flow - FCF

Free cash flow represents the cash a company generates after cash outflows to support operations and maintain its capital assets. Unlike earnings or net income, free cash flow is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets as well as changes in working capital. Interest payments are excluded from the generally accepted definition of free cash flow. Investment bankers and analysts who need to evaluate a company's expected performance with different capital structures will use variations of free cash flow like free cash flow for the firm and free cash flow to equity, which are adjusted for interest payments and borrowings. Similar to sales and earnings, free cash flow is often evaluated on a per share basis to evaluate the effect of dilution. BREAKING DOWN Free Cash Flow - FCF Free cash flow is the cash flow available to all the investors in a company, including common stockholders, preferred shareholders, and lenders. Some investors prefer FCF or FCF per share over earnings and earnings per share as a measure of profitability. However, because FCF accounts for investments in property, plant, and equipment it can be lumpy and uneven over time.

Net Profit Margin

Net profit margin, or net margin, is equal to net income or profits divided by total revenue, and represents how much profit each dollar of sales generates. Net profit margin is the ratio of net profits or net income to revenues for a company, business segment or product. Net profit margin is typically expressed as a percentage but can also be represented in decimal form. The net profit margin illustrates how much of each dollar collected by a company as revenue translates into profit. The term "net profits" is equivalent to "net income" on the income statement, and one can use the terms interchangeably. Most commonly, investors will refer to net profit margin as the "net margin" and describe it as "net income" divided by total sales instead of using the term "net profits."

Return on Equity ( ROE )

Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders' equity. Because shareholders' equity is equal to a company's assets minus its debt, ROE could be thought of as the return on net assets. ROE is expressed as a percentage and can be calculated for any company if net income and equity are both positive numbers. Net income is calculated before dividends paid to common shareholders and after dividends to preferred shareholders and interest to lenders. BREAKING DOWN Return on Equity (ROE): Net income over the last full fiscal year, or trailing twelve months, is found on the income statement: a sum of financial activity over that period. Shareholders' equity comes from the balance sheet: a running balance of a company's entire history of changes in assets and liabilities. It is considered best practice to calculate ROE based on average equity over the period because of this mismatch between the two financial statements. Average shareholder equity is calculated by adding equity at the beginning of the period to equity at the end of the period and dividing by two. Investors can use quarterly balance sheets to calculate an even more accurate equity average.

Asset Turnover Ratio

The asset turnover ratio measures the value of a company's sales or revenues relative to the value of its assets. The asset turnover ratio can be used as an indicator of the efficiency with which a company is using its assets to generate revenue. The asset turnover ratio is calculated on an annual basis. The total assets number used in the denominator can be calculated by taking the average of assets on the balance sheet at the beginning of the year and at the year's end. The higher the asset turnover ratio, the better the company is performing, since higher ratios imply that the company is generating more revenue per dollar of assets. The asset turnover ratio tends to be higher for companies in certain sectors than in others. Retail and consumer staples, for example, have relatively small asset bases but have high sales volume - thus, they have the highest average asset turnover ratio. Conversely, firms in sectors such as utilities and real estate have large asset bases and low asset turnover.

Cash Conversion Cycle - CCC

The cash conversion cycle (CCC) is a metric that expresses the length of time (in days) that it takes for a company to convert its investments in inventory and other resources into cash flows from sales. Also called the Net Operating Cycle or simply Cash Cycle, CCC attempts to measure the duration of time for which each net input dollar (cash) is tied up in the production and sales process before it gets converted into cash received through sales made to customers. This metric takes into account the duration of time it requires to sell its inventory, the duration of time required to collect receivables, and the duration of time the company is allowed to pay its bills without incurring any penalties.

Current Ratio

The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations. To calculate the ratio, analysts compare current assets to current liabilities. Current assets include cash, accounts receivable, inventory and other assets that are expected to be turned into cash in less than a year. Current liabilities include accounts, wages, taxes payable, and the current portion of long-term debt. The formula for calculating a company's current ratio is as follows: Current Ratio = Current Assets / Current Liabilities A current ratio that is in line with the industry average or slightly higher is generally considered acceptable. A current ratio that is lower than the industry average may indicate a higher risk of distress or default. Similarly, if a company has a very high current ratio compared to their peer group, it indicates that management may not be using their assets efficiently. The current ratio is called "current" because, unlike some other liquidity ratios, it incorporates all current assets and liabilities.

Rule Of 72

The rule of 72 is a quick, useful formula that is popularly used to estimate the number of years required to double the invested money at a given annual rate of return. While calculators and spreadsheet programs like excel sheets have inbuilt functions to accurately calculate the precise time required to double the invested money, the rule of 72 comes in handy for mental calculations to quickly gauge an approximate value. Alternatively, it can compute the annual rate of compounded return from an investment given how many years it will take to double the investment.

What is the formula for calculating EBITDA?

There are a number of metrics available to measure profitability. EBITDA (earnings before interest, taxes, depreciation, and amortization) is one indicator of a company's financial performance and is used to determine the earning potential of a company. With EBITDA, factors like debt financing as well as depreciation, and amortization expenses are stripped out when calculating profitability. Also, EBITDA shows a company's profit without taxes and interest expenses on debt. As a result, EBIDTA provides a clearer picture of operational performance since it focuses on a company's profitability from its core operations. There are two formulas for calculating EBITDA. The first formula uses operating income as the starting point, while the second formula uses net income. Both formulas have their benefits and drawbacks. The first formula is below: EBITDA = Operating Income + Depreciation and Amortization Operating income is a company's profit after subtracting operating expenses or the costs of running the daily business. Operating income helps investors separate out the earnings for the company's operating performance by excluding interest and taxes. EBITDA can also be calculated by taking net income and adding back interest, taxes, depreciation, and amortization, whereby: EBITDA = Net Profit + Interest +Taxes + Depreciation + Amortization

Reverse Stock Split

A reverse stock split is a type of corporate action in which a company reduces the total number of its outstanding shares in the open market. A reverse stock split involves the company dividing its existing total quantity of shares by a number such as 5 or 10, which would then be called a 1-for-5 or 1-for-10 reverse split, respectively. A reverse stock split is also known as a stock consolidation, stock merge or share rollback, and is the opposite exercise of stock split where a share is divided (split) into multiple parts.

T-Test

A t-test is a type of inferential statistic which is used to determine if there is a significant difference between the means of two groups which may be related in certain features. It is mostly used when the data sets, like the set of data recorded as outcome from flipping a coin a 100 times, would follow a normal distribution and may have unknown variances. T test is used as a hypothesis testing tool, which allows testing of an assumption applicable to a population. A t-test looks at the t-statistic, the t-distribution values and the degrees of freedom to determine the probability of difference between two sets of data. To conduct a test with three or more variables, one must use an analysis of variance.

Leverage Ratio

A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt (loans), or assesses the ability of a company to meet its financial obligations. The leverage ratio is important given that companies rely on a mixture of equity and debt to finance their operations, and knowing the amount of debt held by a company is useful in evaluating whether it can pay its debts off as they come due. There are several different specific ratios that may be categorized as a leverage ratio, but the main factors considered are debt, equity, assets, and interest expenses. A leverage ratio may also be used to measure a company's mix of operating expenses to get an idea of how changes in output will affect operating income. Fixed and variable costs are the two types of operating costs; depending on the company and the industry, the mix will differ. Finally, the consumer leverage ratio refers to the level of consumer debt as compared to disposable income and is used in economic analysis and by policymakers.

Cash Flow

Cash flow is the net amount of cash and cash-equivalents being transferred into and out of a business. At the most fundamental level, a company's ability to create value for shareholders is determined by its ability to generate positive cash flows, or more specifically, maximize long-term free cash flow. Assessing the amounts, timing and uncertainty of cash flows is one of the most basic objectives of financial reporting. Understanding the cash flow statement - which reports operating cash flow, investing cash flow and financing cash flow — is essential for assessing a company's liquidity, flexibility and overall financial performance. Positive cash flow indicates that a company's liquid assets are increasing, enabling it to settle debts, reinvest in its business, return money to shareholders, pay expenses and provide a buffer against future financial challenges. Companies with strong financial flexibility can take advantage of profitable investments. They also fare better in downturns, by avoiding the costs of financial distress.

DuPont Analysis

DuPont analysis (also known as the "DuPont identity") is framework for analyzing fundamental performance popularized by the DuPont Corporation. DuPont analysis is a useful technique used to decompose the different drivers of return on equity (ROE). Decomposition of ROE allows investors to focus on the key metrics of financial performance individually to identify strengths and weaknesses. There are three major financial metrics that drive return on equity (ROE): operating efficiency, asset use efficiency and financial leverage. Operating efficiency is represented by net profit margin or net income divided by total sales or revenue. Asset use efficiency is measured by the asset turnover ratio. Financial leverage is equal to average assets divided by average equity.

What is the formula for calculating net present value (NPV)?

Net present value (NPV) is a method used to determine the current value of all future cash flows generated by a project, including the initial capital investment. It is widely used in capital budgeting to establish which projects are likely to turn the greatest profit. The formula for NPV varies depending on the number and consistency of future cash flows. If there's one cash flow from a project that will be paid one year from now, the net present value is calculated as follows: NPV = (Cash Flow)/((1+i)^t) - initial investment i = Required return or discount rate t = Number of time periods

Debt/Equity Ratio

The Debt/Equity (D/E) Ratio is calculated by dividing a company's total liabilities by its shareholder equity. These numbers are available on the balance sheet of a company's financial statements. The ratio is used to evaluate a company's financial leverage. The debt/equity ratio is also referred to as a risk or gearing ratio. The formula for calculating the D/E ratio is: Debt/Equity Ratio = Total Liabilities / Total Shareholder Equity

Sharpe Ratio

The Sharpe ratio was developed by Nobel laureate William F. Sharpe, and is used to help investors understand the return of an investment compared to its risk. The ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. Subtracting the risk-free rate from the mean return allows an investor to better isolate the profits associated with risk-taking activities. One intuition of this calculation is that a portfolio engaging in "zero risk" investments, such as the purchase of U.S. Treasury bills (for which the expected return is the risk-free rate), has a Sharpe ratio of exactly zero. Generally, the greater the value of the Sharpe ratio, the more attractive the risk-adjusted return. The Sharpe ratio has become the most widely used method for calculating risk-adjusted return; however, it can be distorted when applied to portfolios or assets that experience large positive and negative movements. A portfolio like this has a return distribution with a high degree of kurtosis ('fat tails') and/or negative skewness.

Quick Ratio

The quick ratio is an indicator of a company's short-term liquidity position, and measures a company's ability to meet its short-term obligations with its most liquid assets. Since it indicates the company's financial position to instantly use its near cash assets (that is, liquid assets) to get rid of its current liabilities, it is also called as the acid test ratio. An acid test is a quick test designed to produce instant results, hence the name. The quick ratio measures the dollar amount of liquid assets available with the company against the dollar amount of its current liabilities. Liquid assets are the assets that can be quickly converted into cash with minimal impact to the price received in the open market, while current liabilities are a company's debts or obligations that are due to be paid to creditors within one year. Mathematically, quick ratio is calculated as follows: Quick Ratio = Liquid Assets / Current Liabilities, or Quick Ratio = (Cash and Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities

Market value versus book value

Valuing a listed company is a complex task, and several different measures are used to arrive at a fair valuation. While none of the methods is precise and each presents a different version with varying results, investors use them in combination to get a good understanding of how the stocks have been fairing. Two most commonly used quantitative measures for valuing a company are market value and book value. This article compares the two popular factors, their differences and how they can be used in analyzing companies. Book Value Book value literally means the value of a business according to its books (accounts) that is reflected through its financial statements. Theoretically, book value represents the total amount a company is worth if all its assets are sold and all the liabilities are paid back. This is the amount that the company's creditors and investors can expect to receive if the company goes for liquidation. Book Value Formula Mathematically, book value is calculated as the difference between a company's total assets and total liabilities. Book value of a company = Total assets - Total liabilities Market Value Market value represents the value of a company according to the stock market. While market value is a generic term that represents the price an asset would get in the marketplace, in the context of companies it represents the market capitalization. It is the aggregate market value of a company represented in dollar amount. Since it represents the "market" value of a company, it is computed based on the current market price (CMP) of its shares. Market Value Formula Market value or market cap is calculated by multiplying a company's outstanding shares by its current market price. Market Cap of a Company = Current Market Price (per share) * Total Number of Outstanding Shares

Working Capital

Working capital, also known as net working capital, is the difference between a company's current assets, like cash, accounts receivable (customers' unpaid bills) and inventories of raw materials and finished goods, and its current liabilities, like accounts payable. Working Capital = Current Assets - Current Liabilities Working capital is a measure of both a company's operational efficiency and its short-term financial health. The working capital ratio (current assets/current liabilities), or current ratio, indicates whether a company has enough short-term assets to cover its short-term debt. A good working capital ratio is considered anything between 1.2 and 2.0. A ratio of less than 1.0 indicates negative working capital, with potential liquidity problems, while a ratio above 2.0 might indicate that a company is not using its excess assets effectively to generate maximum possible revenue.