Finance/Accounting Terminology

Réussis tes devoirs et examens dès maintenant avec Quizwiz!

Investing

-sale of property and equipment -purchase equipment -purchase investments (long-term assets) BUYING/SELLING ITEMS FIRM WILL USE FOR 1+ YEARS

Operating

-selling products -interest earned from deposits - purchasing inventory -paying salaries* INVENTORY

Financing

-issuing long-term debt -issuing stock -borrow $ from bank -repay long-term debt principal -pay dividends to owners* PUTTING IN MONEY TO START AND FINANCE THE BUSINESS

Balance Sheet

Assets = Liabilities + Shareholders Equity These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by shareholders These things must balance out because: This is intuitive: a company has to pay for all the things it owns (assets) by either borrowing money (taking on liabilities) or taking it from investors (issuing shareholders' equity). The balance sheet is a snapshot, representing the state of a company's finances at a moment in time. By itself, it cannot give a sense of the trends that are playing out over a longer period. For this reason, the balance sheet should be compared with those of previous periods. It should also be compared with those of other businesses in the same industry, since different industries have unique approaches to financing.

Liabilities (LT)

Long-term debt: interest and principle on bonds issued Pension fund liability: the money a company is required to pay into its employees' retirement accounts Deferred tax liability: taxes that have been accrued but will not be paid for another year; besides timing, this figure reconciles differences between requirements for financial reporting and the way tax is assessed, such as depreciation calculations Some liabilities are off-balance sheet, meaning that they will not appear on the balance sheet. Operating leases are an example of this kind of liability.

Liquidity

Liquidity describes the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset's price. Market liquidity refers to the extent to which a market, such as a country's stock market or a city's real estate market, allows assets to be bought and sold at stable prices. Cash is the most liquid asset, while real estate, fine art and collectibles are all relatively illiquid. Accounting liquidity measures the ease with which an individual or company can meet their financial obligations with the liquid assets available to them. There are several ratios that express accounting liquidity. Cash is considered the standard for liquidity because it can most quickly and easily be converted into other assets. If a person wants a $1,000 refrigerator, cash is the asset that can most easily be used to obtain it. If that person has no cash, but a rare book collection that has been appraised at $1,000, they are unlikely to find someone willing to trade them the refrigerator for their collection. Instead, they will have to sell the collection and use the cash to purchase the refrigerator. That may be fine if the person can wait months or years to make the purchase, but it could present a problem if the person only had a few days. They may have to sell the books at a discount, instead of waiting for a buyer who was willing to pay the full value. Rare books are therefore an illiquid asset. Market Liquidity In the example given above, the market for refrigerators in exchange for rare books is so illiquid that, for all intents and purposes, it does not exist. The stock market, on the other hand, is characterized by higher market liquidity. If an exchange has a high volume of trade that is not dominated by selling, the price a buyer offers per share (the bid price) and the price the seller is willing to accept (the ask price) will be fairly close to each other. Investors, then, will not have to give up unrealized gains for a quick sale. When the spread between the bid and ask prices grows, the market becomes more illiquid. Markets for real estate are pretty much inherently less liquid than stock markets. Even by the standard of real estate markets, however, a buyer's market is relatively illiquid, since buyers can demand steep discounts from sellers who want to offload their properties quickly. Accounting Liquidity For an entity, such as a person or a company, accounting liquidity is a measure of their ability to pay off debts as they come due, that is, to have access to their money when they need it. In the example above, the rare book collector's assets are relatively illiquid, and would probably not be worth their full value of $1,000 in a pinch. In practical terms, assessing accounting liquidity means comparing liquid assets to current liabilities, or financial obligations that come due within one year. There are a number of ratios that measure accounting liquidity, which differ in how strictly they define "liquid assets." Current Ratio The current ratio is the simplest and least strict ratio. Current assets are those that can reasonably be converted to cash in one year. Current Ratio = Current Assets / Current Liabilities Acid-Test or Quick Ratio The acid-test or quick ratio is slightly more strict. It excludes inventories and other current assets, which are not as liquid as cash and cash equivalents, accounts receivable and short-term investments. Acid-Test Ratio = (Cash and Cash Equivalents + Short-Term Investments + Accounts Receivable) / Current Liabilities A variation of the acid-test ratio simply subtracts inventory from current assets, making it a bit more generous than the version listed above: Acid-Test Ratio (Var) = (Current Assets - Inventories) / Current Liabilities Cash Ratio The cash ratio is the most exacting of the liquidity ratios, excluding accounts receivable as well as inventories and other current assets. More than the current ratio or acid-test ratio, it assess an entity's ability to stay solvent in the case of an emergency. Even highly profitable companies can run into trouble if they do not have the liquidity to react to unforeseen events. Cash Ratio = (Cash and Cash Equivalents + Short-Term Investments) / Current Liabilities

Income Statement 3

Net Sales (a.k.a. sales or revenue): These terms refer to the value of a company's sales of goods and services to its customers. Even though a company's bottom line (its net income) gets most of the attention from investors, the top line is where the revenue or income process begins. Also, in the long run, profit margins on a company's existing products tend to eventually reach a maximum that is difficult on which to improve. Thus, companies typically can grow no faster than their revenues. Cost of Sales (a.k.a. cost of goods/products sold (COGS), and cost of services): For a manufacturer, cost of sales is the expense incurred for labor, raw materials, and manufacturing overhead used in the production of goods. While it may be stated separately, depreciation expense belongs in the cost of sales. For wholesalers and retailers, the cost of sales is essentially the purchase cost of merchandise used for resale. For service-related businesses, cost of sales represents the cost of services rendered or cost of revenues. (To learn more about sales, read Measuring Company Efficiency, Inventory Valuation For Investors: FIFO And LIFO and Great Expectations: Forecasting Sales Growth.) Gross Profit (a.k.a. gross income or gross margin): A company's gross profit does more than simply represent the difference between net sales and the cost of sales. Gross profit provides the resources to cover all of the company's other expenses. Obviously, the greater and more stable a company's gross margin, the greater potential there is for positive bottom line (net income) results. Selling, General and Administrative Expenses: Often referred to as SG&A, this account comprises a company's operational expenses. Financial analysts generally assume that management exercises a great deal of control over this expense category. The trend of SG&A expenses, as a percentage of sales, is watched closely to detect signs, both positive and negative, of managerial efficiency.

Book Value cannot fall below....

Salvage Value

CFS Accrual vs. Cash Accounting

There are two forms of accounting: cash and accrual. Most public companies use accrual accounting, which means the income statement in the annual report is not the same as the company's cash position. For example, if a company lands a major contract, this contract is recognized as revenue, and therefore income, but the company may not receive cash until a later date. The accountant says the company is earning a profit on the income statement and paying income taxes on it, but the company may have less cash on hand. Even profitable companies can fail to adequately manage cash flow, which is why the cash flow statement is such a critical tool for analysts and investors. The cash flow statement is split between three different business activities: operations, investing and financing.

WACC 2

BREAKING DOWN 'Weighted Average Cost Of Capital - WACC' In a broad sense, a company finances its assets either through debt or with equity. WACC is the average of the costs of these types of financing, each of which is weighted by its proportionate use in a given situation. By taking a weighted average in this way, we can determine how much interest a company owes for each dollar it finances. Debt and equity are the two components that constitute a company's capital funding. Lenders and equity holders will expect to receive certain returns on the funds or capital they have provided. Since cost of capital is the return that equity owners (or shareholders) and debt holders will expect, so WACC indicates the return that both kinds of stakeholders (equity owners and lenders) can expect to receive. Put another way, WACC is an investor's opportunity cost of taking on the risk of investing money in a company. A firm's WACC is the overall required return for a firm. Because of this, company directors will often use WACC internally in order to make decisions, like determining the economic feasibility of mergers and other expansionary opportunities. WACC is the discount rate that should be used for cash flows with risk that is similar to that of the overall firm. To help understand WACC, try to think of a company as a pool of money. Money enters the pool from two separate sources: debt and equity. Proceeds earned through business operations are not considered a third source because, after a company pays off debt, the company retains any leftover money that is not returned to shareholders (in the form of dividends) on behalf of those shareholders. Suppose that lenders requires a 10% return on the money they have lent to a firm, and suppose that shareholders require a minimum of a 20% return on their investments in order to retain their holdings in the firm. On average, then, projects funded from the company's pool of money will have to return 15% to satisfy debt and equity holders. The 15% is the WACC. If the only money in the pool was $50 in debt holders' contributions and $50 in shareholders' investments, and the company invested $100 in a project, to meet the lenders' and shareholders' return expectations, the project would need to generate returns of $5 each year for the lenders and $10 a year for the company's shareholders. This would require a total return of $15 a year, or a 15% WACC. Uses of Weighted Average Cost of Capital (WACC) Securities analysts frequently use WACC when assessing the value of investments and when determining which ones to pursue. For example, in discounted cash flow analysis, one may apply WACC as the discount rate for future cash flows in order to derive a business's net present value. WACC may also be used as a hurdle rate against which to gauge ROIC performance. WACC is also essential in order to perform economic value added (EVA) calculations. Investors may often use WACC as an indicator of whether or not an investment is worth pursuing. Put simply, WACC is the minimum acceptable rate of return at which a company yields returns for its investors. To determine an investor's personal returns on an investment in a company, simply subtract the WACC from the company's returns percentage. For example, suppose that a company yields returns of 20% and has a WACC of 11%. This means the company is yielding 9% returns on every dollar the company invests. In other words, for each dollar spent, the company is creating nine cents of value. On the other hand, if the company's return is less than WACC, the company is losing value. If a company has returns of 11% and a WACC of 17%, the company is losing six cents for every dollar spent, indicating that potential investors would be best off putting their money elsewhere. WACC can serve as a useful reality check for investors; however, the average investor would rarely go to the trouble of calculating WACC because it is a complicated measure that requires a lot of detailed company information. Nonetheless, being able to calculate WACC can help investors understand WACC and its significance when they see it in brokerage analysts' reports. Limitations of Weighted Average Cost of Capital (WACC) The WACC formula seems easier to calculate than it really is. Because certain elements of the formula, like cost of equity, are not consistent values, various parties may report them differently for different reasons. As such, while WACC can often help lend valuable insight into a company, one should always use it along with other metrics when determining whether or not to invest in a company.

A/R

Accounts receivable refers to the outstanding invoices a company has or the money the company is owed from its clients. The phrase refers to accounts a business has a right to receive because it has delivered a product or service. Receivables essentially represent a line of credit extended by a company and due within a relatively short time period, ranging from a few days to a year. On a public company's balance sheet, accounts receivable is often recorded as an asset, because there is a legal obligation for the customer to remit cash for the debt. If a company has receivables, this means it has made a sale but has yet to collect the money from the purchaser. Essentially, the company has accepted an IOU from its client. Most companies operate by allowing some portion of their sales to be on credit. In some cases, business offer this type of credit to frequent or special customers who are invoiced periodically. The practice allows customers to avoid the hassle of physically making payments as each transaction occurs. In other cases, businesses routinely offer all of their clients the ability to pay after receiving the service. For example, electric companies typically bill their clients after the clients have received the electricity. While the electricity company waits for its customers to pay their bills, the unpaid invoices are considered accounts receivable

Annuity

An annuity is a contractual financial product sold by financial institutions that is designed to accept and grow funds from an individual and then, upon annuitization, pay out a stream of payments to the individual at a later point in time. The period of time when an annuity is being funded and before payouts begin is referred to as the accumulation phase. Once payments commence, the contract is in the annuitization phase. Annuities were designed to be a reliable means of securing a steady cash flow for an individual during their retirement years and to alleviate fears of longevity risk, or outliving one's assets. Annuities can also be created to turn a substantial lump sum into a steady cash flow, such as for winners of large cash settlements from a lawsuit or from winning the lottery. Defined benefit pensions and Social Security are two examples of lifetime guaranteed annuities that pay retirees a steady cash flow until they pass. Types of Annuities Annuities can be structured according to a wide array of details and factors, such as the duration of time that payments from the annuity can be guaranteed to continue. Annuities can be created so that, upon annuitization, payments will continue so long as either the annuitant or their spouse (if survivorship benefit is elected) is alive. Alternatively, annuities can be structured to pay out funds for a fixed amount of time, such as 20 years, regardless of how long the annuitant lives. Furthermore, annuities can begin immediately upon deposit of a lump sum, or they can be structured as deferred benefits. Annuities can be structured generally as either fixed or variable. Fixed annuities provide regular periodic payments to the annuitant. Variable annuities allow the owner to receive greater future cash flows if investments of the annuity fund do well and smaller payments if its investments do poorly. This provides for a less stable cash flow than a fixed annuity, but allows the annuitant to reap the benefits of strong returns from their fund's investments. One criticism of annuities is that they are illiquid. Deposits into annuity contracts are typically locked up for a period of time, known as the surrender period, where the annuitant would incur a penalty if all or part of that money were touched. These surrender periods can last anywhere from 2 to more than 10 years, depending on the particular product. Surrender fees can start out at 10% or more and the penalty typically declines annually over the surrender period. While variable annuities carry some market risk and the potential to lose principal, riders and features can be added to annuity contracts (usually for some extra cost) which allow them to function as hybrid fixed-variable annuities. Contract owners can benefit from upside portfolio potential while enjoying the protection of a guaranteed lifetime minimum withdrawal benefit if the portfolio drops in value. Other riders may be purchased to add a death benefit to the contract or accelerate payouts if the annuity holder is diagnosed with a terminal illness. Cost of living riders are common to adjust the annual base cash flows for inflation based on changes in the CPI. Who Sells Annuities Life insurance companies and investment companies are the two sorts of financial institutions offering annuity products. For life insurance companies, annuities are a natural hedge for their insurance products. Life insurance is bought to deal with mortality risk - that is, the risk of dying prematurely. Policyholders pay an annual premium to the insurance company who will pay out a lump sum upon their death. If policyholders die prematurely, the insurer will pay out the death benefit at a net loss to the company. Actuarial science and claims experience allows these insurance companies to price their policies so that on average insurance purchasers will live long enough so that the insurer earns a profit. Annuities, on the other hand, deal with longevity risk, or the risk of outliving ones assets. The risk to the issuer of the annuity is that annuity holders will live outlive their initial investment. Annuity issuers may hedge longevity risk by selling annuities to customers with a higher risk of premature death. In many cases, the cash value inside of permanent life insurance policies can be exchanged via a 1035 exchange for an annuity product without any tax implications. Agents or brokers selling annuities need to hold a state-issued life insurance license, and also a securities license in the case of variable annuities. These agents or brokers typically earn a commission based on the notional value of the annuity contract. Who Buys Annuities Annuities are appropriate financial products for individuals seeking stable, guaranteed retirement income. Because the lump sum put into the annuity is illiquid and subject to withdrawal penalties, it is not recommended for younger individuals or for those with liquidity needs. Annuity holders cannot outlive their income stream, which hedges longevity risk. So long as the purchaser understands that he or she is trading a liquid lump sum for a guaranteed series of cash flows, the product is appropriate. Some purchasers hope to cash out an annuity in the future at a profit, however this is not the intended use of the product. Immediate annuities are often purchased by people of any age who have received a large lump sum of money and who prefer to exchange it for cash flows in to the future. The lottery winner's curse is the fact that many lottery winners who take the lump sum windfall often spend all of that money in a relatively short period of time.

Asset Turnover

Asset turnover ratio is the ratio of the value of a company's sales or revenues generated relative to the value of its assets. The Asset Turnover ratio can often be used as an indicator of the efficiency with which a company is deploying its assets in generating revenue. Asset Turnover = Sales or Revenues / Total Assets Generally speaking, 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. Yet, this ratio can vary widely from one industry to the next. As such, considering the asset turnover ratios of an energy company and a telecommunications company will not make for an accurate comparison. Comparisons are only meaningful when they are made for different companies within the same sector. Asset turnover is typically calculated over an annual basis using either the fiscal or calendar year. The total assets number used in the denominator can be calculated by taking the average of assets held by a company at the beginning of the year and at the year's end. For example, suppose company X has an asset base of $400 million at the beginning of a given year and $500 million at the end of the same year, and suppose that company X generated $900 million in revenues over the course of that year. The asset turnover ratio for company X is therefore: $900 million / [($500 million + $400 million) / 2] = $900 million / [$900 million / 2] = $900 million / $450 million = 2.00 The asset turnover ratio tends to be higher for companies in certain sectors than in others. Retail, for example, is the sector that most often yields the highest asset turnover ratios, scoring a 2.05 in 2014. Both it and consumer staples have relatively small asset bases but have high sales volume. Conversely, firms in sectors like utilities and telecommunications, which have large asset bases, will have lower asset turnover. The financial sector, for example, often trails in its asset turnover ratio, scoring a 0.08 in 2014. Using the Asset Turnover Ratio Consider the asset turnover ratio for Wal-Mart Stores Inc. (WMT). When the fiscal year ended on January 31, 2014, Wal-Mart had total revenues of $476 billion. Wal-Mart's total assets were $203 billion at the beginning of that fiscal year and $205 billion at fiscal year-end, for an average of $204 billion. Wal-Mart's asset turnover ratio was therefore 2.36 ($476 billion/ $204 billion). In contrast, AT&T Inc. (T) had total revenues of $132 billion when the fiscal year ended on December 31, 2014. Total assets at the beginning and end of the 2014 fiscal year were $278 billion and $293 billion respectively, for an average asset base of $287 billion. AT&T's asset turnover ratio in 2014 was therefore 0.46 ($132 billion / $287 billion). Clearly, it would not make much sense to compare the asset turnover ratios for Wal-Mart and AT&T, since they operate in very different industries. But comparing the asset turnover ratios for AT&T and Verizon Communications Inc. (VZ), for instance, may provide a clearer picture of asset use efficiency for these telecom companies. In the same fiscal year as in the AT&T example above, Verizon had total revenues of $127 billion. Total assets at the beginning and end of the year were $274 billion and $232 billion, respectively, for an average asset base of $253 billion. As such, in 2014 Verizon's asset turnover ratio was 0.50 ($127 billion / $253 billion), about 9% higher than AT&T's in the same year. Yet, this kind of comparison does not necessarily paint the clearest possible picture. It is possible that a company's asset turnover ratio in any single year differs substantially from previous or subsequent years. For example, while AT&T's asset turnover ratio was 0.30 in 2006, it rose nearly a full fifty percent to reach 0.44 in 2007, the following year. For any specific company, then, one would do well to review the trend in the asset turnover ratio over a period of time to check whether asset usage is improving or deteriorating. Many other factors can affect a company's asset turnover ratio in a given year, such as whether or not an industry is cyclical. (For more, see: Cyclical Versus Non-Cyclical Stocks.) History The Asset Turnover ratio is a key component of DuPont analysis, a system that the DuPont Corporation began using during the 1920s. DuPont analysis breaks down Return on Equity (ROE) into three parts, one of which is asset turnover, the other two being profit margin and financial leverage. In splitting ROE into distinct components, this form of analysis allows one to analyze the nuances of a high or low ROE, to attempt to determine what causes may be contributing to a company's ROE performance and to compare the components of ROE with those of other companies

Credits/Debits

Debit = Left Credit = Right Generally these types of accounts are increased with a debit: Dividends (Draws) Expenses Assets Losses You might think of D - E - A - L when recalling the accounts that are increased with a debit. Generally these types of accounts are increased with a credit: Gains Income Revenues Liabilities Stockholders' (Owner's) Equity You might think of G - I - R - L - S when recalling the accounts that are increased with a credit. To decrease an account you do the opposite of what was done to increase the account. For example, an asset account is increased with a debit. Therefore it is decreased with a credit. The abbreviation for debit is dr. and the abbreviation for credit is cr.

NPV continued

Determining the value of a project is challenging because there are different ways to measure the value of future cash flows. Because of the time value of money (TVM), money in the present is worth more than the same amount in the future. This is both because of earnings that could potentially be made using the money during the intervening time and because of inflation. In other words, a dollar earned in the future won't be worth as much as one earned in the present. The discount rate element of the NPV formula is a way to account for this. Companies may often have different ways of identifying the discount rate. Common methods for determining the discount rate include using the expected return of other investment choices with a similar level of risk (rates of return investors will expect), or the costs associated with borrowing money needed to finance the project. For example, if a retail clothing business wants to purchase an existing store, it would first estimate the future cash flows that store would generate, and then discount those cash flows (r) into one lump-sum present value amount of, say $500,000. If the owner of the store were willing to sell his or her business for less than $500,000, the purchasing company would likely accept the offer as it presents a positive NPV investment. If the owner agreed to sell the store for $300,000, then the investment represents a $200,000 net gain ($500,000 - $300,000) during the calculated investment period. This $200,000, or the net gain of an investment, is called the investment's intrinsic value. Conversely, if the owner would not sell for less than $500,000, the purchaser would not buy the store, as the acquisition would present a negative NPV at that time and would, therefore, reduce the overall value of the larger clothing company. Let's look at how this example fits into the formula above. The lump-sum present value of $500,000 represents the part of the formula between the equal sign and the minus sign. The amount the retail clothing business pays for the store represents Co. Subtract Co from $500,000 to get the NPV: if Co is less than $500,000, the resulting NPV is positive; if Co is more than $500,000, the NPV is negative and is not a profitable investment. Drawbacks and Alternatives One primary issue with gauging an investment's profitability with NPV is that NPV relies heavily upon multiple assumptions and estimates, so there can be substantial room for error. Estimated factors include investment costs, discount rate and projected returns. A project may often require unforeseen expenditures to get off the ground or may require additional expenditure at the project's end. Additionally, discount rates and cash inflow estimates may not inherently account for risk associated with the project and may assume the maximum possible cash inflows over an investment period. This may occur as a means of artificially increasing investor confidence. As such, these factors may need to be adjusted to account for unexpected costs or losses or for overly optimistic cash inflow projections. Payback period is one popular metric that is frequently used as an alternative to net present value. It is much simpler than NPV, mainly gauging the time required after an investment to recoup the initial costs of that investment. Unlike NPV, the payback period (or "payback method") fails to account for the time value of money. For this reason, payback periods calculated for longer investments have a greater potential for inaccuracy, as they encompass more time during which inflation may occur and skew projected earnings and, thus, the real payback period as well. Moreover, the payback period is strictly limited to the amount of time required to earn back initial investment costs. As such, it also fails to account for the profitability of an investment after that investment has reached the end of its payback period. It is possible that the investment's rate of return could subsequently experience a sharp drop, a sharp increase or anything in between. Comparisons of investments' payback periods, then, will not necessarily yield an accurate portrayal of the profitability of those investments. Internal rate of return (IRR) is another metric commonly used as an NPV alternative. Calculations of IRR rely on the same formula as NPV does, except with slight adjustments. IRR calculations assume a neutral NPV (a value of zero) and one instead solves for the discount rate. The discount rate of an investment when NPV is zero is the investment's IRR, essentially representing the projected rate of growth for that investment. Because IRR is necessarily annual - it refers to projected returns on a yearly basis - it allows for the simplified comparison of a wide variety of types and lengths of investments. For example, IRR could be used to compare the anticipated profitability of a 3-year investment with that of a 10-year investment because it appears as an annualized figure. If both have an IRR of 18%, then the investments are in certain respects comparable, in spite of the difference in duration. Yet, the same is not true for net present value. Unlike IRR, NPV exists as a single value applying the entirety of a projected investment period. If the investment period is longer than one year, NPV will not account for the rate of earnings in way allowing for easy comparison. Returning to the previous example, the 10-year investment could have a higher NPV than will the 3-year investment, but this is not necessarily helpful information, as the former is over three times as long as the latter, and there is a substantial amount of investment opportunity in the 7 years' difference between the two investments. Interested in more information on Net Present Value? See: Time Value of Money: Determining Your Future Worth and our Introduction To Corporate Valuation Methods. For more on the relationship between NPV, IRR and associated terms, see the section of our Guide to Corporate Finance called "Net Present Value and Internal Rate of Return."

ROA

Return on assets (ROA) is considered to be a profitability ratio - it shows how much a company is earning on its total assets. Nevertheless, it is worthwhile to view the ROA ratio as an indicator of asset performance. The ROA ratio (percentage) is calculated as: Average total assets can be calculated by dividing the year-end total assets of two fiscal periods (ex 2004 and 2005 PP&E divided by 2). The ROA ratio is expressed as a percentage return by comparing net income, the bottom line of the statement of income, to average total assets. A high percentage return implies well-managed assets. Here again, the ROA ratio is best employed as a comparative analysis of a company's own historical performance and with companies in a similar line of business

Accrual

Revenue recognized when earned, liabilities recognized when obligation incurred Transactions are recorded as they occur, are recorded even if cash not received or paid, affect accounting equation

Cap Rate

The capitalization rate is the rate of return on a real estate investment property based on the income that the property is expected to generate. The capitalization rate is used to estimate the investor's potential return on his or her investment. The capitalization rate of an investment may be calculated by dividing the investment's net operating income (NOI) by the current market value of the property, where NOI is the annual return on the property minus all operating costs. The formula for calculating the capitalization rate can be expressed in the following way: Capitalization Rate = Net Operating Income / Current Market Value Some consider the capitalization rate to be, in essence, the discount rate of a perpetuity, though the use of perpetuity in this case may be slightly misleading as it implies cash flows will be steady on an annual basis. The capitalization rate is expressed as a percentage and is also often known as the "cap rate." The capitalization rate is very useful in that it streamlines information about real estate investments and makes it easy to interpret. For example, if Stephan buys a property for $900,000 and expects that the property will generate $125,000 per year after operating costs, the capitalization rate for his investment is 13.89% ($125,000 / $900,000 = 0.1389 = 13.89%). What this means is that, every year, Stephan is earning 13.89% of the value of his property as profit. This example assumes that all factors of Stephan's cap rate calculations will remain constant, but in reality things often get a little more complicated. Suppose that due to a boom in demand for real estate in Stephan's town after he makes the investment, the value of Stephan's property rises to $2 million by the time two years has passed. Meanwhile, Stephan has been making the same amount of money from the property. Since capitalization rate calculations use the current market value, the capitalization rate of Stephan's investment has changed. Because the market value of the property has risen while Stephan's NOI has not, the cap rate has dropped considerably to a less favorable 6.25% ($125,000 / $2 million = 0.0625 = 6.25%). Examples like this illustrate an important function of capitalization rates. Because the cap rate is a ratio gauging profitability, the proportion of NOI relative to the current market value must remain constant in order for the capitalization rate to remain the same. If NOI rises while the market value does not, the capitalization rate will rise and, if the opposite happens, the capitalization rate will decline. In order for a real estate investment to remain profitable, NOI needs to increase at the same rate as the property value increases, or at an even greater rate. In this respect, capitalization rate is useful because it can be used to track a real estate investment over time to see whether or not its performance is improving. If, for whatever reason, the capitalization rate is declining, it may be a wiser decision to simply sell the property and reinvest elsewhere. With a drop of over 50% in Stephan's cap rate in just two years, he would likely be best off either finding a way to raise his NOI or selling the property and finding an alternative investment. Uses of Capitalization Rate Often, comparing different property investments can be like comparing apples and oranges, so the capitalization rate is a good jumping-off point because it can be used to quickly and easily compare many investment opportunities with one another. Comparing the market values or operating income estimates of various properties will often be difficult and yield results that are difficult to sift through, but comparing percentages is very straightforward. For example, suppose Martha is considering two different investments with market values of $230,000 and $3M and estimates that their NOI values will be $40,000 and $300,000, respectively. While these investments differ substantially, knowing that their respective capitalization rates are 17.39% and 10% may help Martha make her decision. Yet, while the first investment's cap rate is much higher, the second investment will earn much more money annually, so this will likely play into Martha's decision as well. While this example helps illustrate cap rate's ability to help in comparing investments, it is important to note that it is most useful in this function when either the NOI or current market value are comparable. Investments of drastically different sizes may often have additional considerations that can prevent smooth comparisons. When seeking to invest in real estate, investors will often decide on the lowest cap rate that they will accept in order to make the investment worth their while. For example, an investor might decide that, for the amount of money they are looking to spend, they will only accept an investment with a capitalization rate of 10% or higher. When looking at potential investments, then, they will compare the cap rates of those investments against their personal cap rate. The capitalization rate may also be used to roughly calculate the payback period of the investment by dividing 100 by the cap rate when expressed as a whole number. For example, one can calculate the payback period of an investment with a cap rate of 5% by dividing 100 by 5, for an estimated payback period of 20 years. Yet, this method should only be used to get a rough estimate of the investment's payback period because few real estate investments will retain a constant capitalization rate over a long period of time. Additionally, direct capitalization is a method used for valuing a real estate investment that incorporates the capitalization rate. With this method, one can divide NOI by the cap rate in order to determine the investment's capital cost. Though this may sound complicated, it is essentially a reconfiguration of the cap rate formula. Issues with Capitalization Rate While the capitalization rate is a very useful ratio to use when planning or analyzing an investment, it comes with a few important limitations that should be considered before using the cap rate. One such limitation is that the cap rate is not very useful for short-term investments. With little time to develop a reliable cash flow, an investment's NOI can be difficult or impossible to determine, thereby making cap rate calculations difficult or impossible as well. It is also important to note that the capitalization rate is sometimes calculated as NOI divided by the original amount the current owner paid for the property. Because the value of a property will rarely remain the same for very long, this method of calculating cap rates is far less useful than the other method. Calculating a cap rate for a property with a value of $2 million in 2015 based on its 1995 price of $300,000 will not be very useful and will give very misleading results. Additional issues when using this method may also arise in the case of a property given as a gift or through inheritance, as the cap rate cannot be determined with a cost of zero. The capitalization rate is a popular and easy ratio to use, but it should not be the sole factor in any real estate investment decision. Many more factors need to be looked at such as the growth or decline of the potential income, the increase in value of the property and any alternative investments available.

Discount Rate

The interest rate charged to commercial banks and other depository institutions for loans received from the Federal Reserve Bank's discount window. The discount rate also refers to the interest rate used in discounted cash flow (DCF) analysis to determine the present value of future cash flows. The discount rate in DCF analysis takes into account not just the time value of money, but also the risk or uncertainty of future cash flows; the greater the uncertainty of future cash flows, the higher the discount rate. A third meaning of the term "discount rate" is the rate used by pension plans and insurance companies for discounting their liabilities. The Fed's Discount Rate is an administered rate set by the Federal Reserve Banks, rather than a market rate of interest. Use of the Fed's discount window soared in late 2007 and 2008, as financial conditions deteriorated sharply and the Federal Reserve took steps to provide liquidity to the financial system. Discount window borrowing soared to a record $111 billion at the height of the global financial crisis in October 2008, while the Federal Reserve's board of governors set the discount rate at a post-WW II low of 0.5% on Dec. 16, 2008. A simple explanation of the discount rate used in DCF analysis is as follows. Let's say you expect $1,000 in one year. To determine the present value of this $1,000 (what it is worth to you today), you would need to discount it by a particular interest rate. Assuming a discount rate of 10%, the $1,000 in a year's time would be equivalent to $909.09 to you today (1,000 / [1.00 + 0.10]). If you expect to receive the $1,000 in two years, its present value would be $826.45. What is the appropriate discount rate to use for a project? Many companies use their weighted average cost of capital (WACC) if the project's risk profile is similar to that of the company. But if the project's risk profile is substantially different from that of the company, the Capital Asset Pricing Model (CAPM) is often used to calculate a project-specific discount rate that more accurately reflects its risk.

P/E ratio

The price-earnings ratio (P/E Ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings. The price-earnings ratio can be calculated as: Market Value per Share / Earnings per Share For example, suppose that a company is currently trading at $43 a share and its earnings over the last 12 months were $1.95 per share. The P/E ratio for the stock could then be calculated as 43/1.95, or 22.05. EPS is most often derived from the last four quarters. This form of the price-earnings ratio is called trailing P/E, which may be calculated by subtracting a company's share value at the beginning of the 12-month period from its value at the period's end, adjusting for stock splits if there have been any. Sometimes, price-earnings can also be taken from analysts' estimates of earnings expected during the next four quarters. This form of price-earnings is also called projected or forward P/E. A third, less common variation uses the sum of the last two actual quarters and the estimates of the next two quarters. The price-earnings ratio is also sometimes known as the price multiple or the earnings multiple. In essence, the price-earnings ratio indicates the dollar amount an investor can expect to invest in a company in order to receive one dollar of that company's earnings. This is why the P/E is sometimes referred to as the multiple because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings. In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. A low P/E can indicate either that a company may currently be undervalued or that the company is doing exceptionally well relative to its past trends. When a company has no earnings or is posting losses, in both cases P/E will be expressed as "N/A." Though it is possible to calculate a negative P/E, this is not the common convention. The price-earnings ratio can also be seen as a means of standardizing the value of one dollar of earnings throughout the stock market. In theory, by taking the median of P/E ratios over a period of several years, one could formulate something of a standardized P/E ratio, which could then be seen as a benchmark and used to indicate whether or not a stock is worth buying. Limitations of 'Price-Earnings Ratio - P/E Ratio' Like any other metric designed to inform investors as to whether or not a stock is worth buying, the price-earnings ratio comes with a few important limitations that are important to take into account, as investors may often be led to believe that there is one single metric that will provide complete insight into an investment decision, which is virtually never the case. One primary limitation of using P/E ratios emerges when comparing P/E ratios of different companies. Valuations and growth rates of companies may often vary wildly between sectors due both to the differing ways companies earn money and to the differing timelines during which companies earn that money. As such, one should only use P/E as a comparative tool when considering companies within the same sector, as this kind of comparison is the only kind that will yield productive insight. Comparing the P/E ratios of a telecommunications company and an energy company, for example, may lead one to believe that one is clearly the superior investment, but this is not a reliable assumption. An individual company's P/E ratio is much more meaningful when taken alongside P/E ratios of other companies within the same sector. For example, an energy company may have a high P/E ratio, but this may reflect a trend within the sector rather than one merely within the individual company. An individual company's high P/E ratio, for example, would be less cause for concern when the entire sector has high P/E ratios. Moreover, because a company's debt can affect both the prices of shares and the company's earnings, leverage can skew P/E ratios as well. For example, suppose there are two similar companies that differ primarily in the amount of debt they take on. The one with more debt will likely have a lower P/E value than the one with less debt. However, if business is good, the one with more debt stands to see higher earnings because of the risks it has taken. Another important limitation of price-earnings ratios is one that lies within the formula for calculating P/E itself. Accurate and unbiased presentations of P/E ratios rely on accurate inputs of the market value of shares and of accurate earnings per share estimates. While the market determines the value of shares and, as such, that information is available from a wide variety of reliable sources, this is less so for earnings, which are often reported by companies themselves and thus are more easily manipulated. Since earnings are an important input in calculating P/E, adjusting them can affect P/E as well. (See also, How can the P/E ratio mislead investors?) Things to Remember Generally a high P/E ratio means that investors are anticipating higher growth in the future. The average market P/E ratio is 20-25 times earnings. The P/E ratio can use estimated earnings to get the forward looking P/E ratio. Companies that are losing money do not have a P/E ratio.

TVM

The time value of money (TVM) is the idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. TVM is also referred to as present discounted value. Money deposited in a savings account earns a certain interest rate. Rational investors prefer to receive money today rather than the same amount of money in the future because of money's potential to grow in value over a given period of time. Money earning an interest rate is said to be compounding in value. Basic Time Value of Money Formula and Example Depending on the exact situation in question, the TVM formula may change slightly. For example, in the case of annuity or perpetuity payments, the generalized formula has additional or less factors. But in general, the most fundamental TVM formula takes into account the following variables: FV = Future value of money PV = Present value of money i = interest rate n = number of compounding periods per year t = number of years Based on these variables, the formula for TVM is: FV = PV x (1 + (i / n)) ^ (n x t) For example, assume a sum of $10,000 is invested for one year at 10% interest. The future value of that money is: FV = $10,000 x (1 + (10% / 1) ^ (1 x 1) = $11,000 The formula can also be rearranged to find the value of the future sum in present day dollars. For example, the value of $5,000 one year from today, compounded at 7% interest, is: PV = $5,000 / (1 + (7% / 1) ^ (1 x 1) = $4,673 Effect of Compounding Periods on Future Value The number of compounding periods can have a drastic effect on the TVM calculations. Taking the $10,000 example above, if the number of compounding periods is increased to quarterly, monthly or daily, the ending future value calculations are: Quarterly Compounding: FV = $10,000 x (1 + (10% / 4) ^ (4 x 1) = $11,038 Monthly Compounding: FV = $10,000 x (1 + (10% / 12) ^ (12 x 1) = $11,047 Daily Compounding: FV = $10,000 x (1 + (10% / 365) ^ (365 x 1) = $11,052 This shows TVM depends not only on interest rate and time horizon, but how many times the compounding calculations are computed each year

Profit Margin

What is a 'Profit Margin' Profit margin is part of a category of profitability ratios calculated as net income divided by revenue, or net profits divided by sales. Net income or net profit may be determined by subtracting all of a company's expenses, including operating costs, material costs (including raw materials) and tax costs, from its total revenue. Profit margins are expressed as a percentage and, in effect, measure how much out of every dollar of sales a company actually keeps in earnings. A 20% profit margin, then, means the company has a net income of $0.20 for each dollar of total revenue earned. While there are a few different kinds of profit margins, including "gross profit margin," "operating margin," (or "operating profit margin") "pretax profit margin" and "net margin" (or "net profit margin") the term "profit margin" is also often used simply to refer to net margin. The method of calculating profit margin when the term is used in this way can be represented with the following formula: Profit Margin = Net Income / Net Sales (revenue) Other types of profit margins have different ways of calculating net income so as to break down a company's earnings in different ways and for different purposes. Profit margin is similar but distinct from the term "profit percentage," which divides net profit on sales by the cost of goods sold to help determine the amount of profit a company makes on selling its goods, rather than the amount of profit a company is making relative to its total expenditures. Next Up Net Profit Margin Marginal Profit After-Tax Profit Margin Operating Margin BREAKING DOWN 'Profit Margin' Rarely can a company's individual numbers (like revenue or expenditures) indicate much about the company's profitability, and looking at the earnings of a company often doesn't tell the entire story. Increased earnings are good, but an increase does not mean that the profit margin of a company is improving. For example, suppose one year Company A's revenue is $1 million and its total expenditures are $750,000, making its profit margin 25% ($1M - $0.75M / $1M = $0.25M / $1M = 0.25 = 25%). If during the following year its revenue increases to $1.25 million and its expenditures increase to $1 million, its profit margin is then 20% ($1.25M - $1M / $1.25M = $0.25M / $1.25M = 0.20 = 20%). Even though its revenue has increased, Company A's profit margin has diminished because expenses have increased at a faster rate than revenue. In the same way, an increase or decrease in a company's expenditures does not necessarily indicate that the company's profit margin is improving or worsening. Suppose that Company B's revenue and expenditures in one year are $2 million and $1.5 million, respectively, making its profit margin 25%. The following year the company does some restructuring, reducing its expenditures by eliminating a product line, thereby reducing total revenue as well. If Company B's revenue and expenditures in the second year are now $1.5 million and $1.2 million, respectively, then its profit margin is now 20%. Even though Company B was able to substantially cut its costs, its profit margin suffered because its revenue decreased more quickly than its expenditures did. Uses of 'Profit Margin' Profit margin is a useful ratio and can help provide insight about a variety of aspects of a company's financial performance. On a rudimentary level, a low profit margin can be interpreted as indicating that a company's profitability is not very secure. If a company with a low profit margin experiences a decline in sales, its profit margin will decline even further, leading to a very low, neutral or even negative profit margin. Low profit margins may also reveal certain things about the industry in which a company operates or about broader economic conditions. For example, if a company's profit margin is low, it may indicate that it has lower sales than other companies in the industry (a low market share) or that the industry in which the company operates is itself suffering, perhaps because of waning consumer interest (or increasing popularity and/or availability of alternatives) or because of hard economic times or recession. Profit margin may also indicate certain things about a company's ability to manage its expenses. High expenditures relative to revenue (i.e. a low profit margin) may indicate that a company is struggling to keep its costs low, perhaps because of management problems. This is an indication that costs need to be under better control. High expenditures may occur for many reasons, including that the company has too much inventory relative to its sales, that it has too many employees, that it is operating in spaces that are too large and thus is paying too much in rent, and for many other reasons. On the other hand, a higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. Profit margin can also illuminate certain aspects of a company's pricing strategy. For example, a low profit margin may indicate that a company is underpricing​ its goods. Limitations of 'Profit Margin' Though profit margin is a helpful and popular ratio for gauging a company's profitability, like any financial metric or ratio it comes with certain accompanying limitations that any investor should consider when considering a company's profit margin. While profit margin can be very useful for comparing companies with one another, one should only use profit margin to compare companies within the same industry, and ideally with similar business models and revenue numbers as well. Companies in different industries may often have wildly different business models, such that they may also have very different profit margins, thereby rendering a comparison of their profit margins relatively meaningless. For example, a company selling luxury goods may often have a high profit percentage on its wares while having a low inventory and relatively low overhead, earning modest revenue while maintaining a high profit margin. A consumer staples producer, on the other hand, may have a low profit percentage while having a high inventory and a relatively high overhead, due to a need for a larger work force and more space. The consumer staples company, then, could have very high revenue while having a relatively low profit margin. Profit margin is also not very useful when considering companies that are losing money, since they have no profit. Variations of 'Profit Margin' There are a few variations on profit margin that investors and analysts use to measure more (or less) specific elements of a company's profit. One such variation is gross profit margin, which divides gross profit (revenue minus the cost of goods sold including labor, materials and overhead) by revenue earned. This variation comes with certain limitations, such as that management may often have little control over the cost of materials, so gross profit margin is less useful for determining management quality. Additionally, industries with no production process have no or little cost of sales, so gross profit margin is most useful when considering companies that actually produce goods. One particularly popular variation of profit margin is operating profit margin, which divides operating profit (revenue minus selling, general and administrative expenses) by revenue. Investors and analysts may often use pretax profit margin, which divides pretax earnings (revenue without deducting tax costs) by revenue

CAPM

What is the 'Capital Asset Pricing Model - CAPM' The capital asset pricing model (CAPM) is a model that describes the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for the pricing of risky securities, generating expected returns for assets given the risk of those assets and calculating costs of capital. The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The risk-free rate is customarily the yield on government bonds like U.S. Treasuries. The other half of the CAPM formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf): the return of the market in excess of the risk-free rate. Beta reflects how risky an asset is compared to overall market risk and is a function of the volatility of the asset and the market as well as the correlation between the two. For stocks, the market is usually represented as the S&P 500 but can be represented by more robust indexes as well. The CAPM model says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas). Example of CAPM Using the CAPM model and the following assumptions, we can compute the expected return for a stock: The risk-free rate is 2% and the beta (risk measure) of a stock is 2. The expected market return over the period is 10%, so that means that the market risk premium is 8% (10% - 2%) after subtracting the risk-free rate from the expected market return. Plugging in the preceding values into the CAPM formula above, we get an expected return of 18% for the stock 18% = 2% + 2 x (10%-2%)

Cash Flow Statement

A cash flow statement is one of the quarterly financial reports publicly traded companies are required to disclose to the U.S. Securities and Exchange Commission (SEC) and the public. The document provides aggregate data regarding all cash inflows a company receives from its ongoing operations and external investment sources, as well as all cash outflows that pay for business activities and investments during a given quarter Cash Flows From Operations The first set of cash flow transactions is from operational business activities. Cash flows from operations starts with net income and then reconciles all noncash items to cash items within business operations. For example, accounts receivable is a noncash account. If accounts receivables go up, it means sales are up, but no cash was received at the time of sale. The cash flow statement deducts receivables from net income because it is not cash. Also included in cash flows from operations are accounts payable, depreciation, amortization and numerous prepaid items booked as revenue or expenses but with no associated cash flow. Cash Flows From Investing Cash flows from investing activities includes cash spent on property, plant and equipment. This is where analysts look to find changes in capital expenditures (CAPEX). While positive cash flows from investing activities is a good thing, investors prefer companies that generate cash flows primarily from business operations, not investing and financing activities. Cash Flows From Financing Cash flows from financing is the last business activity detailed on the cash flow statement. The section provides an overview of cash used in business financing. Analysts use the cash flows from financing section to find the amount paid out in dividends or share buybacks. Cash obtained or paid back from capital fundraising efforts, such as equity or debt, is also listed

DCF

A discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them to arrive at a present value estimate, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one. There are several variations when it comes to assigning values to cash flows and the discount rate in a DCF analysis. But while the calculations involved are complex, the purpose of DCF analysis is simply to estimate the money an investor would receive from an investment, adjusted for the time value of money. The time value of money is the assumption that a dollar today is worth more than a dollar tomorrow. For example, assuming 5% annual interest, $1.00 in a savings account will be worth $1.05 in a year. Due to the symmetric property (if a=b, then b=a), we must consider $1.05 a year from now to be worth $1.00 today. When it comes to assessing the future value of investments, it is common to use the weighted average cost of capital (WACC) as the discount rate. For a hypothetical Company X, we would apply DCF analysis by first estimating the firm's future cash flow growth. We would start by determining the company's trailing twelve month (ttm) free cash flow (FCF), equal to that period's operating cash flow minus capital expenditures. Say that Company X's ttm FCF is $50 m. We would compare this figure to previous years' cash flows in order to estimate a rate of growth. It is also important to consider the source of this growth. Are sales increasing? Are costs declining? These factors will inform assessments of the growth rate's sustainability. Say that you estimate that Company X's cash flow will grow by 10% in the first two years, then 5% in the following three. After a few years, you may apply a long-term cash flow growth rate, representing an assumption of annual growth from that point on. This value should probably not exceed the long-term growth prospects of the overall economy by too much; we will say that Company X's is 3%. You will then calculate a WACC; say it comes out to 8%. The terminal value, or long-term valuation the company's growth approaches, is calculated using the Gordon Growth Model:

Fixed Costs

A fixed cost is an operating expense of a business that cannot be avoided regardless of the level of production. Fixed costs are usually used in breakeven analysis to determine pricing and the level of production and sales under which a company generates neither profit nor loss. Fixed costs and variable costs form the total cost structure of a company, which plays a crucial role in ensuring its profitability. Examples of Fixed Costs Accountants perform extensive analysis of different expenses to determine whether they are variable or fixed. Higher fixed costs in the total cost structure of a company require it to achieve higher levels of revenues to break even. Fixed costs must be incurred regularly, and they tend to show little fluctuations from period to period. Examples of fixed costs include insurance, interest expense, property taxes, utilities expenses and depreciation of assets. Also, if a company pays annual salaries to its employees irrespective of the number of hours worked, such salaries must be counted as fixed costs. A company's lease on a building is another common example of fixed costs, which can absorb significant funds especially for retail companies that rent their store premises. Fixed Costs and Economies of Scale A business must incur variable and fixed costs to produce a given amount of goods. Variable costs per item stay relatively flat, and the total variable costs change proportionately to the number of product items produced. Fixed costs per item decrease with increases in production. Thus, a company can achieve economies of scale when it produces enough goods to spread the same amount of fixed costs over a larger number of units produced and sold. For example, a $100,000 lease spread out over 100,000 widgets means that each widget carries with it $1 in fixed costs. If the company produces 200,000 widgets, the fixed cost per unit drops to 50 cents. Companies with large fixed costs and unchanged variable costs in their production process tend to have the greatest amount of operating leverage. This means that after a company achieves the breakeven point, all else equal any further increases in sale will produce higher profits in proportion to sales increase for a company up to a point where fixed costs per unit sold become negligible. Conversely, decreases in sales volume can produce disproportionately higher declines in profits. An example of companies with high fixed cost component are utility companies, which have to make large investments in infrastructure and have subsequently large depreciation expenses with relatively stable variable costs per unit of electricity produced

Variable Costs

A variable cost is a corporate expense that varies with production output. Variable costs are those costs that vary depending on a company's production volume; they rise as production increases and fall as production decreases. Variable costs differ from fixed costs such as rent, advertising, insurance and office supplies, which tend to remain the same regardless of production output. Fixed costs and variable costs comprise total cost. Variable costs can include direct material costs or direct labor costs necessary to complete a certain project. For example, a company may have variable costs associated with the packaging of one of its products. As the company moves more of this product, the costs for packaging will increase. Conversely, when fewer of these products are sold the costs for packaging will consequently decrease.

A/P

Accounts payable (AP) is an accounting entry that represents an entity's obligation to pay off a short-term debt to its creditors. On many balance sheets, the accounts payable entry appears under the heading current liabilities. Another common usage of AP refers to a business department or division that is responsible for making payments owed by the company to suppliers and other creditors. Accounts payable are debits that must be paid off within a given period to avoid default. For example, at the corporate level, AP refers to short-term debt payments to suppliers. The payable is essentially a short-term IOU from the business to the other business, who acts as a creditor. How to Record Accounts Payable To record accounts payable, accountants or bookkeepers credit accounts payable when they owe a bill, and they debit accounts payable when they pay the bill. For example, imagine a business incurs a $500 invoice for office supplies. When the AP department receives the invoice or incurs the bill, it records it as a debit in an accounts payable field. As a result, if anyone looks at the total debit in the accounts payable category, he can instantly see what the business owes all of its vendors and short-term lenders. When the bill is paid, the department enters a credit in its accounts payable column. To balance these entries, the accountant must enter a debit in the relevant category, office supplies in this case, when the debt is incurred, and he must enter a credit in the cash column when he pays the invoice. Accounts Payable and Long-Term Debts Accounts payable are a type of short-term debt. Other short-term business debts include expenses such as payroll costs, business income taxes and short-term loans. In contrast, long-term debts include lease payments, retirement benefits, individual notes payable and a range of other debts repaid over a long term.

accrual accounting

Accrual accounting is an accounting method that measures the performance and position of a company by recognizing economic events regardless of when cash transactions occur. The general idea is that economic events are recognized by matching revenues to expenses (the matching principle) at the time in which the transaction occurs rather than when payment is made (or received). This method allows the current cash inflows/outflows to be combined with future expected cash inflows/outflows to give a more accurate picture of a company's current financial condition. Accrual accounting is considered to be the standard accounting practice for most companies, with the exception of very small operations. This method provides a more accurate picture of the company's current condition, but its relative complexity makes it more expensive to implement. This is the opposite of cash accounting, which recognizes transactions only when there is an exchange of cash. The need for this method arose out of the increasing complexity of business transactions and a desire for more accurate financial information. Selling on credit and projects that provide revenue streams over a long period of time affect the company's financial condition at the point of the transaction. Therefore, it makes sense that such events should also be reflected on the financial statements during the same reporting period that these transactions occur. For example, when a company sells a TV to a customer who uses a credit card, cash and accrual methods will view the event differently. The revenue generated by the sale of the TV will only be recognized by the cash method when the money is received by the company. If the TV is purchased on credit, this revenue might not be recognized until next month or next year. Accrual accounting, however, says that the cash method isn't accurate because it is likely, if not certain, that the company will receive the cash at some point in the future because the sale has been made. Therefore, the accrual accounting method instead recognizes the TV sale at the point at which the customer takes ownership of the TV. Even though cash isn't yet in the bank, the sale is booked to an account known in accounting lingo as "accounts receivable," increasing the seller's revenue.

Accum Dep

Accumulated depreciation is the cumulative depreciation of an asset up to a single point in its life. An asset's carrying value on the balance sheet is the difference between its purchase price and accumulated depreciation. A company buys and holds an asset on the balance sheet until the salvage value matches the carrying value. There are two types of assets: Those that are expensed in the year of purchase, and those that are capitalized. Assets that are used within a year of being purchased, like inventory, are considered operating assets. These assets are generally sold or used in the year of purchase, and so they are fully expensed in the year of purchase. Capitalized assets provide value for more than one year, and accountants like to match expenses to sales in the period in which they are incurred. As a solution to this matching problem, accountants use a process called depreciation. Depreciation expenses a portion of the cost of the asset in the year it is purchased and the rest as the asset is used in future years. Accumulated depreciation is the total amount that the asset has been expensed over the asset's life. Accumulated Depreciation Example Straight-line depreciation expense is calculated by dividing the difference between the cost of the asset and its salvage value by the asset's useful life. In this example, the cost of the asset is the purchase price; the salvage value is the value of the asset at the end of its life, also referred to as scrap value; and the useful life is the number of years the asset is expected to provide value. Company A buys a piece of equipment with a useful life of 10 years for $110,000. The equipment has a salvage value of $10,000 at the end of its useful life. The equipment is going to provide the company with value for the next 10 years, so analysts expense the cost of the equipment over the next 10 years. Straight-line depreciation is calculated as $110,000 minus $10,000 divided by 10, or $10,000. This means the company will depreciate $10,000 for the next 10 years until the book value of the asset is $10,000. Each year the contra asset account referred to as accumulated depreciation increases by $10,000. For example, at the end of five years the annual depreciation expense is still $10,000, but accumulated depreciation has grown to $50,000. That is, accumulated depreciation is a cumulative account. It is credited each year as the value of the asset is written off and remains on the books until the asset is sold. It is important to note that accumulated depreciation can't be more than the asset's cost even if the asset is used after its useful life

SE continued

All the information needed to compute a company's shareholders' equity is available on its balance sheet. The shareholders' equity equation requires that you find a company's total assets and total liabilities. This means including both short-term assets and long-term assets. The short-term assets include things such as retained earnings, share capital and other cash assets held in banking and savings accounts, stocks, bonds and money market accounts. Long-term assets include things such as equipment, property, illiquid investments and vehicles. Short-term liabilities include any payments and interest due on loans within the current year, accounts payable, wages, operating costs and insurance premiums. Long-term liabilities include any and all debts owed that are not due within the current year, such as mortgages, loan balances and payments to bondholders. Once the short- and long-term figures are added, computing shareholders' equity is simply a matter of subtraction. Example Assume company ABC's balance sheet shows $600,000 in retained earnings held in cash, $500,000 in stocks, and $1.5 million in equipment and other fixed assets. It also shows the following debts or expenses to be paid: $800,000 in loans and mortgages, $100,000 in wages, $10,000 in insurance premiums, and accounts payable totaling $10,000. According to the balance sheet, ABC has $2.6 million in total assets and $920,000 in total liabilities. After subtracting the liabilities from the assets, ABC's shareholders' equity is $1.68 million. Alternate Equation Shareholders' equity can also be expressed as a company's share capital plus retained earnings, minus the value of treasury shares. This method, however, is less common. Though both methods should yield the same figure, the use of total assets and total liabilities is more illustrative of a company's financial health. By comparing concrete numbers reflecting everything the company owns and everything it owes, this "assets-less-liabilities" shareholders' equity equation paints a clear picture of a company's finances that is easily interpreted by laymen and professionals alike.

Income Statement

An income statement is a financial statement that reports a company's financial performance over a specific accounting period. Financial performance is assessed by giving a summary of how the business incurs its revenues and expenses through both operating and non-operating activities. It also shows the net profit or loss incurred over a specific accounting period. But the income statement is the only one that provides an overview of company sales and net income. (out of balance sheet and statement of CF's) Analysts use the income statement for data to calculate financial ratios such as return on equity (ROE), return on assets (ROA), gross profit, operating profit, earnings before interest and taxes (EBIT), and earnings before interest taxes and amortization (EBITDA). The income statement is often presented in a common-sized format, which provides each line item on the income statement as a percent of sales. In this way, analysts can easily see which expenses make up the largest portion of sales. Analysts also use the income statement to compare year-over-year (YOY) and quarter-over-quarter (QOQ) performance. The income statement typically provides two to three years of historical data for comparison.

Assets (Long Term)

Long-term investments: securities that will not or cannot be liquidated in the next year Fixed assets: these include land, machinery, equipment, buildings and other durable, generally capital-intensive assets Intangible assets: these include non-physical, but still valuable, assets such as intellectual property and goodwill; in general, intangible assets are only listed on the balance sheet if they are acquired, rather than developed in-house; their value may therefore be wildly understated—by not including a globally recognized logo, for example—or just as wildly overstated

Capital Budgeting

Capital budgeting is the process in which a business determines and evaluates potential expenses or investments that are large in nature. These expenditures and investments include projects such as building a new plant or investing in a long-term venture. Often times, a prospective project's lifetime cash inflows and outflows are assessed in order to determine whether the potential returns generated meet a sufficient target benchmark, also known as "investment appraisal." Ideally, businesses should pursue all projects and opportunities that enhance shareholder value. However, because the amount of capital available at any given time for new projects is limited, management needs to use capital budgeting techniques to determine which projects will yield the most return over an applicable period of time. Various methods of capital budgeting can include throughput analysis, net present value (NPV), internal rate of return (IRR), discounted cash flow (DCF) and payback period. There are three popular methods for deciding which projects should receive investment funds over other projects. These methods are throughput analysis, DCF analysis and payback period analysis. Throughput Analysis Throughput is measured as the amount of material passing through a system. Throughput analysis is the most complicated form of capital budgeting analysis, but is also the most accurate in helping managers decide which projects to pursue. Under this method, the entire company is considered a single, profit-generating system. The analysis assumes that nearly all costs in the system are operating expenses, that a company needs to maximize the throughput of the entire system to pay for expenses, and that the way to maximize profits is to maximize the throughput passing through a bottleneck operation. A bottleneck is the resource in the system that requires the longest time in operations. This means that managers should always place higher consideration on capital budgeting projects that impact and increase throughput passing though the bottleneck. DCF Analysis DCF analysis is similar or the same to NPV analysis in that it looks at the initial cash outflow needed to fund a project, the mix of cash inflows in the form of revenue, and other future outflows in the form of maintenance and other costs. These costs, save for the initial outflow, are discounted back to the present date. The resulting number of the DCF analysis is the NPV. Projects with the highest NPV should be ranked over others, unless one or more are mutually exclusive. Payback Analysis Payback analysis is the most simple form of capital budgeting analysis and is therefore the least accurate. However, this method is still used because it's quick and can give managers a "back of the napkin" understanding of the efficacy of a project or group of projects. This analysis calculates how long it will take to recoup the investment of a project. The payback period is identified by dividing the initial investment by the average yearly cash inflow.

Inventory Carrying Costs

Carrying cost of inventory, or carry cost, is often described as a percentage of the inventory value. This percentage could include taxes, employee costs, depreciation, insurance, cost to keep items in storage, opportunity cost, cost of insuring and replacing items and the overall cost of capital for the company as a whole. Also referred to as carry cost of inventory, the carrying cost of inventory is the cost a business incurs over a certain period of time to hold and store its inventory. Businesses use this figure to determine how much profit can be made on current inventory. It also helps businesses find out if there is a need to produce more or less to keep up with expenses or maintain the same income stream. Total Cost of Ownership The way in which a company manages assets can tell a great deal about its future performance as well as management's efficiency. This is why analysts look at ratios such as return on assets (ROA) and inventory turnover. Inventory generally represents the largest portion of current assets. As such, the management of inventory flows can greatly influence the cost of carrying that inventory. Additionally, the cost of inventory can have a direct impact on the cost of capital and future cash flows. The cost of inventory includes all costs associated with holding or storing inventory for sale. These costs include the opportunity cost of the money used to purchase the inventory, the space in which the inventory is stored, the cost of transportation or handling, and the cost of deterioration and obsolescence. The opportunity cost of the money used depends on the source of funds used. The cost of funds obtained via internally generated activates is going to be lower than the cost of obtaining funds by issuing equity. The space used to store inventory includes expenses such as rent, depreciation, insurance and other charges associated with maintenance and operational controls such as security, workplace accidents and permits. The cost of obsolescence can be seen in the average amount of write-offs a company has. Perishable or trendy inventory may have a higher cost of obsolescence than non-perishable or staple items. Inventory Carrying Cost Example Inventory carrying cost is the cost of owning inventory and is generally expressed in percentage terms. For example, if a company has an inventory carrying cost of 10% and the average annual value of inventory is $1 million, the annual cost of inventory is $100,000. Inventory cost is generally between 20% and 30% of the cost to purchase inventory, but the average rate varies based on the industry and size of business. As such, analysts like to compare the rate against other companies in the same peer group and market capitalization.

Common Stock

Common stock is a security that represents ownership in a corporation. Holders of common stock exercise control by electing a board of directors and voting on corporate policy. Common stockholders are on the bottom of the priority ladder for ownership structure; in the event of liquidation, common shareholders have rights to a company's assets only after bondholders, preferred shareholders and other debtholders are paid in full. If a company goes bankrupt, the common stockholders do not receive their money until the creditors and preferred shareholders have received their respective share of the leftover assets. This makes common stock riskier than debt or preferred shares. The upside to common shares is they usually outperform bonds and preferred shares in the long run. Many companies issue all three types of securities. For example, Wells Fargo & Company has several bonds available on the secondary market. It also has preferred stock, such as its Series L (NYSE: WFC-L) and common stock (NYSE: WFC). The first ever common stock was established in 1602 by the Dutch East India Company and introduced on the Amsterdam Stock Exchange. In 2016, there are over 4,000 stocks traded on major exchanges and over 15,000 traded over the counter. Larger U.S.-based stocks are traded on a public exchange such as the New York Stock Exchange or NASDAQ. There are also several international exchanges for foreign stocks, such as the London Stock Exchange or the Japan Stock Exchange. Companies that are smaller in size and unable to meet an exchange's listing requirements are considered unlisted. These unlisted stocks are traded on the Over-The-Counter Bulletin Board (OTCBB) or pink sheets. For a company to issue stock, it must begin by having an initial public offering. An IPO is a great way for a company seeking additional capital to expand. To begin the IPO process, a company must work with an underwriting investment banking firm, which helps determine both the type and pricing of the stock. After the IPO phase is completed, the general public is allowed to purchase the new stock on the secondary market. Why Invest in Stocks? Stocks should be considered an important part of any investor's portfolio. They bear a greater amount of risk when compared to CDs, preferred stock and bonds. However, with the greater risk comes the greater potential for reward. Over the long term, stocks tend to outperform other investments but are more exposed to volatility over the short term. There are also several types of stocks. Growth stocks are companies that tend to increase in value due to growing earnings. Value stocks are companies lower in price in relation to their fundamentals. Value stocks offer a dividend unlike growth stocks. Stocks are categorized by market capitalization in either large, mid or small. Large-cap stocks are much more traded and are an indication of a more stable company. Small-cap stocks are newer companies looking to grow, so they are much more volatile compared to large caps.

Income Statement example

Revenue - COGS = Gross (Margin/Income/Profit) - Operating Expenses SG&A Insurance State/Local Taxes Utilities Rent = Operating Income + Interest Revenues - Int Exp - Loss on lawsuit +Gain on Sale from reinvestment = NET INCOME SG&A Selling = Advertising/Commission Administrative = Office Supplies/Equipment

Contribution Margin

Contribution margin is a cost accounting concept that allows a company to determine the profitability of individual products. The phrase "contribution margin" can also refer to a per unit measure of a product's gross operating margin calculated simply as the product's price minus its total variable costs. This metric allows an entity to evaluate different areas of business to determine which service or product line to emphasize based on the highest margin. Next Up Break-Even Analysis Variable Cost Ratio Cost-Volume Profit Analysis Margin BREAKING DOWN 'Contribution Margin' Contribution margin is calculated by reducing the sales price by the total variable costs - regardless if the cost is materials, labor or overhead. For example, Company XYZ sells an item for $100. The company incurs a unit variable direct material expense of $12, unit variable labor expense of $25, $10 of variable overhead per unit and $8 of fixed overhead per unit. The contribution margin of one unit is ($100 - $12 - $25 - $10) $53 because the fixed overhead per unit of $8 is not considered. Usefulness of Contribution Margin Contribution margin is used by management when making pricing decisions. This is especially true in special pricing or special order situations where fixed costs are sunk costs and should not be factored into the decision whether to accept or reject. Negative or low contribution margins indicate a product line or business segment may not be profitable. In addition, the contribution margin is helpful to analyze the impact of different levels of sales. Finally, a business can use contribution margin to resolve bottlenecks. If limited resources are available, a business wants to contribute that scarce resource towards the most profitable items. Therefore, constraints are eliminated by awarding the most profitable items the resources. Break-even or Target Income Analysis The contribution margin is an integral aspect when calculating the break-even point of sales or a target level of sales. The contribution margin determines the portion of each sale that is attributed to covering fixed costs. For this reason, fixed costs divided by the contribution margin results in the number of units needed to be sold to break-even. To find a target net income, the target amount is added to total fixed costs. Contribution Margin Ratio Contribution margin is directly related to the contribution margin ratio. The contribution margin ratio can be calculated on a per-unit basis or an aggregate basis. The per-unit basis divides the contribution margin per unit by the unit sale price, while the total contribution margin ratio divides the total contribution margin by the total revenue. The figure will result in a percentage that indicates what percentage of each dollar of revenue is generated to cover fixed costs. This metric is calculated by dividing the contribution margin by revenue.

DuPont (ROE/ROA/ROS)

DuPont analysis is a method of performance measurement that was started by the DuPont Corporation in the 1920s. With this method, assets are measured at their gross book value rather than at net book value to produce a higher return on equity (ROE). It is also known as DuPont identity. According to DuPont analysis, ROE is affected by three things: operating efficiency, which is measured by profit margin; asset use efficiency, which is measured by total asset turnover; and financial leverage, which is measured by the equity multiplier. Therefore, DuPont analysis is represented in mathematical form by the following calculation: ROE = Profit Margin x Asset Turnover Ratio x Equity Multiplier. DuPont Analysis Components DuPont analysis breaks ROE into its constituent components to determine which of these components is most responsible for changes in ROE. Net margin: Expressed as a percentage, net margin is the revenue that remains after subtracting all operating expenses, taxes, interest and preferred stock dividends from a company's total revenue. Asset turnover ratio: This ratio is an efficiency measurement used to determine how effectively a company uses its assets to generate revenue. The formula for calculating asset turnover ratio is total revenue divided by total assets. As a general rule, the higher the resulting number, the better the company is performing. Equity multiplier: This ratio measures financial leverage. By comparing total assets to total stockholders' equity, the equity multiplier indicates whether a company finances the purchase of assets primarily through debt or equity. The higher the equity multiplier, the more leveraged the company, or the more debt it has in relation to its total assets. DuPont analysis involves examining changes in these figures over time and matching them to corresponding changes in ROE. By doing so, analysts can determine whether operating efficiency, asset use efficiency or leverage is most responsible for ROE variations. Why Gross Book Value Is Used It is believed that measuring assets at gross book value removes the incentive to avoid investing in new assets. Using gross book value as opposed to net book value for assets results in a higher ROE, which can factor into a company's decision to purchase new assets. By contrast, new asset avoidance can occur as financial accounting depreciation methods artificially produce lower ROEs in the initial years that an asset is placed into service. If ROE is unsatisfactory, DuPont analysis helps locate the part of the business that is underperforming.

Balance Sheet example

For example, if a company takes out a five-year, $4,000 loan from a bank, its assets - specifically the cash account - will increase by $4,000; its liabilities - specifically the long-term debt account - will also increase by $4,000, balancing the two sides of the equation. If the company takes $8,000 from investors, its assets will increase by that amount, as will its shareholders' equity. All revenues the company generates in excess of its liabilities will go into the shareholders' equity account, representing the net assets held by the owners. These revenues will be balanced on the assets side, appearing as cash, investments, inventory, or some other asset.

Debt Cheaper Than Equity?

In this case, the "cost" being referred to is the measurable cost of obtaining capital. With debt, this is the interest expense a company pays on its debt. With equity, the cost of capital refers to the claim on earnings which must be afforded to shareholders for their ownership stake in the business. For example, if you run a small business and need $40,000 of financing, you can either take out a $40,000 bank loan at a 10% interest rate or you can sell a 25% stake in your business to your neighbor for $40,000. Suppose your business earns $20,000 profits during the next year. If you took the bank loan, your interest expense (cost of debt financing) would be $4,000, leaving you with $16,000 in profit. Conversely, had you used equity financing, you would have zero debt (and thus no interest expense), but would keep only 75% of your profit (the other 25% being owned by your neighbor). Thus, your personal profit would only be $15,000 (75% x $20,000). From this example, you can see how it is less expensive for you, as the original shareholder of your company, to issue debt as opposed to equity. Taxes make the situation even better if you had debt, since interest expense is deducted from earnings before income taxes are levied, thus acting as a tax shield (although we have ignored taxes in this example for the sake of simplicity). Of course, the advantage of the fixed-interest nature of debt can also be a disadvantage, as it presents a fixed expense, thus increasing a company's risk. Going back to our example, suppose your company only earned $5,000 during the next year. With debt financing, you would still have the same $4,000 of interest to pay, so you would be left with only $1,000 of profit ($5,000 - $4,000). With equity, you again have no interest expense, but only keep 75% of your profits, thus leaving you with $3,750 of profits (75% x $5,000). So, as you can see, provided a company is expected to perform well, debt financing can usually be obtained at a lower effective cost. However, if a company fails to generate enough cash, the fixed-cost nature of debt can prove too burdensome. This basic idea represents the risk associated with debt financing. Companies are never 100% certain what their earnings will amount to in the future (although they can make reasonable estimates), and the more uncertain their future earnings, the more risk presented. Thus, companies in very stable industries with consistent cash flows generally make heavier use of debt than companies in risky industries or companies who are very small and just beginning operations. New businesses with high uncertainty may have a difficult time obtaining debt financing, and thus finance their operations largely through equity.

IRR

Internal rate of return (IRR) is a metric used in capital budgeting measuring the profitability of potential investments. Internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. IRR calculations rely on the same formula as NPV does. The following is the formula for calculating NPV: where: Ct = net cash inflow during the period t Co= total initial investment costs r = discount rate, and t = number of time periods To calculate IRR using the formula, one would set NPV equal to zero and solve for the discount rate r, which is here the IRR. Because of the nature of the formula, however, IRR cannot be calculated analytically, and must instead be calculated either through trial-and-error or using software programmed to calculate IRR. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. IRR is uniform for investments of varying types and, as such, IRR can be used to rank multiple prospective projects a firm is considering on a relatively even basis. Assuming the costs of investment are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first. IRR is sometimes referred to as "economic rate of return" (ERR). You can think of IRR as the rate of growth a project is expected to generate. While the actual rate of return that a given project ends up generating will often differ from its estimated IRR rate, a project with a substantially higher IRR value than other available options would still provide a much better chance of strong growth. One popular use of IRR is in comparing the profitability of establishing new operations with that of expanding old ones. For example, an energy company may use IRR in deciding whether to open a new power plant or to renovate and expand a previously existing one. While both projects are likely to add value to the company, it is likely that one will be the more logical decision as prescribed by IRR. In theory, any project with an IRR greater than its cost of capital is a profitable one, and thus it is in a company's interest to undertake such projects. In planning investment projects, firms will often establish a required rate of return (RRR) to determine the minimum acceptable return percentage that the investment in question must earn in order to be worthwhile. Any project with an IRR that exceeds the RRR will likely be deemed a profitable one, although companies will not necessarily pursue a project on this basis alone. Rather, they will likely pursue projects with the highest difference between IRR and RRR, as chances are these will be the most profitable. IRRs can also be compared against prevailing rates of return in the securities market. If a firm can't find any projects with IRRs greater than the returns that can be generated in the financial markets, it may simply choose to invest its retained earnings into the market. Although IRR is an appealing metric to many, it should always be used in conjunction with NPV for a clearer picture of the value represented by a potential project a firm may undertake. Issues with 'Internal Rate of Return (IRR)' While IRR is a very popular metric in estimating a project's profitability, it can be misleading if used alone. Depending on the initial investment costs, a project may have a low IRR but a high NPV, meaning that while the pace at which the company sees returns on that project may be slow, the project may also be adding a great deal of overall value to the company. A similar issue arises when using IRR to compare projects of different lengths. For example, a project of a short duration may have a high IRR, making it appear to be an excellent investment, but may also have a low NPV. Conversely, a longer project may have a low IRR, earning returns slowly and steadily, but may add a large amount of value to the company over time. Another issue with IRR is not one strictly inherent to the metric itself, but rather to a common misuse of IRR. People may assume that, when positive cash flows are generated during the course of a project (not at the end), the money will be reinvested at the project's rate of return. This can rarely be the case. Rather, when positive cash flows are reinvested, it will be at a rate that more resembles the cost of capital. Miscalculating using IRR in this way may lead to the belief that a project is more profitable than it actually is in reality. This, along with the fact that long projects with fluctuating cash flows may have multiple distinct IRR values, has prompted the use of another metric called modified internal rate of return (MIRR). MIRR adjusts the IRR to correct these issues, incorporating cost of capital as the rate at which cash flows are reinvested, and existing as a single value. Because of MIRR's correction of the former issue of IRR, a project's MIRR will often be significantly lower than the same project's IRR

Liabiltiies (current)

Liabilities are the money that a company owes to outside parties, from bills it has to pay to suppliers to interest on bonds it has issued to creditors to rent, utilities and salaries. Current liabilities are those that are due within one year and are listed in order of their due date. Long-term liabilities are due at any point after one year. Current liabilities accounts might include: Current portion of long-term debt Bank indebtedness Interest payable Rent, tax, utilities Wages payable Customer prepayments Dividends payable and others Long-term liabilities can include:

Dividends

NOT INCLUDED ON INCOME STATEMENT. NOT EXPENSES

NPV

Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of a projected investment or project. A positive net present value indicates that the projected earnings generated by a project or investment (in present dollars) exceeds the anticipated costs (also in present dollars). Generally, an investment with a positive NPV will be a profitable one and one with a negative NPV will result in a net loss. This concept is the basis for the Net Present Value Rule, which dictates that the only investments that should be made are those with positive NPV values. When the investment in question is an acquisition or a merger, one might also use the Discounted Cash Flow (DCF) metric.

Net Income

Net income (NI) is a company's total earnings (or profit); net income is calculated by taking revenues and subtracting the costs of doing business such as depreciation, interest, taxes and other expenses. This number appears on a company's income statement and is an important measure of how profitable the company is over a period of time. Net income also refers to an individual's income after taking taxes and deductions into account. Businesses use net income to calculate their earnings per share (EPS). Business analysts often refer to net income to as the bottom line, since it is listed at the bottom of the income statement. In the United Kingdom, NI is known as profit attributable to shareholders. Gross Income Versus Net Income Gross income refers to an individual's total earnings or pre-tax earnings, and net income refers to the difference after deductions, credits and taxes are factored into gross income. To calculate taxable income, taxpayers subtract deductions and credits from gross income, and the Internal Revenue Service (IRS) bases income tax on this figure. The difference between taxable income and income tax is an individual's net income. For example, imagine someone has $60,000 in gross income, and he qualifies for $10,000 in deductions. His taxable income is $50,000, and he has an effective tax rate of 15%, making his income tax payment $7,500 and his net income $42,500. Net Income on Tax Returns In the United States, individual taxpayers submit some version of Form 1040 to the IRS to report their annual earnings. This form does not have a line for net income. Instead, it has lines to record gross income, adjusted gross income (AGI) and taxable income. After noting their gross income, taxpayers subtract certain income sources such as Social Security benefits and qualifying deductions such as student loan interest. The difference is their AGI. Taxpayers then subtract standard or itemized deductions from their AGI to determine their taxable income. As indicated above, the difference between taxable income and income tax is the individual's net income, but this number is not noted on individual tax forms. Net Income on Paycheck Stubs Most paycheck stubs have a line devoted to net income. This is the amount that appears on an employee's check. It consists of his gross income, minus taxes and retirement account contributions. Calculating Net Income for Businesses To calculate net income for a business, start with a company's total revenue. From this figure, subtract the businesses expenses and operating costs to calculate the business's earnings before tax. Deduct tax from this amount to find the business's net income. Net income, like other accounting measures, is susceptible to manipulation through such things as aggressive revenue recognition or by hiding expenses. When basing an investment decision on net income numbers, review the quality of the numbers that were used to arrive at the business's taxable income as well as its net income.

Income Statement 4

Operating Income: Deducting SG&A from a company's gross profit produces operating income. This figure represents a company's earnings from its normal operations before any so-called non-operating income and/or costs such as interest expense, taxes and special items. Income at the operating level, which is viewed as more reliable, is often used by financial analysts rather than net income as a measure of profitability. Interest Expense: This item reflects the costs of a company's borrowings. Sometimes companies record a net figure here for interest expense and interest income from invested funds. Pretax Income: Another carefully watched indicator of profitability, earnings garnered before the income tax expense is an important bullet in the income statement. Numerous and diverse techniques are available to companies to avoid and/or minimize taxes that affect their reported income. Because these actions are not part of a company's business operations, analysts may choose to use pretax income as a more accurate measure of corporate profitability. Income Taxes: As stated, the income tax amount has not actually been paid—it is an estimate, or an account that has been created to cover what a company expects to pay. Special Items or Extraordinary Expenses: A variety of events can occasion charges against income. They are commonly identified as restructuring charges, unusual or nonrecurring items and discontinued operations. These write-offs are supposed to be one-time events. Investors need to take these special items into account when making inter-annual profit comparisons because they can distort evaluations. Net Income (a.k.a. net profit or net earnings): This is the bottom line, which is the most commonly used indicator of a company's profitability. Of course, if expenses exceed income, this account caption will read as a net loss. After the payment of preferred dividends, if any, net income becomes part of a company's equity position as retained earnings. Supplemental data is also presented for net income on the basis of shares outstanding (basic) and the potential conversion of stock options, warrants etc. (diluted). (To read more, see Evaluating Retained Earnings: What Gets Kept Counts and Everything You Need To Know About Earnings.)

Operating Cash Flow

Operating cash flow is a measure of the amount of cash generated by a company's normal business operations. Operating cash flow indicates whether a company is able to generate sufficient positive cash flow to maintain and grow its operations, or it may require external financing for capital expansion. Generally accepted accounting principles (GAAP) require public companies to calculate operating cash flow using an indirect method by adjusting net income to cash basis using changes in non-cash accounts, such as depreciation, accounts receivable and changes in inventory. Operating cash flow represents the cash version of a company's net income. Because Generally Accepted Accounting Principles (GAAP) requires the net income to be reported using an accrual basis, it includes various non-cash items, such as stock-based compensation, amortization and expenses that were incurred but not paid for. Also, net income must be adjusted for any changes in working capital accounts on a company's balance sheet. In particular, increases in accounts receivables represent revenues booked for which cash has not been collected yet, and such increases must be subtracted from the net income. However, reported increases in accounts payable represent expenses accrued, but not paid for, resulting in addition to the net income. Operating cash flows concentrate on cash inflows and outflows related to a company's main business activities, such as selling and purchasing inventory, providing services and paying salaries. Any investing and financing transactions are excluded from operating cash flows and reported separately, such as borrowing, buying capital equipment and making dividend payments. Operating cash flow can be found on a company's statement of cash flows, which is broken down into cash flows from operations, investing and financing. Example of Operating Cash Flow Calculation Consider a manufacturing company that reports a net income of $100 million, while its operating cash flow is $150 million. The difference comes from adding to the net income depreciation expense of $150 million, subtracting increases in accounts receivable of $50 million, adding decreases in inventory of $50 million and subtracting decreases in accounts payable of $100 million.

Fixed Asset Turnover Ratio

Property, plant and equipment (PP&E), or fixed assets, is another of the "big" numbers in a company's balance sheet. In fact, it often represents the single largest component of a company's total assets. Readers should note that the term fixed assets is the financial professional's shorthand for PP&E, although investment literature sometimes refers to a company's total non-current assets as its fixed assets. A company's investment in fixed assets is dependent, to a large degree, on its line of business. Some businesses are more capital intensive than others. Natural resource and large capital equipment producers require a large amount of fixed-asset investment. Service companies and computer software producers need a relatively small amount of fixed assets. Mainstream manufacturers generally have around 30-40% of their assets in PP&E. Accordingly, fixed asset turnover ratios will vary among different industries. The fixed asset turnover ratio is calculated as: FATR.gif Average fixed assets can be calculated by dividing the year-end PP&E of two fiscal periods (ex. 2004 and 2005 PP&E divided by two). This fixed asset turnover ratio indicator, looked at over time and compared to that of competitors, gives the investor an idea of how effectively a company's management is using this large and important asset. It is a rough measure of the productivity of a company's fixed assets with respect to generating sales. The higher the number of times PP&E turns over, the better. Obviously, investors should look for consistency or increasing fixed asset turnover rates as positive balance sheet investment qualities.

Retained Earnings

Retained earnings refer to the percentage of net earnings not paid out as dividends, but retained by the company to be reinvested in its core business, or to pay debt. It is recorded under shareholders' equity on the balance sheet. The formula calculates retained earnings by adding net income to, or subtracting any net losses from, beginning retained earnings, and subtracting any dividends paid to shareholders. In most cases, companies retain earnings in order to invest them into areas where the company can create growth opportunities, such as buying new machinery or spending the money on more research and development. Should a net loss be greater than beginning retained earnings, the retained earnings can become negative, creating a deficit. The retained earnings general ledger account is adjusted every time a journal entry is made to a revenue or expense account. Retained Earnings Retained earnings are reported at the end of an accounting period as the accumulated amount of a company's prior earnings, net of dividends. They can show a positive earnings accumulation or can turn negative and have a deficit if a current period's net loss exceeds the period's beginning retained earnings. Even though changes in retained earnings during each accounting period are not explicitly reported, they can be inferred by comparing the amounts of beginning and ending retained earnings of the period. An increase or decrease in accumulated retained earnings during an accounting period is the direct result of the amounts of net income or loss and dividend payouts for that period. Net Income Net income or loss adds to retained earnings by way of recording certain closing entries in accounting. The accounts to record net income, revenues and expenses are periodic and temporary accounts used repeatedly during each accounting period. Their balances must be closed at period end, allowing the accounts to be reused in the next period. Revenues and expenses are closed to an account called income summary, which displays the amount of net income or loss. They are subsequently closed to retained earnings, with net income increasing earnings, and loss decreasing them. Thus, the effect of net income on retained earnings derives from the integral effects of revenues and expenses on retained earnings. Dividends Dividends can be in cash or stock, and both forms of dividends reduce retained earnings. Cash dividends are paid out from a company's earnings or net income, and the more dividends distributed, the less earnings retained. The dividend account is also a temporary account because dividend payments are a periodic recurrence, and are closed to retained earnings at period end, effectively reducing retained earnings. Companies may issue additional shares of its stock as dividends, increasing the amounts of both common-stock and additional-paid-in-capital accounts in the balance sheet. To keep the balance sheet balanced, the account of retained earnings is decreased by the same amounts.

ROE

Return on equity (ROE) is the amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. ROE is expressed as a percentage and calculated as: Return on Equity = Net Income/Shareholder's Equity Net income is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Shareholder's equity does not include preferred shares. The ROE is useful for comparing the profitability of a company to that of other firms in the same industry. There are several variations on the formula that investors may use: 1. Investors wishing to see the return on common equity may modify the formula above by subtracting preferred dividends from net income and subtracting preferred equity from shareholders' equity, giving the following: return on common equity (ROCE) = net income - preferred dividends / common equity. 2. Return on equity may also be calculated by dividing net income by average shareholders' equity. Average shareholders' equity is calculated by adding the shareholders' equity at the beginning of a period to the shareholders' equity at period's end and dividing the result by two. 3. Investors may also calculate the change in ROE for a period by first using the shareholders' equity figure from the beginning of a period as a denominator to determine the beginning ROE. Then, the end-of-period shareholders' equity can be used as the denominator to determine the ending ROE. Calculating both beginning and ending ROEs allows an investor to determine the change in profitability over the period.

ROS

Return on sales (ROS) is a ratio used to evaluate a company's operational efficiency; ROS is also known as a firm's operating profit margin. This measure provides insight into how much profit is being produced per dollar of sales. An increasing ROS indicates that a company is growing more efficient, while a decreasing ROS could signal looming financial troubles. ROS is a financial ratio that calculates how efficiently a company is generating profits from its top-line revenue. It measures the performance of a company by analyzing the percentage of total revenue that is converted into operating profits. Investors, creditors and other debt holders rely on this efficiency ratio because it accurately communicates the percentage of operating cash a company actually makes on its revenue and can provide insight into potential dividends, reinvestment potential and the company's ability to repay debt. ROS is used to compare current period calculations with calculations from previous periods. This allows a company to conduct trend analysis and compare internal efficiency performance over time. ROS is also used by comparing a company's percentage with the percentage of a competing company, regardless of scale. This makes it easier to assess the performance of a small company in relation to a Fortune 500 company. However, ROS varies widely depending on industry and should only be used to compare companies within the same vertical. A grocery chain, for example, has lower margins and therefore a lower ROS compared to a technology company. Calculating ROS The ROS calculation is taken as a company's operating profit in a specific period divided by net sales for that same period. The equation for ROS is as follows: ROS = (Operating Profit) / (Net Sales). The calculation shows how effectively a company is producing its core products and services and how its management team is running the business. Therefore, ROS is used as an indicator of both efficiency and profitability. For example, a company that generates $100,000 in sales and requires $90,000 in total costs to generate its revenue is less efficient than a company that generates $50,000 in sales but only requires $30,000 in total costs. ROS is larger if a company's management team is better cutting costs and increasing revenue. Using the same example, the company with $50,000 in sales and $30,000 in costs has a operating profit of $20,000 and a ROS of 40%, calculated by dividing $20,000 by $50,000. If the company's management team wants to increase efficiency, it can focus on increasing sales while incrementally increasing expenses, or it can focus on decreasing expenses while maintaining or increasing revenue.

Equity

Shareholders' equity is the money attributable to a business' owners, meaning its shareholders. It is also known as "net assets," since it is equivalent to the total assets of a company minus its liabilities, that is, the debt it owes to non-shareholders. Retained earnings are the net earnings a company either reinvests in the business or uses to pay off debt; the rest is distributed to shareholders in the form of dividends. Treasury stock is the stock a company has either repurchased or never issued in the first place. It can be sold at a later date to raise cash or reserved to repel a hostile takeover. Some companies issue preferred stock, which will be listed separately from common stock under shareholders' equity. Preferred stock is assigned an arbitrary par value—as is common stock, in some cases—that has no bearing on the market value of the shares (often, par value is just $0.01). The "common stock" and "preferred stock" accounts are calculated by multiplying the par value by the number of shares issued. Additional paid-in capital or capital surplus represents the amount shareholders have invested in excess of the "common stock" or "preferred stock" accounts, which are based on par value rather than market price. Shareholders' equity is not directly related to a company's market capitalization: the latter is based on the current price of a stock, while paid-in capital is the sum of the equity that has been purchased at any price.

Cash Conversion Cycle

The Cash Conversion Cycle (CCC) The cash conversion cycle is a key indicator of the adequacy of a company's working capital position. In addition, the CCC is equally important as the measurement of a company's ability to efficiently manage two of its most important assets - accounts receivable and inventory. Calculated in days, the CCC reflects the time required to collect on sales and the time it takes to turn over inventory. The shorter this cycle is, the better. Cash is king, and smart managers know that fast-moving working capital is more profitable than tying up unproductive working capital in assets. CCC = DIO + DSO - DPO DIO - Days Inventory Outstanding DSO - Days Sales Outstanding DPO - Days Payable Outstanding There is no single optimal metric for the CCC, which is also referred to as a company's operating cycle. As a rule, a company's cash conversion cycle will be influenced heavily by the type of product or service it provides and industry characteristics. Investors looking for investment quality in this area of a company's balance sheet need to track the CCC over an extended period of time (for example, five to 10 years), and compare its performance to that of competitors. Consistency and/or decreases in the operating cycle are positive signals. Conversely, erratic collection times and/or an increase in inventory on hand are generally not positive investment-quality indicators.

Capital Structure

The capital structure is how a firm finances its overall operations and growth by using different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure. A firm's capital structure can be a mixture of long-term debt, short-term debt, common equity and preferred equity. A company's proportion of short- and long-term debt is considered when analyzing capital structure. When analysts refer to capital structure, they are most likely referring to a firm's debt-to-equity (D/E) ratio, which provides insight into how risky a company is. Usually, a company that is heavily financed by debt has a more aggressive capital structure and therefore poses greater risk to investors. This risk, however, may be the primary source of the firm's growth. Debt vs. Equity Debt is one of the two main ways companies can raise capital in the capital markets. Companies like to issue debt because of the tax advantages. Interest payments are tax-deductible. Debt also allows a company or business to retain ownership, unlike equity. Additionally, in times of low interest rates, debt is abundant and easy to access. Equity is more expensive than debt, especially when interest rates are low. However, unlike debt, equity does not need to be paid back if earnings decline. On the other hand, equity represents a claim on the future earnings of the company as a part owner. Debt-to-Equity Ratio as a Measure of Capital Structure Both debt and equity can be found on the balance sheet. The assets listed on the balance sheet are purchased with this debt and equity. Companies that use more debt than equity to finance assets have a high leverage ratio and an aggressive capital structure. A company that pays for assets with more equity than debt has a low leverage ratio and a conservative capital structure. That said, a high leverage ratio and/or an aggressive capital structure can also lead to higher growth rates, whereas a conservative capital structure can lead to lower growth rates. It is the goal of company management to find the optimal mix of debt and equity, also referred to as the optimal capital structure. Analysts use the D/E ratio to compare capital structure. It is calculated by dividing debt by equity. Savvy companies have learned to incorporate both debt and equity into their corporate strategies. At times, however, companies may rely too heavily on external funding, and debt in particular. Investors can monitor a firm's capital structure by tracking the D/E ratio and comparing it against the company's peers.

Income Statement continued

Unlike the balance sheet, which covers one moment in time, the income statement provides performance information about a time period. It begins with sales and works down to net income and earnings per share (EPS). The income statement is divided into two parts: operating and non-operating. The operating portion of the income statement discloses information about revenues and expenses that are a direct result of regular business operations. For example, if a business creates sports equipment, it should make money through the sale and/or production of sports equipment. The non-operating section discloses revenue and expense information about activities that are not directly tied to a company's regular operations. Continuing with the same example, if the sports company sells real estate and investment securities, the gain from the sale is listed in the non-operating items section.

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, as 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. The method for calculating WACC can be expressed in the following formula: Weighted Average Cost Of Capital (WACC) Where: Re = cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V = E + D = total market value of the firm's financing (equity and debt) E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate

PPE

What is 'Property, Plant And Equipment - PP&E' Property, plant and equipment (PP&E) is a company asset that is vital to business operations but cannot be easily liquidated, and depending on the nature of a company's business, the total value of PP&E can range from very low to extremely high compared to total assets. International accounting standard 16 deals with the accounting treatment of PP&E. It is listed separately in most financial statements because it is treated differently in accounting statements, and improvements, replacements and betterments can pose accounting issues depending on how the costs are recorded. Next Up Fixed Asset Long-Term Assets Business Asset Replacement Cost BREAKING DOWN 'Property, Plant And Equipment - PP&E' PP&E is also called tangible fixed assets. These assets are physical, tangible assets and they are expected to generate economic benefits for a company for a period of longer than one year. Examples of PP&E include land, buildings and vehicles. Industries or businesses that require a large amount of fixed assets are described as capital intensive. Financial Statement Record PP&E is recorded in a company's financial statements in the balance sheet. The cost of PP&E considers the actual cost of purchasing and bringing the asset to its intended use. This cost is called the historical cost. For example, when purchasing a building for a company to run its retail operations, the historical cost could include the purchase price, transaction fees and any improvements made to the building to bring it to its destined use. The value of PP&E is adjusted routinely as fixed assets generally see a decline in value due to use and depreciation. Amortization is used to devalue these assets as they are used, but land is not amortized because it can increase in value. Instead, it is represented at current market value. The balance of the PP&E account is remeasured every reporting period, and, after accounting for historical cost and amortization, is called the book value. This figure is reported on the balance sheet. Significance While PP&E is generally meant to be held and used by the company in the course of its business, it is considered an asset because a company could sell its property, plant or equipment, either because it is no longer of use or if the company runs into financial difficulties. Of course, selling property, plant and equipment that is necessary to a company's course of business could be drastic and could signal that a company is in financial trouble. It is important to note, that whatever the reason a company has in selling some of its property, plant or equipment, it is unlikely that a company will make a profit on the sale of the asset.

Assets (Current Assets)

Within the assets segment, accounts are listed from top to bottom in order of their liquidity, that is, the ease with which they can be converted into cash. They are divided into current assets, those which can be converted to cash in one year or less; and non-current or long-term assets, which cannot. Here is the general order of accounts within current assets: Cash and cash equivalents: the most liquid assets, these can include Treasury bills and short-term certificates of deposit, as well as hard currency Marketable securities: equity and debt securities for which there is a liquid market Accounts receivable: money which customers owe the company, perhaps including an allowance for doubtful accounts (an example of a contra account), since a certain proportion of customers can be expected not to pay Inventory: goods available for sale, valued at the lower of the cost or market price Prepaid expenses: representing value that has already been paid for, such as insurance, advertising contracts or rent

Working Capital or NWC

Working capital is a measure of both a company's efficiency and its short-term financial health. Working capital is calculated as: Working Capital = Current Assets - Current Liabilities The working capital ratio (Current Assets/Current Liabilities) indicates whether a company has enough short term assets to cover its short term debt. Anything below 1 indicates negative W/C (working capital). While anything over 2 means that the company is not investing excess assets. Most believe that a ratio between 1.2 and 2.0 is sufficient. Also known as "net working capital". If a company's current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy. A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis. For example, it could be that the company's sales volumes are decreasing and, as a result, its accounts receivables number continues to get smaller and smaller.Working capital also gives investors an idea of the company's underlying operational efficiency. Money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company's obligations. So, if a company is not operating in the most efficient manner (slow collection), it will show up as an increase in the working capital. This can be seen by comparing the working capital from one period to another; slow collection may signal an underlying problem in the company's operations. Things to Remember If the ratio is less than one then they have negative working capital. A high working capital ratio isn't always a good thing, it could indicate that they have too much inventory or they are not investing their excess cash

A company has cash sales of $900,000 during its fiscal year. Which section of the statement of cash flows will this appear?

a) operating b) investing c) financing d) current asset section OPERATING


Ensembles d'études connexes

Chapter 1 and 2 terms H US history

View Set

quotes - speaker , act , who is being spoken to

View Set

Chapter 7 Cellular Respiration and Fermentation

View Set

Ch 48 Management of Patients with Kidney Disorders

View Set

Holes Anatomy ch 10 Senses Assesment

View Set