Accounting Rate of Return (ARR)

Accounting Rate of Return (ARR) reflects the percentage rate of return expected on an investment, or asset, compared to the initial investment cost.

ARR is considered one of the best ways to calculate potential profitability of an investment, and can help you decide which capital assets or long-term projects to invest in.

ARR = average annual profit / average investment

Accounts Receivable (AR)

Accounts Receivable (AR) is the amount owed to a company resulting from the company providing goods and/or services on credit.

In other words, AR is any money customers owe your business, due to goods or services delivered but not yet paid for

On the balance sheet, AR is treated as an Assets, under ‘Current Assets’

Accounts Payable (AP)

Accounts Payable (AP) represents a company’s short-term debt to its creditors or suppliers. In other words, AP is any money your business owe.

On the balance sheet, AP is treated as a Liability, under ‘Current Liabilities’

 

Balance Sheet

A Balance Sheet is a financial statement that represents a company’s assets, liabilities and equity at a specific point in time. It provides a basis for computing rates of return and evaluating capital structure. In addition, it provides a snapshot of what a company owns and owes, as well as the amount invested by shareholders.

Assets = Liabilities + Shareholders’ Equity

 

Burn Rate

Burn Rate refers to the rate at which a company depletes its cash reserves. In other words; the rate at which a company is losing money. It is often referred to as either gross or net burn rates.

Net Burn Rate = Operating Cash Flow / Net Burn Period

Gross Burn Rate = Cash / Monthly Operating Expenses

 

Compound Annual Growth Rate (CAGR)

Compound annual growth rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer than one year.

This is the rate of return that would be required for an investment to grow from its beginning balance to its ending balance, assuming the profits were reinvested at the end of each year of the investment’s life span.

Capital Expenditures (CapEx)

Capital Expenditures (CapEx) are funds used by a company to acquire, upgrade, and maintain long-term physical assets (e.g. property, plants, buildings, technology, or equipment).

Cash and Cash Equivalents (CCE)

Cash and Cash Equivalents (CCE) refers to the line item on the balance sheet that reports the value of a company’s assets that are cash or can be converted into cash immediately.

Cash equivalents include bank accounts and marketable securities, which are debt securities with maturities of less than 90 days. However, oftentimes cash equivalents do not include equity or stock holdings because they can fluctuate in value.

Cash Flow Statement (CFS)

The Cash Flow Statement (CFS) is a financial statement that summarises the amount of cash and cash equivalents entering and leaving a company. The main components are cash from operating activities, cash from investing activities, and cash from financing activities.

The CFS measures how well a company manages its cash position, meaning how well the company generates cash to pay its debt obligations and fund its operating expenses.

Cost of Goods Sold (COGS)

Cost of goods sold (COGS) refers to the direct costs of producing the goods sold by a company. This amount includes the cost of the materials and labor directly used to create the goods. It excludes indirect expenses, such as distribution costs and sales force costs.

Cost of Goods Sold = Starting inventory + purchases – ending inventory

 

Customer Acquisition Cost (CAC)

Customer Acquisition Cost (CAC) refers to the resources and costs incurred to acquire an additional customer. Customer Acquisition Cost is a key business metric that is commonly used alongside Customer Lifetime Value (LTV), to measure value generated by a new customer.

CAC = Cost of Sales + Cost of Marketing / New Customers Acquired

 

Customer Lifetime Value (LTV)

Customer Lifetime Value (LTV) is the total revenue a company expects to earn over the lifetime of their relationship with a single customer.

CLV = Customer revenue per year * Duration of the relationship in years – Total costs of acquiring and serving the customer

Days Payable Outstanding (DPO)

Days Payable Outstanding (DPO) is the average time, in days, that a company takes to pay its trade creditors, which may include suppliers, vendors, or financiers.

A high DPO indicates that a company takes longer to pay its creditors. Typically, this is preferable, This means that it can retain available funds for a longer duration, allowing the company an opportunity to utilise those funds in a better way to maximise the benefits. On the other hand, it can also mean that the company is struggling to meet its obligations.

It can be beneficial to compare a company’s DPO to the average DPO within its industry. A higher or lower than average DPO may indicate a few different things, depending on the industry context.

DPO = Accounts Payable / Number of Days * Cost of Goods Sold

Days Sales Outstanding (DSO)

Days Sales Outstanding (DSO) is a measure of the average number of days that it takes a company to collect payment for a sale.

The DSO formula is as follows: Divide the total number of accounts receivable during a given period by the total value of credit sales during the same period and multiply the result by the number of days in the period being measured.

DSO = Accounts Receivable / Revenue (Total Value of Credit Sales) * Number of Days

 

Depreciation & Amortisation (D&A)

Amortisation is an accounting technique used to periodically lower the book value of a loan or intangible asset over a set period of time. In relation to a loan, amortisation means spreading out loan payments over time.

In relation to an intangible asset, amortisation is similar to depreciation, and means spreading out capital expenses over a specific time period – usually over the asset’s useful life – for accounting and tax purposes.

Depreciation is an accounting method of allocating the cost of a tangible or physical asset over its useful life or life expectancy. Depreciation represents how much the assets’ value has been reduced, due to ‘wear and tear’.

Depreciating assets helps companies earn revenue from an asset while expensing a portion of its cost each year the asset is in use.

Discount Rate

The Discount Rate has two different definitions and usages. First, the discount rate refers to the interest rate charged to the commercial banks and other financial institutions for the loans they take from the bank through the discount window loan process.

Second, the discount rate refers to the interest rate used in Discounted Cash Flow (DCF) analysis to determine the present value of future cash flows.

Discount Period

The discounted payback period is a capital budgeting procedure used to determine the profitability of a project. A discounted payback period gives the number of years it takes to break even from undertaking the initial expenditure, by discounting future cash flows and recognising the time value of money. The metric is used to evaluate the feasibility and profitability of a given project.

Discounted Cash flows (DCF)

Discounted Cash Flow (DCF) is a valuation method used to estimate the value of an investment based on its expected future cash flows. DCF analysis attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future.

Earnings Before Interest and Taxes (EBIT)

Earnings Before Interest and Taxes (EBIT) is an indicator of a company’s profitability and operating performance.

EBIT is also referred to as operating earnings, operating profit, and profit before interest and taxes.

EBIT = revenues – operating expenses + non-operating income

 

Earnings Before Interest After Taxes (EBIAT)

Earnings Before Interest After Taxes (EBIAT) is an indicator of a company’s profitability and operating performance, while also taking taxes into account.

When calculating EBIAT, capital structure (the combination of debt and stock issues that is reflected in debt to equity) is omitted.

EBIAT is primarily used as a way of understanding how much cash a company has available to pay its creditors, in the event of a liquidation.

EBIAT equals after-tax EBIT

EBIAT = EBIT * (1 – Tax Rate)

 

Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)

Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is the most used measure of a company’s profitability / overall financial performance. This calculation excludes the cost of capital investments (such as property, plants and equipment) and expenses associated with debt.

EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization

or

EBITDA = Operating Profit + Depreciation + Amortization

 

Enterprise Value (EV)

Enterprise Value (EV) is a measure of a company’s total value, and can also be viewed as the estimated cost of purchasing a company. EV is considered a more comprehensive alternative to Equity Value, as it also takes market value into account.

Enterprise Value = Equity Value + Total Debt – Cash and Cash Equivalents

Equity Value

Equity Value, also known as Market Capitalisation, is the value of the company’s shares and loans that the shareholders have made available to the business, after any debts have been paid off.

Once the total equity value is determined, it can be further separated into the value of shareholders’ loans and shares outstanding (common and/or preferred).

Equity Value = Share Price * Number of Shares Outstanding

or

Equity Value = Enterprise Value – Debt and Debt Equivalents – Non-Controlling Interest – Preferred Stock + Cash and Cash Equivalents 

For further explanation and formulas, click here.

Exit Multiple

Exit Multiple is one of the methods for calculating the Terminal Value (TV), using a Discounted Cash Flow formula to value a business. The method assumes that the value of a business can be determined at the end of a projected period, based on the existing public market valuations of comparable companies.

Exit multiples estimate a fair price by multiplying financial metrics, such as sales, profits, or EBITDA by a factor that is common for similar firms that were recently acquired. The most commonly used multiples are EV/EBITDA and EV/EBIT.

A good exit multiple would be at minimum one that reaches your target return as marketed to your investors.

Free Cash Flows (FCF)

Free Cash Flow (FCF) reflects the amount of cash left after having paid for everything the company needs to continue operating (including buildings, equipment, payroll, taxes and inventory). The company is free to use these funds as it sees fit.

Unlike earnings or net income, FCF is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets as well as changes in working capital from the balance sheet.

FCF is a key indicator of a company’s financial health and desirability to investors.

FCF = Cash from Operations – Capital Expenditures

 

Gross Profit

Gross Profit is the profit a company makes after deducting the costs associated with making and selling its products, or the costs associated with providing its services. Gross profit will appear on a company’s Income Statement

Gross Profit = Revenue – Cost of Goods Sold (COGS)

 

Gross Profit Margin

Gross Profit Margin is a measure of the proportion of revenue left after accounting for production costs.  It is the percentage of revenue that exceeds the COGS

Gross Profit Margin = ( Revenue – Cost of Goods Sold (COGS) / Revenue ) * 100

Income Statement

An income statement is one of the three (together with balance sheet and cash flow statement) main financial statements used for reporting a company’s financial performance over a specific accounting period.

The income statement shows the company’s income and expenditures, and reflects whether a company is making profit or loss.

Interest Expenses

Interest Expense are the cost related to borrowing money. This is a non-operating expense shown on the income statement, and represents interest payable on any borrowings – bonds, loans, convertible debt or lines of credit.

Interest Expense = Principal Amount (Total Borrowed Amount) * Interest Rate * Time Period

 

Inventory

Inventory is the goods and materials owned by a company at a particular time, including parts, products being made, and finished product – with the ultimate goals of selling it.

It represents one of the most important assets of a business because the turnover of inventory represents one of the primary sources of revenue generation and subsequent earnings for the company’s shareholders.

Inventory Days / Days Sales of Inventory (DSI)

The Days Sales of Inventory (DSI) indicates the average time in days that a company takes to turn its inventory, including goods that are a work in progress, into sales.

DSI indicates the liquidity of the inventory; how many days a company’s current stock of inventory will last. Generally, a lower DSI is preferred as it indicates a shorter duration to clear off the inventory, though the average DSI varies from one industry to another.

Mid-Year Convention

If using Mid-Year Convention, one treats all cash flows as if they occur at the midpoint, instead of the end, of the given period.

Most bankers apply Mid-Year Convention by default. However, as a founder, when deciding whether to use this practice, you must review the cash flows of your business. In order to apply mid-year discounting, we must assume that an asset’s cash flows is evenly distributed throughout the time period. For companies that have irregular or lumpy cash flows (e.g., highly seasonal businesses), mid-year convention is not a good fit.

Net Income (NI)

Net income (NI), also called net earnings, is calculated as sales minus cost of goods sold, selling, general and administrative expenses, operating expenses, depreciation and amortization, interest, taxes, and other expenses. It is a useful number for investors to assess how much revenue exceeds the expenses. This number appears on a company’s income statement and is also an indicator of a company’s profitability.

 

Net Income = Revenue – Cost of Goods Sold – Expenses

 

Net Interest Expense

Interest Expense are the cost related to borrowing money. This is a non-operating expense shown on the income statement, and represents interest payable on any borrowings – bonds, loans, convertible debt or lines of credit.

Interest Expense = Principal Amount (Total Borrowed Amount) * Interest Rate * Time Period

Net Working Capital (NWC)

Net Working Capital (NWC) is the difference between a company’s current assets, (such as cash, accounts receivable, inventories of raw materials and finished goods) and its current liabilities (such as accounts payable). NWC is a measure of a company’s liquidity and generally, a higher NWC indicates a higher probability to meet financial obligations.

NWC = Current Assets – Current Liabilities

 

Other Income

Other income is income that is not derived from activities related to the main business.

Types of income that are commonly classified as other income are rent, interest income, gains on the sale of assets, and gains from foreign exchange transactions. The exact type of transaction characterised as other income will vary by business and industry.

For example, a manufacturer of washing machines earns rental income from sub-leasing unused office space to a third party; this rental income would be classified as other income on the company’s income statement.

Preferred Stock

Preferred Stock refers are shares of a company’s stock with dividends that are paid out to shareholders before common stock dividends are issued. Unlike common stockholders, preferred stockholders have limited rights which usually does not include voting.

Revenue/Sales

Revenue is the income generated from normal business operations and includes discounts and deductions for returned merchandise. It is the top line or gross income figure from which costs are subtracted to determine net income.

Sales Revenue = Sales Price * Number of Units Sold

 

Return on Investment (ROI)

Return on Investment (ROI) is a performance measure used to evaluate the efficiency or profitability of an investment, relative to the cost of the investment.

ROI = (Net Investment Gain / Cost of Investment) * 100

 

Selling General & Administrative Expenses (SG&A)

Selling, General & Administrative Expenses (SG&A) is reported on the income statement as the sum of all direct and indirect selling expenses (S) and all general and administrative expenses (G&A) of a company. SG&A includes all the costs not directly tied to making a product or performing a service. That is, SG&A includes the costs to sell and deliver products and services and the costs to manage the company.

Terminal value (TV)

Terminal Value (TV) is the value of an asset, business, or project, beyond the forecasted period when future cash flows can be estimated. TV assumes a business will grow at a set growth rate forever after the forecasted period. It often comprises a large percentage of the total assessed value.

Analysts use the Discounted Cash Flow (DCF) model to calculate the total value of a business. DCF has two major component: the forecast period and terminal value.

There are two ways to find Terminal value: Perpetuity Method and Exit Multiple Method

Unlevered Free Cash Flows (UFCF)

Unlevered Free Cash Flow (UFCF) reflects how much cash is available to the firm before taking financial obligations into account. UFCF can be contrasted with Levered Free Cash Flow (LFCF), which is the amount of money left over after all the bills are paid.

Weighted Average Cost of Capital (WACC)

The 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. It is one of the key inputs in Discounted Cash Flow (DCF) analysis.

WACC is used to decide whether the company should use debt or equity to finance new purchases.