A common investor generally does not have profound knowledge of basic financial concepts. It is seen that people often use financial and economic terms loosely without understanding its proper meaning. Gaining financial fluency allows you to evaluate news, understand economic trends and financial implications to plan both personal and professional finances. Understanding basic financial and economic concepts can help in comprehending important business and financial information, to take proper financial and investing decisions. In this write up I have tried to explain some basic financial and economic concepts and provide a brief explanation of each in simple language.
1. Net worth
The net worth of a person or enterprise states its financial worth. In simple terms net worth represents Net Assets owned by an individual or business. Net Worth is determined by calculating the value of the assets owned and subtracting the liabilities owed. This phenomenon is used to determine their organization's financial health, as the net worth summarizes current financial position. You may apply this quantitative concept to individuals, businesses, companies, sectors, business groups or countries. Financial professionals may also refer to net worth as book value of shareholder's equity or Partners/Proprietors equity.
Net worth can be positive or negative. Those with a positive net worth have more assets than liabilities and those with a negative value have liabilities that exceed their assets. A positive net worth indicates good financial health, whereas a negative or declining net worth may indicate a critical financial condition.
2. Liquidity
Liquidity refers to the ability to convert or exchange assets into cash or cash equivalents. It is your accessibility to money or the ease with which you can convert assets into cash. The most liquid of all assets is cash itself, whereas other tangible items are less liquid. For example, immovable properties like land or building are generally not very liquid, as it takes time to sell these assets at a desired price. Liquidity measures an organizations ability to meet its short term liabilities and financial obligations. Liquidity is also required to acquire new assets in the business. To judge liquidity, financial professionals use the current ratio, quick ratio or acid-test ratio, or cash ratio. Measuring liquidity of an enterprise is a financial health check as it ascertains whether it has ability to sustain financially.
The two major types of liquidity are accounting liquidity and market liquidity. Accounting liquidity measures business or individual's ability to meet their financial obligations if they become due. Market liquidity refers to the extent to which a market allows assets to be bought and sold at stable prices.
3. Return on Investment (ROI)
In any business, your investments are the resources you put into for running the enterprise like machinery, materials, human resources, time and money. The return is the profit you make as a result of your investments. In simple terms ROI indicates earnings as percentage to the investment made for it.
ROI is generally defined as the ratio of net profit over the total cost of the investment.
ROI = Net Profit / Cost of Investment x 100
Return on investment (ROI) is a calculation useful for determining profitability of the investment made.
For example a company installs a new modern machine costing Rs.10 Lakhs for production and earns Rs 2 Lakhs more profit as compared to same period in previous year then ROI for that period is (200000/1000000) x 100 = 20%
ROI can also be used for taking future investment decisions using estimated earnings and cost of investments.
4. EBITDA
It is Earnings before interest, tax, depreciation and amortization. We can derive EBITDA by subtracting operating expenses from revenue or simply adding back expenses like interest, amortization, tax and depreciation to the net profit. Operating expenses means ongoing cost that a firm incurs for running its normal business. For example Salary, Rent, Marketing expenses etc.
EBITDA shows profitability of a business as different from its net income. New companies or startups generally take huge loans and acquire high value assets in initial period. EBITDA determines their actual profitability by adding back interest, depreciation, amortization and taxes to Net Profit. It measures the core profitability of a firm. EBITDA reveals what a business can earn rather than net income as per its Profit & Loss Statement. Investors can use EBITDA to assess corporate profitability net of expenses dependent on capital and financing structure, tax strategy, and depreciation schedules.
5. Free Cash Flow (FCF)
Free cash flow refers to how much money a business has left over after it has paid for everything it needs for continuing its operations. Free cash flow, or owner's earnings is a measure of the company's ability to generate cash over a period of time. In simple terms it is the money an owner could take out of his business and spend for his own benefit. FCF is a very reliable measure of a business's ability to generate cash from its core operations and it shows how much cash is left at its disposal at the end of a period that belongs to owners and capital providers.
The simplest way to calculate free cash flow is to deduct capital expenditures from operating cash flow. FCF is basically the cash that a company is able to generate after meeting its operational and fixed costs.
- FCF = Operating cash – Capital expenditure Or
- Free cash flow = Sales revenue – (Operating costs + taxes ) – Capital expenditure needed to run the business.
Businesses calculate free cash flow for making business decisions, such as fresh investment for expansion, cost reduction, working capital management.
6. Price Earning Ratio (P/E Ratio)
The price earnings ratio denotes relationship between a company's share price and its earnings per share. In broader term It is comparison of market capitalization and net earnings. It indicates market's willingness to pay for profits of a company.
P/E Ratio is ascertained by dividing market price of a share by the Earning Per Share (EPS) EPS is calculated by dividing the company's net income (Net Profit after tax) with its total number of outstanding shares.
P/E Ratio = (Current Market Price of a Share / Earnings per Share)
P/E Ratio is most commonly used tool by investors and analysts to determine whether a stock is undervalued or overvalued. Average P/E Ratio of industry can be referred for this purpose. Undervalued stocks of fundamentally good companies are preferred for investment.
7. Venture Capital
Entrepreneurs need money to convert their ideas into business. The capital required by them is called Venture Capital. Venture capital is provided to start ups or new businesses by private equity firms, investment banks or wealthy angel investors. These funds are required for meeting costs for setting up a new business or its expansion and diversification. The venture capital provider generally receives equity in exchange of investment. Some part of it may be in the form of debt. VC firms reduce the risk of investments by co-investing with other VC firms. Usually, there will be the main investor called the 'lead investor' and other investors are called 'followers'.
8. Financial Leverage
When a firm uses more borrowed funds (debts) to finance its assets it is using financial leverage. Financial leverage is employed when there is expectation that returns on assets are more than cost of borrowing. It increases return on equity as there is use of debts to buy more income generating assets. In personal investing if a person borrows money for investing he is using leverage.
Excessive use of financial leverage is risky as it increases liability and may lead to liquidity problem. Financial leverage helps to grow assets faster. If there is good profitability, debts can be repaid faster and volume of return on investment increases.
9. Gross Domestic Product (GDP)
Gross domestic product is the total monetary value of all the finished goods and services produced in a country in a specified period, usually one year. It counts all of the output generated within the borders of a country.
Formula of counting GDP-
GDP = Consumption + Investment + Government Spending + Net Exports
GDP is used as a measure to judge a country's economic health. It is used to estimate size of the economy of a nation. It is an important indicator of economic performance of a country. It is widely used by economists and business analysts.
10. Inflation
Inflation is an economic term that denotes increase in general price levels of goods and services within an economy over a time period. With the increase in general price level purchasing power of given currency decreases. In other words, one can buy fewer goods or services with each unit of currency. Thus rise in inflation results in reduction of purchasing power of money.
The annual percentage change in inflation is called inflation rate. Consumer Price Index is typically used by financial analysts to measure rate of inflation.
The primary cause of inflation is increase in money flow into economy beyond its growth rate. It reduces value of currency. There are two main forces behind inflation. First is demand-pull and second is cost-push. Demand-pull inflation happens when consumer demand increases due to availability of more money to spend. Cost-push inflation occurs when there is increase in input costs of producers and they raise the prices to meet higher cost of production.
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