Key Financial and Accounting Terms Explained
Understanding financial and accounting statements can be a confusing and even overwhelming ordeal, and much of this has to do with the litany of financial jargon that seems like a Harvard MBA is needed to understand it. However, we have done the hard work for you by breaking down and explaining some of the key terms that every business owner should be familiar with.
Capital Expenditure (CAPEX): Funds used by a company to acquire or upgrade physical assets such as property, or equipment. This outlay is made by companies to maintain or increase the scope of their operations.
Capital Structure: The combination of debt and equity that a business uses to finance its operation.
Capitalization Rate: The rate of return on an asset based on the yearly income it is expected to generate. Mathematically, Capitalization Rate = Yearly Income / Total Value.
Cash Flow from Operation (CFO): CFO is the cash generated from the operations of a company. Cash flow is also often used to identify the company’s earnings.
Depreciation: The assignment of cost to a tangible asset, such as machinery, over its lifetime.
Discount Rate: A rate of return that is used to calculate the present value of a future monetary sum or cash flow.
EBIT: Earnings before Interest, and Taxes. It is the Net profit of the business plus interest on long-term debt plus taxes plus depreciation and amortization. Compare with EBITDA, SDE.
EBITDA: Earnings before Interest, Taxes, Depreciation and Amortization. EBITDA is an indicator of a company’s financial performance. Could be normalized or not. When normalized it is net of any discretionary, non-recurring and non-operational expenses or income. In essence, it is the net profit of the business plus interest on long-term debt plus taxes plus depreciation and amortization. Compare with EBIT, SDE.
Enterprise Value (EV): EV is the total value of a company, which includes both debt and equity components. Mathematically, Enterprise Value = Market Capitalization + Total Debt – Cash & Cash Equivalents.
Fair Market Value (FMV): The price at which the business and/or property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of the relevant facts. Compare with Net Book Value.
Free Cash Flow (FCF): FCF represents the cash that a company is able to generate after meeting its reinvestment needs in the form of working capital and capital expenditures. Also called free cash flow to firm (FCFF), it is the cash available to be distributed to all capital providers of the company.
Goodwill: The collection of intangible assets represented in dollars by the difference between the total purchase price for the business and the net value of the tangible assets being purchased.
Gross Margin: Gross margin is an important measure of a company’s profitability. It is mathematically defined as Gross Margin = (Total Revenue – Cost of Goods Sold) / Total Revenue, and expressed as a percentage.
Leverage: The amount of debt that a company uses to finance its operations.
Liquidity: Refers to how quickly and easily an asset can be converted into cash.
Market Capitalization: Commonly referred to as Market Cap, this value represents the total dollar amount of all a company’s outstanding shares, and is a proxy for a company’s size. Mathematically, Market Cap = Total Number of Shares x Share Price.
Net Book Value (NBV): NBV is the value at which an asset is carried on a balance sheet. It is the historical cost of an asset minus accumulated depreciation.
Net Income (Loss): The remainder when all expenses, including taxes, are deducted from revenues from a given period. When this value is positive it is referred to as Net Income, and when it is negative its called Net Loss.
Netbook Value: NBV is the value at which an asset is carried on a balance sheet. It is the historical cost of an asset minus accumulated depreciation. Contrast with Fair Market Value.
Normalized Financial Statements: Normalized financial statements are financial statements that have been adjusted to eliminate non-recurring and non- business related expenditures.
Pro-forma: A method of calculating financial results in order to emphasize projected figures.
Scalability: Refers to a company’s ability to increase revenue by a greater amount than its associated costs increase. Put another way, it means to expand production such that both revenue and profit increase.
Seller’s Discretionary Earnings (SDE): SDE is a commonly used valuation multiple for small businesses where the buyer would most likely be an individual or main street buyer, who would take on a hands-on approach to working in the business. It is typically EBITDA plus one owner’s salary adjusted to FMV.
Working Capital: Also called net working capital, though there are a number of methods for calculating this, it is traditionally calculated as total current assets minus total current liabilities, excluding interest-baring debt. Working Capital is a measure of both a company’s efficiency and its short-term financial health.