Finance Terms and Formulas

Question 1

What is EBIT?

Answer 1

Earnings Before Interest & Tax

-An indicator of a company’s profitability, calculated as revenue minus expenses, excluding tax and interest. EBIT is also referred to as “operating earnings”, “operating profit” and “operating income”,

Question 2

What is the Formula for EBIT

Answer 2

EBIT = Revenue - Operating Expenses

• In other words, EBIT is all profits before taking into account interest payments and income taxes. An important factor contributing to the widespread use of EBIT is the way in which it nulls the effects of the different capital structures and tax rates used by different companies. By excluding both taxes and interest expenses, the figure hones in on the company’s ability to profit and thus makes for easier cross-company comparisons.

Question 3

What is the P/E Ratio

Answer 3

Price to Earnings ratio

• A valuation ratio of a company’s current share price compared to its per-share 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. However, the P/E ratio doesn’t tell us the whole story by itself. It’s usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company’s own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects.

Question 4

What is the formula for P/E ratio?

Answer 4

Market Value per Share
Earnings per Share (EPS)

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.

Question 5

What is DOL?

Answer 5

Degree of Operating Leverage

• A type of leverage ratio summarizing the effect a particular amount of operating leverage has on a company’s earnings before interest and taxes (EBIT). Operating leverage involves using a large proportion of fixed costs to variable costs in the operations of the firm. The higher the degree of operating leverage, the more volatile the EBIT figure will be relative to a given change in sales, all other things remaining the same.

Question 6

What is the formula for DOL?

Answer 6

This ratio is useful as it helps the user in determining the effects that a given level of operating leverage has on the earnings potential of the firm. This ratio can also be used to help the firm determine the most appropriate level of operating leverage in order to maximize the company’s EBIT.

Question 7

What is DFL?

Answer 7

Degree of Financial Leverage

• A leverage ratio summarizing the affect a particular amount of financial leverage has on a company’s earnings per share (EPS). Financial leverage involves using fixed costs to finance the firm, and will include higher expenses before interest and taxes (EBIT). The higher the degree of financial leverage, the more volatile EPS will be, all other things remaining the same.

Question 8

What is the formula for DFL?

Answer 8

Most likely, the firm under evaluation will be trying to optimize EPS, and this ratio can be used to help determine the most appropriate level of financial leverage to use to achieve that goal.

Question 9

What is beta?

Answer 9

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns..

Also known as “beta coefficient”.

Question 10

What is CAPM?

Answer 10

Capital Asset Pricing Model

CAPM is a model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.

The CAPM 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).

Question 11

How is CAPM calculated?

Answer 11

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 other half of the 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).

Using the CAPM model and the following assumptions, we can compute the expected return of a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)).

Question 12

What is Net Margin?

Answer 12

Net margin is the ratio of net profits to revenues for a company or business segment - typically expressed as a percentage – that shows how much of each dollar earned by the company is translated into profits.

Net margins will vary from company to company, and certain ranges can be expected from industry to industry, as similar business constraints exist in each distinct industry. A company like Wal-Mart has made fortunes for its shareholders while operating on net margins less than 5% annually, while at the other end of the spectrum some technology companies can run on net margins of 15-20% or greater.

Most publicly traded companies will report their net margins both quarterly (during earnings releases) and in their annual reports. Companies that are able to expand their net margins over time will generally be rewarded with share price growth, as it leads directly to higher levels of profitability.

Question 13

How is Net Margin calulated?

Answer 13

Question 14

What is IRR?

Answer 14

Internal Rate of Return

The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project’s internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors 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.

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.

Question 15

What is Leverage?

Answer 15

1. The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.
2. The amount of debt used to finance a firm’s assets. A firm with significantly more debt than equity is considered to be highly leveraged.

Leverage is most commonly used in real estate transactions through the use of mortgages to purchase a home.

1. Leverage can be created through options, futures, margin and other financial instruments. For example, say you have $1,000 to invest. This amount could be invested in 10 shares of Microsoft stock, but to increase leverage, you could invest the $1,000 in five options contracts. You would then control 500 shares instead of just 10.
2. Most companies use debt to finance operations. By doing so, a company increases its leverage because it can invest in business operations without increasing its equity. For example, if a company formed with an investment of $5 million from investors, the equity in the company is $5 million - this is the money the company uses to operate. If the company uses debt financing by borrowing $20 million, the company now has $25 million to invest in business operations and more opportunity to increase value for shareholders.

Leverage helps both the investor and the firm to invest or operate. However, it comes with greater risk. If an investor uses leverage to make an investment and the investment moves against the investor, his or her loss is much greater than it would’ve been if the investment had not been leveraged - leverage magnifies both gains and losses. In the business world, a company can use leverage to try to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default destroys shareholder value.

Question 16

How is beta calculated?

Answer 16

Beta is calculated using regression analysis, and you can think of beta as the tendency of a security’s returns to respond to swings in the market. A beta of 1 indicates that the security’s price will move with the market. A beta of less than 1 means that the security will be less volatile than the market. A beta of greater than 1 indicates that the security’s price will be more volatile than the market. For example, if a stock’s beta is 1.2, it’s theoretically 20% more volatile than the market.

Question 17

What is SML?

Answer 17

Security Market Line

A line that graphs the systematic, or market, risk versus return of the whole market at a certain time and shows all risky marketable securities.

Also refered to as the “characteristic line”.

The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML.

The security market line is a useful tool in determining whether an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security’s risk versus expected return is plotted above the SML, it is undervalued because the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued because the investor would be accepting less return for the amount of risk assumed.

Question 18

What is PVIF?

Answer 18

Present Value Interest Factor

A factor that can be used to simplify the calculation for finding the present value of a series of values. PVIFs can be presented in the form of a table with PVIF values seperated by respective period and interest rate combinations.

Question 19

What is the formula for PVIF?

Answer 19

Using the PVIF works best when you are attempting to discount one value in the future. For example, assume you are going to receive $5,000 in four years time, with the current discount interest rate being 8%. Using the standard present value formula the calculation would be $5,000 / (1+.08)4 .

This would result in a present value of approximately $3,675.15. By using a PVIF table, an individual can identify the factor for this calculation being 0.73503 (calculated: 1/(1.08^4)). They can then multiply the $5,000 by 0.73503, which results in $3675.15 as well. This is another way to come to the same answer as the standard present value formula, but becomes a useful technique when you are comparing or dealing with a large number of values.

The ‘r’ represents the discount interest rate, and the ‘t’ represents the number of periods.

Question 20

What is TVM?

Answer 20

Time Value of Money

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.

Also referred to as “present discounted value”.

Everyone knows that money deposited in a savings account will earn interest. Because of this universal fact, we would prefer to receive money today rather than the same amount in the future.

For example, assuming a 5% interest rate, $100 invested today will be worth $105 in one year ($100 multiplied by 1.05). Conversely, $100 received one year from now is only worth $95.24 today ($100 divided by 1.05), assuming a 5% interest rate.

Question 21

What is WACC?

Answer 21

‘Weighted Average Cost of Capital’

A calculation of a firm’s cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation. All else equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk.

Broadly speaking, a company’s assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances.

A firm’s WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm.

Question 22

What is the formula for WACC?

Answer 22

The WACC equation is the cost of each capital component multiplied by its proportional weight and then summing:

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
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

Businesses often discount cash flows at WACC to determine the Net Present Value (NPV) of a project, using the formula:

NPV = Present Value (PV) of the Cash Flows discounted at WACC.

Question 23

What is DCL?

Answer 23

Degree of Combined Leverage

A leverage ratio that summarizes the combined effect the degree of operating leverage (DOL), and the degree of financial leverage has on earnings per share (EPS), given a particular change in sales. This ratio can be used to help determine the most optimal level of financial and operating leverage to use in any firm.

It is worth noting that a firm with a relatively high level of combined leverage is seen as riskier than a firm with less combined leverage, as the high leverage means more fixed costs to the firm.

Question 24

How is DCL calculated?

Answer 24

This ratio can be very useful, as it summarizes the effects of combining both financial and operating leverage, and what effect this combination, or variations of this combination, has on the corporation’s earnings. Not all corporations use both operating and financial leverage, but if they do, then this formula can be used.

Question 25

What is EOQ?

Answer 25

An inventory-related equation that determines the optimum order quantity that a company should hold in its inventory given a set cost of production, demand rate and other variables. This is done to minimize variable inventory costs.

The EOQ formula can be modified to determine production levels or order interval lengths, and is used by large corporations around the world, especially those with large supply chains and high variable costs per unit of production.

Despite the equation’s relative simplicity by today’s standards, it is still a core algorithm in the software packages that are sold to the largest companies in the world.

Question 26

What is the formula for EOQ?

Answer 26

where :
S = Setup costs
D = Demand rate
P = Production cost
I = Interest rate (considered an opportunity cost, so the risk-free rate can be used)