Finance textbooks are often too academic or dense to be useful. Here are a few key finance terms explained in "plain English".
For the past two years, I've been busy completing an Executive MBA from the University of Southern California to pursue my interest in fintech. With program completion only one month away, I am excited to reclaim some free time to blog and share my experiments/experiences working at the intersection of finance and code. In the next few months, I plan to share some cool business solutions using Node, R, Ruby, Swifth and Python.
To kick off this new series of blog posts, I think it's essential first to introduce a financial glossary. My experience producing apps and leading machine learning programs at Amazon Alexa has reinforced the importance of learning the lexicon within any given domain. Since finance textbooks are often too academic or dense to be useful, below are my "plain English" business definitions. My hope is to make these defintions below both easy-to-read and straightforward to understand so please please please share your feedback.
Cost of Goods Sold (COGS) is the direct cost of producing your goods. Line items include raw materials, freight/shipping charges, storage fees, direct labor wages, and overhead expenses such as utilities, rent/lease, etc.
Operating expenses are what you spend day-to-day. They often get lumped into three buckets: compensation, office-related costs, and sales & marketing.
- Compensation expenses include wages, payroll tax, benefits, and even sales commissions.
- Office-related fees include property tax, rent, utilities, equipment depreciation, etc. Some companies use the words operating expenses and COGS interchangeably, so it is worth asking a business where direct labor fits.
- Sales and marketing expenses include advertising, direct mail, brochures, and travel.
Accounts Receivable - In accounting terms, this means money that customers owe you. Since someone owes you money, you can calculate it as an asset.
Accounts Payable - In accounting terms, this means money that you owe another vendor or bank. Since you owe money, it is tracked as a liability.
Working Capital is a proxy for a company's liquidity, operational efficiency and short-term health. If a company starts holding a lot of working capital, then it should have the potential to invest and grow.
You can calculate working capital in a few different ways. The primary method is to calculate the difference between assets (cash, accounts receivables, inventory) and liabilities such as accounts payable.
Net Working Capital (NWC) - Synonym for working capital.
Operating income is how much profit your business makes after you pay your operating expenses.
Capital Expenditures (CapEx) is a category of money you spend to acquire, upgrade, and maintain physical assets such as property, buildings, technology, or equipment. If you're a business looking to make new investments in projects, then it is a capital expenditure.
Note: If you were able to expense the expenditure, it is already accounted for in your EBIT.
Cash Flow (FCF) is cash generated by the firm and paid to creditors and shareholders. Cash flow is classified as:
- Cash flow from operations such as sales of a good or service.
- Cash flow from changes in fixed assets.
- Cash flow from changes in working capital.
Amongst investors, free cash flow is a measure of a company's value. When a publicly-traded company's share price is low, and their cash flow is on the rise, earnings and share value will likely increase.
Free Cash Flows (FCF's) is another name for Cash Flow. It's the cash left over after your company pays for its operating expenses and CapEx. It's "free" to distribute to creditors and stockholders because it is not needed for working capital or investments.
Net Income is not cash flow. You can have a net income of $100MM with a cash flow of $50MM.
Operating Profit is your total profit before interest and taxes. This is often called Earnings Before Interest and Taxes or EBIT.
Earning Before Interest, Taxes, and Amortization (EBITA) is a proxy for measuring the health of a company. It signals to an investor how much your company earns every year in terms of profit by removing the variability of interest and taxes and the subjectivity of depreciation and amortization.
For startups, EBITDA gives investors a sense of how much money a young company might generate before it has to hand over payments to creditors and IRS.
EBITDA should never be your only metric to measure. It's more of a companion metric to Cash Flows. If you want to learn more about the drawbacks of EBITDA, Investopedia has a great article
Net Present Value (NPV) is the metric you calculate for when you are looking for the answer to the question, "Should I invest in this startup?". Or, if you are a director within an organization and you are tasked with making new investments, then NPV will help you answer the question, "Should I invest in this project?". As a rule of thumb, if the NPV is positive, then yes, you should invest.
Weighted Average Cost of Capital (WACC) is the overall cost of money for all funding sources in a company. A company can raise money from the following three sources: equity, debt, and preferred stock. The total cost of capital is the weighted average of each of these costs.
As a business operator or manager, WACC can help you decide if a project is worthwhile to undertake.
This WACC calculator can help you visualize things a bit better.
Enterprise Value is an excellent measure for the total value of the firm and is often the starting point for an M&A. What makes EV useful is that it takes into account the people who own both the equity and the debt. This makes sense because the acquiring firm buys both the debt and the equity.
The first step towards calculating EV is first to find the EBITDA then discount it back to the WACC.