Financial Terms Every Professional Needs to Know
In a previous article, Duke Corporate Education professor Joe Perfetti shared why it is important to improve your knowledge of finance. As a follow-up, here is a short test so you can gauge whether your financial knowledge skills are adequate.
First question – do you understand how value is created? Before reading further, stop and think about this for a second.
Here is what Perfetti says: “Creating value is about exceeding expectations. If you don’t know the expectations – how can you understand whether or not you are creating value? Would you put money on a credit card without knowing any of the terms and conditions? Would you apply for a bank loan if they didn’t tell you the rate of interest or the repayment terms? Of course not. Well, in our organizations, investors and leadership decide where to invest their money based on expectations for financial performance. You need to be aware of these Key Performance Indicators (KPIs) if you are going to be successful.”
Next, here is a list of some key financial terms. See if you can first explain what each of the following terms are (definitions are highlighted later in this article):
- Hurdle Rate or Cost of Capital
- Return on Invested Capital
- EBITDA Margin
- Free Cash Flow
- Internal Rate of Return (IRR)
- Revenue Growth
- Total Shareholder Return (TSR)
So how did you do? Could you confidently explain six out of these eight terms?
If you had no idea about the answers, or if you want to see if your educated guess was correct, here is how Professor Perfetti described these terms in a practical way:
- Hurdle Rate or Cost of Capital: The annual rate of return that you need to make to pay back the money that you are given. Like a bank loan, the rate is adjusted for risk.
- Return on Invested Capital: The annual amount of cash profit generated for every dollar invested. For example, a 10% ROIC means you make 10 cents of cash profit for every dollar invested. An ROIC of 20% means you make 20 cents for every dollar invested.
- Spread: Spread is the difference between what you earn (the ROIC) and what you are expected to earn (the cost of capital also called the hurdle rate).
- EBITDA Margin: Think of it this way: sales represent cash coming in from customers. Expenses represent cash going out of the business. The difference is profit. From the perspective of the day-to-day running of the business, accountants classify some operating (recurring) expenses as cash expenses (payroll, inventory, advertising, etc.) and some expenses are non-cash expenses (spreading the cost of a building over time – something called depreciation.) Earnings Before Interest Tax Depreciation and Amortization (EBITDA) is a measure of the cash sales minus the cash operating expenses. It is a measure of how much cash is being generated from an income statement during a quarter or a year.
- Free Cash Flow: Businesses need to plough money back into the business to maintain operations and fund future growth. Free cash flow is essentially the profit left over after reinvestment. This is important because stockholders and lenders want to know how much cash is available to them.
- Internal Rate of Return (IRR): This is the annual rate of return that a project is earning over time. IRR is similar to ROIC (return on invested capital). The difference is that IRR is on a project basis and ROIC is on a company basis. In other words, a company is the sum of all its projects and ROIC is the average of all its project’s IRRs. In either case, it must be greater than your cost of capital or hurdle rate. Investors will be judging you on the hurdle rate, which is annual rate of return that you need to make to pay back the money that you are given.
- Revenue Growth: Revenue growth tells us how fast a company’s sales are growing over time. Many investor decisions are driven by the attractiveness of a market, so healthy sales are key.
- Total Shareholder Return (TSR): This is an annualized return an investor can expect based on dividends and/or a change in the stock price. This is a key metric used by large institutional investors like Vanguard or Fidelity to judge returns for their investments.
Hope your educated guesses were on target and that this piece helped you learn new knowledge if you were unfamiliar with some of these terms. More importantly, may this fun little financial knowledge quiz spur you to take action to increase your finance knowledge on an ongoing basis so you can grow in your career.
Professor Joe Perfetti is an expert in corporate finance and strategy. He teaches the Building Financial Acumen online course for Duke Corporate Education.