Financial Metrics Explained
Metrics Categories, Definitions, Meaning and Usage
Business Encyclopedia, ISBN 978-1- 929500-10-9. Revised 2014-03-10.
Financial Metrics reveal
characteristics of financial
data that might not be apparent from a simple
review of the numbers.
Each financial metric says something unique about a body of financial data. In that way, financial metrics are like descriptive statistics: the statistical average (arithmetic mean), for example, represents the "typical" value in a data set. Similarly, each financial metric says something unique about a set of cash flow numbers or financial statement figures. The financial metric reveals some characteristic of the whole body of data that might not be apparent from simply reviewing individual financial figures.
The payback period cash flow metric, for instance, takes a series of cash inflows and outflows and measures the time it takes for investment returns to cover investment costs. The estimated payback periods of different potential investments can be compared, to help decide which alternative is the better investment. The wise investor, however, will also want to see other metrics for the same investment choices, as well, such as net present value (NPV), return on investment (ROI), and internal rate of return (IRR).
Most financial metrics used in business belong to one of two families:
- Cash Flow Metrics
These include metrics such as net present value (NPV), return on Investment (ROI), and internal rate of return (IRR), used for evaluating investments and streams of cash flow events.
- Financial Statement Metrics
These include metrics such as the current ratio, inventory turns, or earnings per share, for evaluating a company's financial position and financial performance.
For descriptions, examples, and interpretations of these metrics, see the encyclopedia entries listed below. Or, for more in depth descriptions of these metrics and their variants, along with working spreadsheet examples, see Financial Metrics Pro.
Cash flow metrics
Cash flow metrics describe the value of sets of cash flow events in various ways. They may apply to a single event (e.g., a cash inflow payment coming sometime in the future), or to a stream of cash flow events over time from an investment or action, such as this:
Cash flow metrics address questions like these:
- A company expects a certain cash inflow five years from now. What is the value today of that future inflow? The present value metric provides one answer to that question.
- An investor buys a bond, causing cash outflow from the investor's bank account. Years later, at maturity, the bond brings a cash inflow. How does a potential investor compare one investment possibility with another? The yield to maturity and return on investment metrics provide a basis for such comparisons.
- A business case analyst projects a cash flow stream from an action, such as a five-year marketing campaign. The action will bring many cash inflows and outflows over the years, summarized with a net cash flow stream such as the figure above. Cash flow metrics such as net present value and internal rate of return help describe the cash flow value, for comparing to other actions.
Cash flow metrics are generally used for ...
- Comparing different possible courses of action or investments.
- Justifying a chosen action in financial terms.
- Anticipating the financial consequences of an action for budgeting or planning purposes.
Cash flow metrics explained and illustrated in this encyclopedia include:
- Net cash flow
The net of incoming and outgoing cash flows, usually expressed as net cash flow per period (e.g., net per year or net per month).
- Cumulative cash flow
For a series of cash flow events, the cumulative value of all cash flows through the end of the current period.
- Future value/Compound interest
The value at some time in the future of money that will be received or paid at the future time. For instance, funds deposited in the bank today and earning interest until a future time bring a future value (initial deposit plus earned interest) greater than the initial deposit.
- Present value (Discounted Cash Flow DCF, Net Present Value)
The value today of money that will not be received or paid until sometime in the future; the value today (present value) is discounted below the value the funds will have when the future cash flow actually occurs.
- Payback period
The amount of time required for an investment to pay for itself (the time required for cumulative inflows to balance cumulative outflows exactly).
- Return on investment (ROI)
ROI in cash flow analysis usually means a ratio or percentage, comparing an investment's incremental gains to investment costs.
- Internal rate of return (IRR)
The interest rate that yields a net present value of 0 for a cash flow stream (see the encyclopedia entry IRR for an explanation of how this is determined and what it means). In bond investing, the IRR for a bond is called Yield to maturity.
- Break even point
Usually expressed as the number of units of a product that must be sold at a given price in order for product costs to exactly equal incoming product revenues. Units sold in excess of the break even number represent net gain, or positive margin.
- Total cost of ownership (TCO)
Usually applied to expensive assets or other acquisitions, TCO is the estimated total life cycle cost brought by acquiring, installing/deploying/starting, operating, maintaining, and disposing of the item at the end of its economic life.
See the encyclopedias linked above, or for more in depth coverage and working examples, see Financial Metrics Pro.
Financial statement metrics
Financial statement metrics measure the strength of a company's financial position or the company's performance over certain time periods. These metrics use figures mostly from the company's four primary financial accounting statements:
Financial statement metrics are generally used by…
- Investors considering buying or selling stock or bonds in a company.
- Company management, for identifying strengths, weaknesses, and target levels for business objectives.
- Shareholders and boards of directors, for evaluating senior management.
Financial statement metrics in this encyclopedia are described and illustrated along with financial statements that provide data to derive them. Financial statement metrics are presented in six categories, according to the kinds of questions they address.
- Liquidity metrics address questions like this:
Is the company prepared too meet its short term financial obligations? Liquidity metrics in this encyclopedia include:
- Working Capital
- Current Ratio
- Quick Ratio (Acid-Test Ratio)
- Accounts payable turnover (APT)
- Cash conversion cycle (CCC)
- Activity and efficiency metrics address questions such as this: Is the company using its resources efficiently? Activity metrics in this encyclopedia are:
- Sales Revenues per Employee
- Inventory Turns
- Days Sales in Inventory (or Average Turnover Period, or Days Inventory Outstanding, DIO)
- Accounts Receivable Turnover
- Days payable outstanding (DPO)
- Average Collection Period (or Days Sales Outstanding, DSO)
- Cash Conversion Cycle (CCC)
- Total Asset Turnover
- Fixed Asset Turnover
- Leverage metrics are designed for approaching questions like this: Are the company's funds supplied primarily by owners or by creditors? Leverage metrics in this encyclopedia include:
- Total Debt to Asset Ratio
- Debt to Equity Ratios
- Total Debt to Equity Ratio
- Long Term Debt to Equity Ratio
- Times Interest Earned
- Profitability metrics are designed to answer questions such as this: Is the company profitable? Is it making good use of its assets? Profitability metrics included in this encyclopedia are:
- Profit Margin on Sales
- Operating Profit Margin
- Gross Profit Margin
- Return on total assets (ROA)
- Return on equity (ROE) / Return on owners investment / Return on net worth) / Return on common equity
- Earnings per share (EPS)
- Valuation metrics address questions like this: What are the company's prospects for future earnings? This encyclopedia includes these valuation metrics:
- Price to earnings ratio (P/E)
- Book value per share
- Market to book ratio
- Growth metrics attempt to answer questions like these: How does the company's growth over the last five years compare to similar companies? To industry averages? Growth metrics are illustrated in this encyclopedia with the Cumulative Average Growth Rate metric (CAGR).
By Marty Schmidt. Copyright © 2004-.