WellTax Blog

Key financial terms: Understanding business dynamics

December 5, 2017

Being aware of the main financial terms is an essential requirement to understanding business performance and optimising corporate strategies.

A budget or/and a cash flow, often, do not show a complete analysis of a company performance, therefore it is crucial to review the key financial terms that display a set of performance indicators important to define business objectives.

Each of these indicators has different meanings. The acknowledgement of these items may help startups and small businesses to succeed. In this article, we explain them to ensure that you comprehend what is being referred to when examining your business year.

  • Turnover has various meaning. However, in regards to business, it is the sales volume of goods or services a business makes over a certain period. This item is very useful for the company as it provides an interesting starting point from which the business performance could be evaluated. In addition, it is also important for tax purposes (For instance see VAT threshold).
  • Earnings before interest, tax, depreciation and amortisation (EBITDA) is a measure of a firm’s operating performance. This indicator is used as an evaluation method of a company’s investments without having to consider other factors such as financing decisions (interest on a loan), accounting decisions (loss in value of an intangible/tangible asset over time) or tax payments. This item helps business to simplify the profitability, by removing elements sometimes irrelevant to the company’s existing operating model.
  • The Gross profit is another essential figure to evaluate business growth and performance. It is a firm’s total revenue minus the cost of goods sold. Specifically, Gross Profit is the profit that a business makes after deducting the expenses associated with producing and selling its goods, or the costs associated with providing its services. Gross profit gives a simplified view of the profitability of products and services. It is a useful indicator for an established company trialling a new product, where fixed costs are already considered, hence gross profit is a less relevant element of the direct profitability when adding new goods to the company. It also improves the business process as gross profit can provide an insight into how efficiently a management team handle the creation of products and services. For example, gross profit is more useful than profit when evaluating costs related to both manufacturing and sales processes.
  • Net profit is usually referred to as the ‘bottom line’. It concerns the total income of a company less their total costs and provides an absolute figure than the other items mentioned before. Net profit, therefore, represents the most important figure to the business managers and to the outside investors. Consecutive years of profit implies that company performance and operating costs are efficient. This will encourage the business to spend more due to a reduced chance of a low return, or even loss on investment.

Other figures that help to measure the business success are the profitability ratios. Profitability ratios measure a firm’s potential to generate income, profit and cash flow relative to some metric, often the amount of money invested, sales, assets and equity. ROI, ROE and ROS are considered as the most influential indicators to analyse company investments. Therefore, these indexes highlight how effectively the profitability of a business is being managed.

  • Return on investment (ROI) is a performance indicator used to assess the efficiency of an investment. It compares the size and timing of earnings from investment directly to the magnitude and timing of investment costs. It is one of the most widely used methods for evaluating the financial results of business investments, decisions and/or operations.
  • ROE (Return On Equity) is the amount of net income returned as a percentage of shareholders investments (equity). It shows how much profit a business made in relation to the total amount of shareholder equity located on the balance sheet. The ROE is obtained by calculating the ratio between Net Profit (Profit after Taxes) and Net Equity (Net Capital or Own Equity).
  • Return on sales (ROS) is an index generally used to evaluate an entity’s operating performance. It is also known as “operating profit margin”. ROS indicates how much profit an entity makes after paying for variable costs of production such as wages, raw materials, etc. (but before interest and tax). ROS is usually expressed as a percentage of sales (revenue) and it is obtained by calculating the ratio between operating profit and turnover.

In conclusion, these indicators together with a comprehensive business plan are the best way to go about defining your business and reaching financial success. Therefore, a correct assessment of the business performance is crucial and indispensable when running a company.

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Alessio Menna

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