RETURN ON INVESTMENT - ROI

A performance measure used to evaluate the efficiency of an investment or to compare

the efficiency of a number of different investments. ROI measures the amount
of return on an investment relative to the investment’s cost. To calculate ROI, the
benefit (or return) of an investment is divided by the cost of the investment, and the
result is expressed as a percentage or a ratio.

The return on investment formula:

In the above formula, "Gain from Investment” refers to the proceeds obtained from the
sale of the investment of interest. Because ROI is measured as a percentage, it can be
easily compared with returns from other investments, allowing one to measure a variety
of types of investments against one another.

BREAKING DOWN 'RETURN ON INVESTMENT - ROI'

Return on investment is a very popular metric because of its versatility and simplicity.
Essentially, return on investment can be used as a rudimentary gauge of an
investment’s profitability. ROI can be very easy to calculate and to interpret and can
apply to a wide variety of kinds of investments. That is, if an investment does not have a
positive ROI, or if an investor has other opportunities available with a higher ROI, then
these ROI values can instruct him or her as to which investments are preferable to
others.

For example, suppose Joe invested $1,000 in Slice Pizza Corp. in 2010 and sold
his shares for a total of $1,200 a year later. To calculate the return on his investment, he
would divide his profits ($1,200 - $1,000 = $200) by the investment cost ($1,000), for a
ROI of $200/$1,000, or 20%.

With this information, he could compare the profitability of his investment in Slice Pizza
with that of other investments. Suppose Joe also invested $2,000 in Big-Sale Stores
Inc. in 2011 and sold his shares for a total of $2,800 in 2014. The ROI on Joe’s holdings
in Big-Sale would be $800/$2,000, or 40%. Using ROI, Joe can easily compare the
profitability of these two investments. Joe’s 40% ROI from his Big-Sale holdings is twice
as large as his 20% ROI from his Slice holdings, so it would appear that his investment
in Big-Sale was the wiser move.

LIMITATIONS OF ROI
Yet, examples like Joe's reveal one of several limitations of using ROI, particularly when
comparing investments. While the ROI of Joe’s second investment was twice that of his
first investment, the time between Joe’s purchase and sale was one year for his first
investment and three years for his second. Joe’s ROI for his first investment was 20% in
one year and his ROI for his second investment was 40% over three. If one considers
that the duration of Joe’s second investment was three times as long as that of his first,
it becomes apparent that Joe should have questioned his conclusion that his second
investment was the more profitable one. When comparing these two investments on
an annual basis, Joe needed to adjust the ROI of his multi-year investment accordingly.
Since his total ROI was 40%, to obtain his average annual ROI he would need to divide
his ROI by the duration of his investment. Since 40% divided by 3 is 13.33%, it appears
that his previous conclusion was incorrect. While Joe’s second investment earned him
more profit than did the first, his first investment was actually the more profitable choice
since its annual ROI was higher.

Examples like Joe’s indicate how a cursory comparison of investments using ROI can
lead one to make incorrect conclusions about their profitability. Given that ROI does not
inherently account for the amount of time during which the investment in question is
taking place, this metric can often be used in conjunction with Rate of Return, which
necessarily pertains to a specified period of time, unlike ROI. One may also
incorporate Net Present Value (NPV), which accounts for differences in the value of
money over time due to inflation, for even more precise ROI calculations. The
application of NPV when calculating rate of return is often called the Real Rate of
Return.

Keep in mind that the means of calculating a return on investment and, therefore, its
definition as well, can be modified to suit the situation. it all depends on what one
includes as returns and costs. The definition of the term in the broadest sense simply
attempts to measure the profitability of an investment and, as such, there is no one
"right" calculation.

For example, a marketer may compare two different products by dividing the gross
profitthat each product has generated by its associated marketing expenses. A financial
analyst, however, may compare the same two products using an entirely different ROI
calculation, perhaps by dividing the net income of an investment by the total value of all
resources that have been employed to make and sell the product. When using ROI to
assess real estateinvestments, one might use the initial purchase price of a property as
the “Cost of Investment” and the ultimate sale price as the “Gain from Investment,”
though this fails to account for all of the intermediary costs, like renovations, property
taxes and real estate agent fees.

This flexibility, then, reveals another limitation of using ROI, as ROI calculations can be
easily manipulated to suit the user's purposes, and the results can be expressed in
many different ways. As such, when using this metric, the savvy investor would do well
to make sure he or she understands which inputs are being used. A return on
investment ratio alone can paint a picture that looks quite different from what one might
call an “accurate” ROI calculation—one incorporating every relevant expense that has
gone into the maintenance and development of an investment over the period of time in
question—and investors should always be sure to consider the bigger picture.

DEVELOPMENTS IN ROI
Recently, certain investors and businesses have taken an interest in the development of
a new form of the ROI metric, called "Social Return on Investment," or SROI. SROI was
initially developed in the early 00's and takes into account social impacts of projects and
strives to include those affected by these decisions in the planning of allocation of
capital and other resources.

DEFINITION OF 'ACTIVE RETURN'

The percentage gain or loss of an investment relative to the investment's benchmark.
An active return is the difference between the benchmark and the actual return. It can
be positive or negative and is typically used to assess performance.
BREAKING DOWN 'ACTIVE RETURN'
A portfolio that outperforms the market has a positive active return, assuming that the
market as a whole is the benchmark. For example, if the benchmark return is 5% and
the actual return is 8%, the active return would then be 8% - 5% = 3%.

If the same portfolio returned only 4%, it would have a negative active (4% - 5% = -1%).

If the benchmark is a specific segment of the market, the same portfolio could
hypothetically underperform the market and still have an active return relative to the
chosen benchmark. This is why it is important for investors to know which benchmarks
are being used and why.

DEFINITION OF 'INTERNAL RATE OF RETURN - IRR'

A metric used in capital budgeting measuring the profitability of potential investments.
Internal rate of return is a discount rate that makes the net present value (NPV) of all
cash flows from a particular project equal to zero. IRR calculations rely on the same
formula as NPV does.

The following is the formula for calculating NPV:

where:

Ct = net cash inflow during the period t

Co= total initial investment costs

r = discount rate, and

t = number of time periods

To calculate IRR using the formula, one would set NPV equal to zero and solve for the
discount rate r, which is here the IRR. Because of the nature of the formula, however,
IRR cannot be calculated analytically, and must instead be calculated either through
trial-and-error or using software programmed to calculate IRR.

Generally speaking, the higher a project's internal rate of return, the more desirable it is
to undertake the project. IRR is uniform for investments of varying types and, as such,
IRR can be used to rank multiple prospective projects a firm is considering on a
relatively even basis. Assuming the costs of investment 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).

BREAKING DOWN 'INTERNAL RATE OF RETURN - IRR'

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. One popular use of
IRR is in comparing the profitability of establishing new operations with that of
expanding old ones. For example, anenergy company may use IRR in deciding whether
to open a new power plant or to renovate and expand a previously existing one. While
both projects are likely to add value to the company, it is likely that one will be the more
logical decision as prescribed by IRR.

In theory, any project with an IRR greater than its cost of capital is a profitable one, and
thus it is in a company’s interest to undertake such projects. In planning investment
projects, firms will often establish a required rate of return (RRR) to determine the
minimum acceptable return percentage that the investment in question must earn in
order to be worthwhile. Any project with an IRR that exceeds the RRR will likely be
deemed a profitable one, although companies will not necessarily pursue a project on
this basis alone. Rather, they will likely pursue projects with the highest difference
between IRR and RRR, as chances are these will be the most profitable.
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.

Although IRR is an appealing metric to many, it should always be used in conjunction

with NPV for a clearer picture of the value represented by a potential project a firm may
undertake.

ISSUES WITH 'INTERNAL RATE OF RETURN (IRR)'

While IRR is a very popular metric in estimating a project’s profitability, it can be
misleading if used alone. Depending on the initial investment costs, a project may have
a low IRR but a high NPV, meaning that while the pace at which the company sees
returns on that project may be slow, the project may also be adding a great deal of
overall value to the company.

A similar issue arises when using IRR to compare projects of different lengths. For
example, a project of a short duration may have a high IRR, making it appear to be an
excellent investment, but may also have a low NPV. Conversely, a longer project may
have a low IRR, earning returns slowly and steadily, but may add a large amount of
value to the company over time.

Another issue with IRR is not one strictly inherent to the metric itself, but rather to a
common misuse of IRR. People may assume that, when positive cash flows are
generated during the course of a project (not at the end), the money will
be reinvested at the project’s rate of return. This can rarely be the case. Rather, when
positive cash flows are reinvested, it will be at a rate that more resembles the cost of
capital. Miscalculating using IRR in this way may lead to the belief that a project is more
profitable than it actually is in reality. This, along with the fact that long projects with
fluctuating cash flows may have multiple distinct IRR values, has prompted the use of
another metric called modified internal rate of return (MIRR). MIRR adjusts the IRR to
correct these issues, incorporating cost of capital as the rate at which cash flows are
reinvested, and existing as a single value. Because of MIRR’s correction of the former
issue of IRR, a project’s MIRR will often be significantly lower than the same project’s
IRR. (For more, see: Internal Rate Of Return: An Inside Look.)

DEFINITION OF 'RETURN ON CAPITAL EMPLOYED (ROCE)'

A financial ratio that measures a company's profitability and the efficiency with which its
capital is employed. Return on Capital Employed (ROCE) is calculated as:

ROCE = Earnings Before Interest and Tax (EBIT) / Capital Employed

“Capital Employed” as shown in the denominator is the sum of shareholders' equity and
debt liabilities; it can be simplified as (Total Assets – Current Liabilities). Instead of
using capital employed at an arbitrary point in time, analysts and investors often
calculate ROCE based on “Average Capital Employed,” which takes the average of
opening and closing capital employed for the time period.

A higher ROCE indicates more efficient use of capital. ROCE should be higher than the
company’s capital cost; otherwise it indicates that the company is not employing its
capital effectively and is not generating shareholder value.

BREAKING DOWN 'RETURN ON CAPITAL EMPLOYED (ROCE)'

ROCE is a useful metric for comparing profitability across companies based on the
amount of capital they use. Consider two companies, Alpha and Beta, which operate in
the same industry sector. Alpha has EBIT of $5 million on sales of $100 million in a
given year, while Beta has EBIT of $7.5 million on sales of $100 million in the same
year. On the face, it may appear that Beta should be the superior investment, since it
has an EBIT margin of 7.5% compared with 5% for Alpha. But before making an
investment decision, look at the capital employed by both companies. Let’s assume that
Alpha has total capital of $25 million and Beta has total capital of $50 million. In this
case, Alpha’s ROCE of 20% is superior to Beta’s ROCE of 15%, which means that
Alpha does a better job of deploying its capital than Beta.

ROCE is especially useful when comparing the performance of companies in capital-

intensive sectors such as utilities and telecoms. This is because unlike return on
equity(ROE), which only analyzes profitability related to a company’s common equity,
ROCE considers debt and other liabilities as well. This provides a better indication of
financial performance for companies with significant debt.

Adjustments may sometimes be required to get a truer depiction of ROCE. A company

may occasionally have an inordinate amount of cash on hand, but since such cash is
not actively employed in the business, it may need to be subtracted from the “Capital
Employed” figure to get a more accurate measure of ROCE.

For a company, the ROCE trend over the years is also an important indicator of
performance. In general, investors tend to favor companies with stable and rising ROCE
numbers over companies where ROCE is volatile and bounces around from one year to
the next.

Read more on how ROCE can be an effective analysis tool - Spotting profitability with
ROCE.

DEFINITION OF 'AFTER-TAX REAL RATE OF RETURN'

The actual financial benefit of an investment after accounting for inflation and taxes. The
after-tax real rate of return is an accurate measure of investment earnings and usually
differs significantly from an investment's nominal rate of return, or its return before
inflation and taxes. However, investments in tax-advantaged securities (such as
municipal bonds) and inflation-protected securities (such as TIPS) as well as
investments held in tax-advantaged accounts such as Roth IRAs will show less
discrepancy between nominal returns and after-tax real rates of return.

BREAKING DOWN 'AFTER-TAX REAL RATE OF RETURN'

Over the course of a year, an investor might earn a nominal return of 12% on his stock
investment, but his real return, the money he gets to put in his pocket at the end of the
day, will be less than 12%. Inflation might have been 3% for the year, knocking his real
rate of return down to 9%. And since he sold his stock at a profit, he will have to pay
taxes on those profits, taking another 2% off his return. The commission he paid to buy
and sell the stock also diminishes his return. Thus, in order to truly grow their nest eggs
over time, it is essential that investors focus on the after-tax real rate of return, not the
nominal return.
DEFINITION OF 'CURRENT RATIO'
The current ratio is a liquidity ratio that measures a company's ability to pay short-
term andlong-term obligations. To gauge this ability, the current ratio considers the
total assets of a company (both liquid and illiquid) relative to that company’s
total liabilities.

The formula for calculating a company’s current ratio, then, is:

The current ratio is called “current” because, unlike some other liquidity ratios, it
incorporates all current assets and liabilities.

The current ratio is also known as the working capital ratio.

BREAKING DOWN 'CURRENT RATIO'

The current ratio is mainly used to give an idea of the company's ability to pay back its
liabilities (debt and accounts payable) with its assets (cash,
marketable securities, inventory,accounts receivable). As such, current ratio can be
used to take a rough measurement of a company’s financial health. The higher the
current ratio, the more capable the company is of paying its obligations, as it has a
larger proportion of asset value relative to the value of its liabilities.

A ratio under 1 indicates that a company’s liabilities are greater than its assets and
suggests that the company in question would be unable to pay off its obligations if they
came due at that point. While a current ratio below 1 shows that the company is not in
good financial health, it does not necessarily mean that it will go bankrupt. There are
many ways for a company to access financing, and this is particularly so if a company
has realistic expectations of future earnings against which it might borrow. For example,
if a company has a reasonable amount of short-term debt but is expecting
substantial returns from a project or other investment not too long after its debts are
due, it will likely be able to stave off its debt. All the same, a current ratio below 1 is
usually not a good sign.
On the other hand, a high ratio (over 3) does not necessarily indicate that a company is
in a state of financial well-being either. Depending on how the company’s assets are
allocated, a high current ratio may suggest that that company is not using its current
assets efficiently, is not securing financing well or is not managing its working capital
well. To better assess whether or not these issues are present, a liquidity ratio more
specific than the current ratio is needed.

An example: assume that Big-Sale Stores has $2 billion in cash, $1 billion in securities,
$4 billion in inventory, $2 billion in accounts receivable and $6 billion in liabilities. To
calculate Big-Sale’s current ratio, you would take the sum of its various assets and
divide them by its liabilities, for a current ratio of 1.5 (($2B + $1B + $4B + $2B) / $6B =
$9B / $6B = 1.5). Big-Sale Stores, then, appears to have healthy financials.

The current ratio can give a sense of the efficiency of a company's operating cycle or its
ability to turn its product into cash. Companies that have trouble getting paid on
theirreceivables or have long inventory turnover can run into liquidity problems because
they are unable to alleviate their obligations.

LIMITATIONS OF 'CURRENT RATIO'

No one ratio is a perfect gauge of a company’s financial health or of whether or not
investing in a company is a wise decision. As such, when using them it is important to
understand their limitations, and the same holds true for the current ratio.

One limitation of using the current ratio emerges when using the ratio to compare
different companies with one another. Because business operations can differ
substantially between industries, comparing the current ratios of companies in different
industries with one another will not necessarily lead to any productive insight. For
example, while in one industry it may be common practice to take on a large amount of
debt through leverage, another industry may strive to keep debts to a minimum and pay
them off as soon as possible. Companies within these two industries, then, could
potentially have very different current ratios, though this would not necessarily indicate
that one is healthier than the other because of their differing business practices. As
such, it is always more useful to compare companies within the same industry.
Another drawback of using current ratios, briefly mentioned above, involves its lack of
specificity. Of all of the different liquidity ratios that exist, the current ratio is one of the
least stringent. Unlike many other liquidity ratios, it incorporates all of a company’s
current assets, even those that cannot be easily liquidated. As such, a high current ratio
cannot be used to effectively determine if a company is inefficiently deploying its assets,
whereas certain other liquidity ratios can.

'CURRENT RATIO' AND OTHER LIQUIDITY RATIOS

Generally, liquidity ratios can be used to gauge a company’s ability to pay off its debts.
However, there are a variety of different liquidity ratios that exist and that measure this
in different ways. When considering the current ratio, it is important to understand its
relationship to other popular liquidity ratios.

One popular ratio is the working capital ratio, which is the same as the current ratio.

Another class of liquidity ratios works in a similar way to the current ratio, but are more
specific as to the kinds of assets they incorporate. The cash asset ratio (or cash ratio),
for example, compares only a company’s marketable securities and cash to its current
liabilities. The acid-test ratio (or quick ratio) compares a company’s easily liquidated
assets (including cash, accounts receivable and short-term investments, excluding
inventory and prepaid) to its current liabilities. The operating cash flow ratio compares a
companies active cash flow from operations to its current liabilities. These liquidity ratios
have a more specific purpose than the current ratio, that is, to gauge a company’s ability
to pay off short term debts.

Another similar liquidity ratio is the debt ratio, which is the opposite of the current ratio.
Debt ratio calculations take current liabilities as the numerator and current assets as the
denominator in an attempt to measure a company’s leverage.

DEFINITION OF 'ACID-TEST RATIO'

The acid-test ratio is a strong indicator of whether a firm has sufficient short-term assets
to cover its immediate liabilities. Commonly known as the quick ratio, this metric is more
robust than the current ratio, also known as the working capital ratio, since it
ignores illiquid assets such as inventory.
Calculated by:

BREAKING DOWN 'ACID-TEST RATIO'

Companies with an acid-test ratio of less than 1 do not have the liquid assets to pay
their current liabilities and should be treated with caution. If the acid-test ratio is much
lower than the current ratio, it means that current assets are highly dependent on
inventory.

This is not a bad sign in all cases, however, as some business models are inherently
dependent on inventory. Retail stores, for example, may have very low acid-test ratios
without necessarily being in danger. At the time of writing, Wal-Mart Stores Inc.'s (WMT)
acid-test ratio is 0.20, while Target Corp.'s (TGT) is 0.40. The companies' current ratios
are 0.90 and 1.20, respectively. In such cases other metrics should be considered, such
asinventory turnover. The acceptable range for an acid-test ratio will vary by industry,
and comparisons are most meaningful within a given industry.

For most industries, the acid-test ratio should exceed 1. Then again, a very high ratio is
not always an unalloyed good. It could indicate that cash has accumulated and is idle,
rather than being reinvested, returned to shareholders or otherwise put to productive
use. Some tech companies generate massive cash flows and accordingly have acid-test
ratios as high as 7 or 8. While this is certainly better than the alternative, these
companies have drawn criticism from activist investors who would prefer that
shareholders receive a portion of the profits.

ACID-TEST RATIO CALCULATION

The numerator of the acid-test ratio can be defined in various ways, but the main
consideration should be gaining a realistic view of the company's liquid assets. Cash
and cash equivalents should definitely be included, as should short-term investments,
for example, marketable securities. Accounts receivable are generally included, but this
is not always appropriate. In the construction industry accounts receivable may take a
long time to recover, and their inclusion could make a firm's financial position seem
much more secure than it is.

Another way to calculate the numerator is to take all current assets and subtract illiquid
assets. Most importantly, inventory should be subtracted, keeping in mind that this will
negatively skew the picture for retail businesses, as in the cases of Walmart and Target
mentioned above. Other elements that appear as assets on a balance sheet should be
subtracted if they cannot be used to cover liabilities in the short term, such
as advances to suppliers, prepayments and deferred tax assets.

The denominator should include all current liabilities, which are debts and obligations
that are due within one year.

It is important to note that time is not factored into the acid-test ratio. If a company's
accounts payable are nearly due but its receivables won't come in for months, that
company could be on much shakier ground than its ratio would indicate. The opposite
can also be true.

REAL WORLD EXAMPLE

A company's acid-test ratio can be calculated using its balance sheet. Below is an
abbreviated version of Apple Inc.'s (AAPL) balance sheet for the quarter ended June 27,
2015, showing the components of the company's current assets and current liabilities
(all figures in millions of dollars):

Cash and cash equivalents 15,319

Short-term marketable securities 19,384

Accounts receivable, less allowance of $83 10,370

Inventories 2,042

Deferred tax assets 5,010

Vendor non-trade receivables 9,537

 Other current assets 9,291

Total current assets 70,953

Accounts payable 26,474

Accrued expenses 22,724

Deferred revenue 9,088

Commercial paper 4,499

Current portion of long-term debt 2,500

Total current liabilities 65,285

To obtain the company's liquid current assets we add cash and cash equivalents, short-
term marketable securities, accounts receivable and vendor non-trade receivables. We
then divide current liquid current assets by total current liabilities to calculate the acid-
test ratio.

Apple's acid-test ratio = ( 15,319 + 19,384 + 10,370 + 9,537 ) / 65,285 = 0.84

Not everyone calculates this ratio the same. Reuters, for example, reports a quick ratio
of 1.06 for Apple's most recent quarter, implying that they simply subtracted inventories
from total current assets. There is no single, hard-and-fast method for determining a
company's acid-test ratio, but it is important to understand how data providers arrive at
their conclusions.

THE ACID-TEST GOLD STANDARD

Finally, a note on the term "acid test." One method for testing whether a metal is real
gold is to apply acid to it. If certain mixtures corrode the metal, it is not gold. The more
resistant to corrosion the gold is, the higher the purity. Following the Gold Rush, the
term came to refer to any test that indicates an object's authenticity, veracity, or worth.
In this case, it can let you know if a shiny investment opportunity is actually fool's gold.

DEFINITION OF 'CURRENT ASSETS'

A balance sheet account that represents the value of all assets that can reasonably
expected to be converted into cash within one year. Current assets include cash and
cash equivalents, accounts receivable, inventory, marketable securities, prepaid
expenses and other liquid assets that can be readily converted to cash.

In the United Kingdom, current assets are also known as current accounts.

BREAKING DOWN 'CURRENT ASSETS'

Current assets are important to businesses because they can be used to fund day-to-
day operations and pay ongoing expenses. Depending on the nature of the business,
current assets can range from barrels of crude oil, to baked goods, to foreign currency.
On a balance sheet, current assets will normally be displayed in order of liquidity, or the
ease with which they can be turned into cash.

Assets that cannot feasibly be turned into cash in the space of a year – or a business'
operating cycle, if it is longer – are not included in this category and are instead
considered "long-term assets." These also depend on the nature of the business, but
generally include land, facilities, equipment, copyrights and other illiquid investments.

Accounts receivable, bills to customers that have yet to be paid, are considered current
assets as long as they can be expected to be paid within a year. If a business has been
making sales by offering loose credit terms, a chunk of its accounts receivables might
not come due for a longer period of time. It is also possible that some accounts will
never be paid in full. This consideration is reflected in an allowance for doubtful
accounts, which is subtracted from accounts receivable. If an account is never
collected, it is written down as a bad debt expense.

Inventory is included as current assets, but this item should be taken with a grain of salt.
Different accounting methods can be used to inflate inventory, and in any case it is not
nearly as liquid as other current assets. It may not even be as liquid as accounts
receivable, which can be sold to third-party collection agencies in a pinch, albeit at a
steep discount. Inventories tie up capital, and if demand shifts unexpectedly—which is
more common in some industries than others—inventory can become backlogged. A
seemingly healthy current assets balance can obscure a weak inventory turnover
ratio and other problems.
Prepaid expenses are considered current assets not because they can be converted
into cash, but because they are already taken care of, which frees up cash for other
uses. As the year progresses, the value of prepaid expenses as assets decreases; they
are amortized to reflect this fact. Prepaid expenses could include payments to insurance
companies or contractors.

Components of current assets are used to calculate a number of ratios related to a

business' liquidity. The cash ratio is the most conservative: it divides cash and cash
equivalents bycurrent liabilities, and measures the ability of a company to pay off all of
its short-term liabilities immediately.

The quick ratio or acid-test ratio is slightly less stringent: it adds cash and cash
equivalents, marketable securities and accounts receivable, and divides the sum by
current liabilities. This gives a more realistic picture of a company's ability to meet its
short-term obligations, but can be skewed by a backlog of accounts receivable.

The current ratio is the most accommodating: it divides current assets by current
liabilities. It should be noted that in addition to accounts receivable, this measure
includes inventories, so it probably overstates liquidity in many cases, especially for
retailers and other inventory-intensive businesses.

In personal finance, current assets include cash on hand and in the bank, as well as
marketable securities that are not tied up in long-term investments. In other words,
current assets are anything of value that is highly liquid. Current assets can be used to
pay outstanding debts and cover liabilities without having to sell fixed assets.

DEFINITION OF 'RESTRICTED CASH'

Monies earmarked for a specific purpose and therefore not available for immediate and
general use by an organization. Restricted cash, if the amount is material, is shown
separately from cash and equivalents on the balance sheet. The purpose for which the
cash is restricted is generally disclosed in the notes to the financial statements.

BREAKING DOWN 'RESTRICTED CASH'

Restricted cash can be designated for a range of purposes such as loan repayment,
equipment purchase or investments. It may be classified as a current or non-current
asset, depending on when it is expected to be used. Expected usage of restricted cash
within one year of thebalance sheet date would necessitate it to be classified as a
current asset; expected usage more than a year out would require it to be classified as
a non-current or long-term asset.

DEFINITION OF 'MATERIAL AMOUNT'

The movement of a security's price to the extent that it confirms or refutes the trader's
original prediction. A movement of material amount that refutes the trader's original
prediction should trigger a stop-loss trade.

It can also signify an amount worth mentioning, as in financial statements or conference

calls. If it is not a material amount, then it is considered too insignificant to mention.

BREAKING DOWN 'MATERIAL AMOUNT'

The exact number that is considered a material amount is different for every trade.
Traders that set this number wrong in their systems risk being stopped out early or
taking too much risk. It is often thought that this amount can be more important to a
profitable trading system than actually predicting the price movement correctly.

DEFINITION OF 'WORKING CAPITAL'

A measure of both a company's efficiency and its short-term financial health. The
working capital is calculated as:

The working capital ratio (Current Assets/Current Liabilities) indicates whether a

company has enough short term assets to cover its short term debt. Anything below 1
indicates negative W/C (working capital). While anything over 2 means that the
company is not investing excess assets. Most believe that a ratio between 1.2 and 2.0
is sufficient.Also known as "net working capital".

BREAKING DOWN 'WORKING CAPITAL'

If a company's current assets do not exceed its current liabilities, then it may run into
trouble paying back creditors in the short term. The worst-case scenario is bankruptcy.
A declining working capital ratio over a longer time period could also be a red flag that
warrants further analysis. For example, it could be that the company's sales volumes
are decreasing and, as a result, its accounts receivables number continues to get
smaller and smaller.Working capital also gives investors an idea of the company's
underlying operational efficiency. Money that is tied up in inventory or money that
customers still owe to the company cannot be used to pay off any of the company's
obligations. So, if a company is not operating in the most efficient manner (slow
collection), it will show up as an increase in the working capital. This can be seen by
comparing the working capital from one period to another; slow collection may signal an
underlying problem in the company's operations.

Things to Remember
 If the ratio is less than one then they have negative working
capital.
 A high working capital ratio isn't always a good thing, it could
indicate that they have too much inventory or they are not
investing their excess cash.

DEFINITION OF 'GROSS WORKING CAPITAL'

The sum of all of a company's current assets (assets that are convertible to cash within
a year or less). Gross working capital includes assets such as cash, checking and
savings account balances, accounts receivable, short-term investments, inventory and
marketable securities. From gross working capital, subtract the sum of all of a
company's current liabilities to get net working capital.

BREAKING DOWN 'GROSS WORKING CAPITAL'

A company needs just the right amount of working capital to function optimally. With too
much working capital, some current assets would be better put to other uses. With too
little working capital, a company may not be able to meet its day-to-day cash
requirements. The correct balance is obtained through working capital management.

DEFINITION OF 'COST OF CAPITAL'

The cost of funds used for financing a business. Cost of capital depends on the mode of
financing used – it refers to the cost of equity if the business is financed solely through
equity, or to the cost of debt if it is financed solely through debt. Many companies use a
combination of debt and equity to finance their businesses, and for such companies,
their overall cost of capital is derived from a weighted average of all capital sources,
widely known as the weighted average cost of capital (WACC). Since the cost of capital
represents a hurdle rate that a company must overcome before it can generate value, it
is extensively used in the capital budgeting process to determine whether the company
should proceed with a project.

BREAKING DOWN 'COST OF CAPITAL'

The cost of various capital sources varies from company to company, and depends on
factors such as its operating history, profitability, credit worthiness, etc. In general,
newer enterprises with limited operating histories will have higher costs of capital than
established companies with a solid track record, since lenders and investors will
demand a higher risk premium for the former.

Every company has to chart out its game plan for financing the business at an early
stage. The cost of capital thus becomes a critical factor in deciding which financing track
to follow – debt, equity or a combination of the two. Early-stage companies seldom have
sizable assets to pledge as collateral for debt financing, so equity financing becomes
the default mode of funding for most of them.

The cost of debt is merely the interest rate paid by the company on such debt. However,
since interest expense is tax-deductible, the after-tax cost of debt is calculated as: Yield
to maturity of debt x (1 - T) where T is the company’s marginal tax rate.

The cost of equity is more complicated, since the rate of return demanded by equity
investors is not as clearly defined as it is by lenders. Theoretically, the cost of equity is
approximated by the Capital Asset Pricing Model (CAPM) = Risk-free rate +
(Company’s Beta x Risk Premium).

The firm’s overall cost of capital is based on the weighted average of these costs. For
example, consider an enterprise with a capital structure consisting of 70% equity and
30% debt; its cost of equity is 10% and after-tax cost of debt is 7%. Therefore, its
WACC would be (0.7 x 10%) + (0.3 x 7%) = 9.1%. This is the cost of capital that would
be used to discount future cash flows from potential projects and other opportunities to
estimate their Net Present Value (NPV) and ability to generate value.

Companies strive to attain the optimal financing mix, based on the cost of capital for
various funding sources. Debt financing has the advantage of being more tax-efficient
than equity financing, since interest expenses are tax-deductible and dividends on
common shares have to be paid with after-tax dollars. However, too much debt can
result in dangerously high leverage, resulting in higher interest rates sought by lenders
to offset the higher default risk.

DEFINITION OF 'WEIGHTED AVERAGE COST OF CAPITAL - WACC'

The weighted average cost of capital (WACC) is calculation of a firm's cost of capital in
which each category of capital is proportionately weighted.

All sources of capital, including common stock, preferred stock, bonds and any
other long-term debt, are included in a WACC calculation. A firm’s WACC increases as
the beta andrate of return on equity increase, as an increase in WACC denotes a
decrease in valuationand an increase in risk.

To calculate WACC, multiply the cost of each capital component by its proportional
weight and take the sum of the results. The method for calculating WACC can be
expressed in the following formula:

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 = total market value of the firm’s financing (equity and debt)
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

EXPLANATION OF FORMULA ELEMENTS

Cost of equity (Re) can be a bit tricky to calculate, since share capital does not
technically have an explicit value. When companies pay debt, the amount they pay has
a predetermined associated interest rate that debt depends on size and duration of the
debt, though the value is relatively fixed. On the other hand, unlike debt, equity has no
concrete price that the company must pay. Yet, that doesn't mean there is no cost of
equity. Since shareholders will expect to receive a certain return on their investment in a
company, the equity holders' required rate of return is a cost from the company's
perspective, since if the company fails to deliver this expected return, shareholders will
simply sell off their shares, which leads to a decrease in share price and in the
company’s value. The cost of equity, then, is essentially the amount that a company
must spend in order to maintain a share price that will satisfy its investors.

Calculating cost of debt (Rd), on the other hand, is a relatively straightforward process.
To determine the cost of debt, use the market rate that a company is currently paying
on its debt. If the company is paying a rate other than the market rate, you can estimate
an appropriate market rate and substitute it in your calculations instead.

There are tax deductions available on interest paid, which is often to companies’
benefit. Because of this, the net cost of companies’ debt is the amount of interest they
are paying, minus the amount they have saved in taxes as a result of their tax-
deductible interest payments. This is why the after-tax cost of debt is Rd (1 - corporate
tax rate).

BREAKING DOWN 'WEIGHTED AVERAGE COST OF CAPITAL - WACC'

In a broad sense, a company finances its assets either through debt or with equity.
WACC is the average of the costs of these types of financing, each of which is weighted
by its proportionate use in a given situation. By taking a weighted average in this way,
we can determine how much interest a company owes for each dollar it finances.
Debt and equity are the two components that constitute a company’s capital funding.
Lenders and equity holders will expect to receive certain returns on the funds or capital
they have provided. Since cost of capital is the return that equity owners (or
shareholders) and debt holders will expect, so WACC indicates the return that both
kinds of stakeholders(equity owners and lenders) can expect to receive. Put another
way, WACC is an investor’sopportunity cost of taking on the risk of investing money in a
company.

A firm's WACC is the overall required return for a firm. Because of this,
company directorswill often use WACC internally in order to make decisions, like
determining the economic feasibility of mergers and other expansionary opportunities.
WACC is the discount rate that should be used for cash flows with risk that is similar to
that of the overall firm.

To help understand WACC, try to think of a company as a pool of money. Money enters
the pool from two separate sources: debt and equity. Proceeds earned through
business operations are not considered a third source because, after a company pays
off debt, the company retains any leftover money that is not returned to shareholders (in
the form ofdividends) on behalf of those shareholders.

Suppose that lenders requires a 10% return on the money they have lent to a firm, and
suppose that shareholders require a minimum of a 20% return on their investments in
order to retain their holdings in the firm. On average, then, projects funded from the
company’s pool of money will have to return 15% to satisfy debt and equity holders. The
15% is the WACC. If the only money in the pool was $50 in debt holders’ contributions
and $50 in shareholders’ investments, and the company invested $100 in a project, to
meet the lenders’ and shareholders’ return expectations, the project would need to
generate returns of $5 each year for the lenders and $10 a year for the company’s
shareholders. This would require a total return of $15 a year, or a 15% WACC.

USES OF WEIGHTED AVERAGE COST OF CAPITAL (WACC)

Securities analysts frequently use WACC when assessing the value of investments and
when determining which ones to pursue. For example, in discounted cash flow analysis,
one may apply WACC as the discount rate for future cash flows in order to derive a
business's net present value. WACC may also be used as a hurdle rate against which to
gauge ROICperformance. WACC is also essential in order to perform economic value
added (EVA)calculations.

Investors may often use WACC as an indicator of whether or not an investment is worth
pursuing. Put simply, WACC is the minimum acceptable rate of return at which a
companyyields returns for its investors. To determine an investor’s personal returns on
an investment in a company, simply subtract the WACC from the company’s returns
percentage. For example, suppose that a company yields returns of 20% and has a
WACC of 11%. This means the company is yielding 9% returns on every dollar the
company invests. In other words, for each dollar spent, the company is creating nine
cents of value. On the other hand, if the company's return is less than WACC, the
company is losing value. If a company has returns of 11% and a WACC of 17%, the
company is losing six cents for every dollar spent, indicating that potential investors
would be best off putting their money elsewhere.

WACC can serve as a useful reality check for investors; however, the average investor
would rarely go to the trouble of calculating WACC because it is a complicated measure
that requires a lot of detailed company information. Nonetheless, being able to calculate
WACC can help investors understand WACC and its significance when they see it in
brokerage analysts' reports.

LIMITATIONS OF WEIGHTED AVERAGE COST OF CAPITAL (WACC)

The WACC formula seems easier to calculate than it really is. Because certain elements
of the formula, like cost of equity, are not consistent values, various parties may report
them differently for different reasons. As such, while WACC can often help lend
valuable insight into a company, one should always use it along with other metrics when
determining whether or not to invest in a company.

DEFINITION OF 'CAPITAL BUDGETING'

The process in which a business determines whether projects such as building a new
plant or investing in a long-term venture are worth pursuing. Oftentimes, a prospective
project's lifetime cash inflows and outflows are assessed in order to determine whether
the returns generated meet a sufficient target benchmark.
Also known as "investment appraisal."

BREAKING DOWN 'CAPITAL BUDGETING'

Ideally, businesses should pursue all projects and opportunities that enhance
shareholder value. However, because the amount of capital available at any given time
for new projects is limited, management needs to use capital budgeting techniques to
determine which projects will yield the most return over an applicable period of time.

Popular methods of capital budgeting include net present value (NPV), internal rate of
return (IRR), discounted cash flow (DCF) and payback period.

DEFINITION OF 'EQUIVALENT ANNUAL ANNUITY APPROACH - EAA'

One of two methods used in capital budgeting to compare mutually exclusive projects
with unequal lives. The equivalent annual annuity (EAA) approach calculates the
constant annual cash flow generated by a project over its lifespan if it was an annuity.
The present value of the constant annual cash flows is exactly equal to the project's net
present value (NPV). When used to compare projects with unequal lives, the one with
the higher EAA should be selected.

BREAKING DOWN 'EQUIVALENT ANNUAL ANNUITY APPROACH - EAA'

The EAA approach uses a three-step process to compare projects:

1. Calculate each project's NPV over its lifetime.

2. Compute each project's EAA, such that the present value of the annuities is
exactly equal to the project NPV.
3. Compare each project's EAA and select the one with the highest EAA.

For example, assume that a company with a weighted average cost of capital (WACC)
of 10% is comparing two projects, A and B. Project A has a NPV of $3 million and an
estimated life of five years, while Project B has a NPV of $2 million and an estimated life
of three years. Using a financial calculator*, Project A has an EAA of $791,392.44, and
Project B has an EAA of $804,229.61. Under the EAA approach, Project B would be
selected since it has the higher equivalent annual annuity value.

The EAA approach is relatively easier to use rather than the other method used to
compare projects with unequal lives, the replacement-chain or common life approach.

*Note: Most financial calculators would use the following inputs:

Project A – N (project life) = 5, i (WACC) = 10%, PV = -3,000,000, FV = 0, compute

PMT (the answer should be 791,392.44).

Project B – N (project life) = 3, i (WACC) = 10%, PV = -2,000,000, FV = 0, compute

PMT (the answer should be 804,229.61).

DEFINITION OF 'COST OF EQUITY'

In financial theory, the return that stockholders require for a company. The traditional
formula for cost of equity (COE) is the dividend capitalization model:

A firm's cost of equity represents the compensation that the market demands in
exchange for owning the asset and bearing the risk of ownership.

BREAKING DOWN 'COST OF EQUITY'

Let's look at a very simple example: let's say you require a rate of return of 10% on an
investment in TSJ Sports. The stock is currently trading at $10 and will pay a dividend of
$0.30. Through a combination of dividends and share appreciation you require a $1.00
return on your $10.00 investment. Therefore the stock will have to appreciate by $0.70,
which, combined with the $0.30 from dividends, gives you your 10% cost of equity.

The capital asset pricing model (CAPM) is another method used to determine cost of
equity.

DEFINITION OF 'RETURN ON CAPITAL EMPLOYED (ROCE)'

A financial ratio that measures a company's profitability and the efficiency with which its
capital is employed. Return on Capital Employed (ROCE) is calculated as:

ROCE = Earnings Before Interest and Tax (EBIT) / Capital Employed

“Capital Employed” as shown in the denominator is the sum of shareholders' equity and
debt liabilities; it can be simplified as (Total Assets – Current Liabilities). Instead of
using capital employed at an arbitrary point in time, analysts and investors often
calculate ROCE based on “Average Capital Employed,” which takes the average of
opening and closing capital employed for the time period.

A higher ROCE indicates more efficient use of capital. ROCE should be higher than the
company’s capital cost; otherwise it indicates that the company is not employing its
capital effectively and is not generating shareholder value.

BREAKING DOWN 'RETURN ON CAPITAL EMPLOYED (ROCE)'

ROCE is a useful metric for comparing profitability across companies based on the
amount of capital they use. Consider two companies, Alpha and Beta, which operate in
the same industry sector. Alpha has EBIT of $5 million on sales of $100 million in a
given year, while Beta has EBIT of $7.5 million on sales of $100 million in the same
year. On the face, it may appear that Beta should be the superior investment, since it
has an EBIT margin of 7.5% compared with 5% for Alpha. But before making an
investment decision, look at the capital employed by both companies. Let’s assume that
Alpha has total capital of $25 million and Beta has total capital of $50 million. In this
case, Alpha’s ROCE of 20% is superior to Beta’s ROCE of 15%, which means that
Alpha does a better job of deploying its capital than Beta.
ROCE is especially useful when comparing the performance of companies in capital-
intensive sectors such as utilities and telecoms. This is because unlike return on
equity(ROE), which only analyzes profitability related to a company’s common equity,
ROCE considers debt and other liabilities as well. This provides a better indication of
financial performance for companies with significant debt.

Adjustments may sometimes be required to get a truer depiction of ROCE. A company

may occasionally have an inordinate amount of cash on hand, but since such cash is
not actively employed in the business, it may need to be subtracted from the “Capital
Employed” figure to get a more accurate measure of ROCE.

For a company, the ROCE trend over the years is also an important indicator of
performance. In general, investors tend to favor companies with stable and rising ROCE
numbers over companies where ROCE is volatile and bounces around from one year to
the next.

Read more on how ROCE can be an effective analysis tool - Spotting profitability with
ROCE.

DEFINITION OF 'RETURN ON INVESTMENT - ROI'

A performance measure used to evaluate the efficiency of an investment or to compare
the efficiency of a number of different investments. ROI measures the amount
of return on an investment relative to the investment’s cost. To calculate ROI, the
benefit (or return) of an investment is divided by the cost of the investment, and the
result is expressed as a percentage or a ratio.

The return on investment formula:

In the above formula, "Gain from Investment” refers to the proceeds obtained from the
sale of the investment of interest. Because ROI is measured as a percentage, it can be
easily compared with returns from other investments, allowing one to measure a variety
of types of investments against one another.
BREAKING DOWN 'RETURN ON INVESTMENT - ROI'
Return on investment is a very popular metric because of its versatility and simplicity.
Essentially, return on investment can be used as a rudimentary gauge of an
investment’s profitability. ROI can be very easy to calculate and to interpret and can
apply to a wide variety of kinds of investments. That is, if an investment does not have a
positive ROI, or if an investor has other opportunities available with a higher ROI, then
these ROI values can instruct him or her as to which investments are preferable to
others.

For example, suppose Joe invested $1,000 in Slice Pizza Corp. in 2010 and sold
his shares for a total of $1,200 a year later. To calculate the return on his investment, he
would divide his profits ($1,200 - $1,000 = $200) by the investment cost ($1,000), for a
ROI of $200/$1,000, or 20%.

With this information, he could compare the profitability of his investment in Slice Pizza
with that of other investments. Suppose Joe also invested $2,000 in Big-Sale Stores
Inc. in 2011 and sold his shares for a total of $2,800 in 2014. The ROI on Joe’s holdings
in Big-Sale would be $800/$2,000, or 40%. Using ROI, Joe can easily compare the
profitability of these two investments. Joe’s 40% ROI from his Big-Sale holdings is twice
as large as his 20% ROI from his Slice holdings, so it would appear that his investment
in Big-Sale was the wiser move.

LIMITATIONS OF ROI
Yet, examples like Joe's reveal one of several limitations of using ROI, particularly when
comparing investments. While the ROI of Joe’s second investment was twice that of his
first investment, the time between Joe’s purchase and sale was one year for his first
investment and three years for his second. Joe’s ROI for his first investment was 20% in
one year and his ROI for his second investment was 40% over three. If one considers
that the duration of Joe’s second investment was three times as long as that of his first,
it becomes apparent that Joe should have questioned his conclusion that his second
investment was the more profitable one. When comparing these two investments on
an annual basis, Joe needed to adjust the ROI of his multi-year investment accordingly.
Since his total ROI was 40%, to obtain his average annual ROI he would need to divide
his ROI by the duration of his investment. Since 40% divided by 3 is 13.33%, it appears
that his previous conclusion was incorrect. While Joe’s second investment earned him
more profit than did the first, his first investment was actually the more profitable choice
since its annual ROI was higher.

Examples like Joe’s indicate how a cursory comparison of investments using ROI can
lead one to make incorrect conclusions about their profitability. Given that ROI does not
inherently account for the amount of time during which the investment in question is
taking place, this metric can often be used in conjunction with Rate of Return, which
necessarily pertains to a specified period of time, unlike ROI. One may also
incorporate Net Present Value (NPV), which accounts for differences in the value of
money over time due to inflation, for even more precise ROI calculations. The
application of NPV when calculating rate of return is often called the Real Rate of
Return.

Keep in mind that the means of calculating a return on investment and, therefore, its
definition as well, can be modified to suit the situation. it all depends on what one
includes as returns and costs. The definition of the term in the broadest sense simply
attempts to measure the profitability of an investment and, as such, there is no one
"right" calculation.

For example, a marketer may compare two different products by dividing the gross
profitthat each product has generated by its associated marketing expenses. A financial
analyst, however, may compare the same two products using an entirely different ROI
calculation, perhaps by dividing the net income of an investment by the total value of all
resources that have been employed to make and sell the product. When using ROI to
assess real estateinvestments, one might use the initial purchase price of a property as
the “Cost of Investment” and the ultimate sale price as the “Gain from Investment,”
though this fails to account for all of the intermediary costs, like renovations, property
taxes and real estate agent fees.

This flexibility, then, reveals another limitation of using ROI, as ROI calculations can be
easily manipulated to suit the user's purposes, and the results can be expressed in
many different ways. As such, when using this metric, the savvy investor would do well
to make sure he or she understands which inputs are being used. A return on
investment ratio alone can paint a picture that looks quite different from what one might
call an “accurate” ROI calculation—one incorporating every relevant expense that has
gone into the maintenance and development of an investment over the period of time in
question—and investors should always be sure to consider the bigger picture.

DEVELOPMENTS IN ROI
Recently, certain investors and businesses have taken an interest in the development of
a new form of the ROI metric, called "Social Return on Investment," or SROI. SROI was
initially developed in the early 00's and takes into account social impacts of projects and
strives to include those affected by these decisions in the planning of allocation of
capital and other resources.

DEFINITION OF 'RETURN ON EQUITY - ROE'

The amount of net income returned as a percentage of shareholders equity. Return on
equity measures a corporation's profitability by revealing how much profit a company
generates with the money shareholders have invested.

ROE is expressed as a percentage and calculated as:

Return on Equity = Net Income/Shareholder's Equity

Net income is for the full fiscal year (before dividends paid to common stock holders but
after dividends to preferred stock.) Shareholder's equity does not include preferred
shares.

Also known as "return on net worth" (RONW).

BREAKING DOWN 'RETURN ON EQUITY - ROE'

The ROE is useful for comparing the profitability of a company to that of other firms in
the same industry.

There are several variations on the formula that investors may use:

1. Investors wishing to see the return on common equity may modify the formula above
by subtracting preferred dividends from net income and subtracting preferred equity
from shareholders' equity, giving the following: return on common equity (ROCE) = net
income - preferred dividends / common equity.

2. Return on equity may also be calculated by dividing net income

by average shareholders' equity. Average shareholders' equity is calculated by adding
the shareholders' equity at the beginning of a period to the shareholders' equity at
period's end and dividing the result by two.

3. Investors may also calculate the change in ROE for a period by first using the
shareholders' equity figure from the beginning of a period as a denominator to
determine the beginning ROE. Then, the end-of-period shareholders' equity can be
used as the denominator to determine the ending ROE. Calculating both beginning and
ending ROEs allows an investor to determine the change in profitability over the period.

Things to Remember
 If new shares are issued then use the weighted average of the
number of shares throughout the year.
 For high growth companies you should expect a higher ROE.
 Averaging ROE over the past 5 to 10 years can give you a better
idea of the historical growth.

DEFINITION OF 'RETURN ON INVESTED CAPITAL - ROIC'

A calculation used to assess a company's efficiency at allocating the capital under its
control to profitable investments. Return on invested capital gives a sense of how well a
company is using its money to generate returns. Comparing a company's return on
capital (ROIC) with its weighted average cost of capital (WACC) reveals whether
invested capital is being used effectively.

One way to calculate ROIC is:

This measure is also known as "return on capital."

BREAKING DOWN 'RETURN ON INVESTED CAPITAL - ROIC'

Invested capital, the value in the denominator, is the sum of a company's debt and
equity. There are a number of ways to calculate this value. One is to subtract cash
and non-interest bearing current liabilities (NIBCL) – including tax liabilities
and accounts payable, as long as these are not subject to interest or fees – from total
assets.

Another method of calculating invested capital is to add the book value of a company's
equity to the book value of its debt, then subtract non-operating assets, including cash
and cash equivalents, marketable securities and assets of discontinued operations.

Yet another way to calculate invested capital is to obtain working capital by

subtracting current liabilities from current assets. Next you obtain non-cash working
capital by subtracting cash from the working capital value you just calculated. Finally
non-cash working capital is added to a company's fixed assets, also known as long-term
or non-current assets.

The value in the numerator can also be calculated in a number of ways. The most
straightforward way is to subtract dividends from a company's net income.

On the other hand, because a company may have benefited from a one-time source of
income unrelated to its core business – a windfall from foreign exchange rate
fluctuations, for example – it is often preferable to look at net operating profit after taxes
(NOPAT). NOPAT is calculated by adjusting the operating profit for taxes: (operating
profit) * (1 - effective tax rate). Many companies will report their effective tax rates for
the quarter or fiscal year in their earnings releases, but not all. Operating profit is also
referred to asearnings before interest and tax (EBIT).

ROIC is always calculated as a percentage and is usually expressed as

an annualized or trailing twelve month value. It should be compared to a company's cost
of capital to determine whether the company is creating value. If ROIC is greater than
the weighted average cost of capital (WACC), the most common cost of capital metric,
value is being created. If it is not, value is being destroyed. For this reason ROIC is one
of the most important valuation metrics to calculate. That said, it is more important for
some sectors than others, since companies that operate oil rigs or manufacture
semiconductors invest capital much more intensively than those that require less
equipment.

One downside of this metric is that it tells nothing about what segment of the business is
generating value. If you make your calculation based on net income (minus
dividends) instead of NOPAT, the result can be even more opaque, since it is possible
that the return derives from a single, non-recurring event.

ROIC provides necessary context for other metrics such as the P/E ratio. Viewed in
isolation, the P/E ratio might suggest a company is oversold, but the decline could be
due to the fact that the company is no longer generating value for shareholders at the
same rate—or at all. On the other hand, companies that consistently generate high
rates of return on invested capital probably deserve to trade at a premium to other
stocks, even if their P/E ratios seem prohibitively high.

In Target Corp.'s (TGT) first-quarter 2015 earnings release, the company calculates its
trailing twelve month ROIC, showing the components that go into the calculation:

TTM TTM
(All values in million of U.S. dollars)
5/2/15 5/3/14

Earnings from continuing operations before

4,667 4,579
interest expense and income taxes

+ Operating lease interest * 90 95

- Income taxes 1,575 1,604

Net operating profit after taxes 3,181 3,070

Current portion of long-term debt and other

112 1,466
borrowings

+ Noncurrent portion of long-term debt 12,654 11,391

+ Shareholders' equity 14,174 16,486

+ Capitalized operating lease obligations * 1,495 1,587

- Cash and cash equivalents 2,768 677

- Net assets of discontinued operations 335 4,573

Invested capital 25,332 25,680

Average invested capital 25,506 25,785

After-tax return on invested capital 12.5% 11.9%

It begins with earnings from continuing operations before interest expense and income
taxes ($4,667 million), adds operating lease interest ($90 m), then subtracts income
taxes ($1,575 m), yielding a net profit after taxes of $3,181 m: this is the numerator.
Next it adds the current portion of long-term debt and other borrowings ($112 m), the
noncurrent portion of long-term debt ($12,654 m), shareholders equity ($14,174 m) and
capitalized operating lease obligations ($1,495 m). It then subtracts cash and cash
equivalents ($2,768 m) and net assets of discontinued operations ($335 m), yielding
invested capital of $25,332 m. Averaging this with the invested capital from the end of
the prior-year period ($25,680 m), you end up with a denominator of $25,506 m. The
resulting after-tax return on invested capital is 12.5%.

This calculation would have been difficult to obtain from the income statement and
balance sheet alone, since the asterisked values are buried in an addendum. For this
reason calculating ROIC can be tricky, but it is worth arriving at a ballpark figure in order
to assess a company's efficiency at putting capital to work. Whether 12.5% is a good
result or not depends on Target's cost of capital. Since this is often between 8% and
12%, it is likely that Target is creating value, but slowly and with a thin margin for error.

DEFINITION OF 'LONG-TERM DEBT'

Long-term debt consists of loans and financial obligations lasting over one year. Long-
term debt for a company would include any financing or leasing obligations that are to
come due in a greater than 12-month period. Long-term debt also applies to
governments: nations can also have long-term debt.

In the U.K., long-term debts are known as "long-term loans."

BREAKING DOWN 'LONG-TERM DEBT'

Financial and leasing obligations, also called long-term liabilities, or fixed liabilities,
would include company bond issues or long-term leases that have been capitalized on a
firm'sbalance sheet. Often, a portion of these long-term liabilities must be paid within the
year; these are categorized as current liabilities, and are also documented on the
balance sheet. The balance sheet can be used to track the company's debt
and profitability.

On a balance sheet, the company's debts are categorized as either financial liabilities or
operating liabilities. Financial liabilities refer to debts owed to investors or stockholders;
these include bonds and notes payable. Operating liabilities refer to the leases or
unsettled payments incurred in order to maintain facilities and services for the company.
These include everything from rented building spaces and equipment to employee
pension plans. For more on how a company uses its debt, see Financial Statements:
Long-Term Liabilities.

Bonds are one of the most common types of long-term debt. Companies may issuing
bonds to raise funds for a variety of reasons. Bond sales bring in immediate income, but
the company ends up paying for the use of investors' capital due to interest payments.

WHY INCUR LONG-TERM DEBT?

A company takes on long-term debt in order to acquire immediate capital. For
example, startup ventures require substantial funds to get off the ground and pay for
basic expenses, such as research expenses, Insurance, License and Permit
Fees, Equipment and Supplies and Advertising and Promotion. All businesses need to
generate income, and long-term debt is an effective way to get immediate funds to
finance and operations.
Aside from need, there are many factors that go into a company's decision to take on
more or less long-term debt. During the Great Recession, many companies learned the
dangers of relying too heavily on long-term debt. In addition, stricter regulations have
been imposed to prevent businesses from falling victim to economic volatility. This trend
affected not only businesses, but also individuals, such as homeowners.

LONG-TERM DEBT: HELPFUL OR HARMFUL?

Since debt sums tend to be large, these loans take many years to pay off. Companies
with too much long-term debt will find it hard to pay off these debts and continue to
thrive, as much of their capital is devoted to interest payments and it can be difficult to
allocate money to other areas. A company can determine whether it has accrued too
much long-term debt by examining its debt to equity ratio.

A high debt to equity ratio means the company is funding most of its ventures with debt.
If this ratio is too high, the company is at risk of bankruptcy if it becomes unable to
finance its debt due to decreased income or cash flow problems. A high debt to equity
ratio also tends to put a company at a disadvantage against its competitors who may
have more cash. Many industries discourage companies from taking on too much long-
term debt in order to reduce the risks and costs closely associated with unstable forms
of income, and they even pass regulations that restrict the amount of long-term debt a
company can acquire.

For example, since the Great Recession, banks have begun to scrutinize companies'
balance sheets more closely, and a high level of debt now can prevent a company from
getting further debt financing. Consequently, many companies are adapting to this rule
to avoid being penalized, such as taking steps to reduce their long-term debt and rely
more heavily on stable sources of income.

A low debt to equity ratio is a sign that the company is growing or thriving, as it is no
longer relying on its debt and is making payments to lower it. It consequently has more
leverage with other companies and a better position in the current financial
environment. However, the company must also compare its ratio to those of its
competitors, as this context helps determines economic leverage.
For example, Adobe Systems Inc. (ADBE) reported a higher amount of long-term debt
in Q2 of 2015 than it had in the previous seven years. This debt is still low compared
with many of its competitors, such as Microsoft Corp. (MSFT) and Apple Inc. (AAPL), so
Adobe retains relatively the same place in the market. However, comparisons fluctuate
with competitors such as Symantec Corp. (SYMC) and Quintiles Transnational (Q), who
carry a similar amount of long-term debt as Adobe.

A company's long-term debt may also put bond investors at risk in an illiquid bond
market. The question of the liquidity of the bond market has become an issue since the
Great Recession, as banks that used to make markets for bond traders have been
constrained by greater regulatory oversight.

Long-term debt is not all bad, though, and in moderation, it is necessary for any
company. Think of it as a credit card for a business: in the short-term, it allows the
company to invest in the tools it needs to advance and thrive while it is still young, with
the goal of paying off the debt when the company is established and in the financial
position to do so. Without incurring long-term debt, most companies would never get off
the ground. Long-term debt is a given variable for any company, but how much debt is
acquired plays a large role in the company's image and its future.

Bank loans and financing agreements, in addition to bonds and notes that have
maturities greater than one year, would be considered long-term debt. Other securities
such as repos and commercial papers would not be long-term debt, because their
maturities are typically shorter than one year.

DEFINITION OF 'FINANCIAL BUYER'

A type of buyer in an acquisition that is primarily interested in a company's return on
equity, investment, burden on management and cash flow. To determine this
information, a financial buyer will carefully look over a company's financial statements
and assets.

A financial buyer is typically a long-term investor looking for a solid, well-managed

company. Financial buyers rarely make any immediate changes, except in turnaround
situations where companies are not currently profitable.
BREAKING DOWN 'FINANCIAL BUYER'
Many everyday retail investors could be considered financial buyers. An investor taking
either a value or growth approach to investing over the long term is following many of
the same strategies that large financial buyers do.

Another example of a financial buyer is a former executive looking to purchase a job by

finding a company to manage or turn around; alternatively, he or she could just be
holding companies looking for a good return on investment and plan to keep current
management in place.

DEFINITION OF 'QUALITATIVE ANALYSIS'

Qualitative analysis is securities analysis that uses subjective judgment based on
unquantifiable information, such as management expertise, industry cycles, strength of
research and development, and labor relations. Qualitative analysis contrasts
with quantitative analysis, which focuses on numbers that can be found on reports such
asbalance sheets. The two techniques, however, will often be used together in order to
examine a company's operations and evaluate its potential as an investment
opportunity.

BREAKING DOWN 'QUALITATIVE ANALYSIS'

The distinction between qualitative and quantitative approaches is similar to the
distinction between human and artificial intelligence. Quantitative analysis uses exact
inputs such asprofit margins, debt ratios, earnings multiples and the like. These can be
plugged into a computerized model to yield an exact result, such as the fair value of a
stock or a forecast for earnings growth. Of course, for the time being, a human has to
write the program that crunches these numbers, and that involves a fair bit of subjective
judgment. Once they are programmed, though, computers can perform
quantitative analysis in fractions of a second, while it might take even the most gifted
and highly-trained humans minutes or hours.

Qualitative analysis, on the other hand, deals with intangible, inexact concerns that
belong to the social and experiential realm rather than the mathematical one. This
approach depends on the kind of intelligence that machines (currently) lack, since
things like positive associations with a brand, management trustworthiness, customer
satisfaction, competitive advantage and cultural shifts are difficult, arguably impossible,
to capture with numerical inputs.

ELEMENTS OF QUALITATIVE ANALYSIS

Qualitative analysis can sound almost like "listening to your gut," and indeed many
qualitative analysts would argue that gut feelings have their place in the process. That
does not mean, however, that it is not a rigorous approach. Indeed, it can consume
much more time and energy than quantitative analysis.

People are central to qualitative analysis. An investor might start by getting to know a
company's management, including their educational and professional backgrounds.
One of the most important factors is their experience in the industry. More abstractly, do
they have a record of hard work and prudent decision-making, or are they better at
knowing – or being related to – the right people? Their reputations are also key: are
they respected by their colleagues and peers? Their relationships with business
partners are also worth exploring, since these can have a direct impact on operations.

Perhaps more important is the way employees view the company and its management.
Are they satisfied and motivated, or do they resent their bosses? The rate of employee
turnover can indicate employees' loyalty or lack thereof. What is the workplace
culture like? Overly hierarchical offices promote intrigue and competition and sap
productive energy; a sleepy, unmotivated environment can mean employees are mainly
concerned with punching the clock. The ideal is a vibrant, creative culture that attracts
top talent.

Admittedly, answers to these questions can be difficult to come by. Fortune 500 CEOs
are not known for sitting down with small-time investors for a chat or showing them
around the corporate headquarters. In part, Warren Buffet is able to use qualitative
analysis so effectively because people are so willing to give him access to their time
and information. The rest of us have to sift through news reports and companies' filings
to get a sense of managers' records, strategies and philosophies. The management
discussion and analysissection of a company's 10-K filing and quarterly earnings
conference calls provide a window into strategies and communication styles. Clear,
transparent communication and coherent strategies are good. Buzzwords, evasiveness
and short-termism, not so much.

QUALITATIVE ANALYSIS IN CONTEXT

Customers are the only group more crucial to a company's success than management
and employees, since they are the source of its revenue. Ironically, if a company places
customers' interests before shareholders, it may be a better long-term investment. If
feasible, it's a good idea to try being a customer. Say you're considering investing in an
airline that has reined in costs, beat earnings estimates in three consecutive quarters
and plans to buy back shares. When you try to actually use the airline, however, you
find the website bug-ridden, the customer service reps cranky, the extra fees petty and
your fellow passengers resentful. Now the financials appear to tell a less attractive
story: a jaded incumbent squeezes more from its customers while giving less in return,
throwing sops to investors until a better firm comes along to sweep them away.

A company's business model and competitive advantage are a key component of

qualitative analysis. What gives the firm an enduring leg up over its rivals? Has it
invented a new technology that competitors will find hard to replicate, or that
has intellectual propertyprotection? Does it have a unique approach to solving a
problem for its customers? Is its brand globally recognized—in a good way? Does its
product have cultural resonance or an element of nostalgia? Will there still be a market
for it in twenty years? If you can plausibly imagine another company stepping in and
doing what this one does just a little bit better, then the barrier to entry may be too low.
If the company is not yet established, why will it be the one to create or disrupt its
chosen market, and why won't it then be replaced in turn?

The idea behind quantitative analysis is to measure things; the idea behind qualitative
analysis is to understand them. The latter requires a holistic view and a fact-based
overarching narrative. Context is key. For example, a CEO who dropped out of college
would be a red flag in some cases, but Mark Zuckerburg and Steve Jobs are
exceptions. Silicon Valley is, for better or worse, a different beast. A look at McDonald's
Corp's (MCD) financials a few years ago would have told you nothing about a looming
backlash against, cheap, nutritionless food. On the other hand, a purely qualitative
approach is vulnerable to distortion by blindspots, over-narrativizing and personal
biases. Quantitative measures can act as a check on these tendencies.

DEFINITION OF 'PROFITABILITY RATIOS'

A class of financial metrics that are used to assess a business's ability to generate
earnings as compared to its expenses and other relevant costs incurred during a
specific period of time. For most of these ratios, having a higher value relative to a
competitor's ratio or the same ratio from a previous period is indicative that the company
is doing well.

BREAKING DOWN 'PROFITABILITY RATIOS'

Some examples of profitability ratios are profit margin, return on assets and return on
equity. It is important to note that a little bit of background knowledge is necessary in
order to make relevant comparisons when analyzing these ratios.

For instance, some industries experience seasonality in their operations. The retail
industry, for example, typically experiences higher revenues and earnings for the
Christmas season. Therefore, it would not be too useful to compare a retailer's fourth-
quarter profit margin with its first-quarter profit margin. On the other hand, comparing a
retailer's fourth-quarter profit margin with the profit margin from the same period a year
before would be far more informative.

Profitability ratios are the most popular metrics used in financial analysis. Read the
short guide on Profitability Indicator Ratios: Introduction.

DEFINITION OF 'PREFERRED STOCK'

A class of ownership in a corporation that has a higher claim on
its assets and earnings thancommon stock. Preferred shares generally have
a dividend that must be paid out before dividends to common shareholders, and the
shares usually do not carry voting rights.

Preferred stock combines features of debt, in that it pays fixed dividends, and equity, in
that it has the potential to appreciate in price. The details of each preferred stock
depend on the issue.
BREAKING DOWN 'PREFERRED STOCK'
Preferred shareholders have priority over common stockholders when it comes to
dividends, which generally yield more than common stock and can be paid monthly
orquarterly. These dividends can be fixed or set in terms of a benchmark interest rate
like theLIBOR. Adjustable-rate shares specify certain factors that influence the dividend
yield, and participating shares can pay additional dividends that are reckoned in terms
of common stock dividends or the company's profits.

COMPANIES IN DISTRESS
If a company is struggling and has to suspend its dividend, preferred shareholders may
have the right to receive payment in arrears before the dividend can be resumed for
common shareholders. Shares that have this arrangement are known as cumulative. If
a company has multiple simultaneous issues of preferred stock, these may in turn be
ranked in terms of priority: the highest ranking is called prior, followed by first
preference, second preference, etc.

Preferred shareholders have prior claim on a company's assets if it is liquidated, though

they remain subordinate to bondholders. Preferred shares are equity, but in many ways
they are hybrid assets that lie between stock and bonds. They offer more predicable
income than common stock and are rated by the major credit rating agencies. Unlike
with bondholders, failing to pay a dividend to preferred shareholders does not mean a
company is in default. Because preferred shareholders do not enjoy the same
guarantees as creditors, the ratings on preferred shares are generally lower than the
same issuer's bonds, with the yields being accordingly higher.

VOTING RIGHTS, CALLING AND CONVERTABILITY

Preferred shares usually do not carry voting rights, although under some
agreements these rights may revert to shareholders that have not received their
dividend. Preferred shares have less potential to appreciate in price than common
stock, and they usually trade within a few dollars of their issue price, most commonly
$25. Whether they trade at a discount or premium to the issue price depends on the
company's credit-worthiness and the specifics of the issue: for example, whether the
shares are cumulative, their priority relative to other issues, and whether they are
callable.
If shares are callable, the issuer can purchase them back at par value after a set date. If
interest rates fall, for example, and the dividend yield does not have to be as high to be
attractive, the company may call its shares and issue another series with a lower yield.
Shares can continue to trade past their call date if the company does not exercise this
option.

Some preferred stock is convertible, meaning it can be exchanged for a given number
of common shares under certain circumstances. The board of directors might vote to
convert the stock, the investor might have the option to convert, or the stock might have
a specified date at which it automatically converts. Whether this is advantageous to the
investor depends on the market price of the common stock.

TYPICAL BUYERS OF PREFERRED STOCK

Preferred stock comes in a wide variety of forms. The features described above are only
the more common examples, and these are frequently combined in a number of ways.
A company can issue preferred shares under almost any set of terms, assuming they
don't fall foul of laws or regulations. Most preferred issues have no maturity dates or
very distant ones.

Due to certain tax advantages that institutions enjoy with preferred shares but individual
investors do not, these are the most common buyers. Because these institutions buy in
bulk, preferred issues are a relatively simple way to raise large amounts of capital.
Private or pre-public companies issue preferreds for this reason.

Preferred stock issuers tend to group near the upper and lower limits of the credit-
worthiness spectrum. Some issue preferred shares because regulations prohibit them
from taking on any more debt, or because they risk being downgraded. While preferred
stock is technically equity, it is similar in many ways to a bond issue; some forms,
known as trust preferred stock, can act as debt from a tax perspective and common
stock on the balance sheet. On the other hand, several established names like General
Electric, Bank of America and Georgia Power issue preferred stock to finance projects.

For more on this interesting hybrid security, read A Primer on Preferred Stocks and
Valuation of Preferred Stocks.
DEFINITION OF 'PARTICIPATING PREFERRED STOCK'
A type of preferred stock that gives the holder the right to receive dividends equal to the
normally specified rate that preferred dividends receive as well as an additional dividend
based on some predetermined condition.

The additional dividend paid to preferred shareholders is commonly structured to be

paid only if the amount of dividends that common shareholders receive exceeds a
specified per-share amount.

Furthermore, in the event of liquidation, participating preferred shareholders can also

have the right to receive the stock's purchasing price back as well as a pro-rata share of
any remaining proceeds that the common shareholders receive.

BREAKING DOWN 'PARTICIPATING PREFERRED STOCK'

For example, suppose Company A issues participating preferred shares with a dividend
rate of $1 per share. The preferred shares also carry a clause on extra dividends for
participating preferred stock, which is triggered whenever the dividend for common
shares exceeds that of the preferred shares.

If, during its current quarter, Company A announces that it will release a dividend of
$1.05 per share for its common shares, the participating preferred shareholders will
receive a total dividend of $1.05 per share ($1.00 + 0.05) as well.

Participating preferred stock is rarely issued, but one way in which it is used is as a
poison pill. In this case, current shareholders are issued stock that gives them the right
to new common shares at a bargain price in the event of an unwanted takeover bid.

DEFINITION OF 'CUMULATIVE PREFERRED STOCK'

A type of preferred stock with a provision that stipulates that if any dividends have been
omitted in the past, they must be paid out to preferred shareholders first, before
common shareholders can receive dividends.

BREAKING DOWN 'CUMULATIVE PREFERRED STOCK'

A preferred stock will typically have a fixed dividend yield based on the par value of the
stock. This dividend is paid out at set intervals, usually quarterly, to preferred holders. If
a company runs into some financial problems and is unable to meet all of its obligations,
it will likely suspend its dividend payments and focus on paying the business-specific
expenses. If the company gets through the trouble and starts paying out dividends
again, it will first have to pay back all of the dividends that are owed to preferred share
holders.

DEFINITION OF 'PRIOR PREFERRED STOCK'

A type of preferred stock with a higher claim on assets and dividends than other issues
of preferred stock. If a firm did not generate enough money to fulfill all of its dividend
schedule requirements, those holding prior preferred stocks have first priority.

BREAKING DOWN 'PRIOR PREFERRED STOCK'

Since prior preferred stock holders have a higher claim on the dividends of a company
during normal operations and a higher claim on assets during bankruptcy, these
shareholders are subject to less risk than other preferred or common shareholders. As
with many other lower risk investments, these stocks normally offer a lower rate of
return relative to other forms of stock because they are subject to less risk.

DEFINITION OF 'EARNINGS BEFORE INTEREST & TAX - EBIT'

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 "profit before interest and taxes (PBIT)."

EBIT = Revenue - Operating Expenses

or:

EBIT = Net Income + Interest + Taxes

BREAKING DOWN 'EARNINGS BEFORE INTEREST & TAX - EBIT'
EBIT measures the profit a company generates from its operations, making it
synonymous with "operating profit." By ignoring tax and interest expenses, it focuses
solely on a company's ability to generate earnings from operations, ignoring variables
such as the tax burden and capital structure.
This focus makes EBIT an especially useful metric for certain applications. For example,
if an investor is thinking of buying a firm out, the existing capital structure is less
important than the company's earning potential. Similarly, if an investor is comparing
companies in a given industry that operate in different tax environments and have
different strategies for financing themselves, tax and interest expenses would distract
from the core question: how effectively do these companies generate profits from their
operations?

There are different ways to go about calculating EBIT, which is not a GAAP metric and
therefore not usually included in financial statements. Always begin with total
revenue (or equivalently, total sales) and subtract operating expenses, including
the cost of goods sold. You may take out one-time or extraordinary items, such as the
revenue from the sale of an asset or the cost of a lawsuit, as these do not relate to the
business' core operations, but these may also be included. If a company has non-
operating income, such as income from investments, this may be—but does not have to
be—included; in that case, EBIT is distinct from operating income, which, as the name
implies, does not include non-operating income.

Often, interest income is included in EBIT, but it may be excluded depending on its
source. If the company extends credit to its customers as an integral part of its
business, then this interest income is a component of operating income and is always
included. If, on the other hand, the interest income derives from bond investments, or
charging fees to customers that pay their bills late, it may be excluded. As with the other
adjustments mentioned, this one is up to the investor's discretion, and should be applied
consistently to all companies being compared.

In the simplest terms, EBIT is calculated by taking the net income figure from the
income statement and adding the income tax expense and interest expense back in.
Put a different way, operating expenses are subtracted from total revenue. As an
example, we'll use Procter & Gamble Co's (PG) income statement from the year ending
June 30, 2015 (all figures in millions of USD):

Net sales 76,279

 Cost of products sold 38,876

Gross profit 37,403

Selling, general and administrative expense 23,585

Venezuela charge 2,028

Operating income 11,790

Interest expense 626

Interest income 151

Other non-operating income, net 531

Earnings from continuing operations before income taxes 11,846

Income taxes on continuing operations 2,916

Net earnings (loss) from discontinued operations (1,786)

Net earnings 7,144

Less: net earnings attributable to non-controlling interests 108

Net earnings attributable to Procter & Gamble 7,036

To calculate EBIT, we take net sales ($76,279 m) and subtract the cost of products sold
($38,876 m) along with the "selling, general and administrative expense" ($23,585 m)
and the "Venezuela charge" ($2,028). We then add non-operating income ($531 m),
including interest income ($151 m), to obtain an EBIT of $12,472.

Whether to include the Venezuela charge raises questions. As mentioned above, one-
time expenses can arguably be excluded. In this case, a note in the earnings release
explains that the company is continuing to operate in the country though subsidiaries.
Due to capital controls in effect at the time, however, P&G is taking a one-time hit to
remove Venezuelanassets and liabilities from its balance sheet. Similarly, an argument
could be made for excluding interest income and other non-operating income from the
equation. These considerations are to some extent subjective, but consistent criteria
should be applied to all companies being compared.

Another way to calculate P&G's fiscal 2015 EBIT is to work from the bottom up,
beginning with the net earnings ($7,144 m). We ignore non-controlling interests, as
we're only concerned with the company's operations, and add the net loss
from discontinued operations ($1,786 m), for much the same reason. We then add
income taxes ($2,916 m) and interest expense ($626 m) back in, to obtain the same
EBIT we did via the top-down method: $12,472 m.

DEFINITION OF 'CONSOLIDATED FINANCIAL STATEMENTS'

The combined financial statements of a parent company and its subsidiaries.

BREAKING DOWN 'CONSOLIDATED FINANCIAL STATEMENTS'

Because consolidated financial statements present an aggregated look at the financial
position of a parent and its subsidiaries, they enable you to gauge the overall health of
an entire group of companies as opposed to one company's stand alone position.