Finance is so much jargon. Credits, Debits, Balance Sheets, Cash Flows etc., the list is extremely long. Basic jargon was covered in Jargon buster: Technical terms every mutual fund investor must know the previous post in this series. This post is going to be an extension of that post with a deeper look at other jargon to help you evaluate your mutual fund portfolio.
Return on Equity
The term equity has already been explained in the previous post. To recollect, equity is the difference between the company’s assets and liabilities. The Return on Equity, commonly known as ROE is one of the most important metrics to quickly assess the operating performance of the company. It is defined as the net income generated by the company divided by the total equity. Essentially it means how much money the company is generating by deploying the assets it already has or those that have accrued over a period of time. Higher the ROE, better it is. It is an important factor to consider when comparing companies in the same sector. For example, Infosys has an ROE of around 25% compared to TCS’s 38%. TCS seems to generate more income as a factor.
Return on Capital Employed (ROCE)
The ROCE is slightly different from the ROE. The ROCE measures the efficiency of the usage of capital or simply the return on incremental capital. The ROCE is the ratio of earnings by the total capital employed. This should definitely be above the cost of capital (like the interest rate they pay on the borrowings). You will be surprised that some companies borrow at 12% and the ROCE is negative! This is a sign of a bad business and a bad management. The return on any investment should always be higher than the rate of borrowing. It’s like you borrow from a bank at 12% and invest it in a FD which yields only 7%. You won’t do that, that’s crazy! But companies think they are clever, overestimating returns and ending up eroding wealth. This ratio is very important in capital intensive sectors like automobiles, chemicals and general manufacturing. An ROCE greater than 20% is excellent!
Cash flow is the movement of cash across the business or company. Cash flow is a measure of the health of the company in general as it measures the company’s credit worthiness. A company needs cash to pay suppliers, employees and others. It also receives cash from the sale of products or rendering of services. Cash is liquid cash and not a billed amount. This is critical as it means money in the bank. A company normally cannot sustain a negative cash flow for a long time. On the other hand, a positive cash flow is a sign of good health and indicates credibility in the company’s growth. Fudging cash flow statements is difficult, acting as a safety net for us retail investors.
I am sure you must have heard about this term before. Working capital measures the financial strength of a company, especially companies that have borrowed heavily. Working capital is defined as the difference between the company’s current assets minus the current liabilities (like Debt). A negative working capital is unhealthy as the liabilities outweigh the assets, sometimes leading to bankruptcy! We don’t want that now, do we?
Analysts keep talking about this! It’s all over the news, but what is it? EBITDA is the abbreviation for Earnings Before Interest, Taxes, Depreciation and Amortization. Simply put, it’s like the actual profit of the company less the unimportant items like taxes and depreciation. It’s a good indicator of the profitability. The EBITDA margin is the ratio of the EBITDA to the revenue. An increase in margin is an excellent indicator of the company’s incremental improvement in operational efficiency, the ability to scale up disproportionally etc. Companies exhibiting incremental increases in margin generally attract higher valuations due to the guarantee of exponential growth.
There are some more terms and jargon used in finance and investing. We have tried to cover the critical ones in the two posts, which when used together will help you choose the best portfolio to invest in. While choosing your mutual fund, don’t forget to apply these terms to make the right choice. Every mutual fund will tell you their current portfolio which should be the starting point for your analysis.
Arjun Balakrishnan is an investment fanatic who loves writing about investment topics. He regularly writes at Investment Gyaan.