Return on Investment – ROI

By Adriano Correa | Published: June 5, 2011

Previously, we have discussed financial metrics and why they are important in a business evaluation. Today we will try to focus on a specific metric called “Return on investment” (ROI).

The Return on Investment is one way of valuating an investment. You probably would not like to invest in a business that would give you no return at all. That would be a silly way of losing money. If you do not like your money, please, donate it to someone who does (preferably to a good cause or, if you do not sympathise to any NGO, me). But I guess this is not your case, otherwise you would not be reading this blog now.

So, what does ROI do? Well, it compares the benefits of a project versus its total costs. Therefore, it will be expressed as a percentage, not in monetary units. To calculate it, you have to divide the net income of the project by its costs, or, in a company, by the book value of assets. The formula for it is presented below:

Return on investment (ROI) - Formula

Example: If you have a net income of $ 200 and a book value of assets of $ 100, ROI illustrates that for every $ 1 you invested, you received a net income of $ 2 (ROI = 200%).

You can improve this formula by adjusting the net income by the interest and tax rate. In this case, the formula would be:

Return on investment (ROI) - Formula

Even being an important financial metric for business evaluation, I wouldn’t rely only on the ROI in my analysis, and there are many reasons for it. As you see, the numerator of the formula, the net income, is not totally reliable to determine the company’s success; it doesn’t tell if the operations are or are not profitable. It also does not take into consideration the life length of the project / investment, depreciation rates, capitalization policy, growth rate, and the lag between the cash outflows and inflows.

All these components are important for evaluating an investment; the longer it takes to get the money you invested into a business, the longer you remain without the benefits from the investment made. If you don’t receive cash inflows from the business, you may end up without money to pay your suppliers. In new companies, the growth rate will be bigger. Therefore, if you are comparing a new company to an older one, this financial metric will decrease in utility.

Still, we see this metric being used in many annual reports. Therefore, you should at least know how it’s calculated in order decide if you are using it or not for your business evaluation (it’s especially useful to not be taken advantage of by someone trying to lie to you using statistics and biased parameters). Keep your eyes wide open!

Posted in Financial metrics | 2 Comments

Financial metrics

By Adriano Correa | Published: June 1, 2011

When you are analyzing a company, you go through many documents (balance sheets, income statements, cash flow statements, etc.), each one presenting specific information about the company under analysis. Sometimes you will need to compare two different firms (maybe to decide in which one you should invest in), or the same company in two different periods (in order to compare its progress, determine if the company is on the right path or not, and check if there is room for improvement).

In these situations it is easier to analyse the companies with the help of a financial metric. Financial metrics are calculated using information from many documents, but, normally, you would be able to calculate several metrics just with the balance sheet and income statement in hands. You will convert the information in these documents into parameters of quantitative assessment for measurement, comparison or to track performance. Using metrics helps to convert different situations and many segregated information into a common denominator, helping someone to analyse and compare firms that might even be in different industries.

Below we present a list of commonly used financial metrics that you should be familiar with:

  • Debt Ratio;
  • DCF – Discounted cash flow;
  • EBIT – Earnings before interest and taxes;
  • EBITDA – Earnings before interest, taxes, depreciation, and amortization;
  • EPS – Earning per share;
  • FCF – Free cash flow;
  • Net Working Capital;
  • NPV – Net Present Value;
  • Operating Margin;
  • ROA – Return on Assets;
  • ROE – Return on Equity;
  • ROI – Return on Investment;
  • WACC – Weighted Average Cost of Capital.

Some people may be thinking “I’m totally able to analyse a company only based on the balance sheet and on the income statement. Why should I waste my time calculating financial metrics?”. Well, the first reason is because it summarizes much information about the company. Second, as explained above, it helps in the comparison between two different companies. Third, it provides you information about the company’s financial health. Last, but not the least, if you have to discuss the company’s reality with some stockholder, they will probably ask you something related to a financial metric, and you better be prepared for it!

In the next weeks we will be exploring some specific financial metrics, but we are not trying to cover the whole topic here. We are also not interested in an academic discussion about the uses of financial metrics; we will be adopting a pragmatic approach to it. Our focus is to introduce some metrics that are normally used by entrepreneurs, auditors, financial analysts, private equity firms, strategic investors, and others, for business evaluation. If something is not clear, or if you feel the need for the explanation of a metric that has not being covered yet, please, send us an e-mail asking us to prioritize it.

Our first metric being analyzed will be ROI – Return on Investment.

Visit us again soon for the metrics explanation, or subscribe to our feed to be updated about this blog. See you soon!

Posted in Corporate Finance, Financial metrics | 1 Comment

Sales taxes in Canada

By Adriano Correa | Published: May 30, 2011

Many countries have a value-added tax. In Canada we find something similar, the Goods and Services Tax (GST), which is a multi-stage sales tax set by the federal government. Until July 1, 2006, this taxation was of 7%. Although, it changed to 6% and now, after January 1, 2008, the GST is of 5%.

Besides Alberta, all provincial governments charge sales taxes as well, but they have a few differences among them. Manitoba and Saskatchewan charge a Provincial Sales Tax (PST) of 7% and 5%, respectively. Prince Edward Island and Québec charge a PST of 10% and 8.5%, respectively, but these amounts are applied to the sum of the price and the GST. Therefore, these provinces have effective PSTs of 10.5% and 8.925%, as presented below:

  • Prince Edward Island => 10% x (100% + 5%) = 10.5%
  • Québec => 8.5% x (100% + 5%) = 8.925%

The provinces of British Columbia, New Brunswick, Newfoundland and Labrador, Nova Scotia, and Ontario have harmonized their sales tax with the GST, instead of charging GST and PST separately. Therefore, instead of having these two taxes, they have a Harmonized Sales Tax (HST), which is federally-administered, of 12%, 13%, 13%, 15%, and 13%, respectively.

Just like the province of Alberta, the territories of Northwest Territories, Nunavut and Yukon do not charge sales tax.

Below we present a summary of GST, PST and HST at the retail level on goods and some services for each province:

Province GST PST HST Total
Alberta 5% - - 5%
British Columbia - - 12% 12%
Manitoba 5% 7% - 12%
New Brunswick - - 13% 13%
Newfoundland and Labrador - - 13% 13%
Nova Scotia - - 15% 15%
Ontario - - 13% 13%
Prince Edward Island 5% 10% - 15.5%
Québec 5% 8.5% - 13.925%
Saskatchewan 5% 5% - 10%

If you need help calculating the sales tax for your purchases, you can use our Canadian Sales Tax Calculator.

Note: In Québec the PST will increase to 9.5% in January 1, 2012. Therefore, Québec will have an effective PST of 9.975%.

Posted in Taxation | 2 Comments

What is the Accounting Cycle?

By Adriano Correa | Published: April 26, 2011

The process of collecting, registering, and processing a business’ financial events is called Accounting Cycle (or Bookkeeping Cycle). It consists of a series of activities that starts when the event occurs (transaction) and ends with the closing of the books.

The main steps of this process are:

  • Steps performed as the transactions occur:
    • Identifying the transaction / event;
    • Preparing the transaction’s source document (ex. Invoice);
    • Quantifying the transaction in monetary terms;
    • Identifying the accounts that are affected (those that will be debited or credited);
    • Putting transactions in the chronological order into the general journal;
    • Posting entries to the general ledger.
  • Steps performed at the end of the accounting period:
    • Preparing an unadjusted trial balance;
    • Testing your books to be sure that they are in balance;
    • Adjusting entries appropriately to make sure that the sum of debits equal the sum of credits (look for math errors, transactions registered more than once or by the wrong amount, other record errors, or any other mistakes that may be affecting the balance of the accounts);
    • Preparing adjusting entries to record accrued, deferred, and estimated amounts;
    • Posting adjusting entries to the ledger accounts;
    • Preparing an adjusted trial balance;
    • Organizing the accounts into the financial statements (ex. Balance sheet, income statement, cash flow statement, statement of retained earnings, etc.);
    • Closing the books (posting entries to close revenues, expenses, and other temporary accounts, and to transfer its amounts to the retained earnings account);
    • Journalizing and posting closing entries to the ledger accounts;
    • Preparing the post-closing trial balance (which contains only permanent accounts);
    • Checking the accounts to make sure that the sum of debits equals the sum of credits.

After completing these steps, the process starts all over again for the next year.

Note: All transactions should be registered following the accounting principles.

Posted in Accounting | Tagged , , , | 22 Comments