12 Financial Terms Everyone Should Know
Knowing finance terms is important because it can help you understand and manage your personal financial health. It can also help you be aware of current economic events.
In this article, you will learn 12 financial terms and definitions to develop your financial skills that’ll help you excel professionally.
Here are 12 financial terms and definitions you should know.
1. Assets
An asset is an item owned by an individual or business with the expectation that it will generate economic value, such as cash, bonds, stocks, land, real estate, or inventory.
There are different types of assets, including:
Current Assets: Cash or assets that can be converted into cash within one year. Current assets include cash, cash equivalents, account receivable, inventories, marketable securities, prepaid expenses such as rent and insurance, and other liquid assets.
Fixed Assets: Fixed assets are tangible items that a company owns and uses in its business to generate long-term income. These assets can’t immediately be turned into cash, but are physical assets that are used in the operations of a business such as land, machinery, vehicles, buildings, equipment, etc.
2. Asset Allocation
Asset allocation refers to how investors divide their portfolios among various financial instruments with a different risk/yield ratio. There are three primary investment types. These include:
Equities: Equities give an investor ownership claim to share in the net income and assets of a corporation. Equities are considered long-term securities because they have no maturity date. Equity investments include common stock, preferred stock, mutual funds, and exchange-traded funds.
Cash and Cash Equivalents: This refers to any asset in the form of cash or can be converted to cash easily. Cash equivalents are investments that can generally be liquidated in less than three months. Common examples of cash equivalents include marketable securities, commercial paper, short-term government bonds, money market accounts, and certificates of deposits.
Fixed income assets: Fixed income investments constitute a class of assets that pay investors fixed interest or dividends, often referred to as coupons. Government and corporate bonds are the typical examples of fixed income assets.
3. Balance Sheet
The balance sheet displays the firm’s assets and liabilities at a specific point in time. The balance sheet is divided into two sides with the assets on the left side and the liabilities on the right side. The assets on the left side reflect how the resources are controlled by a firm and the right side shows how a firm finances the acquisition of these resources.
The balance sheet can tell you a lot about the financial health of a firm, which is based on the basic equation:
The assets list cash, inventory, property, and other investments the company has made.
The liabilities show the firm’s obligations to pay money to other people or businesses in the future.
Shareholders’ equity is the firm’s net worth that equals the firm’s total assets minus its total liabilities. This means that if the firm needs to be sold, shareholders’ equity returns to the firm’s owners after all liabilities have been paid down.
If shareholders’ equity is positive; the firm has enough assets to cover its liabilities. But if shareholders’ equity is negative; the firm’s liabilities outnumber its assets, which indicates the firm may default on its liabilities to creditors.
Hey, also want to read additional resources on budgeting, saving, investing, money management and more. You can check out Investopedia and NerdWallet.
4. Capital Markets
The capital market is a financial market in which longer term debt and equity instruments are traded. Capital markets are used to sell different financial instruments including debt and equity instruments with maturities of greater than one year.
These markets are divided into two categories:
Primary market: The primary market is a financial market where new securities are issued and sold to initial buyers for trading. A company issues a new share or bond to the general public to raise capital to finance its long term goals.
Secondary market: The secondary market is a financial market where investors buy and sell previously issued financial instruments such as stocks, bonds, options, and futures contracts.
5. Cash Flow
Cash flow is the increase or decrease in the amount of cash and cash equivalents a company has. Cash flow is generated by business operations, investments, and financing.
Cash flow can either be positive or negative. A positive cash flow shows that the company has enough money to meet its future expenses. On the other hand, a negative cash flow reflects that the company isn’t utilizing its cash and cash equivalents efficiently.
There are three main types of cash flow with different uses for running a business and performing financial analysis.
Operating Cash Flow: It measures the net cash generated from normal business operations within a specified time period. These business operations include cash activities related to revenue and expense.
Investing Cash Flow: It measures the net cash generated from investing activities such as securities investments and purchasing assets. It shows how much money a company spent or made through investment activities within a given time period.
Financing Cash Flow: It measures the net cash generated from financing a business within a certain time period. It shows how much funding a company earns from things like taking out loans, or issuing new equity.
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6. Cash Flow Statement
The cash flow statement is a financial statement that tracks the incoming and outgoing cash and cash equivalents from a company within a particular time period.
It provides information about a company’s available liquid funds. In other words, it measures how a company manages its cash and liquidity position.
The cash flow statement is one of the three most important fundamental financial statements along with the balance sheet and income statement. Because it summarizes all operating, investing, and financing activities of a business.
7. Compound Interest
The effect of earning interest on interest is known as compound interest which is calculated on both the initial principal and the accumulated interest from previous periods.
Compound interest can expand the growth of your savings and investments over time.
However, compounding can also accelerate the debt balances you owe over time.
Here is the compound interest formula:
A = P (1+(r/n))^nt
Where:
A = Ending amount
P = Starting amount
r = interest rate as a decimal (for example 3% becomes 0.03)
n = number of compounding periods per year
t = time in years
Let’s say you put $3.000 into a savings account paying 4% interest.
For example, if you put $3.000 into a savings account paying 4% interest, your ending amount will be like this for 10 years (compounded monthly):
A = P (1+(r/n))^nt
P = $3.000
r = 0.04
n = 12
t = 10
A = 3.000 (1+(0.04/12)^12*10
A = 3.000(1.00333)^120
A = 3.000(1.49024)
A = 4.470,72
In 10 years, you’d have about $7.470,72 in the account which includes your starting amount and interest.
8. EBITDA
EBITDA, or earnings before interest, taxes, depreciation, and amortization is a measure of the cash a company generates from its operations before capital investments. EBITDA is a useful tool to measure a company’s short run ability to meet interest payments.
Here is the formula for calculating:
EBITDA = EBIT + Depreciation and Amortization
EBITDA is calculated by combining EBIT from the income statement and depreciation and amortization from the cash flow statement.
9. Equity
Equity referred to as shareholders’ equity represents the amount of money that would be returned to the firm’s shareholders after all liabilities was paid off in the case of liquidation.
To calculate shareholders’ equity of a company:
The value of a company’s assets is the sum of each current and noncurrent assets on the balance sheet. The value of liabilities is the sum of each current and non-current liabilities on the balance sheet.
For example, if a company’s total assets are $500.000 and total liabilities are $200.000, the shareholders’ equity would be $300.000
10. Income Statement
The income statement also known as the profit and loss (P&L) statement focuses on the firm’s revenues and expenses over a period of time.
The income statement is one of the three important statements used for a company’s financial performance. The other two statements are the balance sheet and the cash flow statement.
The purpose of an income statement is to provide valuable insight into a company’s operations over a given time period.
Components of an income statement include revenues, expenses, cost of goods sold, gross profit, operating income, income before taxes, net income, earning per share, depreciation, EBITDA.
11. Liabilities
Liabilities show the firm’s obligations to pay an amount of money to creditors. Liabilities are categorized as current liabilities and noncurrent liabilities according to their due date.
Current liabilities also known as short-term liabilities refer to any liability due to the creditor within one year, which may include:
- Accounts payable
- Short-term debt or notes payable
- Rent payments
- Utility payments
- Debt financing
Noncurrent liabilities also known as long-term liabilities refer to any obligations or debts which will be due to the creditor more than a year, which may include:
- Long-term debt
- Leases
- Deferred taxes
- Bonds payable
12. Profit Margin
Profit margin measures the firm’s profit as a percentage of its sales. It provides very useful information regarding the value of the firm’s shares.
There are three types of profit margin:
Gross Profit Margin: It is a financial metric expressed as the firm’s net sales minus the cost of goods sold (gross profit). It is formulated as:
The gross profit margin reflects what the firm made after paying for the direct costs of doing business.
Operating Profit Margin: Because there are additional expenses of doing business beyond the direct costs of goods sold, the operating profit margin is used to reveal how much the firm earns before interest and taxes from each dollar of sales. Here is the formula for operating profit margin:
Net Profit Margin: It is a ratio that represents the profitability of an entire company. It measures the profit earned per dollar of revenue a company generates.
The net profit margin formula divides the net income of the firm by the revenue (sales).
The Bottom Line
By mastering these basic financial terms, you will gain the skills and confidence needed to make and convey better financial decisions.
Keep in mind that these 12 financial terms are just the basic finance terms, if you’re ready to learn more, check out these additional resources from Money and Financial Literacy.
