If you wanted to be a successful talk-show host in Germany, what is the one thing you need to know? How to speak German, of course. Similarly, if you want to be a successful investor, you must have a basic understanding of the language of business... Accounting.
Below we discuss four important financial metrics that we believe all investors must know. We have used one of our portfolio companies, Lovisa (ASX: LOV), to provide practical examples.
Revenue is the total amount of income a business generates through the sale of goods and/or services provided.
In the case of Lovisa, they generated revenues of $458.7 million last financial year, primarily consisting of jewellery sales and a small amount of revenue from franchising.
Gross profit is the amount retained from sales after subtracting costs directly associated with the production of its goods or services.
In the image below, Lovisa earned a gross profit of $361.8 million last financial year, equating to a gross profit margin of 78.9%. In other words, last year it cost Lovisa approximately $0.21 for every $1.00 of sales.
It's useful to compare gross margins of competing businesses, as this may help to explain any sustainable demand or supply-side advantages a company may have over its competitors. For instance, a company which can charge a premium price for its products or produce its products at a lower price, relative to the industry average, will earn higher gross margins than its competitors.
Earnings before interest and tax (EBIT)
EBIT is the net profit (revenue less total expenses) a business earns before deducting interest and taxes. This is a useful metric to use when measuring and comparing the underlying profitability of a business, removing the effects of a company's capital structure and tax situation.
In the image below, we can see that Lovisa earned $82.7 million before deducting for interest and taxes.
Free cash flow
Free cash flow is the excess cash generated from a company’s operations after all expenditures have been paid. This surplus amount (free cash flow) may then be used to pay dividends, repurchase shares, acquire another business or reduce debt.
We calculate free cash flow by subtracting capital expenditures (purchase of fixed assets) and payment of lease liabilities (payment of rent expenses) from operating cash flows.
Referring to the amounts highlighted in yellow, Lovisa’s free cash flow was $47.7 million last financial year ($130.6m [operating cash flow] less $37.4m plus $2.9m [net capital expenditure] less $48.4m [rental payments]).
In this case, referring to the amounts highlighted in green, Lovisa used all of its free cash ($47.7 million) to acquire a business for $0.2 million and pay a dividend to shareholders of $59.1 million.
You will note that this exceeds the amount of free cash Lovisa generated throughout the year. As a result, referring to the amounts highlighted in blue, the company financed this deficit by borrowing $10.0 million and using $1.5 million from its existing cash reserves.