Stablecoin is commonly consided to be a cryptocurrency whose price is pegged to a particular fiat currency, such as the Dollar or the Euro. Today, the market capitalization of the three most popular stablcoins (USDT, USDC, BUSD) exceeds $120 billion according to Coinlist.

However, there are other types of stablcoins, such as DAI (fourth place in the top of stablcoins with a capitalization of $ 5.6 billion). By buying DAI, you acquire a "portfolio" of cryptocurrencies at once, including: USDC, ETH, and even Treasury bonds.

Info taken from Daistats.com

DAI is over-collateralized by cryptocurrency to avoid the high volatility inherent in crypto-assets. And the smart contracts on which this stackablecoin is built allow liquidity to be sold to support DAI's collateral in case of necessity.

Another type of stabelcoin is algorithmic stabelcoins. These are digital assets whose price is pegged to a reserve asset, but not collateralized by it. The pegging is done by an algorithm, a program that allows the balancing of the asset's negotiable supply. In other words, an algorithmic stablcoin uses an underlying algorithm that issues more coins when the price goes up and buys them from the market when the price goes down. Examples of algorithmic stablcoin include USDD (top seven on the stablcoin list, market capitalization of $723 million) on the Tron blockchain or the infamous UST on the Terra blockchain.

photo source bit.ly/40o31gl

Each type of Stablecoin has a number of advantages and disadvantages, it is impossible to discuss them all in one article, but let's focus on the most important ones.

1. Classic Stablecoins backed by fiat currency are rightfully ranked in the top three. This is the simplest and seemingly most reliable way to create digital dollars: a company issues 1 cryptodollar, for every real dollar in the company's bank account. In other words, it's a check that gives you the right to exchange a cryptodollar for a real one.

What is the purpose of all this? Cryptodollar has all the charms of cryptocurrency: it uses blockchain technology, ease of use, confidentiality and more. However, there are also risks. The main one is centralization. On the one hand, fiat collateral gives the feeling that you own real money, not “moneyballs”. But at the same time, as recent practice has shown, the bank holding the assets may go bankrupt. In addition, companies that issue Stablecoins are often subjected to pressure from regulators, which distances us from the idea of decentralization in cryptocurrency.

photo source shorturl.at/eBHW0

Important criteria for classic stabelcoins are:

Collateral must be transparent and diversified. Reliably protected from hacker attacks. Possesses high liquidity. 2. Stablecoins backed by cryptocurrency are more decentralized. If we consider DAI token, today it is 57% secured by USDC and only 43% by other cryptocurrency. DAI can be issued by any user. This staplecoin does not formally have any supervisory authority, but is managed by the decentralized MakerDAO organization. The obvious disadvantage of cryptocurrency collateral DAI, at first glance, is the high volatility of the cryptocurrency, because the price of stabelcoin must be strictly tied to the dollar. However, to reduce the risks of sharp price jumps, DAI has excessive collateral: to release 1 DAI, the user must lock his crypto-assets in the equivalent of $1.6.

From this there are other risks: Because you are essentially borrowing the coin, the steiblocoin scheme is somewhat like leveraged trading, and if the Ether falls below the 1:1 ratio, the issuer can ask for more liquidity. In the case of an even deeper drop, a forced liquidation is possible.

1. Algorithmic Stablecoins: Although the idea is not new, algorithmic stablecoins peaked in popularity in the early twenties. The idea of absolute decentralization appealed so much to the crypto community, because these stackablecoins are not physically backed, and pricing is not supported by a specific issuer, but by a smart contract. The peg to the dollar is regulated by algorithms. Seemingly everything is fine, but the algorithm is not always ready to handle the laws of the market. If a large number of big players want to sell their assets, the algorithm simply does not have enough liquidity to support them. A prime example of such events was the collapse of the UST Stablecoin. In May 2022, 84 million UST were put up for sale, causing the token to lose its peg to the Dollar, causing even more panic among asset owners, and a subsequent exponential drop of more than 95% in the price of stabelcoin.

Conclusions: Whether it's regulatory attacks, high volatility, or algorithm errors, the risks in the young cryptocurrency market remain extremely high. We take these risks in the hope of multiple profit.

I wish everyone decentralization and diversification!!!

Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. Yield to maturity is considered a long-term bond yield but is expressed as an annual rate. In other words, it is the internal rate of return (IRR) of an investment in a bond if the investor holds the bond until maturity, with all payments made as scheduled and reinvested at the same rate.

Yield to maturity is also referred to as "book yield" or "redemption yield."

KEY TAKEAWAYS

• Yield to maturity (YTM) is the total rate of return that will have been earned by a bond when it makes all interest payments and repays the original principal.

• YTM is essentially a bond's internal rate of return (IRR) if held to maturity.

• Calculating the yield to maturity can be a complicated process, and it assumes all coupon or interest, payments can be reinvested at the same rate of return as the bond.

0 seconds of 1 minute, 56 secondsVolume 75%

1:56

Bond Yields: Current Yield And YTM

Understanding Yield to Maturity (YTM)

Yield to maturity is similar to current yield, which divides annual cash inflows from a bond by the market price of that bond to determine how much money one would make by buying a bond and holding it for one year. Yet, unlike current yield, YTM accounts for the present value of a bond's future coupon payments. In other words, it factors in the time value of money, whereas a simple current yield calculation does not. As such, it is often considered a more thorough means of calculating the return from a bond.

The YTM of a discount bond that does not pay a coupon is a good starting place in order to understand some of the more complex issues with coupon bonds.

Calculating YTM

The formula to calculate YTM of a discount bond is as follows:

\begin{aligned} &YTM=\sqrt[n]{\frac{\textit{Face Value}}{\textit{Current Price}}}-1\\ &\textbf{where:}\\ &n=\text{number of years to maturity}\\ &\text{Face value}=\text{bond's maturity value or par value}\\ &\text{Current price}=\text{the bond's price today} \end{aligned}​YTM=nCurrent PriceFace Value​​−1where:n=number of years to maturityFace value=bond’s maturity value or par valueCurrent price=the bond’s price today​

Because YTM is the interest rate an investor would earn by reinvesting every coupon payment from the bond at a constant interest rate until the bond's maturity date, the present value of all the future cash flows equals the bond's market price. An investor knows the current bond price, its coupon payments, and its maturity value, but the discount rate cannot be calculated directly. However, there is a trial-and-error method for finding YTM with the following present value formula:

\begin{aligned} \textit{Bond Price} &= \ \frac{\textit{Coupon }1}{(1+YTM)^1} +\ \frac{\textit{Coupon }2}{(1+YTM)^2}\\ &\quad +\ \cdots\ +\ \frac{\textit{Coupon }n}{(1+YTM)^n} \ +\ \frac{\textit{Face Value}}{(1+YTM)^n} \end{aligned}Bond Price​= (1+YTM)1Coupon 1​+ (1+YTM)2Coupon 2​+ ⋯ + (1+YTM)nCoupon n​ + (1+YTM)nFace Value​​

Or this formula:

\begin{aligned} \textit{Bond Price} &=\ \left(\textit{Coupon }\ \times\ \frac{1-\frac{1}{(1+YTM)^n}}{YTM}\right)\\ &\quad+\left(\textit{Face Value }\ \times\ \frac{1}{(1+YTM)^n}\right) \end{aligned}Bond Price​= (Coupon  × YTM1−(1+YTM)n1​​)+(Face Value  × (1+YTM)n1​)​

Each one of the future cash flows of the bond is known and because the bond's current price is also known, a trial-and-error process can be applied to the YTM variable in the equation until the present value of the stream of payments equals the bond's price.

Solving the equation by hand requires an understanding of the relationship between a bond's price and its yield, as well as the different types of bond pricings. Bonds can be priced at a discount, at par, or at a premium. When the bond is priced at par, the bond's interest rate is equal to its coupon rate. A bond priced above par, called a premium bond, has a coupon rate higher than the realized interest rate, and a bond priced below par, called a discount bond, has a coupon rate lower than the realized interest rate.

If an investor were calculating YTM on a bond priced below par, they would solve the equation by plugging in various annual interest rates that were higher than the coupon rate until finding a bond price close to the price of the bond in question.

Calculations of yield to maturity (YTM) assume that all coupon payments are reinvested at the same rate as the bond's current yield and take into account the bond's current market price, par value, coupon interest rate, and term to maturity. The YTM is merely a snapshot of the return on a bond because coupon payments cannot always be reinvested at the same interest rate. As interest rates rise, the YTM will increase; as interest rates fall, the YTM will decrease.

The complex process of determining yield to maturity means it is often difficult to calculate a precise YTM value. Instead, one can approximate YTM by using a bond yield table, financial calculator, or online yield to maturity calculator.

What if you had started investing years ago?

Find out what a hypothetical investment would be worth today.

SELECT A STOCK

TSLA

TESLA INC

AAPL

APPLE INC

NKE

NIKE INC

AMZN

AMAZON.COM, INC

WMT

WALMART INC

SELECT INVESTMENT AMOUNT

$

SELECT A PURCHASE DATE

              2 years ago                      5 years ago                      10 years ago         

CALCULATE

Example: Calculating Yield to Maturity Through Trial and Error

For example, say an investor currently holds a bond whose par value is $100. The bond is currently priced at a discount of $95.92, matures in 30 months, and pays a semi-annual coupon of 5%. Therefore, the current yield of the bond is (5% coupon x $100 par value) / $95.92 market price = 5.21%.

To calculate YTM here, the cash flows must be determined first. Every six months (semi-annually), the bondholder would receive a coupon payment of (5% x $100)/2 = $2.50. In total, they would receive five payments of $2.50, in addition to the face value of the bond due at maturity, which is $100. Next, we incorporate this data into the formula, which would look like this:

\$95.92=\left(\$2.5\ \times\ \frac{1-\frac{1}{(1+YTM)^5}}{YTM}\right) \ +\ \left(\$100\ \times \ \frac{1}{(1+YTM)^5}\right)$95.92=($2.5 × YTM1−(1+YTM)51​​) + ($100 × (1+YTM)51​)

Now we must solve for the interest rate "YTM," which is where things get tough. Yet, we do not have to start simply guessing random numbers if we stop for a moment to consider the relationship between bond price and yield. As mentioned earlier, when a bond is priced at a discount from par, its interest rate will be greater than the coupon rate. In this example, the par value of the bond is $100, but it is priced below the par value at $95.92, meaning the bond is priced at a discount. As such, the annual interest rate we are seeking must necessarily be greater than the coupon rate of 5%.

With this information, we can calculate and test several bond prices by plugging various annual interest rates that are higher than 5% into the formula above. Using a few different interest rates above 5%, one would come up with the following bond prices:

Taking the interest rate up by one and two percentage points to 6% and 7% yields bond prices of $98 and $95, respectively. Because the bond price in our example is $95.92, the list indicates that the interest rate we are solving for is between 6% and 7%.

Having determined the range of rates within which our interest rate lies, we can take a closer look and make another table showing the prices that YTM calculations produce with a series of interest rates increasing in increments of 0.1% instead of 1.0%. Using interest rates with smaller increments, our calculated bond prices are as follows:

Here, we see that the present value of our bond is equal to $95.92 when the YTM is at 6.8%. Fortunately, 6.8% corresponds precisely to our bond price, so no further calculations are required. At this point, if we found that using a YTM of 6.8% in our calculations did not yield the exact bond price, we would have to continue our trials and test interest rates increasing in 0.01% increments.

It should be clear why most investors prefer to use special programs to narrow down the possible YTMs rather than calculating through trial and error, as the calculations required to determine YTM can be quite lengthy and time-consuming.

Uses of Yield to Maturity (YTM)

Yield to maturity can be quite useful for estimating whether buying a bond is a good investment. An investor will determine a required yield (the return on a bond that will make the bond worthwhile). Once an investor has determined the YTM of a bond they are considering buying, the investor can compare the YTM with the required yield to determine if the bond is a good buy.

Because YTM is expressed as an annual rate regardless of the bond's term to maturity, it can be used to compare bonds that have different maturities and coupons since YTM expresses the value of different bonds in the same annual terms.

Variations of Yield to Maturity (YTM)

Yield to maturity has a few common variations that account for bonds that have embedded options:

• Yield to call (YTC) assumes that the bond will be called. That is, a bond is repurchased by the issuer before it reaches maturity and thus has a shorter cash flow period. YTC is calculated with the assumption that the bond will be called at soon as it is possible and financially feasible.

• Yield to put (YTP) is similar to YTC, except the holder of a put bond can choose to sell the bond back to the issuer at a fixed price based on the terms of the bond. YTP is calculated based on the assumption that the bond will be put back to the issuer as soon as it is possible and financially feasible.

• Yield to worst (YTW) is a calculation used when a bond has multiple options. For example, if an investor was evaluating a bond with both calls and put provisions, they would calculate the YTW based on the option terms that give the lowest yield.

Limitations of Yield to Maturity (YTM)

YTM calculations usually do not account for taxes that an investor pays on the bond.1 In this case, YTM is known as the gross redemption yield. YTM calculations also do not account for purchasing or selling costs.

YTM also makes assumptions about the future that cannot be known in advance. An investor may not be able to reinvest all coupons, the bond may not be held to maturity, and the bond issuer may default on the bond.

Yield to Maturity (YTM) Summary

A bond's yield to maturity (YTM) is the internal rate of return required for the present value of all the future cash flows of the bond (face value and coupon payments) to equal the current bond price. YTM assumes that all coupon payments are reinvested at a yield equal to the YTM and that the bond is held to maturity.

Some of the more known bond investments include municipal, treasury, corporate, and foreign. While municipal, treasury, and foreign bonds are typically acquired through local, state, or federal governments, corporate bonds are purchased through brokerages.2 If you have an interest in corporate bonds then you will need a brokerage account.

What Is a Bond’s Yield to Maturity (YTM)?

The YTM of a bond is essentially the internal rate of return (IRR) associated with buying that bond and holding it until its maturity date. In other words, it is the return on investment associated with buying the bond and reinvesting its coupon payments at a constant interest rate. All else being equal, the YTM of a bond will be higher if the price paid for the bond is lower, and vice-versa.

What Is the Difference Between a Bond’s YTM and Its Coupon Rate?

The main difference between the YTM of a bond and its coupon rate is that the coupon rate is fixed whereas the YTM fluctuates over time. The coupon rate is contractually fixed, whereas the YTM changes based on the price paid for the bond as well as the interest rates available elsewhere in the marketplace. If the YTM is higher than the coupon rate, this suggests that the bond is being sold at a discount to its par value. If, on the other hand, the YTM is lower than the coupon rate, then the bond is being sold at a premium.

Is It Better to Have a Higher YTM?

Whether or not a higher YTM is positive depends on the specific circumstances. On the one hand, a higher YTM might indicate that a bargain opportunity is available since the bond in question is available for less than its par value. But the key question is whether or not this discount is justified by fundamentals such as the creditworthiness of the company issuing the bond, or the interest rates presented by alternative investments. As is often the case in investing, further due diligence would be required.

Learn the Basics of Trading and Investing

Looking to learn more about trading and investing? No matter your learning style, there are more than enough courses to get you started. With Udemy, you’ll be able to choose courses taught by real-world experts and learn at your own pace, with lifetime access on mobile and desktop. You’ll also be able to master the basics of day trading, option spreads, and more. Find out more about Udemy and get started today.

Zero-one integer programming (which can also be written as '0-1' integer programming) is a mathematical method of using a series of binary functions; in particular, yes ('1') and no ('0') answers to arrive at a solution when there are two mutually exclusive options.

In the world of finance, zero-one integer programming is often used to provide answers to capital rationing problems, as well as to optimize investment returns and assist in planning, production, transportation, and other issues.

KEY TAKEAWAYS

• Zero-one integer programming relies on mutually exclusive yes (1) and no (0) decisions to find solutions to logic problems.

• In zero-one integer problems, each variable is represented only by 0 ('no') or 1 ('yes'), and could represent selecting or rejecting an option, turning on or off electronic switches, or a straight-forward yes or no answer used in various other applications.

• This type of programming can be useful for companies making decisions on issues like what to invest in or which of two proposed products are easiest to manufacture.

Understanding Zero-One Integer Programming

Integer programming is a branch of mathematical programming or optimization, which involves creating equations in order to solve problems. The term "mathematical programming" is connected with the fact that the goal of solving various problems is choosing programs of action. Assigning a simple yes/no value can be a powerful way to establish a linear problem-solving framework to identify inefficiencies.

Fundamentally, the most basic instructions executed by a computer are binary codes, consisting only of ones and zeros. Those codes are directly translated into the “on” and “off” states of the electricity moving through the computer’s physical circuits. In essence, these simple codes form the basis of “machine language”, the most fundamental variety of programming languages. These on and off positions can also be construed as assigning a "yes" or "no" to a logical function.

Of course, no human would be able to construct modern software programs by explicitly programming ones and zeros. Instead, human programmers must rely on various layers of abstraction that can allow them to articulate their commands in a format that is more intuitive to humans. Specifically, modern programmers issue commands in so-called “high-level languages”, which utilize intuitive syntax such as whole English words and sentences, as well as logical operators such as “And”, “Or”, and “Else” that are familiar to everyday usage.

Ultimately, however, these high-level commands need to be translated into machine language. Rather than doing so manually, programmers rely on assembly languages whose purpose is to automatically translate between these high-level and low-level languages.

Real-World Example of Zero-One Integer Programming

A simple example of how zero-one integer programming might be used in capital rationing would be in determining the number of product development projects that can be completed by a company by a certain date or within a certain budget. For example, a number of variables for each project can be given values that ultimately result in a 1 (yes) or 0 (no) binary decision about whether or not to include the project in a budget. This can be helpful to companies that are unsure about a specific business decision and are looking for a straightforward way to assess the possibilities.

Compete Risk Free with $100,000 in Virtual Cash

Put your trading skills to the test with our FREE Stock Simulator. Compete with thousands of Investopedia traders and trade your way to the top! Submit trades in a virtual environment before you start risking your own money. Practice trading strategies so that when you're ready to enter the real market, you've had the practice you need.

A zero-coupon swap is an exchange of cash flows in which the stream of floating interest-rate payments is made periodically, as it would be in a plain vanilla swap, but where the stream of fixed-rate payments is made as one lump-sum payment at the time when the swap reaches maturity, instead of periodically over the life of the swap.

KEY TAKEAWAYS

• A zero-coupon swap involves the fixed side of the swap being paid in one lump sum when the contract reaches maturity.

• The variable side of the swap still makes regular payments, as they would in a plain vanilla swap.

• Because the fixed leg is paid as a lump sum, valuing a zero-coupon swap involves determining the present value of those cash flows using a zero-coupon bond's implied interest rate.

Understanding a Zero-Coupon Swap

A zero-coupon swap is a derivative contract entered into by two parties. One party makes floating payments which changes according to the future publication of the interest rate index (e.g. LIBOR, EURIBOR, etc.) upon which the rate is benchmarked. The other party makes payments to the other based on an agreed fixed interest rate.

The fixed interest rate is tied to a zero-coupon bond, or a bond that pays no interest for the life of the bond but is expected to make one single payment at maturity. In effect, the amount of the fixed-rate payment is based on the swap's zero-coupon rate. The bondholder on the end of the fixed leg of a zero-coupon swap is responsible for making one payment at maturity, while the party on the end of the floating leg must make periodic payments over the contract life of the swap. However, zero-coupon swaps can be structured so that both floating and fixed-rate payments are paid as a lump sum.

Since there’s a mismatch in the frequency of payments, the floating party is exposed to a substantial level of default risk. The counterparty that does not receive payment until the end of the agreement incurs a greater credit risk than it would with a plain vanilla swap in which both fixed and floating interest rate payments are agreed to be paid on certain dates over time.

Valuing a Zero-Coupon Swap

Valuing a zero-coupon swap involves determining the present value of the cash flows using a spot rate (or zero-coupon rate). The spot rate is an interest rate that applies to a discount bond that pays no coupon and produces just one cash flow at the maturity date. The present value of each fixed and floating leg will be determined separately and summed together.

Since the fixed rate payments are known ahead of time, calculating the present value of this leg is straightforward. To derive the present value of cash flows from the floating rate leg, the implied forward rate must be calculated first. The forward rates are usually implied from spot rates. The spot rates are derived from a spot curve which is built from bootstrapping, a technique that shows a sequence of spot (or zero-coupon) rates that are consistent with the prices and yields on coupon bonds.

Variations of the zero-coupon swap exist to meet different investment needs. A reverse zero-coupon swap pays the fixed lump-sum payment upfront when the contract is initiated, reducing credit risk for the pay-floating party. Under an exchangeable zero-coupon swap, the party scheduled to receive a fixed sum at the maturity date can use an embedded option to turn the lump-sum payment into a series of fixed payments.

The floating payer will benefit from this structure if volatility declines and interest rates are relatively stable to declining. It is also possible for the floating-rate payments to be paid as a lump sum in a zero-coupon swap under an exchangeable zero-coupon swap.

Learn the Basics of Trading and Investing

Looking to learn more about trading and investing? No matter your learning style, there are more than enough courses to get you started. With Udemy, you’ll be able to choose courses taught by real-world experts and learn at your own pace, with lifetime access on mobile and desktop. You’ll also be able to master the basics of day trading, option spreads, and more. Find out more about Udemy and get started today.

Retained earnings are an important concept in accounting. The term refers to the historical profits earned by a company, minus any dividends it paid in the past. The word "retained" captures the fact that because those earnings were not paid out to shareholders as dividends, they were instead retained by the company. For this reason, retained earnings decrease when a company either loses money or pays dividends and increase when new profits are created.

KEY TAKEAWAYS

• Retained earnings (RE) is the amount of net income left over for the business after it has paid out dividends to its shareholders.

• The decision to retain the earnings or distribute them among the shareholders is usually left to the company management.

• A growth-focused company may not pay dividends at all or pay very small amounts because it may prefer to use retained earnings to finance expansion activities.

0 seconds of 1 minute, 39 secondsVolume 75%

1:39

Retained Earnings

Retained Earnings Formula and Calculation

\begin{aligned} &\text{RE} = \text{BP} + \text{Net Income (or Loss)} - \text{C} - \text{S} \\ &\textbf{where:}\\ &\text{BP} = \text{Beginning Period RE} \\ &\text{C} = \text{Cash dividends} \\ &\text{S} = \text{Stock dividends} \\ \end{aligned}​RE=BP+Net Income (or Loss)−C−Swhere:BP=Beginning Period REC=Cash dividendsS=Stock dividends​

What Retained Earnings Can Tell You

The following options broadly cover all possible uses a company can make of its surplus money. The first option leads to the earnings money going out of the books and accounts of the business forever because dividend payments are irreversible.

All the other options retain the earnings for use within the business, and such investments and funding activities constitute the retained earnings (RE).

• The income money can be distributed (fully or partially) among the business owners (shareholders) in the form of dividends.

• It can be invested to expand the existing business operations, like increasing the production capacity of the existing products or hiring more sales representatives.

• It can be invested to launch a new product/variant, like a refrigerator maker foraying into producing air conditioners or a chocolate cookie manufacturer launching orange- or pineapple-flavored variants.

• The money can be used for any possible merger, acquisition, or partnership that leads to improved business prospects.

• It can also be used for share buybacks.

• The earnings can be used to repay any outstanding loan (debt) the business may owe.

By definition, retained earnings are the cumulative net earnings or profits of a company after accounting for dividend payments. It is also called earnings surplus and represents reserve money, which is available to the company management for reinvesting back into the business. When expressed as a percentage of total earnings, it is also called the retention ratio and is equal to (1 – the dividend payout ratio).

Though the last option of debt repayment also leads to the money going out of the business, it still has an impact on the business's accounts (for example, on saving future interest payments, which qualifies it for inclusion in retained earnings).

Profits give a lot of room to the business owner(s) or the company management to use the surplus money earned. This profit is often paid out to shareholders, but it can also be reinvested back into the company for growth purposes. The money not paid to shareholders counts as retained earnings.

Management and Retained Earnings

The decision to retain the earnings or to distribute them among shareholders is usually left to the company management. However, it can be challenged by the shareholders through a majority vote because they are the real owners of the company.

Management and shareholders may want the company to retain the earnings for several different reasons. Being better informed about the market and the company’s business, the management may have a high-growth project in view, which they may perceive as a candidate for generating substantial returns in the future.

In the long run, such initiatives may lead to better returns for the company shareholders instead of those gained from dividend payouts. Paying off high-interest debt may also be preferred by both management and shareholders, instead of dividend payments.

On the other hand, when a company generates surplus income, a portion of the long-term shareholders may expect some regular income in the form of dividends as a reward for putting their money in the company. Traders who look for short-term gains may also prefer dividend payments that offer instant gains.

Most often, the company's management takes a balanced approach. It involves paying out a nominal amount of dividends and retaining a good portion of the earnings, which offers a win-win.

Retained Earnings vs. Dividends

Dividends can be distributed in the form of cash or stock. Both forms of distribution reduce retained earnings. Cash payment of dividends leads to cash outflow and is recorded in the books and accounts as net reductions. As the company loses ownership of its liquid assets in the form of cash dividends, it reduces the company’s asset value on the balance sheet, thereby impacting RE.

On the other hand, though stock dividends do not lead to a cash outflow, the stock payment transfers part of the retained earnings to common stock. For instance, if a company pays one share as a dividend for each share held by the investors, the price per share will reduce to half because the number of shares will essentially double. Because the company has not created any real value simply by announcing a stock dividend, the per-share market price is adjusted according to the proportion of the stock dividend.

Though the increase in the number of shares may not impact the company’s balance sheet because the market price is automatically adjusted, it decreases the per-share valuation, which is reflected in capital accounts, thereby impacting the RE.

A growth-focused company may not pay dividends at all or pay very small amounts because it may prefer to use the retained earnings to finance activities such as research and development, marketing, working capital requirements, capital expenditures, and acquisitions to achieve additional growth. Such companies have high retained earnings over the years.

A maturing company may not have many options or high-return projects for which to use the surplus cash, and it may prefer handing out dividends. Such companies tend to have low RE.

Retained Earnings vs. Revenue

Both revenue and retained earnings are important in evaluating a company's financial health, but they highlight different aspects of the financial picture. Revenue sits at the top of the income statement and is often referred to as the top-line number when describing a company's financial performance.

Revenue is the money generated by a company during a period but before operating expenses and overhead costs are deducted. In some industries, revenue is called gross sales because the gross figure is calculated before any deductions.

Retained earnings are the portion of a company's cumulative profit that is held or retained and saved for future use. Retained earnings could be used for funding an expansion or paying dividends to shareholders at a later date. Retained earnings are related to net (as opposed to gross) income because it's the net income amount saved by a company over time.

Limitations of Retained Earnings

For an analyst, the absolute figure of retained earnings during a particular quarter or year may not provide any meaningful insight. Observing it over a period of time (for example, over five years) only indicates the trend of how much money a company is adding to retained earnings.

As an investor, one would like to know much more—such as the returns the retained earnings have generated and if they were better than any alternative investments. Additionally, investors may prefer to see larger dividends rather than significant annual increases to retained earnings.

Retained Earnings-to-Market Value

One way to assess how successful a company is in using retained money is to look at a key factor called retained earnings to market value. It is calculated over a period of time (usually a couple of years) and assesses the change in stock price against the net earnings retained by the company.

For example, during the period between September 2016 and September 2020, Apple Inc.'s (AAPL) stock price rose from $28.18 to $112.28 per share.1 During the same period, the total earnings per share (EPS) was $13.61, while the total dividend paid out by the company was $3.38 per share.

As Morningstar indicates, Apple had the following EPS and dividend figures over the given time frame, and summing them up gives the above values for total EPS and total dividend.2

The difference between total EPS and total dividend gives the net earnings retained by the company: $13.61 - $3.38 = $10.23. That is, over the period, the company retained a total of $10.23 earnings per share.

Over the same duration, its stock price rose by ($112.28 - $28.18 = $84.10) per share. Dividing this price rise per share by net earnings retained per share gives a factor of ($84.10 / $10.23 = 8.22), which indicates that for each dollar of retained earnings, the company managed to create $8.22 worth of market value.

If the company had not retained this money and instead taken an interest-bearing loan, the value generated would have been less due to the outgoing interest payment. RE offers internally-generated capital to finance projects, allowing for efficient value creation by profitable companies. However, readers should note that the above calculation is indicative of the value created with respect to the use of retained earnings only, and it does not indicate the overall value created by the company.

Example of Retained Earnings

Companies publicly record retained earnings under the shareholders' equity section on the balance sheet. For instance, Apple Inc.’s balance sheet from fiscal Q3 of 2019 shows that the company had retained earnings of $53.724 billion as of the end of the quarter in June 2019:3

Similarly, the iPhone maker, whose fiscal year ends in September, had $70.4 billion in retained earnings as of September 2018.3

The retained earnings are calculated by adding net income to (or subtracting net losses from) the previous term’s retained earnings and then subtracting any net dividend(s) paid to the shareholders.

The figure is calculated at the end of each accounting period (monthly/quarterly/annually). As the formula suggests, retained earnings are dependent on the corresponding figure of the previous term. The resultant number may either be positive or negative, depending upon the net income or loss generated by the company over time. Alternatively, the company paying large dividends that exceed the other figures can also lead to the retained earnings going negative. 

Any item that impacts net income (or net loss) will impact the retained earnings. Such items include sales revenue, cost of goods sold (COGS), depreciation, and necessary operating expenses.

Are Retained Earnings a Type of Equity?

Retained earnings are a type of equity and are therefore reported in the shareholders’ equity section of the balance sheet. Although retained earnings are not themselves an asset, they can be used to purchase assets such as inventory, equipment, or other investments. Therefore, a company with a large retained earnings balance may be well-positioned to purchase new assets in the future or offer increased dividend payments to its shareholders.

What Does Negative Retained Earnings Mean?

Generally speaking, a company with a negative retained earnings balance would signal weakness because it indicates that the company has experienced losses in one or more previous years. However, it is more difficult to interpret a company with high retained earnings.

What Does It Mean for a Company to Have High Retained Earnings?

On one hand, high retained earnings could indicate financial strength since it demonstrates a track record of profitability in previous years. On the other, it could be indicative of a company that should consider paying more dividends to its shareholders. This, of course, depends on whether the company has been pursuing profitable growth opportunities.

The Fundamentals of Corporate Finance and Accounting

Whatever your learning style, understanding corporate finance and accounting is easy when you can choose from 183,000 online video courses. With Udemy, you’ll be able to learn accounting terminology and how to prepare financial statements and analyze business transactions. What’s more, each course has new additions published every month and comes with a 30-day money-back guarantee. Learn more about Udemy and sign up today.

A positive correlation is a relationship between two variables that move in tandem—that is, in the same direction. A positive correlation exists when one variable decreases as the other variable decreases, or one variable increases while the other increases.

KEY TAKEAWAYS

• A positive correlation is a relationship between two variables that tend to move in the same direction.

• A positive correlation exists when one variable tends to decrease as the other variable decreases, or one variable tends to increase when the other increases.

• In finance, correlations are used to describe how individual stocks move with respect to the wider market.

• Beta is a common measure of market correlation, usually using the S&P 500 index as a benchmark.

• A beta of 1.0 describes a stock that is perfectly correlated with the S&P 500. Values higher than 1.0 describe stocks that are more volatile than the S&P 500, while lower values describe stocks that are less volatile.

0 seconds of 0 secondsVolume 75%

2:02

Correlation

Understanding Positive Correlation

A perfectly positive correlation means that 100% of the time, the variables in question move together by the exact same percentage and direction. A positive correlation can be seen between the demand for a product and the product's associated price. In situations where the available supply stays the same, the price will rise if demand increases.

In statistics, a perfect positive correlation is represented by the correlation coefficient value +1.0, while 0 indicates no correlation, and -1.0 indicates a perfect inverse (negative) correlation.

Additionally, gains or losses in certain markets may lead to similar movements in associated markets. As the price of fuel rises, the prices of airline tickets also rise. Since airplanes require fuel to operate, an increase in this cost is often passed to the consumer, leading to a positive correlation between fuel prices and airline ticket prices.

A positive correlation does not guarantee growth or benefit. Instead, it is used to denote any two or more variables that move in the same direction together, so when one increases, so does the other. But the existence of a correlation does not necessarily indicate a causal relationship between variables.

Correlation is a form of dependency, where a shift in one variable means a change is likely in the other, or that certain known variables produce specific results. A general example can be seen within complementary product demand. If the demand for vehicles rises, so will the demand for vehicular-related products and services, such as tires. An increase in one area has an effect on complementary industries.

In some situations, positive psychological responses can cause positive changes within an area. This can be demonstrated within the financial markets, in cases where general positive news about a company leads to a higher stock price.

Correlation among variables does not necessarily imply causation.

Positive Correlation in Finance

A simple example of positive correlation involves the use of an interest-bearing savings account with a set interest rate. The more money that is added to the account, whether through new deposits or earned interest, the more interest that can be accrued. Similarly, a rise in the interest rate will correlate with a rise in interest generated, while a decrease in the interest rate causes a decrease in actual interest accrued.

Investors and analysts also look at how stock movements correlate with one another and with the broader market. Most stocks have a correlation between each other's price movements somewhere in the middle of the range, with a coefficient of 0 indicating no relationship whatsoever between the two securities. A stock in the online retail space, for example, likely has little correlation with the stock of a tire and auto body shop, while two similar retail companies will see a higher correlation. This is because businesses that have very different operations will produce different products and services using different inputs.

A brick-and-mortar book retailer, on the other hand, is likely to have a negative correlation with the stock of Amazon.com, as the online retailer's popularity is typically bad news for traditional book stores. The stock of the popular payment processor PayPal is likely to be positively correlated with the stocks of online retailers that use its services. If the stocks of eBay, Amazon, and Best Buy pick up due to increased online revenue, it is likely that PayPal will experience a similar boost as its fee-driven income picks up and positive earnings reports encourage investors.

Beta and Correlation

Beta is a common measure of how correlated an individual stock's price is with the broader market, often using the S&P 500 index as a benchmark. If a stock has a beta of 1.0, it indicates that its price activity is strongly correlated with the market. A stock with a beta of 1.0 has a systematic risk, but the beta calculation can’t detect any unsystematic risk. Adding a stock to a portfolio with a beta of 1.0 doesn’t add any risk to the portfolio, but it also doesn’t increase the likelihood that the portfolio will provide an excess return.

A beta of less than 1.0 means that the security is theoretically less volatile than the market, meaning the portfolio is less risky with the stock included than without it. For example, utility stocks often have low betas because they tend to move more slowly than market averages.

A beta that is greater than 1.0 indicates that the security's price is theoretically more volatile than the market. For example, if a stock's beta is 1.2, it is assumed to be 20% more volatile than the market. Technology stocks and small caps tend to have higher betas than the market benchmark. This indicates that adding the stock to a portfolio will increase the portfolio’s risk, but also increase its expected return.

Some stocks even have negative betas. A beta of -1.0 means that the stock is inversely correlated to the market benchmark as if it were an opposite, mirror image of the benchmark’s trends. Put options or inverse ETFs are designed to have negative betas, but there are a few industry groups, like gold miners, where a negative beta is also common.

Beta

A beta of +1.0 indicates a stock that moves in the same direction as the rest of the market. A beta of -1.0 indicates that a stock moves opposite to the rest of the market.

Positive Correlation vs. Inverse Correlation

In statistics, positive correlation describes the relationship between two variables that change together, while an inverse correlation describes the relationship between two variables which change in opposing directions. Inverse correlation is sometimes described as negative correlation. Examples of positive correlations occur in most people's daily lives. The more hours an employee works, for instance, the larger that employee's paycheck will be at the end of the week. The more money is spent on advertising, the more customers buy from the company.

Inverse correlations describe two factors that seesaw relative to each other. Examples include a declining bank balance relative to increased spending habits and reduced gas mileage relative to increased average driving speed. One example of an inverse correlation in the world of investments is the relationship between stocks and bonds. As stock prices rise, the bond market tends to decline, just as the bond market does well when stocks are underperforming.

It is important to understand that correlation does not necessarily imply causation. Variables A and B might rise and fall together, or A might rise as B falls, but it is not always true that the rise of one factor directly influences the rise or fall of the other. Both may be caused by an underlying third factor, such as commodity prices, or the apparent relationship between the variables might be a coincidence.

The number of people connected to the Internet, for example, has been increasing since its inception, and the price of oil has generally trended upward over the same period.12 This is a positive correlation, but the two factors almost certainly have no meaningful relationship. That both the population of Internet users and the price of oil have increased is explainable by a third factor, namely, general increases due to time passed.

What Is an Example of Positive Correlation?

One example of positive correlation is the relationship between employment and inflation. High levels of employment require employers to offer higher salaries in order to attract new workers, and higher prices for their products in order to fund those higher salaries. Conversely, periods of high unemployment experience falling consumer demand, resulting in downward pressure on prices and inflation.

What Is the Relationship Between Beta and Positive Correlation?

Beta is a common measure of the correlation between an individual stock and the wider market, often using the S&P 500 index as a benchmark. A beta value greater than zero indicates that the stock is positively correlated with the market, meaning that its share price tends to rise when the market rises. If a stock has a beta less than 1.0, its movements will be smaller than the movements of the wider market. A beta higher than 1.0 indicates that the stock will fluctuate more than the market as a whole.

What Is Inverse Correlation?

A positive correlation describes a relationship between variables that move together, and an inverse correlation describes variables that tend to move in opposite directions. This may also be referred to as a negative correlation. In investing, negative correlations are indicated by beta values below zero: a beta of -1.0 indicates a stock whose movements are a mirror opposite of the benchmark's trends.

Does Correlation Imply Causation?

Correlation does not require causation, and it is a common logical fallacy to believe otherwise. When two variables are positively correlated, that does not necessarily mean that one variable causes changes in the other. Both variables may be influenced by an unknown third factor, or the apparent relationship between the variables might be a coincidence.

The Fundamentals of Corporate Finance and Accounting

Whatever your learning style, understanding corporate finance and accounting is easy when you can choose from 183,000 online video courses. With Udemy, you’ll be able to learn accounting terminology and how to prepare financial statements and analyze business transactions. What’s more, each course has new additions published every month and comes with a 30-day money-back guarantee. Learn more about Udemy and sign up today.

A memorandum of understanding is an agreement between two or more parties outlined in a formal document. It is not legally binding but signals the willingness of the parties to move forward with a contract.

The MOU can be seen as the starting point for negotiations as it defines the scope and purpose of the talks. Such memoranda are most often seen in international treaty negotiations but also may be used in high-stakes business dealings such as merger talks.

0 seconds of 1 minute, 33 secondsVolume 75%

1:33

Memorandum Of Understanding (MOU)

How a Memorandum of Understanding (MOU) Works

An MOU is an expression of agreement to proceed. It indicates that the parties have reached an understanding and are moving forward. Although it is not legally binding, it is a serious declaration that a contract is imminent.

KEY TAKEAWAYS

• A memorandum of understanding is a document that describes the broad outlines of an agreement that two or more parties have reached.

• MOUs communicate the mutually accepted expectations of all of the parties involved in a negotiation.

• While not legally binding, the MOU signals that a binding contract is imminent.

• The MOU is most often found in international relations.

Under U.S. law, an MOU is the same as a letter of intent. In fact, arguably a memorandum of understanding, a memorandum of agreement, and a letter of intent are virtually indistinguishable. All communicate an agreement on a mutually beneficial goal and a desire to see it through to completion.

MOUs communicate the mutually accepted expectations of the people, organizations, or governments involved. They are most often used in international relations because, unlike treaties, they can be produced relatively quickly and in secret. They also are in use in many U.S. and state government agencies, particularly when major contracts are in the planning stages.

Contents of a Memorandum of Understanding (MOU)

An MOU clearly outlines specific points of understanding. It names the parties, describes the project on which they are agreeing, defines its scope, and details each party's roles and responsibilities.

While not a legally enforceable document, the MOU is a significant step because of the time and effort involved in negotiating and drafting an effective document. To produce an MOU, the participating parties need to reach a mutual understanding. In the process, each side learns what is most important to the others before moving forward.

The process often begins with each party effectively drafting its own best-case MOU. It considers its ideal or preferred outcome, what it believes it has to offer to the other parties, and what points may be non-negotiable on its side. This is each party's starting position for negotiations.

An MOU communicates the mutually accepted expectations of the people, organizations, or governments involved.

Advantages and Disadvantages of a Memorandum of Understanding (MOU)

A memorandum of understanding allows all parties to clearly state all of their objectives and goals. This makes for less uncertainty and prevents future unexpected disputes to occur. Furthermore, by clearly laying out what each party expects of the other, an MOU provides a blueprint for any contract both parties may or may not wish to draw up in the future.

The biggest drawback, of an MOU, however, depending on your point of view, is that it is not legally binding. While in some cases this may be a benefit, since neither party is required to do what they say in the MOU, they can simply walk away or change their expectations. MOUs can take significant time and planning to create and if one party completely changes their requirements, creating the MOU was a big waste of resources.

Real-Life Example of a Memorandum of Understanding (MOU)

During trade talks with a representative of China in Washington in April 2019, U.S. President Donald Trump was asked by a reporter how long he expected U.S.-China memorandums of understanding to last. "I don't like MOUs because they don't mean anything," the former president replied.1 After some discussion, it was decided that any document that emerged from the talks would be called a trade agreement, never an MOU.

Memorandum of Understanding FAQs

Is an MOU a legal document?

A memorandum of understanding (MOU) is not legally binding, although it usually signals a legal contract is imminent.

What is the difference between an MOU and MOA?

An MOU is a document that describes very broad concepts of mutual understanding, goals, and plans shared by the parties. In contrast, an MOA is a document describing in detail the specific responsibilities of, and actions to be taken by, each of the parties so that their goals may be accomplished.

How do you write an MOU?

An MOU should clearly state the following: what parties are involved, the context of the agreement, the proposed date of when the agreement will become effective, the contact details of all relevant parties, the broad purpose of the agreement, what each party is hoping to achieve, as well as a space for all necessary signatures.

Why is an MOU important?

An MOU is important because it allows each party to clearly state their objectives and what they expect from one another. Drafting an MOU can help solve any disputes before each party enters into a legally binding contract.

The Bottom Line

Although an MOU is not legally binding, it allows parties to prepare for signing a contract by explaining the broad concepts and expectations of their agreement. Communicating in clear terms what each party hopes to gain from an agreement can be essential to the smooth execution of signing a legal contract in the future.

Compete Risk Free with $100,000 in Virtual Cash

Put your trading skills to the test with our FREE Stock Simulator. Compete with thousands of Investopedia traders and trade your way to the top! Submit trades in a virtual environment before you start risking your own money. Practice trading strategies so that when you're ready to enter the real market, you've had the practice you need.

Key performance indicators (KPIs) refer to a set of quantifiable measurements used to gauge a company’s overall long-term performance.

KPIs specifically help determine a company's strategic, financial, and operational achievements, especially compared to those of other businesses within the same sector.

KEY TAKEAWAYS

• Key performance indicators (KPIs) measure a company's success versus a set of targets, objectives, or industry peers.

• KPIs can be financial, including net profit (or the bottom line, gross profit margin), revenues minus certain expenses, or the current ratio (liquidity and cash availability).

• Customer-focused KPIs generally center on per-customer efficiency, customer satisfaction, and customer retention.

• Process-focused KPIs aim to measure and monitor operational performance across the organization.

• Generally speaking, businesses measure and track KPIs through business analytics software and reporting tools.

0 seconds of 1 minute, 40 secondsVolume 75%

1:40

Key Performance Indicators (KPI)

Understanding Key Performance Indicators (KPIs)

Also referred to as key success indicators (KSIs), KPIs vary between companies and between industries, depending on performance criteria.

For example, a software company striving to attain the fastest growth in its industry may consider year-over-year (YOY) revenue growth as its chief performance indicator. Contrarily, a retail chain might place more value on same-store sales, as the best KPI metric in which to gauge its growth.

Key performance indicators (KPI) gauge a company's output against a set of targets, objectives, or industry peers.

Types of Key Performance Indicators (KPIs)

Financial Metrics

Key performance indicators tied to the financials typically focus on revenue and profit margins. Net profit, the most tried and true of profit-based measurements, represents the amount of revenue that remains, as profit for a given period, after accounting for all of the company's expenses, taxes, and interest payments for the same period.

Calculated as a dollar amount, net profit must be converted into a percentage of revenue (known as "net profit margin"), to be used in comparative analysis.

For example, if the standard net profit margin for a given industry is 50%, a new business in that space knows it must work toward meeting or beating that figure if it wishes to remain competitively viable. The gross profit margin, which measures revenues after accounting for expenses directly associated with the production of goods for sale, is another common profit-based KPI.

A financial KPI that's known as the “current ratio” focuses largely on liquidity and can be calculated by dividing a company's current assets by its current debts.

A financially healthy company typically has sufficient cash on hand to meet its financial obligations for the current 12-month period. However, different industries rely on different amounts of debt financing, therefore a company ought to only compare its current ratio to those of other businesses within the same industry, to ascertain how its cash flow stacks up amongst its peers. 

Customer Metrics

Customer-focused KPIs generally center on per-customer efficiency, customer satisfaction, and customer retention.

Customer lifetime value (CLV) represents the total amount of money that a customer is expected to spend on your products over the entire business relationship.

Customer acquisition cost (CAC), by comparison, represents the total sales and marketing cost required to land a new customer. By comparing CAC to CLV, businesses can measure the effectiveness of their customer acquisition efforts.

Process Performance Metrics

Process metrics aim to measure and monitor operational performance across the organization.

By dividing the number of defective products by total products produced, for example, businesses can measure the percentage of defective products. Naturally, the goal would be to get this number down as low as possible.

Throughput time represents the total amount of time it takes to run a particular process. For example, a drive-through restaurant throughput can measure how long it takes to service an average customer; from the time they make their order to the time they drive away with their food.

Examples of Key Performance Indicators (KPIs)

Let's take a look at electric vehicle-maker Tesla (TSLA) for a few examples of KPIs in real life. These numbers are all from their Q4 2021 earnings release.

Vehicle Production

During the quarter, Tesla produced a record 305,840 vehicles and delivered 308,650 vehicles.1 Production is a big deal for the company because it has consistently been criticized for being bad at ramping up.

Increased manufacturing scale means more market share and profits for Tesla.

Automotive Gross Margin

For the quarter, Tesla's automotive gross margin expanded to 30.6%.2 Gross margin is one of the best measures of profitability for Tesla because it isolates its vehicle production costs.

Tesla managed to expand its gross margin in Q4 even as sales of lower-priced models outpaced its higher-margin models.1

Free Cash Flow

Tesla's free cash flow clocked in at $2.8 billion during the quarter. That represents a vast improvement from the $1.9 billion free cash flow in the year-ago period.2

Tesla's current level of free cash flow production suggests that the company is reaching a scale of profitability without the help of regulatory credits.3

Limitations of Using Key Performance Indicators (KPIs)

Some of the disadvantages to using KPIs include:

• The long time frame required for KPIs to provide meaningful data

• They require constant monitoring and close follow-up to be useful

• They open up the possibility for managers to "game" KPIs

• Quality has a tendency to drop when managers are hyperfocused on productivity KPIs

• Employees can be pushed too hard aiming specifically for KPIs

Special Considerations

KPIs do not necessarily have to be solely tied to financial data.

While profits and debt levels are indeed important key financial indicators, a company’s relationships with both its customers and its employees are no less important to establishing its general health.

Non-Financial KPIs

Common non-financial KPIs include measures of foot traffic, employee turnover rates, the number of repeat customers versus new customers, and various quality metrics. 

KPI FAQs

What Is a KPI Example?

One of the most basic examples of a KPI is Revenue Per Client (RPC). For example, if you generate $100,000 in revenue annually and you have 100 clients, then your RPC is $1,000.

What Are the 5 Key Performance Indicators?

KPIs vary from business to business. But in general, five of the most commonly used KPIs include:

1. Revenue growth

2. Revenue per client

3. Profit margin

4. Client retention rate

5. Customer satisfaction

How Do You Measure KPIs?

It depends on the actual KPI being measured. But generally speaking, businesses measure and track KPIs through business analytics software and reporting tools.

What Is a Good KPI?

A good KPI has the following attributes:

• Provides objective and clear information of progress towards an end goal

• Tracks and measures factors such as efficiency, quality, timeliness, and performance

• Provides a way to measure performance over time

• Helps make more informed decisions

How Do I Create a KPI Report?

Follow these general steps to create a KPI report:

1. Create an overview or introduction

2. Clearly define the KPIs

3. Present your KPIs using appropriate graphs, charts, and tables

4. Make final edits to the report and distribute

The Bottom Line

KPIs offer an effective way to measure and track a company’s performance on a variety of different metrics. By understanding exactly what KPIs are and how to implement them properly, managers are better able to optimize the business for long-term success.

The Fundamentals of Corporate Finance and Accounting

Whatever your learning style, understanding corporate finance and accounting is easy when you can choose from 183,000 online video courses. With Udemy, you’ll be able to learn accounting terminology and how to prepare financial statements and analyze business transactions. What’s more, each course has new additions published every month and comes with a 30-day money-back guarantee. Learn more about Udemy and sign up today.

Financial statements are written records that convey the business activities and the financial performance of a company. Financial statements are often audited by government agencies, accountants, firms, etc. to ensure accuracy and for tax, financing, or investing purposes. Financial statements include the

• Balance sheet

• Income statement

• Cash flow statement

KEY TAKEAWAYS

• Financial statements are written records that convey the business activities and the financial performance of a company.

• The balance sheet provides an overview of assets, liabilities, and stockholders' equity as a snapshot in time.

• The income statement primarily focuses on a company’s revenues and expenses during a particular period. Once expenses are subtracted from revenues, the statement produces a company's profit figure called net income.

• The cash flow statement (CFS) measures how well a company generates cash to pay its debt obligations, fund its operating expenses, and fund investments.

0 seconds of 1 minute, 47 secondsVolume 75%

1:47

Financial Statements

Understanding Financial Statements

Investors and financial analysts rely on financial data to analyze the performance of a company and make predictions about the future direction of the company's stock price. One of the most important resources of reliable and audited financial data is the annual report, which contains the firm's financial statements.

The financial statements are used by investors, market analysts, and creditors to evaluate a company's financial health and earnings potential. The three major financial statement reports are the balance sheet, income statement, and statement of cash flows.

Balance Sheet

The balance sheet provides an overview of a company's assets, liabilities, and stockholders' equity as a snapshot in time. The date at the top of the balance sheet tells you when the snapshot was taken, which is generally the end of the reporting period. Below is a breakdown of the items in a balance sheet.

Assets

• Cash and cash equivalents are liquid assets, which may include Treasury bills and certificates of deposit.

• Accounts receivables are the amount of money owed to the company by its customers for the sale of its product and service.

• Inventory

Liabilities

• Debt including long-term debt

• Wages payable

• Dividends payable

Shareholders' Equity

• Shareholders' equity is a company's total assets minus its total liabilities. Shareholders' equity represents the amount of money that would be returned to shareholders if all of the assets were liquidated and all of the company's debt was paid off.

• Retained earnings are part of shareholders' equity and are the amount of net earnings that were not paid to shareholders as dividends.

Example of a Balance Sheet

Below is a portion of ExxonMobil Corporation's (XOM) balance sheet for fiscal-year 2021, reported as of Dec. 31, 2021.

• Total assets were $338.9 billion.

• Total liabilities were $163.2 billion.

• Total equity was $175.7 billion.

• Total liabilities and equity were $338.9 billion, which equals the total assets for the period.1

ExxonMobil

Income Statement

Unlike the balance sheet, the income statement covers a range of time, which is a year for annual financial statements and a quarter for quarterly financial statements. The income statement provides an overview of revenues, expenses, net income, and earnings per share.

Revenue

Operating revenue is the revenue earned by selling a company's products or services. The operating revenue for an auto manufacturer would be realized through the production and sale of autos. Operating revenue is generated from the core business activities of a company.

Non-operating revenue is the income earned from non-core business activities. These revenues fall outside the primary function of the business. Some non-operating revenue examples include:

• Interest earned on cash in the bank

• Rental income from a property

• Income from strategic partnerships like royalty payment receipts

• Income from an advertisement display located on the company's property

Other income is the revenue earned from other activities. Other income could include gains from the sale of long-term assets such as land, vehicles, or a subsidiary.

Expenses

Primary expenses are incurred during the process of earning revenue from the primary activity of the business. Expenses include the cost of goods sold (COGS), selling, general and administrative expenses (SG&A), depreciation or amortization, and research and development (R&D).

Typical expenses include employee wages, sales commissions, and utilities such as electricity and transportation.

Expenses that are linked to secondary activities include interest paid on loans or debt. Losses from the sale of an asset are also recorded as expenses.

The main purpose of the income statement is to convey details of profitability and the financial results of business activities; however, it can be very effective in showing whether sales or revenue is increasing when compared over multiple periods.

Investors can also see how well a company's management is controlling expenses to determine whether a company's efforts in reducing the cost of sales might boost profits over time.

Example of an Income Statement

Below is a portion of ExxonMobil Corporation's income statement for fiscal-year 2021, reported as of Dec. 31, 2021.

• Total revenue was $276.7 billion.

• Total costs were $254.4 billion.

• Net income or profit was $23 billion.2

ExxonMobil

Cash Flow Statement

The cash flow statement (CFS) measures how well a company generates cash to pay its debt obligations, fund its operating expenses, and fund investments. The cash flow statement complements the balance sheet and income statement.

The CFS allows investors to understand how a company's operations are running, where its money is coming from, and how money is being spent. The CFS also provides insight as to whether a company is on a solid financial footing.

There is no formula, per se, for calculating a cash flow statement. Instead, it contains three sections that report cash flow for the various activities for which a company uses its cash. Those three components of the CFS are listed below.

Operating Activities

The operating activities on the CFS include any sources and uses of cash from running the business and selling its products or services. Cash from operations includes any changes made in cash, accounts receivable, depreciation, inventory, and accounts payable. These transactions also include wages, income tax payments, interest payments, rent, and cash receipts from the sale of a product or service.

Investing Activities

Investing activities include any sources and uses of cash from a company's investments into the long-term future of the company. A purchase or sale of an asset, loans made to vendors or received from customers, or any payments related to a merger or acquisition is included in this category.

Also, purchases of fixed assets such as property, plant, and equipment (PPE) are included in this section. In short, changes in equipment, assets, or investments relate to cash from investing.

Financing Activities

Cash from financing activities includes the sources of cash from investors or banks, as well as the uses of cash paid to shareholders. Financing activities include debt issuance, equity issuance, stock repurchases, loans, dividends paid, and repayments of debt.

The cash flow statement reconciles the income statement with the balance sheet in three major business activities.

Example of a Cash Flow Statement

Below is a portion of ExxonMobil Corporation's cash flow statement for fiscal-year 2021, reported as of Dec. 31, 2021. We can see the three areas of the cash flow statement and their results.

• Operating activities generated a positive cash flow of $48 billion.

• Investing activities generated negative cash flow or cash outflows of -$10.2 billion for the period. Additions to property, plant, and equipment made up the majority of cash outflows, which means the company invested in new fixed assets.

• Financing activities generated negative cash flow or cash outflows of -$35.4 billion for the period. Reductions in short-term debt and dividends paid out made up the majority of the cash outflows.3

ExxonMobil

Limitations of Financial Statements

Although financial statements provide a wealth of information on a company, they do have limitations. The statements are open to interpretation, and as a result, investors often draw vastly different conclusions about a company's financial performance.

For example, some investors might want stock repurchases while other investors might prefer to see that money invested in long-term assets. A company's debt level might be fine for one investor while another might have concerns about the level of debt for the company.

When analyzing financial statements, it's important to compare multiple periods to determine if there are any trends as well as compare the company's results to its peers in the same industry.

What Are the 3 Most Important Financial Statements?

The three most important financial statements are the balance sheet, the income statement, and the cash flow statement. These three statements together show the assets and liabilities of a business, its revenues and costs, as well as its cash flows from operating, investing, and financing activities.

What Are the Main Items Shown in Financial Statements?

Depending on the corporation, the line items in a financial statement will differ; however, the most common line items are revenues, costs of goods sold, taxes, cash, marketable securities, inventory, short-term debt, long-term debt, accounts receivable, accounts payable, and cash flows from investing, operating, and financing activities.

What Are the Benefits of Financial Statements?

Financial statements show how a business operates. It provides insight into how much and how a business generates revenues, what the cost of doing business is, how efficiently it manages its cash, and what its assets and liabilities are. Financial statements provide all the detail on how well or poorly a company manages itself.

The Fundamentals of Corporate Finance and Accounting

Whatever your learning style, understanding corporate finance and accounting is easy when you can choose from 183,000 online video courses. With Udemy, you’ll be able to learn accounting terminology and how to prepare financial statements and analyze business transactions. What’s more, each course has new additions published every month and comes with a 30-day money-back guarantee. Learn more about Udemy and sign up today.

Financial statements are written records that convey the business activities and the financial performance of a company. Financial statements are often audited by government agencies, accountants, firms, etc. to ensure accuracy and for tax, financing, or investing purposes. Financial statements include the

• Balance sheet

• Income statement

• Cash flow statement

KEY TAKEAWAYS

• Financial statements are written records that convey the business activities and the financial performance of a company.

• The balance sheet provides an overview of assets, liabilities, and stockholders' equity as a snapshot in time.

• The income statement primarily focuses on a company’s revenues and expenses during a particular period. Once expenses are subtracted from revenues, the statement produces a company's profit figure called net income.

• The cash flow statement (CFS) measures how well a company generates cash to pay its debt obligations, fund its operating expenses, and fund investments.

0 seconds of 1 minute, 47 secondsVolume 75%

1:47

Financial Statements

Understanding Financial Statements

Investors and financial analysts rely on financial data to analyze the performance of a company and make predictions about the future direction of the company's stock price. One of the most important resources of reliable and audited financial data is the annual report, which contains the firm's financial statements.

The financial statements are used by investors, market analysts, and creditors to evaluate a company's financial health and earnings potential. The three major financial statement reports are the balance sheet, income statement, and statement of cash flows.

Balance Sheet

The balance sheet provides an overview of a company's assets, liabilities, and stockholders' equity as a snapshot in time. The date at the top of the balance sheet tells you when the snapshot was taken, which is generally the end of the reporting period. Below is a breakdown of the items in a balance sheet.

Assets

• Cash and cash equivalents are liquid assets, which may include Treasury bills and certificates of deposit.

• Accounts receivables are the amount of money owed to the company by its customers for the sale of its product and service.

• Inventory

Liabilities

• Debt including long-term debt

• Wages payable

• Dividends payable

Shareholders' Equity

• Shareholders' equity is a company's total assets minus its total liabilities. Shareholders' equity represents the amount of money that would be returned to shareholders if all of the assets were liquidated and all of the company's debt was paid off.

• Retained earnings are part of shareholders' equity and are the amount of net earnings that were not paid to shareholders as dividends.

Example of a Balance Sheet

Below is a portion of ExxonMobil Corporation's (XOM) balance sheet for fiscal-year 2021, reported as of Dec. 31, 2021.

• Total assets were $338.9 billion.

• Total liabilities were $163.2 billion.

• Total equity was $175.7 billion.

• Total liabilities and equity were $338.9 billion, which equals the total assets for the period.1

ExxonMobil

Income Statement

Unlike the balance sheet, the income statement covers a range of time, which is a year for annual financial statements and a quarter for quarterly financial statements. The income statement provides an overview of revenues, expenses, net income, and earnings per share.

Revenue

Operating revenue is the revenue earned by selling a company's products or services. The operating revenue for an auto manufacturer would be realized through the production and sale of autos. Operating revenue is generated from the core business activities of a company.

Non-operating revenue is the income earned from non-core business activities. These revenues fall outside the primary function of the business. Some non-operating revenue examples include:

• Interest earned on cash in the bank

• Rental income from a property

• Income from strategic partnerships like royalty payment receipts

• Income from an advertisement display located on the company's property

Other income is the revenue earned from other activities. Other income could include gains from the sale of long-term assets such as land, vehicles, or a subsidiary.

Expenses

Primary expenses are incurred during the process of earning revenue from the primary activity of the business. Expenses include the cost of goods sold (COGS), selling, general and administrative expenses (SG&A), depreciation or amortization, and research and development (R&D).

Typical expenses include employee wages, sales commissions, and utilities such as electricity and transportation.

Expenses that are linked to secondary activities include interest paid on loans or debt. Losses from the sale of an asset are also recorded as expenses.

The main purpose of the income statement is to convey details of profitability and the financial results of business activities; however, it can be very effective in showing whether sales or revenue is increasing when compared over multiple periods.

Investors can also see how well a company's management is controlling expenses to determine whether a company's efforts in reducing the cost of sales might boost profits over time.

Example of an Income Statement

Below is a portion of ExxonMobil Corporation's income statement for fiscal-year 2021, reported as of Dec. 31, 2021.

• Total revenue was $276.7 billion.

• Total costs were $254.4 billion.

• Net income or profit was $23 billion.2

ExxonMobil

Cash Flow Statement

The cash flow statement (CFS) measures how well a company generates cash to pay its debt obligations, fund its operating expenses, and fund investments. The cash flow statement complements the balance sheet and income statement.

The CFS allows investors to understand how a company's operations are running, where its money is coming from, and how money is being spent. The CFS also provides insight as to whether a company is on a solid financial footing.

There is no formula, per se, for calculating a cash flow statement. Instead, it contains three sections that report cash flow for the various activities for which a company uses its cash. Those three components of the CFS are listed below.

Operating Activities

The operating activities on the CFS include any sources and uses of cash from running the business and selling its products or services. Cash from operations includes any changes made in cash, accounts receivable, depreciation, inventory, and accounts payable. These transactions also include wages, income tax payments, interest payments, rent, and cash receipts from the sale of a product or service.

Investing Activities

Investing activities include any sources and uses of cash from a company's investments into the long-term future of the company. A purchase or sale of an asset, loans made to vendors or received from customers, or any payments related to a merger or acquisition is included in this category.

Also, purchases of fixed assets such as property, plant, and equipment (PPE) are included in this section. In short, changes in equipment, assets, or investments relate to cash from investing.

Financing Activities

Cash from financing activities includes the sources of cash from investors or banks, as well as the uses of cash paid to shareholders. Financing activities include debt issuance, equity issuance, stock repurchases, loans, dividends paid, and repayments of debt.

The cash flow statement reconciles the income statement with the balance sheet in three major business activities.

Example of a Cash Flow Statement

Below is a portion of ExxonMobil Corporation's cash flow statement for fiscal-year 2021, reported as of Dec. 31, 2021. We can see the three areas of the cash flow statement and their results.

• Operating activities generated a positive cash flow of $48 billion.

• Investing activities generated negative cash flow or cash outflows of -$10.2 billion for the period. Additions to property, plant, and equipment made up the majority of cash outflows, which means the company invested in new fixed assets.

• Financing activities generated negative cash flow or cash outflows of -$35.4 billion for the period. Reductions in short-term debt and dividends paid out made up the majority of the cash outflows.3

ExxonMobil

Limitations of Financial Statements

Although financial statements provide a wealth of information on a company, they do have limitations. The statements are open to interpretation, and as a result, investors often draw vastly different conclusions about a company's financial performance.

For example, some investors might want stock repurchases while other investors might prefer to see that money invested in long-term assets. A company's debt level might be fine for one investor while another might have concerns about the level of debt for the company.

When analyzing financial statements, it's important to compare multiple periods to determine if there are any trends as well as compare the company's results to its peers in the same industry.

What Are the 3 Most Important Financial Statements?

The three most important financial statements are the balance sheet, the income statement, and the cash flow statement. These three statements together show the assets and liabilities of a business, its revenues and costs, as well as its cash flows from operating, investing, and financing activities.

What Are the Main Items Shown in Financial Statements?

Depending on the corporation, the line items in a financial statement will differ; however, the most common line items are revenues, costs of goods sold, taxes, cash, marketable securities, inventory, short-term debt, long-term debt, accounts receivable, accounts payable, and cash flows from investing, operating, and financing activities.

What Are the Benefits of Financial Statements?

Financial statements show how a business operates. It provides insight into how much and how a business generates revenues, what the cost of doing business is, how efficiently it manages its cash, and what its assets and liabilities are. Financial statements provide all the detail on how well or poorly a company manages itself.

The Fundamentals of Corporate Finance and Accounting

Whatever your learning style, understanding corporate finance and accounting is easy when you can choose from 183,000 online video courses. With Udemy, you’ll be able to learn accounting terminology and how to prepare financial statements and analyze business transactions. What’s more, each course has new additions published every month and comes with a 30-day money-back guarantee. Learn more about Udemy and sign up today.

The debt-service coverage ratio applies to corporate, government, and personal finance. In the context of corporate finance, the debt-service coverage ratio (DSCR) is a measurement of a firm's available cash flow to pay current debt obligations. The DSCR shows investors whether a company has enough income to pay its debts.

KEY TAKEAWAYS

• The debt-service coverage ratio (DSCR) is a measure of the cash flow available to pay current debt obligations.

• DSCR is used to analyze firms, projects, or individual borrowers.

• The minimum DSCR that a lender demands depends on macroeconomic conditions. If the economy is growing, lenders may be more forgiving of lower ratios.

0 seconds of 1 minute, 39 secondsVolume 75%

1:39

The Debt-Service Coverage Ratio (DSCR)

Formula and Calculation of the Debt-Service Coverage Ratio (DSCR)

DSCR Formula and Calculation

The formula for the debt-service coverage ratio requires net operating income and the total debt servicing for the entity. Net operating income is a company's revenue minus certain operating expenses (COE), not including taxes and interest payments. It is often considered the equivalent of earnings before interest and tax (EBIT).

\begin{aligned} &\text{DSCR} = \frac{ \text{Net Operating Income} }{ \text{Total Debt Service} } \\ &\textbf{where:} \\ &\text{Net Operating Income} = \text{Revenue} - \text{COE} \\ &\text{COE} = \text{Certain operating expenses} \\ &\text{Total Debt Service} = \text{Current debt obligations} \\ \end{aligned}​DSCR=Total Debt ServiceNet Operating Income​where:Net Operating Income=Revenue−COECOE=Certain operating expensesTotal Debt Service=Current debt obligations​

Some calculations include non-operating income in EBIT. As a lender or investor comparing different companies' creditworthiness—or a manager comparing different years or quarters—it is important to apply consistent criteria when calculating DSCR. As a borrower, it is important to realize that lenders may calculate DSCR in slightly different ways.

Total debt service refers to current debt obligations, meaning any interest, principal, sinking fund, and lease payments that are due in the coming year. On a balance sheet, this will include short-term debt and the current portion of long-term debt.

Income taxes complicate DSCR calculations because interest payments are tax deductible, while principal repayments are not. A more accurate way to calculate total debt service is, therefore, to compute the following:

\begin{aligned} &\text{TDS} = ( \text{Interest} \times ( 1 - \text{Tax Rate} ) ) + \text{Principal} \\ &\textbf{where:} \\ &\text{TDS} = \text{Total debt service} \\ \end{aligned}​TDS=(Interest×(1−Tax Rate))+Principalwhere:TDS=Total debt service​

Calculating DSCR Using Excel

To create a dynamic DSCR formula in Excel, you cannot simply run an equation that divides net operating income by debt service. Rather, you would title two successive cells, such as A2 and A3, "net operating income" and "debt service." Then, adjacent to those cells, in B2 and B3, you would place the respective figures from the income statement.

In a separate cell, enter a formula for DSCR that uses the B2 and B3 cells rather than actual numeric values (e.g., B2 / B3).

Even for a calculation this simple, it is best to use a dynamic formula that can be adjusted and recalculated automatically. One of the primary reasons to calculate DSCR is to compare it to other firms in the industry, and these comparisons are easier to run if you can simply plug in the numbers.

What Debt-Service Coverage Ratio (DSCR) Can Tell You

In the context of government finance, the DSCR is the amount of export earnings needed by a country to meet annual interest and principal payments on its external debt. In the context of personal finance, it is a ratio used by bank loan officers to determine income property loans.

Whether the context is corporate finance, government finance, or personal finance, the debt-service coverage ratio reflects the ability to service debt given a particular level of income. The ratio states net operating income as a multiple of debt obligations due within one year, including interest, principal, sinking funds, and lease payments.

Lenders will routinely assess a borrower's DSCR before making a loan. A DSCR of less than 1 means negative cash flow, which means that the borrower will be unable to cover or pay current debt obligations without drawing on outside sources—in essence, borrowing more.

For example, a DSCR of 0.95 means that there is only sufficient net operating income to cover 95% of annual debt payments. In the context of personal finance, this would mean that the borrower would have to delve into their personal funds every month to keep the project afloat. In general, lenders frown on negative cash flow, but some allow it if the borrower has strong resources in addition to their income.

If the debt-service coverage ratio is too close to 1, for example, 1.1, the entity is vulnerable, and a minor decline in cash flow could render it unable to service its debt. Lenders may, in some cases, require that the borrower maintain a certain minimum DSCR while the loan is outstanding. Some agreements will consider a borrower who falls below that minimum to be in default. Typically, a DSCR greater than 1 means the entity—whether an individual, company, or government—has sufficient income to pay its current debt obligations.

The minimum DSCR a lender will demand can depend on macroeconomic conditions. If the economy is growing, credit is more readily available, and lenders may be more forgiving of lower ratios. A tendency to lend to less-qualified borrowers can, in turn, affect the economy's stability, as was the case leading up to the 2008 financial crisis. Subprime borrowers were able to obtain credit, particularly mortgages, with little scrutiny. When these borrowers began to default en masse, the financial institutions that had financed them collapsed.1

Real-World Example

Let's say a real estate developer is looking to obtain a mortgage loan from a local bank. The lender will want to calculate the DSCR to determine the ability of the developer to borrow and pay off their loan as the rental properties they build generate income.

The developer indicates that net operating income will be $2,150,000 per year, and the lender notes that debt service will be $350,000 per year. The DSCR is calculated as 6.14x, which should mean the borrower can cover their debt service more than six times given their operating income.

\begin{aligned} &\text{DSCR} = \frac{ \$2,150,000 }{ \$350,000 } = 6.14 \\ \end{aligned}​DSCR=$350,000$2,150,000​=6.14​

Interest Coverage Ratio vs. DSCR

The interest coverage ratio indicates the number of times that a company's operating profit will cover the interest it must pay on all debts for a given period. This is expressed as a ratio and is most often computed on an annual basis.

To calculate the interest coverage ratio, simply divide the EBIT for the established period by the total interest payments due for that same period. The EBIT, often called net operating income or operating profit, is calculated by subtracting overhead and operating expenses, such as rent, cost of goods, freight, wages, and utilities, from revenue. This number reflects the amount of cash available after subtracting all expenses necessary to keep the business running.

The higher the ratio of EBIT to interest payments, the more financially stable the company. This metric only considers interest payments and not payments made on principal debt balances that may be required by lenders.

The debt-service coverage ratio is slightly more comprehensive. This metric assesses a company's ability to meet its minimum principal and interest payments, including sinking fund payments, for a given period. To calculate DSCR, EBIT is divided by the total amount of principal and interest payments required for a given period to obtain net operating income. Because it takes into account principal payments in addition to interest, the DSCR is a slightly more robust indicator of a company's financial fitness.

In either case, a company with a debt-service coverage ratio of less than 1.00 does not generate enough revenue to cover its minimum debt expenses. In terms of business management or investment, this represents a risky prospect since even a brief period of lower-than-average income could spell disaster.

Special Considerations

A limitation of the interest coverage ratio is that it does not explicitly consider the ability of the firm to repay its debts. Most long-term debt issues contain provisions for amortization with dollar sums involved comparable to the interest requirement, and failure to meet the sinking fund requirement is an act of default that can force the firm into bankruptcy. A ratio that attempts to measure the repayment ability of a firm is the fixed charge coverage ratio.

How Do You Calculate the Debt Service Coverage Ratio (DSCR)?

The DSCR is calculated by taking net operating income and dividing it by total debt service (which includes the principal and interest payments on a loan). For example, if a business has a net operating income of $100,000 and a total debt service of $60,000, its DSCR would be approximately 1.67.

Why Is the DSCR Important?

DSCR is a commonly used metric when negotiating loan contracts between companies and banks. For instance, a business applying for a line of credit might be obligated to ensure that their DSCR does not dip below 1.25. If it does, the borrower could be found to have defaulted on the loan. In addition to helping banks manage their risks, DSCRs can also help analysts and investors when analyzing a company’s financial strength.

What Is a Good DSCR?

A “good” DSCR depends on the company’s industry, competitors, and stage of growth. For instance, a smaller company that is just beginning to generate cash flow might face lower DSCR expectations compared to a mature company that is already well established. As a general rule, however, a DSCR above 1.25 is often considered “strong,” whereas ratios below 1.00 could indicate that the company is facing financial difficulties.

The Fundamentals of Corporate Finance and Accounting

Whatever your learning style, understanding corporate finance and accounting is easy when you can choose from 183,000 online video courses. With Udemy, you’ll be able to learn accounting terminology and how to prepare financial statements and analyze business transactions. What’s more, each course has new additions published every month and comes with a 30-day money-back guarantee. Learn more about Udemy and sign up today.

Asset management is the practice of increasing total wealth over time by acquiring, maintaining, and trading investments that have the potential to grow in value.

Asset management professionals perform this service for others. They may also be called portfolio managers or financial advisors. Many work independently while others work for an investment bank or other financial institution.

KEY TAKEAWAYS

• The goal of asset management is to maximize the value of an investment portfolio over time while maintaining an acceptable level of risk.

• Asset management as a service is offered by financial institutions catering to high net-worth individuals, government entities, corporations, and institutional investors like colleges and pension funds.

• Asset managers have fiduciary responsibilities. They make decisions on behalf of their clients and are required to do so in good faith.

0 seconds of 1 minute, 43 secondsVolume 75%

1:43

Asset Management

Understanding Asset Management

Asset management has a double-barreled goal: increasing value while mitigating risk. That is, the client's tolerance for risk is the first question to be posed. A retiree living on the income from a portfolio, or a pension fund administrator overseeing retirement funds, is (or should be) risk-averse. A young person, or any adventurous person, might want to dabble in high-risk investments.

Most of us are somewhere in the middle, and asset managers try to identify just where that is for a client.

The asset manager's role is to determine what investments to make, or avoid, to realize the client's financial goals within the limits of the client's risk tolerance. The investments may include stocks, bonds, real estate, commodities, alternative investments, and mutual funds, among the better-known choices.

The asset manager is expected to conduct rigorous research using both macro and microanalytical tools. This includes statistical analysis of prevailing market trends, reviews of corporate financial documents, and anything else that would aid in achieving the stated goal of client asset appreciation.

How Asset Management Companies Work

Asset management companies compete to serve the investment needs of high-net-worth individuals and institutions.

Accounts held by financial institutions often include check-writing privileges, credit cards, debit cards, margin loans, and brokerage services.

When individuals deposit money into their accounts, it is typically placed into a money market fund that offers a greater return than a regular savings account. Account-holders can choose between Federal Deposit Insurance Company-backed (FDIC) funds and non-FDIC funds.

The added benefit to account holders is all of their banking and investing needs can be met by the same institution.

These types of accounts have only been possible since the passage of the Gramm-Leach-Bliley Act in 1999, which replaced the Glass-Steagall Act. The Glass-Steagall Act of 1933, passed during the Great Depression, had forced a separation between banking and investing services. Now, they have only to maintain a "Chinese wall" between divisions.

Example of an Asset Management Institution

Merrill Lynch offers a Cash Management Account (CMA) to fulfill the needs of clients who wish to pursue banking and investment options with one vehicle, under one roof.1

The account gives investors access to a personal financial advisor. This advisor offers advice and a range of investment options that include initial public offerings (IPO) in which Merrill Lynch may participate, as well as foreign currency transactions.

Interest rates for cash deposits are tiered. Deposit accounts can be linked together so that all eligible funds aggregate to receive the appropriate rate. Securities held in the account fall under the protective umbrella of the Securities Investor Protection Corporation (SIPC). SIPC does not shield investor assets from inherent risk but rather protects those assets from the financial failure of the brokerage firm itself.

Along with typical check writing services, the account offers worldwide access to Bank of America automated teller machines (ATM) without transaction fees. Bill payment services, fund transfers, and wire transfers are available. The MyMerrill app allows users to access the account and perform a number of basic functions via a mobile device.

Accounts with more than $250,000 in eligible assets sidestep both the annual $125 fee and the $25 assessment applied to each sub-account held.

How Does an Asset Management Company Differ From a Brokerage?

Asset management institutions are fiduciary firms. That is, their clients give them discretionary trading authority over their accounts, and they are legally bound to act in good faith on the client's behalf.

Brokers must get the client's permission before executing a trade. (Online brokers let their clients make their own decisions and initiate their own trades.)

Asset management firms cater to the wealthy. They usually have higher minimum investment thresholds than brokerages do, and they charge fees rather than commissions.

Brokerage houses are open to any investor. The companies have a legal standard to manage the fund to the best of their ability and in line with their clients' stated goals.

What Does an Asset Manager Do?

An asset manager initially meets with a client to determine what the client's long-term financial objectives are and how much risk the client is willing to accept to get there.

From there, the manager will propose a mix of investments that matches the objectives.

The manager is responsible for creating the client's portfolio, overseeing it from day to day, making changes to it as needed, and communicating regularly to the client about those changes.

What Are the Top Asset Management Institutions?

As of 2021, the five largest asset management institutions, based on global assets under management (AUM), were Black Rock (7.3 trillion), The Vanguard Group ($6.1 trillion), UBS Group ($3.5 trillion), Fidelity Investments ($3.3 trillion), and State Street Global Advisors ($3 trillion).2

Learn the Basics of Trading and Investing

Looking to learn more about trading and investing? No matter your learning style, there are more than enough courses to get you started. With Udemy, you’ll be able to choose courses taught by real-world experts and learn at your own pace, with lifetime access on mobile and desktop. You’ll also be able to master the basics of day trading, option spreads, and more. Find out more about Udemy and get started today.