Though you’re not expected to be a master of finance when you join a consulting firm, you will be quickly exposed to financial terms on the job. After all, at the end of the day, a business exists to maximize profits. In order to help clients reach their goals, consultants need to be able to understand some of the common financial vocabulary used in business settings.
Don’t worry if you’re not a quantitative expert – the financial terms you need to know for consulting are fairly intuitive. If you have a degree in some kind of business field, you may already be up to speed.
This article will act as a financial dictionary of sorts, from accounting terms and definitions to finance definitions. The corporate finance terms we’ll be covering are ones that you will have a high probability of coming across as a consultant. The list of financial terms is a great start to helping you be ready for your consulting career.
These financial terms include: (Click on the term for more info.)
- 5 C’s of Credit
- Business Valuation Methods
- Capital Expenditures
- Fixed and Variable Costs
- Financial Due Diligence
- Guesstimates and Market Sizing
- Net Present Value
- Operating Expenses
- Opportunity Cost
Assets are resources that have value, whether tangible or intangible. Common examples of assets are cash, accounts receivable, buildings, equipment, and inventory. The common thread behind all assets is that they can eventually be liquidated into cash.
2. 5 C’s of Credit
The 5C’s of Credit are the primary elements lenders evaluate when determining whether or not to make you a loan. The 5 C’s include character, capacity, capital, collateral, and conditions.
- A borrower’s general trustworthiness, credibility, and personality
- A borrower’s ability to repay the loan
- The amount of money invested by the business owner or management team
- Assets that can be pledged as security
- How the business will use the loan and how that could be affected by economic or industry factors.
Businesses need to understand the 5 C’s of Credit to increases chances of obtaining loans and better interest rates.
3. Business Valuation Methods
Some of the more complicated ideas in business finance are valuation methodologies. Though you don’t need to master these practices like investment bankers do. But it is still helpful to have some familiarity with these financial terms.
Trading Comparables Analysis
Trading comparables analysis, also known as trading comps, is a valuation method in which you compare a company to its closest competitors (who are usually trading in public markets). With trading comps, you typically use ratios based on a company’s overall value (i.e. equity value or enterprise value) divided by operating financial metrics (i.e. revenue, EBIT, EBITDA, net income). This results in ratios, also known as multiples, that you apply to the company you are valuing.
For example, imagine you are trying to value Company A, which earns $15 million in revenue each year. Company A’s closest competitors have the following metrics:
Company B – Enterprise value of $100 million and revenue of $20 million
Implies revenue multiple of 5x ($100 million / $20 million)
Company C – Enterprise value of $200 million and revenue of $50 million
Implies revenue multiple of 4x ($200 million / $50 million)
Company D – Enterprise value of $150 million and revenue of $50 million
Implies revenue multiple of 3x ($150 million / $50 million)
The average revenue multiple of these competitors is 4x. Given that Company A’s revenue is $20 million, this implies that your company’s enterprise value is $80 million (4 x $20 million).
One of the biggest advantages of using trading comps is that you are comparing against companies that are currently trading in the market. This provides your valuation perspective with an up-to-date valuation since the value of public companies change on a daily basis based on investor sentiment.
Precedent Transactions Analysis
Precedent transaction analysis, also known as transaction comps, is a valuation method similar to trading comps. However, instead of comparing against companies that are currently operating, transaction comps use ratios and multiples to compare against similar companies that have were acquired in the past. These multiples also typically include company’s overall value (i.e. equity value or enterprise value) divided by operating financial metrics (i.e. revenue, EBIT, EBITDA, net income).
The main advantage of using transaction comps is that you are able to use multiples that previous acquirers have been willing to pay. As an analogy, imagine you were trying to sell a bicycle. Wouldn’t it be comforting to know at what prices similar bicycles have sold for in the past? The same is true with transaction comps.
Discounted Cash Flow Analysis
The Discounted Cash Flow (DCF) analysis measure the intrinsic value of a company based on its present value of future free cash flows. The DCF implies that a company’s value should be based on the cash it is able to produce in the future. Though the DCF is much more predominantly used in investment banking, you should have a rudimentary understanding of what a DCF is as a consultant.
Compound annual growth rate (CAGR) is the rate at which a financial metric grows over multiple periods. From an investment perspective, CAGR provides the rate of return that gets you from your initial investment value to an ending investment value if you assume that the investment has been compounded annually over time. This is a financial term that will appear often during your time as a consultant.
You can calculate CAGR by using the following formula:
CAGR = (EV / BV)^(1 / n) – 1
EV = Ending value of investment
BV = Beginning value of investment
n = number of periods (months, years, etc.)
5. Capital Expenditures
Capital expenditures are money spent on acquiring or maintaining fixed assets, most notably plants, property, and equipment. Capital expenditures are often spent in order to undertake new projects or investments.
Examples of common capital expenditures include the purchase of a new factory, repairs to existing machinery, and purchase of land. This financial term is an important accounting metric that will appear often on the consulting job.
6. Fixed and Variable Costs
Minimizing costs is extremely important to every organization, whether it’s a business, a government institution, or a nonprofit. All costs can be broken down into two main categories: fixed costs and variable costs. These financial terms are extremely important to understand, as they often appear in case interviews (and you’ll be dealing with them everyday on the job!)
Fixed costs are costs that remain the same regardless of output. Some common examples include rent, machinery, and buildings.
For instance, imagine a shoe manufacturer produces 10 shoes versus 1,000 shoes in the same factory. The company’s rent will be the same no matter how many shoes are produced.
Variable costs are costs that vary with output. Some common examples include utilities, wages, and raw materials.
For the same example with our shoe manufacturer, imagine the company produces 10 shoes versus 1,000 shoes. The company’s variable costs will increase depending on the number of shoes that are produced, since more shoes will require more raw materials, workers, etc.
7. Financial Due Diligence
Financial due diligence is an investigation or audit of a potential investment that is performed before purchasing the asset. Financial due diligence is one of the common investment terms that consultants come across on M&A related projects.
During financial due diligence, the auditing firm reviews financial records to ensure the validity of an organization’s numbers. This can include looking at revenue builds, cost structures, assumptions driving projections, and more.
8. Guesstimates and Market Sizing
Guesstimates, also known as market sizing, are very common in consulting interviews. These questions involve estimating a value for something you’ve in all likelihood never considered estimating before. Just as in consulting cases, the interviewer is not necessarily looking for one correct answer or approach. Instead, what’s important is being able to structure your thought process in a logical way, communicating each step concisely to your interviewer, and determining appropriate assumptions.
Some examples of guesstimate questions include the following:
- How many ping pong balls can fit inside a football stadium?
- What is the monthly profit of your favorite restaurant?
- How many trees are there in New York City?
- What is the size of the dog collar market in the U.S.?
- How many chocolate bars are sold in the UK each year?
Liabilities are legal obligations that need to be repaid. Liabilities are considered either current (payable within one year or less) or long-term (payable after one year) and are listed on a business’s balance sheet. Common examples of liabilities include accounts payable, wages, taxes, and accrued expenses.
10. Net Present Value
Net present value (NPV) is the sum of the present values of money in different future points in time. Net present value is based on what’s known as the time value of money. The time value of money is a concept that states that money today is worth more than money tomorrow (or any future time period). This is because you could use that money to invest in financial instruments like equities in the stock market to earn more than what you started with. Calculating your NPV is a helpful method of comparing projects or investments that produce different cash flows over time.
The Interest Rate
One key component of net present value is the interest rate (also called the discount rate) used to discount the future value of cash into present value. This interest rate in essence is the estimated return you would receive each year if you invested your money and therefore, what you would lose if you did not invest your money. This interest rate depends on the riskiness of your investment. Generally speaking, the higher the risk, the higher the interest rate because there is less certainty about your future potential earnings. An increase in your interest rate results in a lower NPV, while a lower interest rate results in a higher NPV.
Net Present Value Formula
PV = present value
FV = future value
i = interest rate or discount rate for a specific period
n = the number of periods between present and future
11. Operating Expenses
Operating expenses are short-term expenses required to meet the ongoing operational costs of running a business or organization. Unlike capital expenditures, operating expenses can be fully deducted on the company’s taxes in the same year in which the expenses occur.
Examples of common operating expenses include marketing, research and development, and general administrative costs. This financial term is an important accounting metric that will appear often on the consulting job.
12. Opportunity Cost
Opportunity cost is the benefit that is missed or given up when choosing one alternative over another. Businesses aren’t required to report opportunity costs on their financial reports, but management teams can calculate them in order to make educated decisions on where to invest their capital and resources.
How to Calculate Opportunity Cost
Calculating opportunity cost simply is the difference between the expected returns of the options you are comparing.
For example, let’s say you have the option to invest in one of two stocks, Stock A and Stock B. If Stock A is estimated to generate a 10% return, while Stock B is estimated to generate a 15% return, your opportunity cost in investing in Stock A is 5% (15% – 10%).
Understanding these financial terms is important to your success as a consultant. Some of these financial terms may or may not come up in a case interview, but they will definitely come up at some point in your consulting career. We hope this list equips you with the basic knowledge to exceed expectations from Day 1.