Key Financial Metrics for Investment Analysis

Understanding Key Financial Concepts in Multifamily Investing 💡🔥 As a multifamily investing coach and mentor, I often emphasize the importance of mastering a few critical financial metrics that can make or break your investment strategy. Last Monday, I covered Net Operating Income (NOI) but lets take it a step further and look at NOI’s relation to cash flow, Cash on Cash Return, and Debt Service Coverage Ratio (DSCR). These metrics are fundamental in assessing the performance and viability of any multifamily investment. 1. Net Operating Income (NOI) and Cash Flow Net Operating Income, or NOI, is a core metric used to evaluate a multifamily property's profitability before financing costs and taxes. It's calculated by subtracting all operational expenses from the property’s total income. Operational expenses include costs such as property management, maintenance, insurance, and utilities, but exclude mortgage payments and capital expenditures. To understand cash flow, you subtract the debt service (the total of all payments required to service the debt including principal and interest) from the NOI. Here’s the formula: Cash Flow = NOI - Debt Service This calculation tells you the cash that remains after all operational costs and debt obligations have been paid. It’s a direct indicator of the property's ability to generate enough income to cover its debts and provide income to the investor. 2. Cash on Cash Return Cash on Cash Return is a popular metric used by real estate investors to evaluate the return on their cash investments in a property. It is particularly useful when dealing with leveraged properties. The formula for Cash on Cash Return is: Cash on Cash Return = (Annual Pre-Tax Cash Flow divided Total Cash Invested) x 100. This metric gives investors an insight into the effectiveness of their capital employed and the yield their cash investment is generating on an annual basis. It's critical for comparing the performance of properties where different levels of investment cash are required. Debt Service Coverage Ratio (DSCR) The Debt Service Coverage Ratio is a measure used by lenders and investors to assess a property’s ability to cover its debt obligations with its income. It is calculated by dividing the NOI by the total debt service: DSCR = NOI divided by Debt Service Most lenders typically look for a DSCR of at least 1.2 to 1.25 Let’s look at an example to illustrate this concepts: Gross Income: $120,000 Operational Expenses: $50,000 Debt Service: $60,000 Down Payment: $200,000 The NOI calculation is: NOI = $120,000 (gross income) - $50,000 (operational expenses) = $70,000 in NOI. Cash Flow = $70,000 {NOI} - $60,000 {Debt Service} = $10,000 in cash flow. Cash on Cash Return = $10,000 divided by $200,000 times 100 = 5% DSCR = NOI ($70,000} divided by debt service ($60,000} = 1.17

Terry Smith of Fundsmith has returned 440% over the past decade. He uses ROCE to help him find the best investments. The simple graphic below will help explain the metric. Return on Capital Employed (ROCE) is a financial ratio that measures the efficiency and profitability of a company in generating returns from its capital employed in both debt and equity. The ratio is calculated by dividing the company's operating profit (earnings before interest and taxes or EBIT) by the total capital employed, expressed as a percentage. ROCE=(Operating ProfitTotal Capital Employed)×100 ROCE=(Total Capital Employed / Operating Profit)×100 ROCE provides insights into how effectively a company utilizes its capital to generate profits, making it a key metric for assessing operational efficiency and financial performance. Return on capital employed is part of the profitability metrics we can use to find great investments, along with Return on Equity (ROE) and Return on Invested Capital (ROIC). Some top companies ROCE: - Google = 20.9% - Microsoft = 27.3% - Nvidia = 24.9% - Visa = 27.4% 5 ways we can use ROCE: 1. Operational Efficiency: ROCE measures how efficiently a company utilizes its capital to generate profits. A higher ROCE indicates effective capital utilization and strong operational efficiency, while a lower ROCE may suggest inefficiencies in capital deployment. 2. Investment Comparison: ROCE allows for the comparison of different companies or industry peers. Investors can use ROCE to identify companies that consistently generate higher returns on the capital they employ, helping them make more informed investment decisions. 3. Capital Allocation: Companies can use ROCE to evaluate the success of their capital allocation strategies. A consistently high ROCE may indicate effective investment decisions, while a declining ROCE could prompt a review of capital allocation strategies. 4. Financial Health: ROCE is an indicator of a company's financial health. A sustained and competitive ROCE over time suggests a robust and well-managed business. On the other hand, a declining or volatile ROCE may signal financial challenges that require attention. 5. Benchmarking Performance: ROCE serves as a benchmark for performance evaluation over different periods. Comparing a company's current ROCE with its historical performance or industry averages helps in understanding the company's trajectory and competitiveness. *** P.S. Want to grow as an investor? Join our FREE Nuggets emails to receive six weekly knowledge nuggets every Tuesday. Join here (it's free) → https://lnkd.in/gxbjyspK

8 cash flow KPIs for CFOs: 1. Operating cash flow Pros: - Key indicator of liquidity and financial health - Shows a company's ability to generate cash from operations Cons: - Doesn't account for long-term investments or financing activities - Can be manipulated through adjustments like extended payment terms 2. Free cash flow Pros: - Useful for analyzing a company's financial flexibility - Measures cash available for debt payments, investments, dividends Cons: - Doesn't indicate causes behind changes in free cash flow - Can fluctuate significantly year-over-year due to capital expenditures 3. Cash flow per share Pros: - Shows cash available for dividends per share - More difficult to manipulate than earnings per share Cons: - Limited without looking at full financial statements - Doesn't include non-cash items from income statement 4. Cash flow yield Pros: - Measures how efficiently capital is converted to cash - Helps determine a company's valuation and attractiveness to investors Cons: - Can be limited without industry and economic context - Most useful when combined with other metrics like return on capital 5. Cash conversion cycle Pros: - Shows efficiency in converting sales into cash - Helps optimize working capital and cash management Cons: - Only applies to companies with inventory - Provides limited financial insight on its own 6. Cash flow margin Pros: - Indicates the company's ability to collect on accounts receivable - Measures the quality of revenue by comparing cash generated to sales Cons: - Volatile and less useful as a short-term metric - Prone to manipulation through payment term adjustments 7. Cash flow return on invested capital Pros: - Helps assess the strength of capital investment strategies - Evaluates profitability versus funds invested to generate returns Cons: - One-off events can mislead results - Doesn't show which activities are driving value 8. Net debt to free cash flow Pros: - Useful metric of financial stability and liquidity - Shows ability to pay down debt from free cash flow generated Cons: - Too little debt could signal underinvestment - Context needed to interpret high or low ratios + do this : → Compare ratios to competitors and industry benchmarks. → Track KPI trends over time rather than relying on one-off metrics. → Use cash flow KPIs alongside other financial metrics for better insights. → Focus on operating cash flow as an overall indicator of business health. → Be wary of distortions like deferring payments to boost short-term cash flow. These cash flow KPIs help identify strengths, weaknesses, and risks to better manage liquidity and financial health. Combined with scenario planning, CFOs can protect their companies.