investment

Warren Buffett gained his reputation as a legendary investor and business leader not just for his financial expertise but also for his ability to form successful business relationships.

Buffett, the CEO of Berkshire Hathaway (BRK.A), has consistently compared successful marriages to thriving business partnerships because he sees them as grounded in similar principles. His straightforward, at times humorous, advice on relationships offers practical wisdom for anyone looking to build lasting connections, whether personal or professional.

Key Takeaways

• According to Buffett, low expectations are the key to lasting marriages and business partnerships.
• He has said that selecting the right spouse is one of the most important decisions you can make.
• He has argued that people tend to become like the people they spend time with, recommending that people associate themselves with those who are better than them.

The Power of Low Expectations

Pushing back on the conventional wisdom that suggests one should have high standards going into a relationship, Buffett advises the opposite. “Do you look for brains? Do you look for humor? Do you look for character? Do you look for beauty? No,” he told students at the University of Georgia’s Terry College of Business in 2001. “You look for low expectations. That is the marriage that’s going to last—if you both have low expectations.”

His advice isn’t about settling for less, but about creating a realistic foundation for your relationships. Buffett said he applies the same principle to his business partnerships. “I want my partners to be on the low side on expectations coming in because I want the marriage to last,” he said. “It’s a financial marriage when they join me at Berkshire, and I don’t want them to think I’m going to do things that I’m not going to do.”

Buffett suggests that disappointment often stems from unrealistic expectations. By starting with modest expectations, both parties can be pleasantly surprised rather than consistently disappointed.

Choose Your Partners Wisely

Buffett doesn’t mince words when discussing the significance of choosing the right spouse. “The most important thing is finding the right spouse. If you make the wrong decision on that, you will regret it,” he said in a 2008 conversation with Ivey Business School students. “If you make that one decision right, I will guarantee you a good result in life.”

While Buffett has made billions in the financial world, he still says personal relationships serve as the foundation for overall success and happiness in life.

Buffett famously chooses companies with stable fundamentals combined with leadership teams that share his principles and vision for the long term. He has said that business partnerships should be approached with the same thoughtfulness as one might have when entering a marriage. For both, he says it’s important to have values and objectives that are aligned.

Associate With People Better Than Yourself

Perhaps more importantly, Buffett said in 2017 that good relationships are crucial because you become more like your partners. “You will move in the direction of the people that you associate with. So it’s important to associate with people that are better than yourself,” he said in a conversation with Bill Gates at Columbia University. “And the most important person by far in that respect is your spouse. I can’t overemphasize how important that is.”

The right partner in business and life doesn’t just stand by your side—they inspire you to become better. Likewise, in the business world, surrounding yourself with colleagues who can bring fresh perspectives and a strong sense of ethics can create success unlikely to be found on your own. It’s why Buffett says he always valued the contrarian thinking of his longtime business partner, Charlie Munger, and why he carefully selects business partners who complement rather than merely echo his own approach.

The Bottom Line

Warren Buffett says that both marriages and business partnerships depend on genuine interactions and realistic expectations, and he encourages people to select personal and professional partners carefully. Successful relationships require mutual understanding and shared values, he argues, rather than unrealistic standards or expectations.

Reviewed by Samantha Silberstein
Fact checked by Vikki Velasquez

The arrival of a baby can be both exciting and financially overwhelming. A baby can mean big changes and major expenses for new parents. How much money can you expect to spend on your little one in the first year? What financial tools should you consider creating? Here we’ll show you how to financially prepare for your family’s newest addition before they arrive.

Key Takeaways

• The cost of the delivery largely depends on the location of the facility and the health insurance policy.
• One-time costs include a stroller and nursery furniture.
• Other things to consider include the cost of child care and college savings plans.
• It’s important to have an emergency fund, especially if one parent stays at home.

One-Time Expenses

With a first born, you’ll be starting from scratch, from nursery furniture to a stroller to toys. There’s also the one-time medical expense of delivery.

Medical Bills

It is important to remember that the cost of routine birthing care is highly variable based on your location and insurance coverage.

In the United States, a woman with insurance coverage can expect to pay an average of $2,854 in out-of-pocket costs from pregnancy to postpartum, which includes labor and delivery. That’s according to the Peterson-Kaiser Family Foundation (KFF) Health System Tracker. Delivering via cesarean section had a higher average out-of-pocket cost ($3,214) than a vaginal delivery ($2,655).

According to a 2022 research article published by the Healthcare Cost Institute, the average price of labor and delivery was $13,393 in 2020 (an average of $17,103 for a c-section, and an average of $11,453 for a vaginal delivery). Prices varied by state and by hospital. The state with the lowest average price was Mississippi ($7,639) and the highest was California ($19,230).

If you have an insurance policy, review it to determine your out-of-pocket costs for prenatal care, hospital stay, tests, and postpartum care. Unfortunately, it’s nearly impossible to accurately predict how much you’ll pay without reviewing the health coverage you have available to you. Then, call the hospitals to get pricing information. Compare the hospitals against one another.

Important

An insurance policy and location are important factors when determining how much the delivery of a baby will cost. If you lack a private insurance program, Medicaid or the Children’s Health Insurance Program (CHIP) could be options for you and your child.

Travel

To get out and about you will most likely want to purchase a stroller, an infant car seat (required by law), a baby carrier, and a diaper bag. Like many of the things on this list, there is a wide range of costs.

Some brands of strollers come with a $1,000 price tag—or even higher. On the other hand, more modest options can be purchased new for under $150. Used equipment can be even more affordable.

At the very least, it’s worth buying a new infant car seat, because there’s no way to ensure that a used one hasn’t been compromised in an accident.

Home

At the very least, you’ll need a bassinet and/or crib with a mattress and sheets. Other fixtures are for convenience and comfort: a changing table, a rocking chair, a monitor, and a diaper pail. To keep your child occupied, you may want to consider a portable swing, bouncer, and play mat. The costs for these items range based on your budget, and all of them can be bought second-hand.

Feeding

Feeding costs will vary based on your particular situation. A mother who has no issues breastfeeding around the clock will see very minimal costs for months before a high chair and dishes are required. A breastfeeding pillow may be helpful. Perhaps nipple balm, as well.

If the mother will be pumping and storing breast milk, then a range of items will be needed: a breast pump, bottles, cleaning equipment, and storage bags. The cost of formula will also add significant costs to your first year of parenting.

Adoption

Adoption comes with its own set of expenses. The costs vary but can go as high as $50,000 or more. Some employers offer adoption benefits, such as time off or financial assistance. There are also government programs that may be worth exploring.

Ongoing Expenses

Once your baby arrives, the regular expenses to care for your little one kick in. Factor the following costs into your budget.

Child Care

Your single biggest budget item may be child care. Your child care costs will vary by where you live, how much care you require, and what type of care you use.

The Care Index pegs in-center child care costs at just under $10,000 per year. The average cost of a nanny is around $28,350 a year, but again, that can be higher or lower based on your location.

Some costs might be offset by a tax credit: the child and dependent care credit. Be sure to confirm if you are eligible.

Food

Once you begin feeding your child solid food, you can expect to spend roughly $100 a month. The early food costs for children are relatively small compared to what you will see from a teenager.

Clothing and Diapers

According to the USDA’s most recent The Cost of Raising a Child report, new parents should estimate clothing costs at around $670 up to $1,110 for the first two years. The amount ranges greatly based on personal preference and budget, but the lower end falls around $56 a month.

Diapers also vary in cost, but experts advise that you should budget at least $1,000 for diapers and $450 for wipes for the first year alone. That’s approximately $120 a month. Parents who choose to use disposable diapers should also expect to go through as many as 3,500 diapers in their child’s first year alone.

Making homemade cloth diapers out of repurposed fabrics (either fabrics you have on hand, or inexpensive fabrics found at thrift stores) is an option that would reduce diaper costs significantly.

Medical Bills

Plan on six wellness visits the first year for evaluations, immunizations, etc., and a few additional visits for illnesses. Check your health insurance policy for your rates.

If One Parent Stays at Home

If you become a stay-at-home parent, there are important budget changes to consider. First, you’ll have a reduced family income. You’ll also lose your benefits. And if you eventually decide to try to re-enter the workforce, your earning potential may not be where it once was.

Under the Family Medical Leave Act (FMLA), certain employers must grant you up to 12 work weeks of unpaid leave for your baby’s arrival. (Note: Small businesses do not fall under the FMLA.) Check to see what type of leave you may qualify for with your employer. If you take unpaid leave, calculate your regular expenses during that period—mortgage, utilities, insurance, groceries, etc.—and determine how you will meet those costs.

It’s a good idea to practice living on one income before the baby arrives. And work hard to try to build up an emergency fund of three to six months’ worth of living expenses.

Financial Tools to Consider

With your child’s arrival, you’ll want to create financial tools to help provide for your child’s future. Determine your priorities to begin budgeting.

College Savings Tools

According to the College Board Report, the average cost per year for college in 2024 to 2025 ranged between $11,610 to attend a public four-year in-state school and $43,350 for a private four-year education. Start saving now through one of several college education investment tools, such as a 529 plan, a Coverdell Education Savings Account, or an UGMA/UTMA account.

There have been some changes to the way some accounts can be used—namely the 529 plan. The Tax Cuts and Jobs Act (TCJA) of 2017 and the Setting Every Community Up for Retirement Enhancement Act (SECURE) of 2019 have expanded the use of 529 plans to include K to 12 education, apprenticeship programs, and the ability to pay down student debt.

The SECURE Act 2.0, passed in January 2023, offers another newly expanded benefit for 529 plans. It allows beneficiaries of these plans to roll over up to $35,000 from any 529 accounts in their name to a Roth IRA in their name over the course of their lifetimes.

Life Insurance

If you do not have life insurance, now is the time to buy it if you can afford to do so. For just a few dollars a month, you can be assured that your child will have financial resources if you and/or your partner were to die unexpectedly. Talk to your employer or an insurance agent for options on both life insurance and disability insurance. 

Health Insurance

Without health insurance, just one serious accident or illness could deplete your savings and put you in significant debt. Investigate your insurance options if you don’t already have coverage, or budget for the increased monthly premium to add your child to your policy.

Flexible Spending Accounts (FSAs)

Flexible Spending Accounts (FSAs) enable you to use pretax dollars to pay for important family budget items, like child care and healthcare expenses. Talk with your employer or financial advisor about setting up a dependent-care FSA and/or healthcare FSA. 

Ways to Save Money

No matter your income, there are numerous ways to meet your new baby’s needs without breaking the bank:

• Consignment/Thrift Stores: Babies grow quickly. Instead of paying full price for their clothing, check out gently used and even new items at your local consignment or thrift store. Many stores will also buy back items after your child has outgrown them for cash or store credit. Online swap groups and parent networks can also provide quality goods for little money—and sometimes, it’s free. 
• Family/Friends for Back-Up Childcare: Instead of having to take a day off (possibly without pay) when your child is sick, make arrangements for family or friends to help out with emergency back-up daycare.
• Borrow Items from Friends: Ask friends with young children if you could borrow items—particularly big-ticket items they’re not using, like a crib, high chair, or rocking chair.
• Baby Shower Gifts: Register so party-goers can buy what you really need and avoid ending up with what you don’t.
• Downgrade Your Lifestyle: Having a child is going to change a lot of things, including your financial priorities. After reviewing your new budget, you may not be able to make the numbers add up. Consider closing the gap by downgrading in a few key areas. For example, think about trading in your vehicle for a more affordable model, shopping at less expensive stores, or buying more generic items.

How Much Does It Realistically Cost to Have a Baby?

From pregnancy to postpartum care, it costs an average of $18,865 to have a baby, according to the Peterson-Kaiser Family Foundation (KFF) Health System Tracker. That includes childbirth. For families with health insurance, the cost is much lower, with out-of-pocket costs averaging $2,854.

How Much Does Daycare Cost?

On average, daycare was $343 per week in 2024. (In 2023, it was $321 per week.)

How Expensive Is a Nanny?

In 2024, a nanny cost an average of $827 per week. (In 2023, it was $766 per week.)

The Bottom Line

Children are a wonderful gift—but an expensive one. Good health insurance can protect you from hospital bills for the most part, but only planning and budgeting can help you handle the rest.

Reviewed by Chip Stapleton
Fact checked by Suzanne Kvilhaug

Investors can monitor the financial health of a company by understanding its debt. Gross debt is the total of the book value of a company’s debt obligations. Net debt is the company’s gross debt minus any cash and cash-like assets on the balance sheet. Net debt tells investors how much remains on the balance sheet if the company pays all obligations with its existing cash balances.

Key Takeaways:

• Gross debt is the total book value of a company’s debt obligations.
• Net debt is the book value of a company’s gross debt minus any cash and cash-like assets on the balance sheet.
• Net debt is a liquidity metric used to determine how well a company can pay all its debts if they come due immediately.

What Is Gross Debt?

A debt is money borrowed from another entity. Debts typically involve paying interest to the lender and may include bank loans, mortgages, and bonds. Gross debt is the total debt a company has at a specific time. For example, if a small business borrows $40,000 from a bank and $10,000 from a family member and has no other debts, the gross debt is $50,000.

Burdensome debt loads can be problematic for company stakeholders. Just because a company has more debt does not necessarily mean it is financially worse off than a company with less debt. For example, what may appear to be a large debt load on a company’s balance sheet may be smaller than an industry competitor’s debt on a net basis. Investors can look to net debt to further evaluate the company’s books.

Note

Net Debt = Short Term Debt + Long Term Debt – Cash or Cash Equivalents

Evaluating Net Debt

Net debt reveals additional details of a company’s financial health beyond gross debt. Net debt compares metrics between industry peers. A company’s balance sheet is used to calculate net debt. Net debt also provides insights into a company’s operational strategy.

If the difference between net and gross debt is substantial, the company has a large cash balance along with significant debt. This may occur due to liquidity concerns, capital investment opportunities, and planned acquisitions. Therefore, net debt should be examined using an industry benchmark and company strategy.

Why Is Net Debt Important During an Acquisition?

Net debt is a key factor during a buyout. When a buyer is looking to acquire a company, net debt is more relevant than gross debt from a valuation standpoint. A buyer is not interested in spending cash to acquire cash. It is more meaningful for the buyer to use the target company’s debt net of its cash balances to accurately assess the acquisition.

What Is the Difference Between Short-Term and Long-Term Debt?

Short-term debt is due in one year or less and can include short-term bank loans, accounts payable, and lease payments. Long-term debt has a maturity date over one year and includes bonds, lease payments, and term loans.

What Is Enterprise Value?

Enterprise value (EV) measures a company’s total value. It measures the market capitalization of a company, its short-term and long-term debt, and any cash or cash equivalents on the company’s balance sheet. Enterprise value is often used as a more comprehensive alternative to market capitalization when valuing a company.

The Bottom Line

Gross debt is the total book value of a company’s debt obligations that includes short term and long term debt. Net debt is gross debt minus any cash and cash-like assets on the balance sheet. Net debt tells investors how liquid a company is and how well the business can pay its debts if they come due immediately.

Fact checked by Giselle Cancio

Many assume the ultra-wealthy pay sky-high inheritance taxes. In reality, most pay far less than expected—or even nothing at all. How? Through a mix of high exemptions, legal trusts, and strategic gifting that shift tax burdens away from their heirs.

By following the same key strategies that reduce inheritance taxes and learning the loopholes that keep wealth in the family, you may be able to take your estate planning up a notch.

Key Takeaways

• Wealthy individuals often use legal strategies like trusts, gifts, and charitable donations to minimize inheritance taxes.
• High exemptions mean most estates avoid federal estate taxes, but proper planning also ensures that heirs don’t face unexpected tax bills.
• Estate planning isn’t just for the super-rich—it helps families at all income levels protect their assets and ensure a smooth transfer to heirs.

How Inheritance Taxes Work

Inheritance taxes are often misunderstood, and for good reason. Depending on where you live, they might take a sizable chunk of an estate—or leave heirs with no tax bill. The federal threshold is so high that most estates fall well below the taxable limit.

For those who owe, strategies like trusts, gifting, and charitable donations can significantly lower their tax liability and, in some cases, eliminate it.

Inheritance Tax vs. Estate Tax

Though often confused, inheritance and estate taxes are distinct.

• Estate tax is taken from the total value of a deceased person’s estate before assets are distributed.
• Inheritance tax is paid by heirs on what they receive, but only in certain states. The federal government imposes estate taxes, while inheritance taxes depend on state laws and a beneficiary’s relationship to the deceased.

Federal vs. State Inheritance Taxes

As of 2025, the federal estate tax exemption, or the amount an individual can pass on tax-free, stands at $13.99 million. This high threshold means that many estates fall below the taxable limit, thereby reducing potential tax liabilities.

Only six U.S. states impose an inheritance tax, making it easier for wealthy individuals in most regions to avoid this tax altogether. Plus, federal tax thresholds are so high that many estates don’t reach them, further reducing tax liabilities.

Common Misconceptions About Inheritance Taxes

It’s a common misconception that wealthy individuals pay substantial inheritance taxes. In reality, tax exemptions, trusts, and smart financial strategies can significantly reduce their payments. Since only a handful of states impose inheritance taxes and the federal estate tax exemption is so high, most estates owe little to nothing. In many cases, careful planning can result in little to no inheritance taxes for heirs.

How Wealthy Families Minimize Inheritance Taxes

Wealthy families often pass down fortunes while paying little to nothing in inheritance taxes. They accomplish this through high estate tax exemptions, strategic gifting, and estate planning tools like trusts. All of these methods legally minimize tax obligations and, in some cases, eliminate them altogether. Here’s how they do it.

Tax Exemptions and Thresholds

The federal estate tax exemption is extremely high—$13.99 million in 2025—meaning estates below this threshold pay no federal estate tax. If an estate exceeds this amount, tax planning becomes essential to reduce the tax burden.

One key strategy used to minimize estate taxes is the step-up in cost basis, which can significantly reduce capital gains taxes for heirs. Jason Escamilla, CFA, founder, CEO, and Chief Investment Officer of ImpactAdvisor LLC, explains that with proper planning, inherited assets can transfer tax-free if they remain below the estate exclusion limits.

“That comes across completely tax-free when you do the proper planning and when you’re below the estate exclusion limits,” he said.

Trusts and Estate Planning Strategies

Dynasty trusts, revocable trusts, and other strategies allow wealthy individuals to transfer assets without triggering high tax liabilities.

Beyond trusts, estate planning strategies like wills, beneficiary designations, and family-limited partnerships can also help structure wealth transfers efficiently.

Proper planning allows your assets to be distributed according to your wishes while minimizing tax exposure and reducing legal complications.

Setting up a trust can help reduce inheritance tax liability and provide long-term financial benefits for your heirs. Learn how to create a trust fund for your family.

Gifting Strategies

Gift-giving is another tool used to reduce the size of taxable estates and pass on wealth to heirs with minimal tax liability. However, deciding when to give and when to hold assets does require careful planning. Every time you sell an asset and pay taxes, you have less wealth working for you.

Escamilla cautions, “It’s important to keep in mind, ‘every time I do that I have less wealth.’ And so it’s a constant trade-off to consider—do we just let it ride?”

Holding onto appreciated assets until inheritance can allow heirs to benefit from the step-up in cost basis, which eliminates capital gains taxes on past appreciation.

Charitable Giving As a Tax Shield

Charitable donations can not only help causes that matter but also reduce taxable estates. By giving to charity, wealthy individuals can lower their estate’s taxable value, which reduces their inheritance taxes.

Escamilla explained that tax planning around charitable giving allows people to be more intentional with their donations, making sure that they align with their long-term financial strategy.

“You can do tax planning around it and then you can be thoughtful and say…we really wanted to donate this anyway, you know, and so we’re going to donate it in a couple of years,” he said.

Valuation Discounts for Family-Owned Businesses

Family-owned businesses can use valuation discounts to reduce the taxable value of the estate and help heirs retain more wealth after inheritance. Valuation discounts allow certain assets, like family-owned businesses, to be appraised at a lower value for tax purposes, reducing the overall estate tax burden.

For example, a Discount for Lack of Marketability (DLOM) accounts for the difficulty in selling a privately-held business interest, while a Discount for Lack of Control (DLOC) reflects the reduced influence of someone with minority ownership.

The Bottom Line

For those managing inherited assets, a lack of awareness can lead to costly mistakes.

“People eventually take over management for their parents, and this is very important, but they’re not thinking about these things. When they take this stuff over, they might think, let’s blow out these stocks, and let’s do this,” said Escamilla. Selling assets haphazardly can trigger unexpected tax bills, reducing the value of the inheritance.

Careful tax planning is crucial. Wealthy folks often pay less thanks to strategies like high exemptions, trusts, gifting, and charitable donations. Learning how these strategies work can give you more control over your own estate planning, allowing you to reduce unnecessary taxes.

Whether you’re part of a high-net-worth family or simply looking to protect your own wealth, it’s never too early to start planning for a smoother transfer to your heirs.

It depends on who’s doing the garnishing

Reviewed by Anthony Battle
Fact checked by Vikki Velasquez

Can Social Security benefits be garnished? The answer is a definite no in some situations, but in others, it becomes a distinct possibility. Ultimately, it depends on who’s doing the garnishing. Certain government entities, such as the U.S. Treasury and the Social Security Administration can garnish your wages for unpaid debts, such as child support, federal student loans, and back taxes.

Key Takeaways

• The U.S. Treasury and the Social Security Administration can garnish your Social Security benefits for unpaid debts such as back taxes, child support, or a federal student loan that’s in default.
• If you owe money to the IRS, a court order is not required to garnish your benefits.
• You’ll have to shell out 15% of your Social Security for federal back taxes and as much as 65% for alimony or child support owed. 

What Is Wage Garnishment and How Does It Work?

Here’s how garnishing works. A commercial creditor to whom you are in debt takes you into court and wins a judgment against you. Then the creditor asks the judge for an order to garnish your wages, bank account, and any other assets you may have to satisfy that debt.

The judge approves the garnishment to square the debt. Are all your assets vulnerable, including Social Security and retirement benefits such as a 401(k) or an individual retirement account (IRA)?

When the Creditor Is a Commercial Entity

When it comes to federal benefit payments—Social Security benefits, Veterans Affairs benefits, railroad retirement benefits, federal student aid, and Office of Personnel Management retirement benefits—the answer is no.

A creditor who has issued you a credit card or an auto loan can’t garnish these federal benefits, even if your payment is late. Creditors holding medical bills, along with personal and payday loans, are also prohibited from garnishing these benefits.

401(k)s are generally safe from garnishment by commercial creditors as long as the money stays in the account, thanks to the Employment Retirement Income Security Act of 1974 (ERISA). IRAs are more vulnerable to garnishment.

If you’re not ordered to pay back taxes or child support, then the bank has to review a two-month history of your account(s). If your Social Security or other protected benefits have been directly deposited into your account(s) within that two months—the so-called “look-back period”—the bank must protect the funds.

However, your creditor can still garnish your wages and, depending on the state where you live, other allowable assets you may have, such as a house or car.

When the Creditor Is the Federal Government

Suppose that you owe the federal government back taxes. You’re going to have to hand over 15% of your Social Security benefits. Funds in a 401(K) or an IRA are also vulnerable.

If you owe alimony or child support, the federal government can get involved in that too: You may have to forfeit as much as 65% of your Social Security benefit. And the Internal Revenue Service (IRS) doesn’t need a court order to garnish your benefits.

When your bank receives the garnishment order, it has two business days to conduct a review and identify your accounts. Depending on the order, the bank may freeze those accounts.

You can avoid the garnishment if you arrange with the IRS to pay off back taxes. In that case, it will no longer garnish your Social Security benefits, though it retains the right to do so if you fail to hold up your end of the bargain.

Important

Retirement plans set up under the Employee Retirement Income Security Act (ERISA), such as 401(k)s, are generally protected from judgment creditors.

When the Credit Is a Federal Student Loan

If you become delinquent on a federal student loan, the government can take “the lesser of 15% of the monthly benefit payment, the amount by which the benefit payment exceeds $750 per month, or the outstanding amount of the debt.” This means the government is not entitled to the first $750 of your monthly Social Security and retirement benefits.

For example, if you receive $850 in benefits per month, 15% of that would be $127.50. Because you can’t be given less than $750 per month, the most that can be garnished from your benefits is $100. Note: This rule applies only to federal student loans, not private loans.

Are Pensions and Social Security Protected from Creditors?

Though Social Security benefits are generally exempt from garnishment and levies—as long as the direct deposit is used—the Department of the Treasury can collect the debt; it’s one exception. Up to 15% of your monthly Social Security benefit may be levied to pay overdue federal taxes.

How Much of My Social Security Can Be Garnished?

Up to 65% of your Social Security benefit can be garnished for child support or alimony that is 12 or more weeks late. For court-ordered restitution, it’s up to 25% of your monthly benefit. For delinquent student loans and overdue taxes, it’s up to 15%.

Is Retirement Income Protected From Garnishment?

It depends. Some retirement income, such as Social Security and 401(k)s, is protected from certain creditors, while vulnerable to others. Other retirement income, such as an IRA, is more vulnerable.

The Bottom Line

Only the federal government can garnish your Social Security and other federal retirement benefits. If you are in danger of such a scenario, get legal help. The American Bar Association provides links to free and low-cost lawyers who can advise you.

Reviewed by Andy Smith
Fact checked by Vikki Velasquez

Financial statements provide a snapshot of a corporation’s financial health at a particular point in time, giving insight into its performance, operations, cash flow, and overall conditions. Shareholders need financial statements to make informed decisions about their equity investments, especially when it comes time to vote on corporate matters.

Key Takeaways

• Financial statements provide a snapshot of a corporation’s financial health, giving insight into its performance, operations, and cash flow.
• Financial statements are essential since they provide information about a company’s revenue, expenses, profitability, and debt.
• Financial ratio analysis involves the evaluation of line items in financial statements to compare the results to previous periods and competitors.
• Liquidity and solvency ratios provide information about a company’s ability to repay its debts and obligations.
• Valuation ratios help determine a fair value or price target for a company’s shares.

Understanding Financial Statements

Financial statements are the financial records that show a company’s business activity and financial performance. Companies are required to report their financial statements on a quarterly and annual basis by the U.S. Securities and Exchange Commission (SEC). The SEC monitors the markets and companies to ensure that everyone is playing by the same rules and that markets function efficiently. There are specific guidelines that are required by the SEC when issuing financial reports so that investors can analyze and compare one company with another easily.

Financial statements are important to investors because they can provide information about a company’s revenue, expenses, profitability, debt load, and ability to meet its short-term and long-term financial obligations. There are three major financial statements.

Balance Sheet

The balance sheet shows a company’s assets (what they own), liabilities (what they owe), and stockholders’ equity (or ownership) at a given moment. It represents the financial position of a company at a specific point in time. For instance, you’ll often notice a company issues their balance sheet as of a certain date such as the last day of the calendar year (12/31/20xx). This report shows the exact amount of assets, liabilities, and equity that exist as of that specific day.

Income Statement

The income statement reports the revenue generated from sales, the operating expenses involved in creating that revenue as well as other costs, such as taxes and interest expense on any debt on the balance sheet. The net amount or the bottom line of the income statement is the net income or the profit for the period. Net income is revenue minus all of the costs of doing business.

As opposed to a balance sheet, the income statement represents a period of time. You may also notice a company issues an income statement with a certain date on it, such as “for the period ending 12/31/20xx)”. This means the report shows all of the sales and expenses for a period of time. Most commonly, for companies with a fiscal year that is equal to a calendar year, that period would be the entire calendar year.

Cash Flow Statement

The cash flow statement (CFS) measures the cash generated for a period, including all of the transactions added to or subtracted from cash. Cash flow is important because it shows how much cash is available to meet short-term obligations, invest in the company, or pay dividends to shareholders. Note that the components of the balance sheet and income statement can feed into the cashflow statement. It’s a way to translate operating results into how cash was directly impacted.

In addition to reviewing a company’s financial statements themselves, also pay attention to the information provided in the footnotes to the financial statements.

The Usefulness of Financial Ratios

Financial ratios help investors break down the enormous amount of financial data that are reported by companies. A ratio is merely a metric to help analyze the data and make useful comparisons with other companies and other reporting periods.

Financial ratio analysis analyzes specific financial line-items within a company’s financial statements to provide insight as to how well the company is performing. Ratios determine profitability, a company’s indebtedness, the effectiveness of management, and operational efficiency.

It’s important to consider that the results from financial ratios are often interpreted differently by investors. Although financial ratio analysis provides insight into a company, individual ratios should be used in tandem with other metrics and evaluated against the overall economic backdrop. Below are some of the most common financial ratios that investors use to interpret a company’s financial statements.

Profitability Ratios

Profitability ratios are a group of financial metrics that show how well a company generates earnings compared to its associated expenses. However, investors should take care not to make a general comparison. Instead, they will get a better sense of how well a company is doing by comparing ratios of a similar period. For example, comparing the fourth quarter of this year with the same quarter from last year will net a better result.

Return on Equity

Return on equity, or ROE, is a common profitability ratio used by many investors to calculate a company’s ability to generate income from shareholders’ equity or investments. Companies issue shares of stock to raise capital and use the money to invest in the company. Shareholders’ equity is the amount that would be returned to shareholders if a company’s assets were liquidated, and all debts were paid off. The higher the return or ROE, the better the company’s performance since it generated more money for each dollar of investment in the company.

​Return on Equity=Average Shareholders’ Equity/Net Income

Operating Margin

Operating profit margin evaluates the efficiency of a company’s core financial performance. Operating income is the revenue generated from a company’s core business operations. Although the operating margin is the profit from core operations, it doesn’t include expenses such as taxes and interest on debt.

As a result, operating margin provides insight as to how well a company’s management is running the company since it excludes any earnings due to ancillary or exogenous events. For example, a company might sell an asset or a division and generate revenue, which would inflate earnings. The operating margin would exclude that sale. Ultimately, the operating profit is the portion of revenue that can be used to pay shareholders, creditors, and taxes.

Operating Margin = Operating Earnings / Revenue

Liquidity Ratios

Liquidity ratios help shareholders determine how well a company handles its cash flow and short-term debts without needing to raise any extra capital from external sources, such as a debt offering.

Current Ratio

The most commonly used liquidity ratio is the current ratio, which reflects current assets divided by liabilities, giving shareholders an idea of the company’s efficiency in using short-term assets to cover short-term liabilities. Short-term assets would include cash and accounts receivables which are money owed to the company by customers. Conversely, current liabilities would include inventory and accounts payables, which are short-term debts owed by the company to suppliers.

Higher current ratios are a good indication the company manages its short-term liabilities well and generates enough cash to run its operation smoothly. The current ratio generally measures if a company can pay its debts within 12 months. It can also be useful in providing shareholders with an idea of the ability a company possesses to generate cash when needed.

Current Ratio = Current Assets / Current Liabilities

Note

Other liquidity ratios include the quick ratio (also known as the acid test) and the operating cash flow ratio.

Debt Ratios

Debt ratios indicate a company’s debt situation and whether they can manage their outstanding debt as well as the debt servicing costs, such as interest. Debt includes borrowed funds from banks but also bonds issued by the company.

Bonds are purchased by investors where companies receive the money from the bonds upfront. When the bonds come due–called the maturity date–the company must pay back the amount borrowed. If a company has too many bonds coming due in a specific period or time of the year, there may not be enough cash being generated to pay the investors. In other words, it’s important to know that a company can pay its interest due on its debts, but also it must be able to meet its bond maturity date obligations.

Debt-to-Equity Ratio

The debt-to-equity (D/E) ratio measures how much financial leverage a company has, which is calculated by dividing total liabilities by stockholders’ equity. A high debt-to-equity ratio indicates a company has vigorously funded its growth with debt. However, it’s important to compare the debt-to-equity ratios of companies within the same industry. Some industries are more debt-intensive since they need to buy equipment or expensive assets such as manufacturing companies. On the other hand, other industries might have little debt, such as software or marketing companies.

D/E = Total Liabilities / Total Equity

Interest-Coverage Ratio

The interest coverage ratio measures the ease with which a company handles interest on its outstanding debt. A lower interest coverage ratio is an indication the company is heavily burdened by debt expenses.

Interest Coverage = EBIT / Interest Expense

EBIT stands for earnings before income and taxes, and is also referred to as operating profit.

Efficiency Ratios

Efficiency ratios show how well companies manage assets and liabilities internally. They measure the short-term performance of a company and whether it can generate income using its assets.

Inventory Turnover

The inventory or asset turnover ratio reveals the number of times a company sells and replaces its inventory in a given period. The results from this ratio should be used in comparison to industry averages. Low inventory turnover ratio values indicate low sales and excessive inventory, and therefore, overstocking. High ratio values commonly indicate strong sales and good inventory management.

Inventory Turnover = Cost of Goods Sold / Average Inventories

Valuation Ratios

Price ratios focus specifically on a company’s stock price and its perceived value in the market.

Price-to-Earning (P/E)

The price/earnings (or P/E) ratio is an evaluation metric comparing the current share price of a company’s stock with its per-share earnings. Higher P/E values indicate investors expect continued future growth in earnings. However, a P/E that’s too high could indicate that the stock price is too high relative to the earnings or profit being generated. Investors use the P/E ratio to evaluate whether the stock price is fairly valued, overvalued, or undervalued.

The P/E ratio is most helpful when compared to historical P/Es of the same company and companies within the same industry.

P/E = Stock Price / Earnings per Share

Note

Trailing P/E uses a stock’s historical earnings relative to its market price, while forward P/E uses earnings forecasts.

Dividend Yield

The dividend yield ratio shows the amount of dividends a company pays out yearly in relation to its share price. The dividend yield provides investors with the return on investment from dividends alone. Dividends are important because many investors, including retirees, look for investments that provide steady income. Dividend income can help offset, at least in part, losses that might occur from owning the stock. Essentially, the dividend yield ratio is a measurement of the amount of cash flow received for each dollar invested in equity.

Dividend Yield = Annual Dividends per Share / Share Price

Why Do Shareholders Need Financial Statements?

Shareholders rely on financial statements to make informed investment decisions, assess company performance, and evaluate potential risks. They do so using the financial ratios mentioned above.

One of the primary reasons shareholders need financial statements is to assess a company’s profitability and growth using the profitability ratios. By comparing past and present earnings, shareholders can evaluate whether a company is growing sustainably or facing challenges. Profitability ratios, such as gross margin and return on equity, also help investors gauge how efficiently a company generates returns on its capital. Last, companies need financial statements to generate these metrics to compare a company against its competitors to see which one is doing the best at generating profits.

A strong balance sheet with healthy cash reserves and manageable debt levels indicates a company’s ability to withstand economic downturns or invest in future growth. On the other hand, excessive liabilities or declining assets may signal financial distress. Shareholders need the balance sheet to assess short-term health. Liquidity ratios like the current ratio can indicate whether a company can pay its short-term bills. The balance sheet also helps tell the story on whether certain debt covenants will be met or if the company will soon face regulatory complications.

Shareholders need the statement of cash flow to assess whether a company can pay dividends, reinvest in its operations, or handle unexpected financial challenges. This financial statement communicates what a company has done (and may do in the future) with the money it earns. Shareholders need to care about not only how much money a company earns but what exactly they do with their earnings.

Which Financial Statement Is Most Important to Shareholders?

No single financial statement is most important, since the balance sheet, income statement, and statement of cash flows all contain crucial pieces of information. Moreover, many ratios computed using fundamental analysis will draw pieces of data from places found on different statements. For instance, ROE uses information from both the income statement and balance sheet.

What Do Financial Statements Tell You?

A company’s financial statements provide insights into a company’s financial position, profitability, and growth potential. Taken together, financial statements allow analysts to conduct fundamental analysis to evaluate a stock’s value and growth prospects. Financial statements also can signal red flags about financial instability or accounting improprieties.

Are All Shareholders Entitled to a Company’s Financial Statements?

Publicly traded companies are required by the SEC to release their financial statements for public consumption. Investors and non-investors alike are able to access these documents online and for free, from a company’s own website or through the SEC’s EDGAR database.

The Bottom Line

There is no one indicator that can adequately assess a company’s financial position and potential growth. That is why financial statements are so important for shareholders and market analysts alike. These metrics (along with many others) can be calculated using the figures released by a company on its financial statements.

Reviewed by Thomas J. Catalano
Fact checked by Yarilet Perez

Provident Fund vs. Pension Fund: An Overview

Provident funds and pension funds are two types of retirement plans used around the world, but their specifics differ from region to region. Provident funds, for example, are prominent in Asia, generally operating like Social Security does in the United States.

Pension funds, also known as pension plans or defined-benefit plans, are offered by employers and governments, usually providing a retirement benefit to participants equal to a portion of their working income. There are some differences in how contributions are made and how benefits are accrued. The most significant differences are based on how benefits are paid.

Key Takeaways

• A provident fund is a government-backed retirement fund.
• A pension plan is a retirement plan run by employers and governments.
• Pension funds operate much like annuities.
• Provident funds operate like a mix of Social Security and 401(k)s.

Provident Fund

A provident fund is a retirement fund run by the government. They are generally compulsory, often through taxes, and are funded by both employer and employee contributions. Governments set the rules regarding withdrawals, including minimum age and withdrawal amount. If a participant dies, their surviving spouse and dependents may be able to continue drawing payments. Unlike the U.S. Social Security system, workers in provident funds often only pay into their own retirement account, rather than a group account, so in this sense, a provident fund is similar to a 401(k) account. One key difference, though, is that in a 401(k) account, the account holder makes the investment decisions, while in a provident fund, the government makes the investment decisions.

Members of provident funds are able to take out a portion of their retirement benefits, typically up to one-third, in a lump sum up-front. The remaining benefits are distributed in monthly payouts. The tax treatment of lump-sum withdrawals may vary between regions.

Pension Fund

A pension plan is a retirement plan in which an employer, and often the employees, make contributions into a pool of funds set aside for the workers’ future benefit. The funds are invested on the employees’ behalf, and the earnings on the investments help fund the workers’ lives upon retirement.

Some pension funds may allow individual participants to choose investments and contribution amounts, while most provident funds have compulsory contributions and centrally-run investments. Pension fund payouts are taxed.

Note

If you have questions about the ins and outs of your plan, talk to your plan administrator.

Key Differences

Here’s an overview of the differences between provident funds and pension funds:

Nature of the Benefits

A provident fund provides a lump sum benefit upon retirement, resignation, or termination. The accumulated balance, including both employee and employer contributions along with accrued interest, is paid out as a single lump sum. Meanwhile, a pension fund is designed to provide a steady stream of income post-retirement. Instead of a lump sum, the retiree typically receives periodic annuity payments.

Contribution Structure

In a provident fund, both the employer and the employee contribute a fixed percentage of the employee’s salary. These contributions accumulate over time with interest, forming a growing balance that the employee can withdraw upon retirement. In the case of a pension fund, contributions can be made by the employer, employee, or both. However, a portion of the accumulated funds is typically earmarked for generating annuity payments rather than being fully available for withdrawal.

Flexibility For Withdrawals

A provident fund allows partial or full withdrawal under specific conditions. For example, you can withdraw money from a provident fund for medical emergencies, home purchases, or educational expenses. Some jurisdictions also permit early withdrawals after a minimum number of years of service. In contrast, a pension fund generally restricts early withdrawals. Its purpose is to ensure financial security in old age, meaning its structure is to make sure the funds/benefits are there in the future. Note there may be exemptions, and those early pension withdrawals may come with penalties.

Risk and Investment Strategy

Provident funds generally invest in low-risk assets such as government bonds, fixed deposits, and other stable financial instruments. This is a conservative approach. The goal here is to make sure capital is preserved and consistent returns are generated over time. Pension funds, on the other hand, may adopt a more diversified investment strategy. The goal may be closely aligned with maximizing long-term growth, meaning pension fund administrators may be willing to take on more risk.

Tax Treatment

Tax treatment varies by country, but in many cases, provident fund contributions are tax-exempt up to a certain limit. The accumulated interest may also be tax-free or tax-deferred. Withdrawals from a provident fund may be partially or fully taxable, depending on when and how the funds are accessed.

On the other hand, pension funds often offer tax benefits on contributions, allowing individuals to reduce taxable income while saving for retirement. However, annuity payments received from a pension fund may be subject to income tax. In some jurisdictions, pension funds provide additional tax advantages, such as tax-free payouts after a certain age or preferential tax treatment for retirees. However, there are still some slight tax differences between the two.

Portability

Provident funds are generally portable, meaning employees can transfer their accumulated balance when switching jobs. This ensures continuity in retirement savings. Pension funds, however, may have restrictions on portability. This is especially true if they are tied to a specific employer’s pension scheme. Some pension funds allow for rollovers into other retirement accounts, but transferring benefits from one employer’s pension plan to another is often more complex. Very generally speaking, it’s often a bit hard to port a pension.

Important

Upon retirement, members of a pension fund may be able to take out their benefits in a lump sum, though the more common course is to receive monthly payments.

Key Similarities

Still, there is some overlap between provident funds and pension funds. A quick highlight of those similarities includes:

• Both a provident fund and a pension fund are designed to help individuals accumulate savings for their retirement.
• In many cases, both provident funds and pension funds require contributions from both the employer and the employee.
• Both provident funds and pension funds are regulated by government bodies to ensure compliance, security, and fair management of contributions.
• Both provident funds and pension funds typically discourage premature withdrawals (though there are some differences mentioned in the previous section).
• Many countries offer tax advantages for both provident fund and pension fund contributions.
• Both provident funds and pension funds often include provisions for dependents in case of the contributor’s death. If an employee passes away before retirement, the accumulated balance in a provident fund is typically transferred to the nominee or legal heirs.

What Is the Purpose of a Provident Fund?

A provident fund is designed to create a secure retirement for you. Though some people may not embrace its compulsory requirements, a provident fund’s mandatory contributions take the guesswork out of how much to save.

What Is a Provident Fund in Simple Words?

A provident fund is way to save for retirement. It’s backed by the government. You and your employer put money in so it can grow. Then when you retire, you can take money out, either all at once (up to a point) or month by month.

How Does a Provident Fund Pay Out?

A provident fund may pay out as a monthly payment, similar to an annuity, or as a lump sum. Typically there is a cap on the lump sum payment, such as up to a third of the entire benefit. It depends on the details of the plan.

What Is the Difference Between a Provident Fund and a Retirement Annuity?

Annuities may give you more options for your investments than a provident fund. Also, with a provident fund, contributions are often compulsory. That’s not the case with annuities. And whereas a provident fund is offered through an employer, you can purchase an annuity directly through an insurance company. However, annuities tend to come with higher fees.

The Bottom Line

In a sense, the benefits of a pension fund are more like an annuity, while the benefits of a provident fund are more like Social Security. The other major difference lies in the compulsory nature of provident fund contributions, whereas saving for a pension is not mandatory. Both are low-cost, tax-advantaged accounts.

To overcome these challenges, you’ll have to manage clients, money, and coworkers

Fact checked by Suzanne Kvilhaug
Reviewed by Margaret James

Starting a business is a significant achievement for many entrepreneurs, but maintaining one is the larger challenge. Every business—large or small—faces many challenges. Some common challenges are hiring the right people, building a brand, and developing a customer base. However, there are some unique challenges to operating a small business. Here are the five significant challenges for small businesses.

Key Takeaways

• It’s important that a small business is never dependent on a single client.
• Small businesses can struggle with money management; hiring a professional to help with money management can free up time to focus on operating concerns.
• Overworking is another challenge of operating a small business; it’s essential to find the right balance between working long hours and business success.
• Many small businesses can become dependent on their founder; a small business owner should not create a situation where the business cannot continue in their absence.
• Starting a small business may be different than simply working as a freelancer.

1. Client Dependence

If a single client makes up more than half of your income, you are operating in a way that more closely resembles an independent contractor than a business owner. Diversifying your client base is vital to growing a business, but it can be difficult—especially when the client in question pays well. (Having a client who pays on time for a service is a godsend for many small businesses.)

Unfortunately, client dependence can result in a longer-term handicap; even if you have employees, you may still be technically operating as a subcontractor for another business. This arrangement allows the client to avoid any of the risks of adding payroll to an area of its business operations where work may dry up at any time; as a result, all of that risk is transferred from the larger company to your small business (and your employees). This arrangement is risky, but it can work if your main client has a consistent need for your product or service.

2. Money Management

Having enough cash to cover the bills is necessary for any business, but it is also necessary for your personal finances. Between your business and your personal finances, one of these will likely emerge as a capital drain and put pressure on the other. To avoid this problem, small business owners must be heavily capitalized—or secure extra income to shore up cash reserves when needed. Many small businesses start with the founders working a job and building a business simultaneously. While this split focus can make it challenging to grow a business, running out of cash actually makes growing a business impossible.

Money management becomes even more important when cash is flowing into the business. Although handling business accounting and taxes may be within the purview of most business owners, professional help is usually a good idea. The complexity of a company’s books increases with each client and employee; seeking out assistance on bookkeeping tasks can prevent it from becoming a reason not to expand.

3. Fatigue

The hours, the work, and the constant pressure to perform wear on even the most passionate individuals. Many business owners—even successful ones—get stuck working much longer hours than their employees. Moreover, small business owners may fear their business will stall in their absence and avoid taking any time away from work to recharge.

Fatigue can lead to rash decisions about the business, including the desire to abandon it altogether. Finding a pace that keeps the business humming, without wearing out the owner, is a challenge that can come up early in the evolution of a small business.

Important

It is generally better for a business to have a diversified client base to pick up the slack when any single client quits paying.

4. Founder Dependence

A business that can’t operate without its founder is a business with a deadline. Many businesses suffer from founder dependence; this is often caused by the founder being unable to let go of certain decisions and responsibilities as the business grows.

In theory, meeting this challenge is easy—a business owner needs to give more control to employees or partners. In practice, however, this is a significant stumbling block for founders because it usually involves compromising (at least initially) the quality of work being done.

Growth should never be the enemy of quality. A small business needs both.

5. Balancing Quality and Growth

Even when a business is not founder-dependent, there comes a time when the challenges that arise as a result of the business’s growth are equal to (or even outweigh) the benefits. Whether it’s a service or a product, at some point a business must sacrifice quality to scale up. This may mean not being able to personally manage every client relationship or not inspecting every component of a final product.

Unfortunately, it may be that level of personal engagement and attention to detail that makes a business successful. Therefore, many small business owners find themselves tied to these habits. There is a large middle ground between shoddy work and an unhealthy obsession with quality; it is up to the business owner to navigate its processes toward a compromise that allows growth without hurting the brand.

What Is the Biggest Problem for Small Businesses?

While small business owners face many challenges in growing and scaling their businesses, it is an excellent time to be a small business owner in the U.S. today. Between March 2021 and March 2022, 1.4 million new small businesses opened in the U.S. When opening a small business, many founders struggle with finding qualified, hardworking employees. Another big problem that small businesses face is a lack of funds. If even one client fails to make a payment, it can have huge consequences for the business. Finally, many businesses struggle with balancing growth and quality. Sometimes it may be necessary to sacrifice quality in order to scale in size.

What Is the Biggest Mistake Small Businesses Make?

Starting a small business is undoubtedly challenging, even for the most experienced entrepreneur; the statistics about the high number of businesses that close within a year are a testament to these challenges. However, there are certain mistakes you can avoid in the short term to make success in the long term more likely. One of the most common mistakes that small business owners make is not creating a comprehensive business plan in the beginning. This business plan should include a large amount of research. (Research that should be done before starting the business.) The business plan should include information about how the profit model of the business, market research about the local competition and demand for the product, the operations of the business, an outline of all sales and marketing efforts, investment data, and financial projections.

What Are the Disadvantages Facing Owners of Small Businesses?

There are many advantages to being an entrepreneur. First and foremost, working for yourself can offer a level of freedom you cannot find working in a traditional job, with a boss or manager. However, owners of small businesses face many disadvantages that employees do not face. Top of mind for many people considering opening a small business is the high probability of income instability. There is also a significant amount of financial risk that you incur if you finance your small business with a business loan. You may also work longer hours than a traditional employee. Plus, you’ll lack the guidance or direction of a traditional employee, who has a boss or manager to provide support. In the beginning stages of starting a business, seek out the help of a mentor or a consultant.

The Bottom Line

The problems faced by small businesses are considerable, and one of the worst things a would-be owner can do is go into business without considering the challenges ahead. We’ve looked at ways to help make these challenges more accessible, but there is no avoiding them. On the other hand, a competitive drive is often one of the reasons people start their own businesses, and every challenge represents another opportunity to compete.

Reviewed by David Kindness
Fact checked by Michael Rosenston

Net Income vs. Operating Cash Flow: An Overview

Financial statements provide a wealth of information about a company and its operations. Many investors, analysts, and creditors refer to a firm’s net income and operating cash flows to understand how well a company has performed and used its cash in operations. Net income, also known as the bottom line, is just as its name implies. It is the remaining income—or revenues—after deducting expenses, taxes, and costs of goods sold (COGS). Operating cash flow (OCF) is the amount of cash generated from operations, and is calculated by subtracting operating expenses from revenue.

Key Takeaways

• Net Income is the result of revenues minus the expenses, taxes, and costs of goods sold (COGS).
• Operating cash flow is the cash generated from operations, or revenues, less operating expenses.
• Many investors and analysts prefer using operating cash flow as an indicator of a company’s health.
• Net income is important to investors and analysts but does not necessarily provide a complete picture of a company’s development.

Net Income

Net income is earned revenues minus incurred expenses, including taxes, and costs of goods sold (COGS). It follows gross income and operating income and is the final income number in a monthly, quarterly, or annual report. A net income statement is important for potential investors and creditors, but it does not always show the company’s actual development. For instance, after a high, one-time asset sale, monthly net income may be higher than operating income, followed by a much lower quarterly net income.

Operating Cash Flow

Operating cash flow is calculated by subtracting operating expenses from revenue. The operating cash flow reports inflows and outflows as a result of regular operating activities. It is the cash from revenues generated by business activities, excluding non-operating sources (e.g., investments and interest). The best demonstration of operating cash flow is the cash cycle, which converts accrual accounting-based sales into cash.

Key Differences

Cash flow and net income statements are different in most cases because there is a time gap between documented sales and actual payments. If invoiced customers pay in cash during the next period, the situation is under control. If the payments are postponed further, there is a larger difference between net income and operative cash flow statements. If the trend does not change, the annual report may demonstrate equally low total cash flow and net income.

Usually, rapidly developing companies report low net income as they invest in improvement and expansion. In the long run, high operating cash flow brings a stable net income rise, though some periods may show net income decreasing tendency.

Constant generation of cash inflow is a more important indicator of a company’s viability and strength than net income. Cash flow is a better criterion and barometer of a company’s financial health. Managers and investors can avoid many traps if they pay more attention to operating cash flow analyses.

Reviewed by David Kindness
Fact checked by Ryan Eichler

Gross, Operating, and Net Profit Margin: An Overview

Gross profit margin, operating profit margin, and net profit margin are the three main margin analysis measures that are used to analyze the income statement activities of a firm.

Each margin individually gives a very different perspective on the company’s operational efficiency. Comprehensively the three margins taken together can provide insight into a firm’s operational strengths and weaknesses (SWOT). Margins are also useful in making competitor comparisons and identifying growth and loss trends against past periods.

Key Takeaways

• An income statement is divided by direct, indirect, and interest and tax expenses.
• Gross profit, operating profit, and net profit margins are important measures for analyzing an income statement.
• Each profit margin measure shows the amount of profit per dollar of a company’s revenue.

Important

Overall, margin analysis metrics measure the efficiency of a firm by comparing profits against costs at three different spots on an income statement.

Gross Profit Margin

Gross profit margin analyzes the relationship between gross sales revenue and the direct costs of sales. This comparison forms the first section of the income statement. Companies will have varying types of direct costs depending on their business. Companies that are involved in the production and manufacturing of goods will use the cost of goods sold measure while service companies may have a more generalized notation.

Overall, the gross profit margin seeks to identify how efficiently a company is producing its product. The calculation for gross profit margin is gross profit divided by total revenue. In general, it is better to have a higher gross profit margin number as it represents the total gross profit per dollar of revenue.

Operating Profit Margin

Operating efficiency forms the second section of a company’s income statement and focuses on indirect costs. Companies have a wide range of indirect costs which also influence the bottom line. Some commonly reported indirect costs includes research and development, marketing campaign expenses, general and administrative expenses, and depreciation and amortization.

Operating profit margin examines the effects of these costs. Operating profit is obtained by subtracting operating expenses from gross profit. The operating profit margin is then calculated by dividing the operating profit by total revenue.

Operating profit shows a company’s ability to manage its indirect costs. Therefore, this section of the income statement shows how a company is investing in areas it expects will help to improve its brand and business growth through several channels. A company may have a high gross profit margin but a relatively low operating profit margin if its indirect expenses for things like marketing, or capital investment allocations are high.

Net Profit Margin

Net profit margin is the third and final profit margin metric used in income statement analysis. It is calculated by analyzing the last section of the income statement and the net earnings of a company after accounting for all expenses.

Net profit margin takes into consideration the interest and taxes paid by a company. Net profit is calculated by subtracting interest and taxes from operating profit—also known as earnings before interest and taxes (EBIT). The net profit margin is then calculated by dividing net profit over total revenue.

Net profit spotlights a company’s ability to manage its interest payments and tax payments. Interest payments can take several varieties. Interest includes the interest a company pays stakeholders on debt for capital instruments. It also includes any interest earned from short-term and long-term investments. 

Taxes are charged at a flat rate for corporations. Just like individuals, corporations must also identify and account for corporate tax breaks that come in the form of credits, deductions, exemptions, and more.

Special Considerations

The net profit margin of a company shows how the company is managing all the expenses associated with the business. On the income statement, expenses are typically broken out by direct, indirect, and interest and taxes. Companies seek to manage expenses in each of these three areas individually.

By analyzing how the gross, operating, and net profit margins compare to each other, industry analysts can get a clear picture of a company’s operating strengths and weaknesses.

Market and business factors may affect each of the three margins differently. Systematically if direct sales expenses increase across the market, then a company will have a lower gross profit margin that reflects higher costs of sales.

Companies may go through different cycles of growth that lead to higher operational, and interest expenses. A company may be investing more in marketing campaigns or capital investments that increase operating costs for a period which can decrease operating profit margin. Companies may also raise capital through debt which can decrease their net profit margin when interest payments rise.

Understanding these different variables and their effects on margin analysis can be important for investors when analyzing the worthiness of corporate investment.