Some Important Financial Terms

Time Value of Money 

The idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. For example, assuming a 5% interest rate, Rs.100 invested today will be worth Rs.105 in one year (Rs.100 multiplied by 1.05). Conversely, Rs.100 received one year from now is only worth Rs.95.24 today (Rs.100 divided by 1.05), assuming a 5% interest rate.

Discounting

The act of determining the present value of future cash flows. Because money is subject to inflation and has the ability to earn interest, one dollar today is worth more than one dollar tomorrow. Discounting, then, is the act of determining how much less tomorrow dollar is is worth.

Compounding

A process whereby the value of an investment increases exponentially over time due to compound interest.

Retained earnings

The percentage of net earnings not paid out as dividends, but retained by the company to be reinvested in its core business or to pay debt. It is recorded under Shareholders equity on the balance sheet. The formula calculates retained earnings by adding net income to (or subtracting any net losses from) beginning retained earnings and subtracting any dividends paid to shareholders:

Retained Earnings (RE) = Beginning RE + Net Income - Dividends

Also known as the "retention ratio" or "retained surplus".

In most cases, companies retain their earnings in order to invest them into areas where 

the company can create growth opportunities, such as buying new machinery or spending the money on more research and development. Should a net loss be greater than beginning retained earnings, retained earnings can become negative, creating a deficit. The retained earnings general ledger account is adjusted every time a journal entry is made to an income or expense account.

Cost of capital

The required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity. The cost of capital determines how a company can raise money (through a stock issue, borrowing, or a mix of the two). This is the rate of return that a firm would receive if it invested in a different vehicle with similar risk.