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Oct

2025

How to Read a Financial Statements: The Basics

How to Read Financial Statements: The Basics

By Austin Kilham | Growing Wealth, invest, Investing | Comments Off

Table of Contents

Understanding Each Section of a Financial Statement
Financial Statement Ratios and Calculations
FAQ

A company’s financial statements are like a report card that tells investors how much money a company has made, what it spends on, and how much money it currently has.

Knowing how to read a financial statement and understand the key performance indicators it includes is essential for evaluating a company. Any investor conducting fundamental analysis will pull much of the information they need from past and present financial statements when valuing a stock and deciding whether to buy it.

Each publicly traded company in the United States is required to produce a set of financial statements every quarter. These include a balance sheet, income statement, and cash flow statement. In addition, companies produce an annual report. These statements tell a fairly complete story about a company’s financial health.

Key Points

• Financial statements serve as a report card, reflecting a company’s financial health.

• Balance sheets outline assets, liabilities, and shareholder equity.

• Income statements itemize revenue, expenses, and net income.

• Cash flow statements monitor cash inflows and outflows.

• Annual reports and 10-Ks offer extensive insights and management analysis.

Understanding Each Section of a Financial Statement

Along with a company’s earnings call, reading financial statements can give investors clues about whether or not it’s a good idea to invest in a given company.

Here’s what the different sections of a financial statement consist of.

Balance Sheet

A company’s balance sheet is a ledger that shows its assets, liabilities, and shareholder equity at a given point in time. Assets are anything the company owns with quantifiable value. This includes tangible items, such as real estate, equipment, and inventory, as well as intangible items like patents and trademarks. The cash and investments a company holds are also considered assets.

On the other side of the balance sheet are liabilities, or the debts a company owes, including rent, taxes, outstanding payroll expenses and money owed to vendors. When liabilities are subtracted from assets, the result is shareholder value, or owner equity. This figure is also known as book value and represents the amount of money that would be left over if a company shut down, sold all its assets, and paid off its debt. This money belongs to shareholders, whether public or private.

Income Statement

The income statement, also known as the profit and loss (P&L) statement, shows a detailed breakdown of a company’s financial performance over a given period. It’s a summary of how much a company earned, spent, and lost during that time. The top of the statement shows revenue, or how much money a company has made selling goods or providing services.

The income statement subtracts the costs associated with running the business from revenue. These include expenses, costs of goods sold, and asset depreciation. A company’s revenues less its costs are its bottom-line earnings.

The income statement also provides information about net income, earnings per share, and earnings before interest, taxes, depreciation, and amortization (EBITDA).

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Cash Flow Statement

A cash flow statement is a detailed view of what has happened with regards to a business’ cash over the accounting period. Cash flow refers to the money that’s flowing in and out of a company, and it is not the same as profit. A company’s profit is the money left over after expenses have been subtracted from revenue. The cash flow statement is broken down into three sections:

• Cash flow from operating activities is cash generated by the regular sale of a company’s goods and services.

• Cash flow from investment activity usually comes from buying or selling assets using cash, not debt.

• Cash flow from financing activity details cash flow that comes from debt and equity financing.

At established companies, investors typically look for cash flow from operating activities to be greater than net income. This positive cash flow may indicate that a company is financially stable and has the ability to grow.

Annual Report and 10-K

Public companies must publish an annual report to shareholders detailing their operations and financial conditions. Look for an annual report to include the following:

• A letter from the company’s CEO that gives investors insight into the company’s mission, goals, and achievements. There may be other letters from key company officials, such as the CFO.

• Audited financial statements that describe financial performance. This is where you might find a balance sheet, income statement and cash flow statement. A summary of financial data may provide notes or discussion of financial statements.

• The auditor’s report lets investors know whether the company complied with generally accepted accounting principles as they prepared their financial statements.

• Management’s discussion and analysis (MD&A).

In addition, the Securities and Exchange Commission (SEC) requires companies to produce a 10-K report that offers even greater detail and insight into a company’s current status and where it hopes to go.

The annual report and 10-K are not the same thing. They share similar data, but 10-Ks tend to be longer and denser. The 10-K must include complete descriptions of financial activities. It must outline corporate agreements, an evaluation of risks and opportunities, current operations, executive compensation and market activity. They must be filed with the SEC 60 to 90 days after the company’s fiscal year ends.

Management’s Discussion and Analysis (MD&A)

The management’s discussion and analysis provides context for the financial statements. It’s a chance for company management to provide information they feel investors should have to understand the company’s financial statements, condition, and how that condition has changed or might change in the future. The MD&A also discloses trends, events and risks that might have an impact on the financial information the company reports.

Footnotes

It can be really tempting to skip footnotes as you read financial statements, but they can reveal important clues about a company’s financial health. Footnotes can help explain how a company’s accountants arrived at certain figures and help explain anything that looks irregular or inconsistent with previous statements.

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Financial Statement Ratios and Calculations

Financial statements can be the source of important ratios investors use for fundamental analysis. Here’s a look at some common examples:

Debt-to-equity

To calculate debt-to-equity, divide total liabilities by shareholder equity. It shows investors whether the debt a company uses to fund its operation is tilted toward debt or equity financing. For example, a debt-to-equity ratio of 2:1 suggests that the company takes on twice as much debt as shareholders invest in the company.

Price-to-earnings (P/E)

Calculate price-to-earnings by dividing a company’s stock price by its earnings per share. This ratio gives investors a sense of the value of a company. Higher P/E suggests that investors expect continued growth in earnings, but a P/E that’s too high could indicate that a stock is overvalued compared to its earnings.

Return on equity (ROE)

Calculated by dividing net income by shareholder’s equity, return on equity (ROE) shows investors how efficiently a company uses its equity to turn a profit.

Earnings Per Share

Calculate earnings per share by dividing net earnings by total outstanding shares to understand the amount of income earned for each outstanding share.

Current Ratio

This metric measures a company’s abilities to pay off its short-term liabilities with its current assets. Find it by dividing current assets by current liabilities.

Asset Turnover

Used to measure how well a company is using its assets to generate revenue, you can calculate asset turnover by dividing net sales by average total assets.

The Takeaway

The financial statements that a company provides are all related to one another. For instance, the income statement reflects information from the balance sheet, while cash flow statements can tell you more about the cash on the balance sheet.

Understanding financial statements can give you clues that could help you determine whether a stock is a good value and whether it makes sense to buy or sell.

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FAQ

What does a financial statement tell investors?

There are various types of financial statements, but what they tend to tell investors is how a company is performing in relation to its financial health and key indicators.

What are some examples of financial statements?

Financial statements can include balance sheets, income statements, cash flow statements, and annual reports, among other things.

What does a balance sheet include?

Balance sheet is more or less a ledger that shows a company’s assets, liabilities, and shareholder equity at a given point in time.

Photo credit: iStock/Traimak_Ivan

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SOIN-Q325-122

Oct

2025

Is Inflation a Good or Bad Thing for Consumers?

By Rebecca Lake | Growing Wealth, invest, Investing | Comments Off

Table of Contents

What Is Inflation?
Is Inflation Good or Bad?
Who Benefits From Inflation?
Who Does Inflation Hurt the Most?
How to Invest During Times of Inflation
FAQ

There are two sides to inflation for consumers: The rising cost of goods and services means that the basic cost of living rises for most people. But a certain amount of inflation can spur production and economic growth.

Deciding whether inflation is good or bad therefore depends on how various factors might play out in different economic sectors.

Key Points

• Inflation has a dual impact on consumers, affecting economic growth and wages while raising living costs and causing instability.

• Moderate inflation can boost employment and sustain economic expansion by encouraging spending and investment.

• Excessive inflation pressures household budgets, increases costs, and reduces purchasing power, potentially leading to higher unemployment and lower investment returns.

• Core inflation, excluding food and energy, provides a stable measure for long-term economic analysis and trend tracking.

• Strategies to help protect investments during inflation may include TIPS, real estate ETFs, REITs, dollar-cost averaging, and portfolio diversification.

What Is Inflation?

Inflation is an economic trend in which prices for goods and services rise over time. The Federal Reserve (the Fed) uses different price indexes to track inflation and determine how to shape monetary policy.

Generally speaking, the Fed targets a 2% annual inflation rate as measured by pricing indexes, including the Consumer Price Index. Rising demand for goods and services can trigger inflation when there’s an imbalance in supply. This is known as demand-pull inflation.

Cost-push inflation occurs when the price of commodities rises, pushing up the price of goods or services that rely on those commodities.

Asking whether inflation is bad isn’t the right lens for this economic factor. Inflation can have both pros and cons for consumers and investors. Understanding the potential effects of inflation can help increase the positives while decreasing the negatives.

Is Inflation Good or Bad?

Answering the question of whether inflation is good or bad means understanding why inflation matters so much. The Federal Reserve takes an interest in inflation because it relates to broader economic and monetary policy.

Some level of inflation in an economy is normal, and an indication that the economy is continuing to grow. Inflation rates have, historically, seen the most change during or right after recessions.

The Fed believes that its 2% target inflation rate encourages price stability and maximum employment.

Broadly speaking, high inflation can make it difficult for households to afford basic necessities, such as food and shelter. When inflation is too low, that can lead to economic weakening. If inflation trends too low for an extended period of time, consumers may come to expect that to continue, which can create a cycle of low inflation rates.

That may sound good, as lower inflation means prices are not increasing over time for goods and services. So consumers may not struggle to afford the things they need to maintain their standard of living. But prolonged low inflation can impact interest rate policy.

The Federal Reserve uses interest rate cuts and hikes as a tool to help keep the economy on an even keel. For example, if the economy is in danger of overheating because it’s growing too rapidly, or inflation is increasing too quickly, the Fed may raise rates to encourage a pullback in borrowing and spending.

Conversely, when the economy is in a downturn, the Fed may cut rates to try to promote spending and borrowing. If borrowing money is cheaper, more people will do it in order to finance purchases, or so goes the logic.

When both inflation and interest rates are low, that may not leave much room for further rate cuts in an economic crisis, which may spur higher employment rates. If prices for goods and services continue to decline, that could lead to a period of deflation or even a recession.

So, is inflation good or bad? The answer is that it can be a little of both. How deeply inflation affects consumers or investors, and who it affects most, depends on what’s behind rising prices, how long inflation lasts, and how the Fed manages interest rates.

What Is Core Inflation?

Core inflation measures the rising cost of goods and services in the economy, but excludes food and energy costs. Food and energy prices are notoriously volatile, even though demand for these staples tends to remain steady.

Both food and energy prices are partly driven by the price of commodities, which also tend to fluctuate, owing to speculation in the commodities markets. So the short-term price changes in these two markets make it difficult to include them in a long-term reading of inflationary trends: hence the core inflation metric.

The Consumer Price Index and the core personal consumption expenditures index (PCE) are the two main ways to measure underlying inflation that’s long term.

Who Benefits From Inflation?

The Federal Reserve believes some inflation is good and even necessary to maintain a healthy economy. The key is keeping inflation rates at acceptable levels, such as the 2% annual inflation rate target. Staying within this proverbial Goldilocks zone can result in numerous positive impacts for consumers and the economy in general.

Pros of Inflation

Sustainable inflation can yield these benefits:

• Higher employment rates

• Continued economic growth

• Potential for higher wages if employers offer cost-of-living pay raises

• Cost-of-living adjustments for those receiving Social Security retirement benefits

The danger, of course, is that inflation escalates too rapidly, requiring the Federal Reserve to raise interest rates as a result. This increases the overall cost of borrowing for consumers and businesses.

Who Is Inflation Good For?

Inflation can benefit certain groups, depending on how it impacts Fed shapes monetary policy. Some of the people who can benefit from inflation include:

• Savers, if an interest rate hike results in higher rates on savings accounts, money market accounts or certificates of deposit

• Debtors, if they’re repaying loans with money that’s worth less than the money they borrowed

• Homeowners who have a low, fixed-rate mortgage

• People who hold investments that appreciate in value as inflation rises

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Who Does Inflation Hurt the Most?

Some of the negative effects of inflation are more obvious than others. And there may be different consequences for consumers versus investors.

Cons of Inflation

In terms of what’s bad about inflation, here are some of the biggest cons:

• Higher inflation means goods and services cost more, potentially straining consumer paychecks

• Investors may see their return on investment erode if higher inflation diminishes purchasing power, or if they’re holding low-interest bonds

• Unemployment rates may climb if employers lay off staff to cope with rising overhead costs

• Rising inflation can weaken currency values

Inflation can be particularly bad if it leads to hyperinflation. This phenomenon occurs when prices for goods and services increase uncontrolled over an extended period of time. Generally, this would mean an inflation growth rate of 50% or more per month.

While hyperinflation has never happened in the United States, there are many examples from different time periods around the world: For example, Zimbabwe experienced a daily inflation rate of 98% in 2007-2008, when prices doubled every day.

Recommended: How to Protect Yourself From Inflation

Who Is Inflation Bad For?

The negative impacts of inflation can affect some more than others. In general, inflation may be bad for:

• Consumers who live on a fixed income

• People who plan to borrow money, if higher interest rates accompany the inflation

• Homeowners with an adjustable-rate mortgage

• Individuals who aren’t investing in the market as a hedge against inflation

Inflation and higher prices can be detrimental to retirees whose savings may not stretch as far, particularly when health care becomes more expensive.

If the cost of living increases but wages stagnate, that can also be problematic for workers because they end up spending more for the same things.

How to Invest During Times of Inflation

While inflation is an investment risk to consider, some investing strategies can help minimize its impact on your portfolio.

How to Protect Your Money From Inflation

The first step is to understand that inflation rates may be variable from year to year, but the upward trend in the cost of goods and services is typically a factor investors must contend with. Essentially, if inflation is historically about 2% per year, it’s ideal to look for returns above that.

For example, while savings accounts may yield more interest if the Fed raises interest rates, investing in stocks, exchange-traded funds (ETFs) or mutual funds could generate higher returns, though these investments also come with a higher degree of risk.

• Diversification. Having a diversified portfolio that includes a mix of stock and bonds and other asset classes may help mitigate the impact of inflation.

• Always be aware of investment costs and the impact of taxes and fees. Minimizing investment costs is a time-honored way to keep more of what you earn.

• Investing in Treasury-Inflation Protected Securities (TIPS). TIPS are government-issued securities designed to generate consistent returns regardless of inflationary changes.

• If prices are rising, that can increase rental property incomes. Some investors could benefit from that by investing in real estate ETFs or real estate investment trusts (REITs) if you’re seeking to not own directly property.

• Compounding interest allows you to earn interest on your interest, which is consideration for building wealth.

• Dollar-cost averaging means investing continuously, whether stock prices are low or high. When inflationary changes are part of a larger shift in the economic cycle, investors who dollar-cost average can still reap long term benefits, despite rising prices.

The Takeaway

Inflation is unavoidable, but you can take steps to help minimize the impact to your personal financial situation. Building a well-rounded portfolio of stocks, ETFs and other investments is one strategy for keeping pace with rising inflation. Being aware of how taxes and fees can impact your returns is another way to keep more of what you earn.

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FAQ

How is economic deflation different from inflation?

Deflation is when the cost of goods and services trends downward rather than upward (the sign of inflation). Deflation can be positive for consumers, as their money goes further, but prolonged deflation can also be a sign of a contraction.

How do homeowners benefit from inflation?

Typically tangible assets like real estate tend to increase in value over time, even in the face of inflation. Currency, on the other hand, tends to lose value.

How does the government measure inflation?

The Bureau of Labor Statistics produces the Consumer Price Index (CPI), based on the change in cost for a range of goods and services. The CPI is the most common indicator of inflation.

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Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.

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Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

Dollar Cost Averaging (DCA): Dollar cost averaging is an investment strategy that involves regularly investing a fixed amount of money, regardless of market conditions. This approach can help reduce the impact of market volatility and lower the average cost per share over time. However, it does not guarantee a profit or protect against losses in declining markets. Investors should consider their financial goals, risk tolerance, and market conditions when deciding whether to use dollar cost averaging. Past performance is not indicative of future results. You should consult with a financial advisor to determine if this strategy is appropriate for your individual circumstances.

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Alternative investments, including funds that invest in alternative investments, are risky and may not be suitable for all investors. Alternative investments often employ leveraging and other speculative practices that increase an investor's risk of loss to include complete loss of investment, often charge high fees, and can be highly illiquid and volatile. Alternative investments may lack diversification, involve complex tax structures and have delays in reporting important tax information. Registered and unregistered alternative investments are not subject to the same regulatory requirements as mutual funds.
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SOIN-Q325-125

Sep

2025

What Is Book Value Per Share (BVPS)?

By Matthew Warholak | Growing Wealth, invest, Investing | Comments Off

Table of Contents

What Is Book Value Per Share?
Book Value Per Share vs Market Value Per Share
What Does Book Value Per Share Tell You?
How to Calculate Book Value Per Share
Example of Book Value Per Share
How to Increase Book Value Per Share
FAQ

Unlike market capitalization, which measures a company’s total equity value based on its current share price, book value per share (BVPS) is a way to calculate a company’s total assets minus liabilities, and divide that total by the number of outstanding shares to get a more accurate gauge of its share price.

Thus, BVPS can be useful when deciding whether a stock is overvalued or undervalued. For example, the book value per share of an undervalued stock would be higher than its current market price, so knowing the BVPS can help investors better assess stock prices.

Key Points

• Book value per share (BVPS) is a financial metric that calculates a company’s total assets minus liabilities, divided by the number of outstanding shares.

• BVPS helps investors assess whether a stock is overvalued or undervalued by comparing it to the company’s current market price.

• A BVPS higher than the current market price can indicate that a stock is undervalued, while a declining BVPS may signal a potential stock price decrease.

• BVPS theoretically represents what shareholders would receive if a company were liquidated after all assets were sold and liabilities paid.

• Companies can increase their BVPS by repurchasing common stocks or by increasing assets and reducing liabilities using profits.

Book value per share (BVPS) is the ratio of a company’s equity available to common shareholders relative to the number of outstanding company shares.

Using BVPs helps investors assess whether a stock price is undervalued or overvalued by comparing it to the firm’s market value per share (more on that below). BVPS represents what shareholders would likely receive if the firm was liquidated and its assets sold and its debts were paid.

This ratio calculates the minimum value of a company’s equity and determines a firm’s book value, or net asset value (NAV), on a per-share basis. In other words, it defines the accounting value (i.e. book value) of a share of a company’s publicly traded stock.

The book value per share provides information about how the value of a company’s stock compares to the current market value per share (MVPS), or current stock price. For example, if the BVPS is greater than the MVPS, the stock market may be undervaluing a company’s stock.

The market value per share is a more complex measurement that includes metrics such as the price-to-earnings ratio. It’s forward-looking, since it’s based on what investors think a company should be worth.

Commonly used by stock investors and analysts, the book value per share (BVPS) metric helps investors determine whether it’s undervalued compared to the stock’s current market price.

An undervalued stock will have a BVPS higher than its current stock price, which can help investors make decisions when they buy stocks online.

If the company’s BVPS increases, investors may consider the stock more valuable, and the stock’s price may increase. On the other hand, a declining book value per share could indicate that the stock’s price may decline, and some investors might consider that a signal to sell the stock.

Book value per share also theoretically reflects what shareholders would receive in a company liquidation after all its assets were sold and all of its liabilities paid.

BVPS Can Indicate a Vulnerability

If a company’s share prices dip below its BVPS, the company can potentially be vulnerable to a hostile takeover by a corporate raider who could buy the company and liquidate its assets risk-free.

Conversely, a negative book value could indicate that a company’s liabilities exceed its assets, making its financial condition “balance sheet insolvent.”

Understanding Preferred Shares

Book value per share solely includes common stockholders’ equity and does not include preferred stockholders’ equity. This is because preferred stockholders are ranked differently than common stockholders in the event the company is liquidated.

If a corporate raider intends to liquidate a company’s assets, the preferred stockholders with a higher claim on assets and earnings than common shareholders are paid first and that amount gets deducted from the final shareholders’ equity distributed among common stockholders.

Recommended: Stock Market Basics

Whereas some price models and fundamental analyses are complex, calculating book value per share is fairly straightforward. At its core, it’s subtracting a company’s preferred stock from shareholder equity and dividing that sum by the average amount of outstanding shares.

Book Value Per Share = (Total Equity – Preferred Equity) / Total Shares Outstanding

Total Equity = Total equity of all shareholders.

Total Shares Outstanding = Company’s stock currently held by all shareholders.

Company X has $10 million of shareholder equity, of which $1 million are preferred stocks and an average of 3 million shares outstanding. With this information, the BVPS would be calculated as follows:

BVPS = ($10,000,000 – $1,000,000) / 3,000,000

BVPS = $9,000,000 / 3,000,000

BVPS = $3.00

A company can increase its book value per share in two ways.

Repurchase Common Stocks

A common way of increasing BVPS is for companies to buy back common stocks from shareholders. This reduces the stock’s outstanding shares and decreases the amount by which the total stockholders’ equity is divided.

For example, in the above example, Company X could repurchase 500,000 shares to reduce its outstanding shares from 3,000,000 to 2,500,000.

The above scenario would be revised as follows:

BVPS = ($10,000,000 – $1,000,000) / 2,500,000

BVPS = $9,000,000 / 2,000,000

BVPS = $4.50

By repurchasing 1,000,000 common shares from the company’s shareholders, the BVPS increased from $3.00 to $4.50.

Increase Assets and Reduce Liabilities

Rather than buying more of its own stock, a company can use profits to accumulate additional assets or reduce its current liabilities. For example, a company can use profits to either purchase more company assets, pay off debts, or both. These methods would increase the common equity available to shareholders, and hence, raise the BVPS.

The Takeaway

There are many methods that investors can use to evaluate the value of a company. By leveraging formulas such as a company’s book value per share, investors can assess a company’s value relative to its current market price.

While it has limitations, the BVPS can help identify companies that are undervalued (or overvalued) according to core fundamental principles, and it’s a relatively straightforward calculation that even beginner investors can use.

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FAQ

What does BVPS tell an investor?

Book value per share gives investors the company’s net value on a per share basis. It’s a way of evaluating a company’s share price before making a trade.

Is a higher BVPS better?

A higher book value per share than the market share price tells investors that the company seems to be well-funded and the stock may be a bargain (i.e., undervalued).

What is book value vs market value?

The book value is the net value of a company’s assets, as shown on its balance sheet. Book value per share, then, is the per-share price that reflects the book value. The market value is what the market is willing to pay per share, and is a more complex calculation that’s reflected by the market price.

Photo credit: iStock/Tempura

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SOIN-Q325-075

Sep

2025

Payback Period: Formula and Calculation Examples

By Laurel Tincher | Growing Wealth, invest, Investing, Terminology | Comments Off

Table of Contents

What Is the Payback Period?
How to Calculate the Payback Period
Payback Period Formula (Averaging Method)
Payback Formula (Subtraction Method)
Benefits of Using the Payback Period
Downsides of Using the Payback Period
When Would an Investor Use the Payback Period?
FAQ

The payback period is when an investment generates enough cashflow or value to cover its initial cost. It’s the time it takes to get to the break-even point. Knowing the payback period is something that investors, corporations, and consumers use as a way to gauge whether an investment or purchase is likely to be profitable or worthwhile.

For example, if a $1 million investment in new technology is likely to increase company revenue by $200,000 a year, the payback period for that technology is five years.

A longer payback period is associated with higher risk, and a shorter payback period is associated with lower risk and a greater potential for returns. While calculating the payback period is fairly straightforward, it doesn’t take into account a number of factors, including the time value of money.

Key Points

• The payback period is the time it takes for an investment to generate enough cash flow or value to cover its initial cost, essentially reaching a break-even point.

• A shorter payback period generally indicates lower risk and a greater potential for returns, while a longer period is associated with higher risk.

• There are two primary methods for calculating the payback period: the averaging method (Initial Investment / Yearly Cash Flow) for consistent cash flows, and the subtraction method for variable cash flows.

• Benefits of using the payback period include its simplicity, ease of calculation, and its utility in risk assessment and comparing investment options.

• However, a key limitation of the payback period is that it does not consider earnings after the initial investment is recouped or the time value of money.

What Is the Payback Period?

The payback period is the amount of time it will take to recoup the initial cost of an investment, or to reach its break-even point.

Although investors who are thinking about buying stock in a certain company may want to consider the payback period for certain capital projects at that company (and whether those might support growth), the payback period is more commonly used for budgeting purposes by companies deciding how best to allocate resources for maximum return.

While the payback period is only an estimate, and it doesn’t factor in unforeseen or future outcomes, it’s a useful tool that can provide a baseline for assessing the relative value of one investment over another.

The Value of Time

The payback period can help investors decide between different investments that may be similar, when investing online or via a broker-dealer, as they’ll often want to choose the one that will pay back in the shortest amount of time.

The longer money remains locked up in an investment without earning a return, the more time an investor must wait until they can access that cash again, and the more risk there is of losing the initial investment capital.

How to Calculate the Payback Period

The payback period is calculated by dividing the cost of the investment by the annual cash flow until the cumulative cash flow is positive, which is the payback year. Payback period is generally expressed in years.

Prior to calculating the payback period of a particular investment, one might consider what their maximum payback period would be in order to move forward with the investment. This will help give them some parameters to work with when making investment decisions.

Payback Period Formula (Averaging Method)

There are two basis payback period formulas:

Payback Period = Initial Investment / Yearly Cash Flow

Using the averaging method, the initial amount of the investment is divided by annualized cash flows an investment is projected to generate. This works well if cash flows are predictable or expected to be consistent over time, but otherwise this method may not be very accurate.

Example of a Payback Period

If a company makes an investment of $1,000,000 in new equipment which is expected to generate $250,000 in revenue per year, the calculation would be:

$1,000,000 / $250,000 = 4-year payback period

If they have another option to invest $1,000,000 into equipment which they expect to generate $280,000 in revenue per year, the calculation would be:

$1,000,000 / $280,000 = 3.57-year payback period

Since the second option has a shorter payback period, this may be a more cost effective choice for the company.

Payback Formula (Subtraction Method)

Using the subtraction method, an investor can start by subtracting individual annual cash flows from the initial investment amount, and then do the division. This method is more effective if cash flows vary from year to year.

Payback Period = the last year with negative cash flow + (Amount of cash flow at the end of that year / Cash flow during the year after that year)

Example of Payback Period Using the Subtraction Method

Here’s an example of calculating the payback period using the subtraction method:

A company is considering making a $550,000 investment in new equipment. The expected cash flows are as follows:

Year 1 = $75,000
Year 2 = $140,000
Year 3 = $200,000
Year 4 = $110,000
Year 5 = $60,000

Calculation:

Year 0 : -$550,000
Year 1 : -$550,000 + $75,000 = -$475,000
Year 2 : -$475,000 + $140,000 = -$335,000
Year 3 : -$335,000 + $200,000 = -$135,000
Year 4 : -$135,000 + $110,000 = -$25,000
Year 5 : -$25,000 + $60,000 = $35,000

Year 4 is the last year with negative cash flow, so the payback period equation is:

4 + ($25,000 / $60,000) = 4.42

So, the payback period is 4.42 years.

Other factors

Investors might also choose to add depreciation and taxes into the equation, to account for any lost value of an investment over time.

Consumers may want to consider the payback period when making repairs to their home, or investing in a new amenity. For example: How long would it take to recoup the cost of installing a fuel-efficient furnace?

Benefits of Using the Payback Period

The payback period is simple to understand and calculate. It can provide individuals and companies with valuable insights into potential investments, and help them decide which option provides the best return on investment (ROI). It also helps with assessing the risk of different investments. Advantages include:

• Easy to understand

• Simple to calculate

• Tool for risk assessment

• Helps with comparing and choosing investment options

• Provides insights for financial planning

• Other calculations, such as net present value and internal rate of return, may not provide similar insights

• A look at the amount of time it takes to recoup an investment

Recommended: Stock Market Basics

Downsides of Using the Payback Period

Although the payback period can be a useful calculation for individuals and companies considering and comparing investments, it has some downsides.

A Limited Time Period

The calculation only looks at the time period up until the initial investment will be recouped. It doesn’t consider the earnings the investment will bring in after that, which may either be higher or lower, and could determine whether it makes sense as a long-term investment.

If earnings will continue to increase, a longer payback period might be acceptable. If earnings might decrease after a certain number of years, the investment may not be a good idea even if it breaks even quickly. On the other hand, an investment with a short lifespan could need replacement shortly after its payback period, making it a potentially poor investment.

Other Factors May Add or Subtract Value

The payback period also doesn’t take into consideration other ways an investment might bring value, such as partnerships or brand awareness. This can result in investors overlooking the long-term benefits of the investment since they’re too focused on short-term ROI.

The payback period equation also doesn’t take into account the effects an investment might have on the rest of the company’s operations. For instance, new equipment might require a significant amount of expensive power, or might not be able to run as often as it would need to in order to reach the payback goal.

The Time Value of an Investment

Another limitation of the payback period is that it doesn’t take the time value of money (TVM) into account. The time value of money is the idea that cash will be worth more in the future than it is worth today, due to the amount of interest that it can generate.

Not only does this apply to the initial capital put into an investment, but it’s also important because as an investment generates returns, that cash can then be reinvested into something else that earns interest or income. This is another reason that a shorter payback period could be viewed as an attractive investment.

When Would an Investor Use the Payback Period?

The payback period can apply to personal investments such as solar panels or property maintenance, or investments in equipment or other assets that a company might consider acquiring.

Often an investment that requires a large amount of capital upfront generates steady or increasing returns over time, although there is also some risk that the returns won’t turn out as hoped or predicted.

How Companies Use the Payback Period

Calculating payback periods is especially important for startup companies with limited capital that want to be sure they can recoup their money without going out of business. Companies also use the payback period to select between different investment opportunities or to help them understand the risk-reward ratio of a given investment.

Knowing the payback period is helpful if there’s a risk of a project ending in the future. For example, if a company might lose a lease or a contract, the sooner they can recoup any investments they’re making into their business the less risk they have of losing that capital.

Any particular project or investment can have a short or long payback period. A short period means the investment breaks even or gets paid back in a relatively short amount of time by the cash flow generated by the investment, whereas a long period means the investment takes longer to recoup. How investors understand that period will depend on their time horizon.

Test your understanding of what you just read.

The Takeaway

Understanding the potential payback period for a given investment can help you gauge possible risks and reward for a certain asset, because it helps you to calculate when you’re likely to recoup your initial investment. You can also use the payback period when making large purchase decisions and considering their opportunity cost.

Understanding the way that companies calculate their payback period is also helpful to determine their financial viability and whether it makes sense for you to invest in them as part of your portfolio.

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FAQ

What are the two payback period formulas?

Two of the simplest and most common payback period formulas are the averaging method and the subtraction method.

What does the payback period refer to in investing?

The payback period is the estimated amount of time it will take to recoup an investment or to break even. Generally, the longer the payback period, the higher the risk of the associated investment.

What are some downsides of using the payback period?

The payback period may not consider the earnings an investment brings in following an initial investment, or other ways that an investment could generate value. It also doesn’t take into account the time value of money.

Photo credit: iStock/MicroStockHub

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SOIN-Q325-070

Sep

2025

Exchange-Traded Notes: What Are ETNs? ETN Risks, Explained

What Is an Exchange-Traded Note (ETN)?

By Ashley Kilroy | Growing Wealth, invest, Investing | Comments Off

Table of Contents

What Is an Exchange-Traded Note (ETN)?
Exchange-Traded Notes Meaning
Pros of ETNs
Cons of ETN
ETN vs. ETF: What’s the Difference?
FAQ

Exchange-traded notes, or ETNs, are debt securities that offer built-in diversity, and offer alternatives to other investment vehicles that may have certain downsides for investors, like potential tracking errors and short-term capital gains taxes.

ETNs are similar to ETFs (exchange-traded funds), in that they may be a popular pathway to diversification because they expose investors to a wide range of financial assets, and come with lower expense ratios compared to mutual funds. As such, it can be beneficial for investors to understand ETNs and how they work.

Key Points

• Exchange-traded notes (ETNs) are debt securities that trade on exchanges.

• ETNs track the performance of an underlying commodity or index.

• ETNs may offer access to niche markets without high minimum investments.

• ETNs may provide accurate performance tracking, avoiding tracking errors.

• ETNs have potential risks, including default, redemption, and credit risks.

What Is an Exchange-Traded Note (ETN)?

An ETN, or an exchange-traded note, is a debt security that acts much like a loan or a bond. Issuers like banks or other financial institutions sell the “note,” which tracks the performance of an underlying commodity or stock market index benchmark.

ETNs do not yield dividends or interest in the way that ETFs do. Before investors can earn a profit from an ETN, they must hold the security long enough for it to mature, typically 10 to 30 years. Upon maturity, the ETN pays out one lump sum according to their underlying commodity’s return.

Exchange-Traded Notes Meaning

The term “exchange-traded note” may sound a bit off to some investors, but its meaning is fairly straightforward. For one, ETNs are “exchange-traded” because they’re literally traded on exchanges, like many other securities. And they’re called “notes” because they are debt securities, not pools of investments like a fund (as in an ETF).

Examples of ETNs

To further illustrate how an ETN works and is constructed, suppose you purchase an ETN that tracks the price of gold. As an investor, you don’t own physical gold, but the note’s value tracks gold’s performance. When you sell the ETN, during or at the end of the holding period, your return will be the difference between gold’s sale price at that time and its original purchase price, deducting any associated fees.

Similarly, you could, hypothetically, create an ETN that tracks the price of a commodity like oil. Again, investors don’t actually own barrels of crude, but the ETN would track oil prices until it matures, and then pay out applicable returns.

💡 Quick Tip: Did you know that opening a brokerage account typically doesn’t come with any setup costs? Often, the only requirement to open a brokerage account — aside from providing personal details — is making an initial deposit.

Pros of ETNs

ETNs are a relatively newer type of financial security compared to some others available on the market. Their design comes with perks that some investors may find appealing.

Access to New Markets

Some individual investors may struggle to access niche markets like currencies, international markets, and commodity futures, since they require high minimum investments and significant commission prices. ETNs don’t have these limitations, making them more available to a larger pool of investors.

Accurate Performance Tracking

Unlike ETFs, ETNs don’t require rebalancing. That’s because ETNs do not own an underlying asset, rather they duplicate the index or asset class value it tracks. This means investors won’t miss any profits due to tracking errors, which means a difference between the market’s return and the ETF’s actual return.

Tax Treatment Advantages

Investors of ETNs don’t receive interest, monthly dividends, or annual capital gains distributions — which in turn means they don’t pay taxes on them. In fact, they only face long-term capital gains taxes when they sell or wait for an ETN to mature.

Liquidity

Investors have two options when selling ETNs: They can buy or sell them during regular day trading hours or redeem them from the issuing bank once a week.

Cons of ETN

Every investor must be wary of their investments’ drawbacks. Here are some potential cons of trading ETNs.

Limited Investment Options

Currently, there are fewer ETN options available to investors than other investment products. Additionally, though issuers try to keep valuations at a constant rate, pricing can vary widely depending on when you buy.

Liquidity Shortage

ETFs and stocks can be exchanged throughout the trading day according to price fluctuations. With ETNs, however, investors can only redeem large blocks of the security for their current underlying value once a week. This has the potential to leave them vulnerable to holding-period risks while waiting.

Credit, Default, and Redemption Risk

There are a range of risks associated with ETNs.

1. Risk of default. An ETN is tied to a financial institution such as a bank. It’s possible for that bank to issue an ETN but fail to pay back the principal after the holding period. If so, they’ll go into default, leaving you with a loss. There’s no absolute protection for owners in this case since ETNs are unsecured. External and social factors can lead to a default, too, not just economic influences.

2. Redemption risk. Investors can also take a loss if the institution calls its issued ETNs before maturity. This is called call or redemption risk. In this case, the early redemption may result in a lower sale price than the purchase price, leading to a loss.

3. Credit risk. The institution that issues the ETN impacts the credit rating of the security, which has to do with credit risk. If a bank experiences a drop in its credit rating, so will the ETN. That leads to a loss of value, regardless of the market index it tracks.

ETN vs. ETF: What’s the Difference?

Comparing ETNs and ETFs may help investors to see the pros and cons of either asset more clearly. Both ETNs and ETFs are exchange-traded products (ETPs) that track the metrics of an underlying commodity they represent. Other than that, though, they operate differently from each other.

Asset Ownership

ETFs are similar to a mutual fund, in that investors have some ownership over multiple assets that the ETF bundles together. You invest in a fund that holds assets. They issue periodic dividends in returns as well.

In comparison, ETNs are debt instruments and represent one index or commodity. They are an unsecured debt note that tracks the performance of an asset but doesn’t actually hold the asset itself. As a result, they only issue one payout when you sell or redeem them.

Taxation

These differences impact taxation. An ETF’s distributions are taxable on a yearly basis. Every time a long-term holder of a conventional ETF receives a dividend, they face a short-term capital gains tax.

Comparatively, ETN’s one lump-sum incurs a single tax, making it beneficial for investors who want to minimize their annual taxes.

Recommended: ETF Trading & Investing Guide

The Takeaway

ETNs are unsecured debt notes that track an index or commodity, and are sold by banks and other financial institutions. Like any investment, ETNs have both benefits and drawbacks, and while they may sound like ETFs, there are differences between these two products, notably that with ETNs you do not own any underlying assets.

ETNs may have a place in an investment portfolio, but it’s important that investors fully understand what they are, how they work, and how they can be incorporated into an investment strategy. It may be helpful to speak with a financial professional for guidance.

Opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.¹

FAQ

Who developed ETNs?

Barclays, a large international bank, first developed exchange-traded notes (ETNs) in 2006 as a way to give retail investors an easier path to investing in asset classes like commodities and currencies.

How is an ETN related to ETPs?

ETPs, or exchange-traded products, is a term that refers to a range of financial securities that trade on exchanges. ETNs, or exchange-traded notes, fall under the ETP umbrella, since they are investments that trade on exchanges.

Where are ETNs listed?

ETNs are listed on different exchanges, and can often be found by searching for their respective ticker or symbol.

About the author

Ashley Kilroy

Ashley Kilroy is a seasoned personal finance writer with 15 years of experience simplifying complex concepts for individuals seeking financial security. Her expertise has shined through in well-known publications like Rolling Stone, Forbes, SmartAsset, and Money Talks News. Read full bio.

Photo credit: iStock/Drazen_

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SOIN-Q325-126

How to Read Financial Statements: The Basics

Understanding Each Section of a Financial Statement

Balance Sheet

Income Statement

Cash Flow Statement

Annual Report and 10-K

Management’s Discussion and Analysis (MD&A)

Footnotes

Financial Statement Ratios and Calculations

Debt-to-equity

Price-to-earnings (P/E)

Return on equity (ROE)

Earnings Per Share

Current Ratio

Asset Turnover

The Takeaway

FAQ

What does a financial statement tell investors?

What are some examples of financial statements?

What does a balance sheet include?

Is Inflation a Good or Bad Thing for Consumers?

What Is Inflation?

Is Inflation Good or Bad?

What Is Core Inflation?

Who Benefits From Inflation?

Pros of Inflation

Who Is Inflation Good For?

Who Does Inflation Hurt the Most?

Cons of Inflation

Who Is Inflation Bad For?

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How to Invest During Times of Inflation

How to Protect Your Money From Inflation

The Takeaway

FAQ

How is economic deflation different from inflation?

How do homeowners benefit from inflation?

How does the government measure inflation?

What Is Book Value Per Share (BVPS)?

What Is Book Value Per Share?

Book Value Per Share vs Market Value Per Share

What Does Book Value Per Share Tell You?

BVPS Can Indicate a Vulnerability

Understanding Preferred Shares

How to Calculate Book Value Per Share

Example of Book Value Per Share

How to Increase Book Value Per Share

Repurchase Common Stocks

Increase Assets and Reduce Liabilities

The Takeaway

FAQ

What does BVPS tell an investor?

Is a higher BVPS better?

What is book value vs market value?

Payback Period: Formula and Calculation Examples

What Is the Payback Period?

The Value of Time

How to Calculate the Payback Period

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Payback Period Formula (Averaging Method)

Example of a Payback Period

Payback Formula (Subtraction Method)

Example of Payback Period Using the Subtraction Method

Other factors

Benefits of Using the Payback Period

Downsides of Using the Payback Period

A Limited Time Period

Other Factors May Add or Subtract Value

The Time Value of an Investment

When Would an Investor Use the Payback Period?

How Companies Use the Payback Period

The Takeaway

FAQ

What are the two payback period formulas?

What does the payback period refer to in investing?

What are some downsides of using the payback period?

What Is an Exchange-Traded Note (ETN)?

What Is an Exchange-Traded Note (ETN)?

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