Stock vs. Flow Financial Variables
Understanding the financial health of a government, company, nonprofit, or individual requires looking at various factors, which are usually classified into stock and flow financial variables.
This article looks at the difference between stock and flow variables, and how they are applied to understand and assess the financial standing of various entites.
Key Takeaways – Stock vs. Flow Financial Variables
- Understanding the financial health of any entity requires analyzing both stock and flow financial variables.
- Stock variables provide a snapshot of the financial situation at a specific point in time, while flow variables track the rate of change over a period.
- Stock variables include measures like market capitalization, total debt, outstanding shares, and account balances, representing the quantity of a particular asset or liability.
- Flow variables, such as revenue, interest payments, net income, and deposit/withdrawal amounts, help assess the dynamic aspects of financial performance and provide insights into the rate of change over time.
Stock Variables
Stock variables are measures taken at a specific point in time and represent the quantity of a particular asset.
They provide a snapshot of the financial situation at a particular moment.
Some common examples of stock variables include:
Market Capitalization of a Company
The total value of all outstanding shares of a company, calculated by multiplying the share price by the number of shares outstanding.
Total Amount of Debt Held by a Company
The sum of all the debts and obligations owed by a company at a given point in time.
Total Number of Outstanding Shares of a Company
The total number of issued shares held by shareholders, which includes both public and private investors.
Total Amount of Money Held in a Savings Account
The current balance in a savings account at a specific point in time.
The Current Balance of a Checking Account
The available funds in a checking account at a particular moment.
“Balance Sheet” Items
In general, anything that’s a balance sheet item (e.g., how much cash, how much debt, how much equipment, etc.) is a stock variable.
Flow Variables
Flow variables, on the other hand, are measured over a period of time and represent the rate of change of a particular asset.
They help analysts understand the dynamic aspects of financial performance.
Examples of flow variables include:
Revenue Generated by a Company in a Quarter
The total amount of money a company earns from its business activities during a specific quarter.
Total Amount of Interest Paid on a Loan Over a Period of Time
The cumulative amount of interest paid on a loan over a specified period, such as monthly or annually.
Net Income Earned by a Company in a Fiscal Year
The difference between a company’s total revenue and its total expenses, including taxes, during a fiscal year.
The Amount of Money Deposited or Withdrawn from a Savings Account Over a Period of Time
The net change in the balance of a savings account resulting from deposits and withdrawals made during a specified period.
The Amount of Money Spent on a Credit Card Over a Month
The total amount charged to a credit card during a specific month, which is the difference between the beginning and ending balances.
Examples
National Debt (Stock) vs. Non-Debt Items (Flow)
A lot of attention is placed on the national debt, which is a stock variable.
However, less attention is paid to non-debt items that are much larger in size (at least in the US and most other developed markets) that are flow variables and debt-like in nature.
These include things like Medicare (health insurance obligations), Social Security (pension obligations), and other non-debt forms.
Net Worth vs. Income (Flow)
Net worth is a stock variable.
Income is a flow variable.
Sometimes you’ll see comparisons made between net worth (e.g., market capitalization of Apple or net worth of Bill Gates) and GDP (of a certain country).
But these are not apt comparisons, given one is a stock variable (assets minus liabilities) while GDP is a flow variable – i.e., analogous to the revenue of a country from the sale of all new goods and services produced.
Converting a Flow Variable to a Stock Variable
Converting a flow variable to a stock variable involves capitalizing the flow variable using a discount rate.
As we explained earlier, a flow variable represents a quantity measured over a period of time, such as income or expenses, while a stock variable represents a quantity measured at a specific point in time, like wealth or debt.
Why would you want to do this?
The most common example is when you want to convert an income-generating asset to a potential market value.
For example, say you have an asset generating $10,000 per month. That $10,000 income is a flow variable.
But let’s say you’re willing to sell it or at least want to know its market value.
This means you essentially want to convert it into a stock variable.
How to do flow to stock conversion
In order to make this conversion, you need to find the present value of the flow variable using the discount rate.
Here’s a step-by-step explanation of how to convert a flow variable to a stock variable using a discount rate:
1) Identify the flow variable
Determine the flow variable you want to convert to a stock variable.
For example, let’s say you have an annual rental income of $10,000.
After this, you…
2) Determine the discount rate
The discount rate is the interest rate used to convert future cash flows to their present value.
This rate can be derived from various sources, such as the risk-free rate plus a risk premium, the expected or desired return on investment (what’s it worth to me if I need 10% returns per year), or simply a required rate of return based on the risk associated with the cash flows.
Let’s assume a discount rate of 5% (0.05) for our example.
3) Calculate the present value
The present value is the value of the future cash flows discounted to the present using the discount rate.
For a perpetuity, which is a constant cash flow that continues indefinitely, the formula to calculate the present value is:
Present Value = (Flow Variable) / (Discount Rate)
In our example:
Present Value = ($10,000) / (0.05) = $200,000
4) Interpret the results
The present value calculated represents the stock variable or the capitalized value of the flow variable, which, in our example, is $200,000.
This means that, given the 5% discount rate, the capitalized value of the rental income of $10,000 per year is $200,000.
This example assumes a perpetuity, and the formula may differ for other types of cash flows (e.g., growing perpetuity, finite cash flows).
Always be sure to use the appropriate formula based on the specific characteristics of the cash flows you are dealing with.
We have many related articles about this below:
- Dividend Discount Model
- FCFF Valuation Model
- FCFE Valuation Model
- How to Choose the Appropriate Business Valuation Model
- How to Value a Private Company
The Relation Between Stock and Flow Variables
Stock and flow variables tend to be mutually reinforcing.
For example, if you have a lot of income, you can more easily build assets.
If you have assets, you can more easily generate income.
However, there are exceptions.
For example, a company can have a high operating income (e.g., EBIT) or net income, but if it has too many liabilities, it can be insolvent.
This is why earnings are not the only thing one should use to evaluate a company because earnings ignore a company’s balance sheet.
Likewise, a doctor may have a high income. But with many having high amounts of student loans and consumer debt, many doctors are “broke” despite having a higher income relative to most earners.
Stocks and Flows Explained in One Minute: Definition/Meaning, Examples and Comparison
FAQs – Stock vs. Flow Variables
What are stock and flow variables and what are some examples?
Stock variables are measures that are taken at a specific point in time and represent the quantity of a particular asset, while flow variables are measured over a period of time and represent the rate of change of a particular asset.
Some examples of stock and flow financial variables are:
Stock Variables
- Market capitalization of a company
- Total amount of debt held by a person, company, nonprofit, or government
- Total number of outstanding shares of a company
- The current balance of a checking or savings account
Flow Variables
- Revenue generated by a company in a month, quarter, or year
- Total amount of interest paid on a loan over a period of time
- Net income earned by a company in a fiscal year
- The amount of money deposited or withdrawn from a savings account over a period of time
- The amount of money spent on a credit card over a month
What is the primary difference between stock and flow financial variables?
The primary difference between stock and flow financial variables lies in their measurement.
Stock variables are measured at a specific point in time and represent the quantity of a particular asset, while flow variables are measured over a period of time and represent the rate of change of a particular asset.
Balance sheet items are stock variables. Income statement items are flow variables.
Why is it important to understand the difference between stock and flow variables?
Understanding the difference between stock and flow variables is important for conducting financial analysis.
Stock variables provide a snapshot of the financial situation at a specific moment, while flow variables help track the dynamic aspects of financial performance over time.
Analyzing both types of variables allows for better-informed decisions regarding investments, financial planning, and assessing the overall financial health of companies and individuals.
What’s an example of how stock and flow variables can be used together in financial analysis?
Let’s take a company’s financial performance as an example.
The company’s market capitalization (a stock variable) provides a “snapshot” of its current value based on outstanding shares.
Meanwhile, the company’s quarterly revenue (a flow variable) can show how the business is performing over time.
By analyzing both stock and flow variables, investors/traders can better assess the company’s financial standing and make informed decisions about whether to invest, hold, or sell their shares.
How do flow variables help in tracking the financial performance of a company or an individual?
Flow variables provide insights into the dynamic aspects of financial performance by measuring the rate of change in assets or liabilities over a specific period.
For example, the net income earned by a company in a fiscal year (a flow variable) demonstrates its profitability and efficiency in managing its expenses.
Similarly, the amount of money deposited or withdrawn from a savings account over a period of time can help individuals monitor their saving habits and make adjustments to their financial plans as needed.
Can stock variables change over time?
Yes, stock variables can change over time due to various factors, such as market conditions, corporate actions, and individual financial decisions.
For instance, the market capitalization of a company may fluctuate due to changes in stock prices or outstanding shares.
Similarly, the total amount of debt held by a company might change as it acquires new debt or pays off existing debt.
It is essential to monitor stock variables regularly to keep track of changes in financial standing.
How can I use stock and flow variables in personal financial planning?
Stock and flow variables can help individuals assess their financial health and create a comprehensive financial plan.
For example, you can use stock variables such as the current balance of your checking and savings accounts to gauge your current financial position.
Flow variables, such as the amount of money spent on a credit card over a month or the money deposited in a savings account, can help you identify spending patterns and saving habits.
By analyzing these variables, you can set realistic financial goals, create budgets, and make adjustments to your financial plans to achieve your long-term objectives.
Conclusion
Stock and flow financial variables are essential tools for understanding the financial health of a company or an individual.
Stock variables provide a snapshot of the financial situation at a particular moment, while flow variables help track the dynamic aspects of financial performance over time.
Both types of variables have their unique applications and are crucial for conducting comprehensive financial analysis.
By understanding the differences between stock and flow variables, analysts, investors, and individuals can make better-informed decisions regarding their financial well-being.