What is Annual Basis?
The term annual basis has multiple applications in finance. In each sense, it refers to an observed figure over the course of the year. It can also refer to something that happens every year.
Annual basis can refer to the return earned by an investment over the course of a year. Projections containing the phrase "on an annual basis" have usually used less than a year's worth of data to project a full year's worth of returns. Annual basis can also refer to the cost of something over the course of a year.
Understanding Annual Basis
Most people are familiar with cash flows or returns that are converted on an annual basis. For instance, many employees work on annual salary basis. Investors and portfolio managers similarly record their performance on an annual return basis. In options markets, volatility is calculated on an annual basis, and interest payments on deposits and loans (including bonds or other fixed income instruments) are conveyed as annual yields.
An annualized rate of return is calculated as the equivalent annual return an investor receives over a given period. The Global Investment Performance Standards (GIPS) dictate that returns of portfolios or composites for periods of less than one year may not be annualized. This prevents "projected" performance in the remainder of the year from occurring. Nevertheless, people do extrapolate for informal purposes - an investment might have returned 1.5% in one month. By multiplying this return by 12, an 18% annual basis is the result. The shorter the period of data used to determine an annual return, the less accurate that projection is likely to be. Statements about what an investment will return on an annual basis are always estimates.
- The term annual basis has multiple applications in finance. In each sense, it refers to an observed figure over the course of the year. It can also refer to something that happens every year.
- Salaries, interest rates, and returns are all often quoted on an annual basis.
- Annual basis can be computed by extrapolating out from a shorter period of time.
Annual Basis as Occurring Each Year
Closely related to the method of conveying sums or cash flows on an annual basis, the term may refer to recurring items that happen annually. For instance a salary of $60,000 per year is not only quoted on an annual basis, but also occurs each year on an annual basis. The same can be said for yields on fixed rate bonds. Say a bond pays 5% per year interest, the rate is quoted on an annual basis, and assuming the bond has 10 years left to maturity, it will pay that 5% out each year on an annual basis as well.
Example of Annual Basis
For example, if Angela wanted to establish a household budget for the year and it was April 1, she could look at how much money her family had spent on groceries in January, February and March to estimate what her family's grocery costs would be on an annual basis. She sees that she spent $300 in January, $250 in February and $350 in March, for a total of $900. Since 25% of the year has passed, she multiplies $900 x 4 to determine that groceries should cost her family around $3,600 on an annual basis.