This technique, like declining balance, is also an accelerated
method. It makes the sum of the digits in the machineâ€™s ex-
pected life the denominator for a series of yearly depreciation
fractions. The numerators of these fractions are the machineâ€™s
years of life in reverse order, which means a steadily smaller depre-
ciation fraction is applied to the assetâ€™s value (cost-salvage value)
The sum-of-the-yearsâ€™ digits for the nit picker is 1+2+3+4+5
= 15. Here we go!
Year 1 5/15 X $14,000 = $4,667
Year 2 4/15 X $14,000 = $3,733
Year 3 3/15 X $14,000 = $2,800
Year 4 2/15 X $14,000 = $1,867
Year 5 1/15 X $14,000 = $933
A Word About MACRS
MACRS stands for Modified Accelerated Cost Recovery Sys-
tem (sure, you knew that!). It was set up by the IRS under the
Tax Reform Act of 1986 as a depreciation method for federal
income tax purposes. All fixed assets installed after December
31, 1986, have to use the MACRS method, which is a lot like
84 THE AGILE MANAGERâ€™S GUIDE TO UNDERSTANDING FINANCIAL STATEMENTS
the sum-of-the-yearsâ€™ digits and declining balance methods.
Under MACRS, there are eight categories of assets distin-
guished by their estimated useful lives.The categories range from
3-year property (such as over-the-road tractors) to 31.5-year
property (office buildings). The IRS, helpful souls that they are,
provides tables with depreciation rates to be applied each year
of an assetâ€™s life.
Although itâ€™s not unusual for companies to use MACRS for
both tax and financial reporting purposes, many firms use the
straight-line method for financial reporting (like the kind that
appears in an annual report). Thatâ€™s because of its consistent im-
pact on net income from one year to the next.
The Agile Managerâ€™s Checklist
You recover the cost of a high-priced piece of equipment
gradually by depreciating it.
Depreciation can be figured using four methods:
Straight line racks up an equal amount of deprecia-
tion expense against an asset each year of its useful life.
s Units of production depreciates a machine according
to what it made each year.
s Declining balance and sum-of-the-yearsâ€™-digits both
charge more depreciation expense against a machine in
its newer years.
You donâ€™t depreciate equipment past its estimated
salvage or scrap value.
ACCOUNTS PAYABLE. Amounts a company owes to creditors.
ACCOUNTS RECEIVABLE. Amounts owed to a company by cus-
tomers that it sold to on credit. Total accounts receivable are
usually reduced by an allowance for doubtful accounts.
ACID-TEST RATIO. A ratio that shows how well a company
could pay its current debts using only its most liquid or â€śquickâ€ť
assets. Itâ€™s a more pessimisticâ€”but also realisticâ€”measure of safety
than the current ratio, because it ignores sluggish, hard-to-
liquidate current assets like inventory and notes receivable. Hereâ€™s
Cash + Accounts receivable + Marketable securities
ACCRUAL. A method of accounting in which you record ex-
penses when you incur them and sales as you make themâ€”not
when you pay bills or receive checks in the mail.
ASSETS. Anything of value that a company owns.
BALANCE SHEET. A â€śsnapshotâ€ť statement that freezes a com-
pany on a particular day, like the last day of the year, and shows
86 THE AGILE MANAGERâ€™S GUIDE TO UNDERSTANDING FINANCIAL STATEMENTS
the balances in its asset, liability, and stockholdersâ€™ equity ac-
counts. Itâ€™s governed by the formula Assets = Liabilities + Stock-
BOND. A long-term, interest-bearing promissory note that
companies may use to borrow money for periods of time such
as five, ten, or twenty years.
BOOK VALUE. An assetâ€™s cost basis minus accumulated depre-
BOOK VALUE OF COMMON STOCK. The theoretical amount per
share that each stockholder would receive if a companyâ€™s assets
were sold on the balance sheetâ€™s date. Book value equals:
Common stock shares outstanding
CAPITAL. The money, raised by selling stock or bonds or tak-
ing out loans, that you use to start, operate, and grow a business.
CAPITAL IN EXCESS OF PAR VALUE. What a company collected
when it sold stock for more than the par value per share.
CASH AND CASH EQUIVALENTS. The balance in a companyâ€™s
checking account(s) plus short-term or temporary investments
(sometimes called â€śmarketable securitiesâ€ť), which are highly liq-
CASH-FLOW STATEMENT. A statement that shows where a com-
panyâ€™s cash came from and where it went for a period of time,
such as a year.
CASH FLOWS FROM FINANCING ACTIVITIES. A section on the
cash-flow statement that shows how much cash a company raised
by selling stocks or bonds this year and how much was paid out
for cash dividends and other finance-related obligations.
CASH FLOWS FROM INVESTING ACTIVITIES. A section on the cash-
flow statement that shows how much cash came in and went
out because of various investing activities like purchasing ma-
CASH FLOWS FROM OPERATIONS. A section on the cash-flow
statement that shows how much cash came into a company and
how much went out during the normal course of business.
Cost basis. An assetâ€™s purchase price, plus costs associated with
the purchase, like installation fees, taxes, etc.
Cost of goods sold. The cost of merchandise that a company
sold this year. For manufacturing companies, the cost of raw
materials, components, labor and other things that went into
producing an item.
Current assets. Cash, things that will be converted into cash
within a year (such as accounts receivable), and inventory.
Current liabilities. Bills a company must pay within the next
Current ratio. A ratio that shows how many times a com-
pany could pay its current debts if it used its current assets to
pay them. The formula:
Declining balance. An accelerated depreciation method that
calculates depreciation each year by applying a fixed rate to the
assetâ€™s book (costâ€“accumulated depreciation) value. Deprecia-
tion stops when the assetâ€™s book value reaches its salvage value.
Depreciation. A technique by which a company recovers the
high cost of its plant-and-equipment assets gradually during the
number of years theyâ€™ll be used in the business. Depreciation
can be physical, technological, or both.
Dividend. A payment a company makes to stockholders.
Earnings before income tax. The profit a company made
before income taxes.
Earnings per share of common stock. How much profit a
company made on each share of common stock this year.
FIFO (First In, First Out). An inventory valuation method
that presumes that the first units received were the first ones
88 THE AGILE MANAGERâ€™S GUIDE TO UNDERSTANDING FINANCIAL STATEMENTS
GENERAL-AND-ADMINISTRATIVE EXPENSES. What was spent to
run the non-sales and non-manufacturing part of a company,
such as office salaries and interest paid on loans.
GROSS PROFIT. The profit a company makes before expenses
and taxes are taken away.
INCOME STATEMENT. An accounting statement that summa-
rizes information about a company in the following format:
â€“ Cost of goods sold
â€“ Operating expenses
Earnings before income tax
â€“ Income tax
= Net income or (Net loss)
Formally called a â€śconsolidated earnings statement,â€ť it covers
a period of time such as a quarter or a year.
INCOME TAX. What the business paid to the IRS.
INVENTORY TURNOVER. The number of times a company sold
out and replaced its average stock of goods in a year. The for-
Cost of goods sold
Average inventory (beginning inventory + ending)/2
LIABILITIES. What a company owes to its creditors. In other
LIFO (Last In, First Out). An inventory valuation method
that presumes that the last units received were the first ones
LONG-TERM LIABILITIES. Bills that are payable in more than
one year, such as a mortgage or bonds.
MACRS (Modified Accelerated Cost Recovery System). A de-
preciation method created by the IRS under the Tax Reform Act
of 1986. Companies must use it to depreciate all plant and equip-
ment assets installed after December 31, 1986 (for tax purposes).
MERCHANDISE INVENTORY. The value of the products that a
retailing or wholesaling company intends to resell for a profit.
In a manufacturing business, inventories would include finished
goods, goods in process, raw materials, and parts and compo-
nents that will go into the end product.
NET INCOME. The profit a company makes after cost of goods
sold, expenses, and taxes are subtracted from net sales.
NET SALES (revenue). The amount sold after customersâ€™ re-
turns, sales discounts, and other allowances are taken away from
gross sales. (Companies usually just show the net sales amount
on their income statements, omitting returns, allowances, and
NOTES RECEIVABLE. Notes receivable are promissory notes that
the company has accepted from its debtors. Most promissory
notes pay interest. Those that are due within a year are shown
under â€śCurrent Assets.â€ť Those that mature in more than a year
would be listed under â€śLong-term Assets.â€ť If a note is being
collected in installments, the payments due within the next twelve
months are shown as a current asset, and the remainder is shown
as a long-term asset.
NUMBER OF DAYS SALES IN RECEIVABLES (average collection
period). The number of days of net sales that are tied up in
credit sales (accounts receivable) that havenâ€™t been collected yet.
OPERATING EXPENSES. The total amount that was spent to run
a company this year.
PAR VALUE. An arbitrary value that a company may assign to
its stock. Par value has no relationship to what the stock is sell-
ing for on the open market.
PROFIT. Whatâ€™s left over after you subtract the cost of goods
sold and all your expenses from sales.
PROPERTY AND EQUIPMENT. Assets such as land, buildings, ma-
chinery, and equipment that the business will use for several
years to make the product or provide the service that it sells.
They are shown at the cost a company paid to buy or build
them minus the amount theyâ€™ve depreciated since they were
bought or built. (Except for land, which is not depreciated.)
90 THE AGILE MANAGERâ€™S GUIDE TO UNDERSTANDING FINANCIAL STATEMENTS
RATE OF RETURN ON STOCKHOLDERSâ€™ EQUITY. The percentage
return or profit that management made on each dollar stock-
holders invested in a company. Hereâ€™s how you figure it:
RATE OF RETURN ON TOTAL ASSETS. The percentage return or
profit that management made on each dollar of assets. The for-
RATIO OF DEBT TO STOCKHOLDERSâ€™ EQUITY. A ratio that shows
which groupâ€”creditors or stockholdersâ€”has the biggest stake
in or the most control of a company:
RATIO OF NET INCOME TO NET SALES. A ratio that shows how
much net income (profit) a company made on each dollar of net
sales. Hereâ€™s the formula:
RATIO OF NET SALES TO NET INCOME. A ratio that shows how
much a company had to collect in net sales to make a dollar of
profit. Figure it this way:
RETAINED EARNINGS. Profits a company plowed back into the
business over the years. Last Januaryâ€™s retained earnings, plus the
net income or profit that a company made this year (which is
calculated on the income statement), minus dividends paid out,
equals the retained earnings balance on the balance sheet date.
RETURN ON INVESTMENT (ROI). In its most basic form, the