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to pay its short-term current liabilities. This ratio is an extreme test that
is not likely to be imposed on a business unless it is in financial straits.
This ratio is quite relevant when a business is in a liquidation situation
or bankruptcy proceedings.

activity based costing (ABC) A relatively new method advocated for the
allocation of indirect costs. The key idea is to classify indirect costs,
many of which are fixed in amount for a period of time, into separate
activities and to develop a measure for each activity called a cost driver.
The products or other functions in the business that benefit from the
activity are allocated shares of the total indirect cost for the period based
on their usage as measured by the cost driver.

amortization This term has two quite different meanings. First, it may
refer to the allocation to expense each period of the total cost of an
intangible asset (such as the cost of a patent purchased from the inven-
tor) over its useful economic life. In this sense amortization is equivalent


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APPENDIX A


to depreciation, which allocates the cost of a tangible long-term operating
asset (such as a machine) over its useful economic life. Second, amortiza-
tion may refer to the gradual paydown of the principal amount of a debt.
Principal refers to the amount borrowed that has to be paid back to the
lender as opposed to interest that has to be paid for use of the principal.
Each period, a business may pay interest and also make a payment on
the principal of the loan, which reduces the principal amount of the loan,
of course. In this situation the loan is amortized, or gradually paid down.

asset turnover ratio A broad-gauge ratio computed by dividing annual
sales revenue by total assets. It is a rough measure of the sales-generating
power of assets. The idea is that assets are used to make sales, and the
sales should lead to profit. The ultimate test is not sales revenue on
assets, but the profit earned on assets as measured by the return on
assets (ROA) ratio.

bad debts Refers to accounts receivable from credit sales to customers
that a business will not be able to collect (or not collect in full). In hind-
Y
sight, the business shouldn™t have extended credit to these particular
FL
customers. Since these amounts owed to the business will not be col-
lected, they are written off. The accounts receivable asset account is
decreased by the estimated amount of uncollectible receivables, and the
AM


bad debts expense account is increased this amount. These write-offs
can be done by the direct write-off method, which means that no
expense is recorded until specific accounts receivable are identified as
TE




uncollectible. Or the allowance method can be used, which is based on
an estimated percent of bad debts from credit sales during the period.
Under this method, a contra asset account is created (called allowance
for bad debts) and the balance of this account is deducted from the
accounts receivable asset account.

balance sheet A term often used instead of the more formal and correct
term”statement of financial condition. This financial statement summa-
rizes the assets, liabilities, and owners™ equity sources of a business at a
given moment in time. It is prepared at the end of each profit period and
whenever else it is needed. It is one of the three primary financial state-
ments of a business, the other two being the income statement and the
statement of cash flows. The values reported in the balance sheet are the
amounts used to determine book value per share of capital stock. Also,
the book value of an asset is the amount reported in a business™s most
recent balance sheet.

basic earnings per share (EPS) This important ratio equals the net
income for a period (usually one year) divided by the number capital

294
APPENDIX A


stock shares issued by a business corporation. This ratio is so important
for publicly owned business corporations that it is included in the daily
stock trading tables published by the Wall Street Journal, the New York
Times, and other major newspapers. Despite being a rather straight-
forward concept, there are several technical problems in calculating
earnings per share. Actually, two EPS ratios are needed for many busi-
nesses”basic EPS, which uses the actual number of capital shares out-
standing, and diluted EPS, which takes into account additional shares of
stock that may be issued for stock options granted by a business and
other stock shares that a business is obligated to issue in the future.
Also, many businesses report not one but two net income figures”one
before extraordinary gains and losses were recorded in the period and a
second after deducting these nonrecurring gains and losses. Many busi-
ness corporations issue more than one class of capital stock, which
makes the calculation of their earnings per share even more complicated.

big bath A street-smart term that refers to the practice by many busi-
nesses of recording very large lump-sum write-offs of certain assets or
recording large amounts for pending liabilities triggered by business
restructurings, massive employee layoffs, disposals of major segments of
the business, and other major traumas in the life of a business. Busi-
nesses have been known to use these occasions to record every conceiv-
able asset write-off and/or liability write-up that they can think of in
order to clear the decks for the future. In this way a business avoids
recording expenses in the future, and its profits in the coming years will
be higher. The term is derisive, but investors generally seem very forgiv-
ing regarding the abuses of this accounting device. But you never
know”investors may cast a more wary eye on this practice in the future.

book value and book value per share Generally speaking, these terms
refer to the balance sheet value of an asset (or less often of a liability) or
the balance sheet value of owners™ equity per share. Either term empha-
sizes that the amount recorded in the accounts or on the books of a busi-
ness is the value being used. The total of the amounts reported for
owners™ equity in its balance sheet is divided by the number of stock
shares of a corporation to determine the book value per share of its capi-
tal stock.

bottom line A commonly used term that refers to the net income (profit)
reported by a business, which is the last, or bottom line, in its income
statement. As you undoubtedly know, the term has taken on a much
broader meaning in everyday use, referring to the ultimate or most impor-
tant effect or result of something. Not many accounting-based terms have
found their way into everyday language, but this is one that has.

295
APPENDIX A


breakeven point The annual sales volume level at which total contribution
margin equals total annual fixed expenses. The breakeven point is only a
point of reference, not the goal of a business, of course. It is computed by
dividing total fixed expenses by unit margin. The breakeven point is
quite useful in analyzing profit behavior and operating leverage. Also, it
gives manager a good point of reference for setting sales goals and
understanding the consequences of incurring fixed costs for a period.

capital A very broad term rooted in economic theory and referring to
money and other assets that are invested in a business or other venture
for the general purpose of earning a profit, or a return on the invest-
ment. Generally speaking, the sources of capital for a business are
divided between debt and equity. Debt, as you know, is borrowed money
on which interest is paid. Equity is the broad term for the ownership
capital invested in a business and is most often called owners™ equity.
Owners™ equity arises from two quite different sources: (1) money or
other assets invested in the business by its owners and (2) profit earned
by the business that is retained and not distributed to its owners (called
retained earnings).

capital budgeting Refers generally to analysis procedures for ranking
investments, given a limited amount of total capital that has to be allo-
cated among the various capital investment opportunities of a business.
The term sometimes is used interchangeably with the analysis tech-
niques themselves, such as calculating present value, net present value,
and the internal rate of return of investments.

capital expenditures Refers to investments by a business in long-term
operating assets, including land and buildings, heavy machinery and
equipment, vehicles, tools, and other economic resources used in the
operations of a business. The term capital is used to emphasize that
these are relatively large amounts and that a business has to raise capi-
tal for these expenditures from debt and equity sources.

capital investment analysis Refers to various techniques and proce-
dures used to determine or to analyze future returns from an invest-
ment of capital in order to evaluate the capital recovery pattern and the
periodic earnings from the investment. The two basic tools for capital
investment analysis are (1) spreadsheet models (which I strongly pre-
fer) and (2) mathematical equations for calculating the present value or
internal rate of return of an investment. Mathematical methods suffer
from a lack of information that the decision maker ought to consider. A
spreadsheet model supplies all the needed information and has other
advantages as well.

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APPENDIX A


capital recovery Refers to recouping, or regaining, invested capital over
the life of an investment. The pattern of period-by-period capital recov-
ery is very important. In brief, capital recovery is the return of capital”
not the return on capital, which refers to the rate of earnings on the
amount of capital invested during the period. The returns from an
investment have to be sufficient to provide for both recovery of capital
and an adequate rate of earnings on unrecovered capital period by
period. Sorting out how much capital is recovered each period is rela-
tively easy if you use a spreadsheet model for capital investment analy-
sis. In contrast, using a mathematical method of analysis does not
provide this period-by-period capital recovery information, which is a
major disadvantage.

capital stock Ownership shares issued by a business corporation. A busi-
ness corporation may issue more than one class of capital stock shares.
One class may give voting privileges in the election of the directors of the
corporation while the other class does not. One class (called preferred
stock) may entitle a certain amount of dividends per share before cash
dividends can be paid on the other class (usually called common stock).
Stock shares may have a minimum value at which they have to be issued
(called the par value), or stock shares can be issued for any amount
(called no-par stock). Stock shares may be traded on public markets such
as the New York Stock Exchange or over the Nasdaq network. There are
about 10,000 stocks traded on public markets (although estimates vary
on this number). In this regard, I find it very interesting that there are
more than 8,000 mutual funds that invest in stocks.

capital structure, or capitalization Terms that refer to the combination of
capital sources that a business has tapped for investing in its assets”in
particular, the mix of its interest-bearing debt and its owners™ equity. In a
more sweeping sense, the terms also include appendages and other fea-
tures of the basic debt and equity instruments of a business. Such things
as stock options, stock warrants, and convertible features of preferred
stock and notes payable are included in the more inclusive sense of the
terms, as well as any debt-based and equity-based financial derivatives
issued by the business.

capitalization of costs When a cost is recorded originally as an increase
to an asset account, it is said to be capitalized. This means that the out-
lay is treated as a capital expenditure, which becomes part of the total
cost basis of the asset. The alternative is to record the cost as an expense
immediately in the period the cost is incurred. Capitalized costs refer
mainly to costs that are recorded in the long-term operating assets of a
business, such as buildings, machines, equipment, tools, and so on.

297
APPENDIX A


cash burn rate A relatively recent term that refers to how fast a business
is using up its available cash, especially when its cash flow from operat-
ing activities is negative instead of positive. This term most often refers
to a business struggling through its start-up or early phases that has not
yet generated enough cash inflow from sales to cover its cash outflow for
expenses (and perhaps never will).

cash flow An obvious but at the same time elusive term that refers to cash
inflows and outflows during a period. But the specific sources and uses
of cash flows are not clear in this general term. The statement of cash
flows, which is one of the three primary financial statements of a busi-
ness, classifies cash flows into three types: those from operating activi-
ties (sales and expenses, or profit-making operations), those from
investing activities, and those from financing activities. Sometimes the
term cash flow is used as shorthand for cash flow from profit (i.e., cash
flow from operating activities).

cash flow from operating activities, also called cash flow from profit
This equals the cash inflow from sales during the period minus the cash
outflow for expenses during the period. Keep in mind that to measure
net income, generally accepted accounting principles require the use of
accrual-basis accounting. Starting with the amount of accrual-basis net
income, adjustments are made for changes in accounts receivable,
inventories, prepaid expenses, and operating liabilities”and deprecia-
tion expense is added back (as well as any other noncash outlay
expense)”to arrive at cash flow from profit, which is formally labeled
cash flow from operating activities in the externally reported statement
of cash flows.

cash flows, statement of One of the three primary financial statements
that a business includes in the periodic financial reports to its outside
shareowners and lenders. This financial statement summarizes the busi-
ness™s cash inflows and outflows for the period according to a threefold
classification: (1) cash flow from operating activities (cash flow from
profit), (2) cash flow from investing activities, and (3) cash flow from
financing activities. Frankly, the typical statement of cash flows is diffi-
cult to read and decipher; it includes too many lines of information and
is fairly technical compared with the typical balance sheet and income
statement.

contribution margin An intermediate measure of profit equal to sales rev-

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