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enue minus cost-of-goods-sold expense and minus variable operating
expenses”but before fixed operating expenses are deducted. Profit at
this point contributes toward covering fixed operating expenses and

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APPENDIX A


toward interest and income tax expenses. The breakeven point is the
sales volume at which contribution margin just equals total fixed
expenses.

conversion cost Refers to the sum of manufacturing direct labor and over-
head costs of products. The cost of raw materials used to make products
is not included in this concept. Generally speaking, this is a rough mea-
sure of the value added by the manufacturing process.

cost of capital Refers to the interest cost of debt capital used by a business
plus the amount of profit that the business should earn for its equity
sources of capital to justify the use of the equity capital during the
period. Interest is a contractual and definite amount for a period,
whereas the profit that a business should earn on the equity capital
employed during the period is not. A business should set a definite goal
of earning at least a certain minimum return on equity (ROE) and com-
pare its actual performance for the period against this goal. The costs of
debt and equity capital are combined into either a before-tax rate or an
after-tax rate for capital investment analysis.

current assets Current refers to cash and those assets that will be turned
into cash in the short run. Five types of assets are classified as current:
cash, short-term marketable investments, accounts receivable, invento-
ries, and prepaid expenses”and they are generally listed in this order in
the balance sheet.

current liabilities Current means that these liabilities require payment in
the near term. Generally, these include accounts payable, accrued
expenses payable, income tax payable, short-term notes payable, and
the portion of long-term debt that will come due during the coming year.
Keep in mind that a business may roll over its debt; the old, maturing
debt may be replaced in part or in whole by new borrowing.

current ratio Calculated to assess the short-term solvency, or debt-paying
ability of a business, it equals total current assets divided by total current
liabilities. Some businesses remain solvent with a relatively low current
ratio; others could be in trouble with an apparently good current ratio.
The general rule is that the current ratio should be 2:1 or higher, but
please take this with a grain of salt, because current ratios vary widely
from industry to industry.

debt-to-equity ratio A widely used financial statement ratio to assess the
overall debt load of a business and its capital structure, it equals total lia-
bilities divided by total owners™ equity. Both numbers for this ratio are
taken from a business™s latest balance sheet. There is no standard, or

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APPENDIX A


generally agreed on, maximum ratio, such as 1:1 or 2:1. Every industry
is different in this regard. Some businesses, such as financial institu-
tions, have very high debt-to-equity ratios. In contrast, many businesses
use very little debt relative to their owners™ equity.

depreciation Refers to the generally accepted accounting principle of allo-
cating the cost of a long-term operating asset over the estimated useful
life of the asset. Each year of use is allocated a part of the original cost of
the asset. Generally speaking, either the accelerated method or the
straight-line method of depreciation is used. (There are other methods,
but they are relatively rare.) Useful life estimates are heavily influenced
by the schedules allowed in the federal income tax law. Depreciation is
not a cash outlay in the period in which the expense is recorded”just
the opposite. The cash inflow from sales revenue during the period
includes an amount to reimburse the business for the use of its fixed
assets. In this respect, depreciation is a source of cash. So depreciation is
added back to net income in the statement of cash flows to arrive at cash
flow from operating activities.

diluted earnings per share (EPS) This measure of earnings per share
recognizes additional stock shares that may be issued in the future for
stock options and as may be required by other contracts a business has
entered into, such as convertible features in its debt securities and pre-
ferred stock. Both basic earnings per share and, if applicable, diluted
earnings per share are reported by publicly owned business corpora-
tions. Often the two EPS figures are not far apart, but in some cases the
gap is significant. Privately owned businesses do not have to report earn-
ings per share. See also basic earnings per share.

discounted cash flow (DCF) Refers to a capital investment analysis tech-
nique that discounts, or scales down, the future cash returns from an
investment based on the cost-of-capital rate for the business. In essence,
each future return is downsized to take into account the cost of capital
from the start of the investment until the future point in time when the
return is received. Present value (PV) is the amount resulting from dis-
counting the future returns. Present value is subtracted from the entry
cost of the investment to determine net present value (NPV). The net
present value is positive if the present value is more than the entry cost,
which signals that the investment would earn more than the cost-of-
capital rate. If the entry cost is more than the present value, the net
present value is negative, which means that the investment would earn
less than the business™s cost-of-capital rate.


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APPENDIX A


dividend payout ratio Computed by dividing cash dividends for the year
by the net income for the year. It™s simply the percent of net income dis-
tributed as cash dividends for the year.

dividend yield ratio Cash dividends paid by a business over the most
recent 12 months (called the trailing 12 months) divided by the current
market price per share of the stock. This ratio is reported in the daily
stock trading tables in the Wall Street Journal and other major news-
papers.

double-entry accounting See accrual-basis accounting.

earnings before interest and income tax (EBIT) A measure of profit that
equals sales revenue for the period minus cost-of-goods-sold expense
and all operating expenses”but before deducting interest and income
tax expenses. It is a measure of the operating profit of a business before
considering the cost of its debt capital and income tax.

earnings per share (EPS) See basic earnings per share and diluted
earnings per share.

equity Refers to one of the two basic sources of capital for a business, the
other being debt (borrowed money). Most often, it is called owners™
equity because it refers to the capital used by a business that “belongs”
to the ownership interests in the business. Owners™ equity arises from
two quite distinct sources: capital invested by the owners in the business
and profit (net income) earned by the business that is not distributed to
its owners (called retained earnings). Owners™ equity in our highly devel-
oped and sophisticated economic and legal system can be very com-
plex”involving stock options, financial derivatives of all kinds, different
classes of stock, convertible debt, and so on.

extraordinary gains and losses No pun intended, but these types of gains
and losses are extraordinarily important to understand. These are non-
recurring, onetime, unusual, nonoperating gains or losses that are
recorded by a business during the period. The amount of each of these
gains or losses, net of the income tax effect, is reported separately in the
income statement. Net income is reported before and after these gains
and losses. These gains and losses should not be recorded very often, but
in fact many businesses record them every other year or so, causing
much consternation to investors. In addition to evaluating the regular
stream of sales and expenses that produce operating profit, investors
also have to factor into their profit performance analysis the perturba-
tions of these irregular gains and losses reported by a business.


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APPENDIX A


financial condition, statement of See balance sheet.

financial leverage The equity (ownership) capital of a business can serve
as the basis for securing debt capital (borrowing money). In this way, a
business increases the total capital available to invest in its assets and
can make more sales and more profit. The strategy is to earn operating
profit, or earnings before interest and income tax (EBIT), on the capital
supplied from debt that is more than the interest paid on the debt capi-
tal. A financial leverage gain equals the EBIT earned on debt capital
minus the interest on the debt. A financial leverage gain augments earn-
ings on equity capital. A business must earn a rate of return on its assets
(ROA) that is greater than the interest rate on its debt to make a financial
leverage gain. If the spread between its ROA and interest rate is unfavor-
able, a business suffers a financial leverage loss.

financial reports and statements Financial means having to do with
money and economic wealth. Statement means a formal presentation.
Financial reports are printed and a copy is sent to each owner and each
major lender of the business. Most public corporations make their finan-
cial reports available on a web site, so all or part of the financial report
can be downloaded by anyone. Businesses prepare three primary finan-
cial statements: the statement of financial condition, or balance sheet;
the statement of cash flows; and the income statement. These three key
financial statements constitute the core of the periodic financial reports
that are distributed outside a business to its shareowners and lenders.
Financial reports also include footnotes to the financial statements and
much other information. Financial statements are prepared according to
generally accepted accounting principles (GAAP), which are the authori-
tative rules that govern the measurement of net income and the report-
ing of profit-making activities, financial condition, and cash flows.
Internal financial statements, although based on the same profit
accounting methods, report more information to managers for decision
making and control. Sometimes, financial statements are called simply
financials.

financing activities One of the three classes of cash flows reported in the
statement of cash flows. This class includes borrowing money and pay-
ing debt, raising money from shareowners and the return of money to
them, and dividends paid from profit.

fixed assets An informal term that refers to the variety of long-term oper-
ating resources used by a business in its operations”including real
estate, machinery, equipment, tools, vehicles, office furniture, computers,
and so on. In balance sheets, these assets are typically labeled property,

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APPENDIX A


plant, and equipment. The term fixed assets captures the idea that the
assets are relatively fixed in place and are not held for sale in the normal
course of business. The cost of fixed assets, except land, is depreciated,
which means the cost is allocated over the estimated useful lives of the
assets.

fixed expenses (costs) Expenses or costs that remain the same in amount,
or fixed, over the short run and do not vary with changes in sales vol-
ume or sales revenue or other measures of business activity. Over the
longer run, however, these costs increase or decrease as the business
grows or declines. Fixed operating costs provide capacity to carry on
operations and make sales. Fixed manufacturing overhead costs provide
production capacity. Fixed expenses are a key pivot point for the analysis
of profit behavior, especially for determining the breakeven point and for
analyzing strategies to improve profit performance.

free cash flow Generally speaking, this term refers to cash flow from
profit (cash flow from operating activities, to use the more formal term).
The underlying idea is that a business is free to do what it wants with its
cash flow from profit. However, a business usually has many ongoing
commitments and demands on this cash flow, so it may not actually be
free to decide what do with this source of cash. Warning: This term is
not officially defined anywhere and different persons use the term to
mean different things. Pay particular attention to how an author or
speaker is using the term.
generally accepted accounting principles (GAAP) This important term
refers to the body of authoritative rules for measuring profit and prepar-
ing financial statements that are included in financial reports by a busi-
ness to its outside shareowners and lenders. The development of these
guidelines has been evolving for more than 70 years. Congress passed a
law in 1934 that bestowed primary jurisdiction over financial reporting
by publicly owned businesses to the Securities and Exchange Commis-
sion (SEC). But the SEC has largely left the development of GAAP to the
private sector. Presently, the Financial Accounting Standards Board is
the primary (but not the only) authoritative body that makes pronounce-
ments on GAAP. One caution: GAAP are like a movable feast. New rules
are issued fairly frequently, old rules are amended from time to time,
and some rules established years ago are discarded on occasion. Profes-
sional accountants have a heck of time keeping up with GAAP, that™s for
sure. Also, new GAAP rules sometimes have the effect of closing the barn
door after the horse has left. Accounting abuses occur, and only then,
after the damage has been done, are new rules issued to prevent such
abuses in the future.

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APPENDIX A


gross margin, also called gross profit This first-line measure of profit
equals sales revenue less cost of goods sold. This is profit before operat-
ing expenses and interest and income tax expenses are deducted. Finan-
cial reporting standards require that gross margin be reported in
external income statements. Gross margin is a key variable in manage-
ment profit reports for decision making and control. Gross margin
doesn™t apply to service businesses that don™t sell products.

income statement Financial statement that summarizes sales revenue
and expenses for a period and reports one or more profit lines for the
period. It™s one of the three primary financial statements of a business.
The bottom-line profit figure is labeled net income or net earnings by
most businesses. Externally reported income statements disclose less
information than do internal management profit reports”but both are
based on the same profit accounting principles and methods. Keep in
mind that profit is not known until accountants complete the recording
of sales revenue and expenses for the period (as well as determining any

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