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ture and fixtures, and other tangible long-lived resources that are not
held for sale but are used in the operations of a business. The less formal
name for these assets is fixed assets, which see.

quick ratio See acid test ratio.

return on assets (ROA) Although there is no single uniform practice for
calculating this ratio, generally it equals operating profit (before interest
and income tax) for a year divided by the total assets that are used to
generate the profit. ROA is the key ratio to test whether a business is
earning enough on its assets to cover its cost of capital. ROA is used for
determining financial leverage gain (or loss).

309
APPENDIX A


return on equity (ROE) This key ratio, expressed as a percent, equals net
income for the year divided by owners™ equity. ROE should be higher than
a business™s interest rate on debt because the owners take more risk.

return on investment (ROI) A very general concept that refers to some
measure of income, earnings, profit, or gain over a period of time
divided by the amount of capital invested during the period. It is almost
always expressed as a percent. For a business, an important ROI mea-
sure is its return on equity (ROE), which is computed by dividing its net
income for the period by its owners™ equity during the period.

return on sales This ratio equals net income divided by sales revenue.

revenue-driven expenses Operating expenses that vary in proportion to
changes in total sales revenue (total dollars of sales). Examples are sales
commissions based on sales revenue, credit card discount expenses, and
rents and franchise fees based on sales revenue. These expenses are one
of the key variables in a profit model. Segregating these expenses from
other types of expenses that behave differently is essential for manage-
ment decision-making analysis. (These expenses are not disclosed sepa-
rately in externally reported income statements.)

Securities and Exchange Commission (SEC) The federal agency that
oversees the issuance of and trading in securities of public businesses.
The SEC has broad powers and can suspend the trading in securities of a
business. The SEC also has primary jurisdiction in making accounting
and financial reporting rules, but over the years it has largely deferred to
the private sector for the development of generally accepted accounting
principles (GAAP).

solvency Refers to the ability of a business to pay its liabilities on time
when they come due for payment. A business may be insolvent, which
means that it is not able to pay its liabilities and debts on time. The cur-
rent ratio and acid test ratio are used to evaluate the short-term solvency
prospects of a business.

spontaneous liabilities See operating liabilities.

stockholders™ equity, statement of changes in Although often considered
a financial statement, this is more in the nature of a supporting schedule
that summarizes in one place various changes in the owners™ equity
accounts of a business during the period”including the issuance and
retirement of capital stock shares, cash dividends, and other transac-
tions affecting owners™ equity. This statement (schedule) is very helpful
when a business has more than one class of stock shares outstanding

310
APPENDIX A


and when a variety of events occurred during the year that changed its
owners™ equity accounts.

straight-line depreciation This depreciation method allocates a uniform
amount of the cost of long-lived operating assets (fixed assets) to each
year of use. It is the basic alternative to the accelerated depreciation
method. When using the straight-line method, a business may estimate a
longer life for a fixed asset than when using the accelerated method
(though not necessarily in every case). Both methods are allowed for
income tax and under generally accepted accounting principles (GAAP).

sunk cost A cost that has been paid and cannot be undone or reversed.
Once the cost has been paid, it is irretrievable, like water over the dam
or spilled milk. Usually, the term refers to the recorded value of an asset
that has lost its value in the operating activities of a business. Examples
are the costs of products in inventory that cannot be sold and fixed
assets that are no longer usable. The book value of these assets should
be written off to expense. These costs should be disregarded in making
decisions about what to do with the assets (except that the income tax
effects of disposing of the assets should be taken into account).

times interest earned A ratio that tests the ability of a business to make
interest payments on its debt, which is calculated by dividing annual
earnings before interest and income tax by the interest expense for the
year. There is no particular rule for this ratio, such as 3 or 4 times, but
obviously the ratio should be higher than 1.

unit margin The profit per unit sold of a product after deducting product
cost and variable expenses of selling the product from the sales price of
the product. Unit margin equals profit before fixed operating expenses
are considered and before interest and income tax are deducted. Unit
margin is one of the key variables in a profit model for decision-making
analysis.

unit-driven expenses Expenses that vary in close proportion to changes
in total sales volume (total quantities of sales). Examples of these types of
expenses are delivery costs, packaging costs, and other costs that depend
mainly on the number of products sold or the number of customers
served. These expenses are one of the key factors in a profit model for
decision-making analysis. Segregating these expenses from other types
of expenses that behave differently is essential for management decision-
making analysis. The cost-of-goods-sold expense depends on sales vol-
ume and is a unit-driven expense. But product cost (i.e., the cost of
goods sold) is such a dominant expense that it is treated separately from
other unit-driven operating expenses.

311
APPENDIX A


variable expenses Expenses that change with changes in either sales vol-
ume or sales revenue, in contrast to fixed expenses that remain the same
over the short run and do not fluctuate in response to changes in sales
volume or sales revenue. See also revenue-driven expenses and unit-
driven expenses.

weighted-average cost of capital Weighted means that the proportions of
debt capital and equity capital of a business are used to calculate its
average cost of capital. This key benchmark rate depends on the interest
rate(s) on its debt and the ROE goal established by a business. This is a
return-on-capital rate and can be applied either on a before-tax basis or
an after-tax basis. A business should earn at least its weighted-average
rate on the capital invested in its assets. The weighted-average cost-of-
capital rate is used as the discount rate to calculate the present value
(PV) of specific investments.




312
B
APPENDIX




Topical Guide
to Figures

Accounting functions and system 1.1
Accrual-basis accounting versus cash 2.1
flows
Balance sheet (statement of financial 2.3, 4.2, 5.2, 5.4, 6.4, 7.2, 16.1
condition)
Breakeven point (sales volume) 8.1
Budget profit plan for coming period 7.1
Capital investment analysis 14.2, 14.3, 14.4, 14.5, 15.1,
15.2, 15.3
Cash flow changes from profit changes 13.2, 13.3
Cash flows, statement of 2.4, 2.5, 4.3, 7.3
Contribution margin analysis 3.4
Cost changes 10.4, 12.1, 12.2, 12.3
Cost of capital 14.1
Discounted cash flow 15.2
Expenses connected with their operating 5.3, 5.4
assets and liabilities
Financial leverage 6.3
Fixed expenses (costs) allocation 17.2
Gross margin analysis 3.2
Income statement 2.2, 3.1, 4.1, 5.1, 5.4, 6.1, 7.1,
16.1
Internal rate of return 15.3
Inventories, excessive accumulation of 18.3


313
APPENDIX B


Management profit report 3.3, 8.1, 9.1, 9.2, 9.3, 10.1,
10.3, 10.4, 12.4, 12.5, 12.6,
12.7, 13.1, 16.2, 17.2, 18.1
Manufacturing costs summary 18.1
Manufacturing costs, misclassification of 18.2
Operating profit (earnings before interest 14.1
and income tax) and cost of capital
Price/volume trade-offs 11.2, 11.3, 11.4
Profit model 11.1, 11.2, 11.3, 11.4, 12.4,
12.5, 12.6, 12.7, 16.4
Profit ratios 4.5
Profit report (see Management profit
report; Income statement)
Return on assets 6.2
Return on equity 6.2
Sales price changes 10.1, 10.2, 10.3, 12.2, 13.3,
16.3, 16.4
Y
Sales revenue “negatives” 17.1
FL
Sales revenue connected with its 5.3, 5.4
operating asset
Sales volume changes 9.2, 9.3, 10.2, 12.1, 12.3, 13.1,
AM


13.2, 16.3, 16.4
Service businesses 16.1
Spreadsheet model (for capital 14.2, 14.3, 14.5, 15.1,
TE




investment analysis) 15.2, 15.3
Stockholders™ equity, statement of 4.4
changes in




314
INDEX




Absorption costing method, American Institute of Certified
383“384 Public Accountants (AICPA),
Accelerated depreciation 249
method, 33, 206 Amortization (of debt principal),
Account (record-keeping ele- 83“84
ment), 4, 18 Apple Computer, 29
Accounting, external functions, Assets, 7, 12, 18, 20, 22, 40, 63,
4“5, 6, 11“12 66, 76, 81, 191
Accounting, internal functions, as capital investments,
4“5, 6 195“197
Accounting equation, 65 connections with sales rev-
Accounting methods, 8, 19, 33, enue and expenses, 69“73,
40 100, 101“102
Accounting system, 4“5, 247 Asset turnover ratio, 59, 64
Accounts payable, 20, 70, 71, Auditing, internal, 249“250
75, 79, 104, 183, 184, Audit of external financial state-
232“233, 241 ments by CPA, 7, 9, 34, 41,
Accounts receivable, 18, 20, 34, 249
40, 69, 76“77, 81, 143,
165, 251“252 Bad debts expense, 34, 40, 143,
Accounts receivable turnover 255“256
ratio, 58 Balance sheet (also called state-
Accrual-basis accounting, ment of financial condi-
13“15, 16, 21, 24, tion), 12, 18“21, 44“45,
179“180, 184“185 74“76, 232“233, 271
Accrued expenses payable, 20, Basic earnings per share,
70, 72, 75, 79, 184 51“52
Accumulated depreciation, 20, Big bath, 47
103“104, 114 Book value of assets, 18, 154
Acid test ratio (also called quick Book value of owners™ equity
ratio), 56 and stock shares, 49“50
Activity-based costing (ABC), Bottom line. See Net income
140n, 268“269 Breakeven point (volume), 118,
Advance payments from cus- 120“121, 122, 170, 173
tomers, 20 Budgeting, 101, 270“273, 274
Advertising expense, 34, 129, Burden rate (for fixed manufac-
149, 279 turing overhead costs),
After-tax cost of capital, 283“284
224“226 Business valuation, 82


315
INDEX


Capacity, 112“113, 130, 133, Contribution margin, 31, 33,
150, 170, 239, 260. See 35“36, 111, 132, 143, 152,

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