Prentice Hall's one-day MBA in finance & accounting (45 page)

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 liabilities 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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generally agreed on, maximum ratio, such as 1:1 or 2:1. Every industry is different in this regard. Some businesses, such as financial institutions, 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 allocating 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 preferred stock. Both basic earnings per share and, if applicable, diluted earnings per share are reported by publicly owned business corporations. 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 earnings per share. See also
basic earnings per share.

discounted cash flow (DCF)
Refers to a capital investment analysis technique 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 discounting 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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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 distributed 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 newspapers.

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 developed and sophisticated economic and legal system can be very complex—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 nonrecurring, 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 perturbations of these irregular gains and losses reported by a business.

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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 capital. A financial leverage gain equals the EBIT earned on debt capital minus the interest on the debt. A financial leverage gain augments earnings 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 unfavorable, 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 financial reports available on a web site, so all or part of the financial report can be downloaded by anyone. Businesses prepare three primary financial 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 authoritative rules that govern the measurement of net income and the reporting 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 paying 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 operating 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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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 volume 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 preparing financial statements that are included in financial reports by a business 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 Commission (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 pronouncements 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. Professional 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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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 extraordinary gains and losses that should be recorded in the period).

Profit measurement depends on the reliability of a business’s accounting system and the choices of accounting methods by the business.
Caution:
A business may engage in certain manipulations of its accounting meth-

ods, and managers may intervene in the normal course of operations for the purpose of improving the amount of profit recorded in the period, which is called
earnings management, income smoothing, cooking the
books,
and other pejorative terms.

internal accounting controls
Refers to forms used and procedures TEAMFLY

established by a business—beyond what would be required for the record-keeping function of accounting—that are designed to prevent errors and fraud. Two examples of internal controls are (1) requiring a second signature by someone higher in the organization to approve a transaction in excess of a certain dollar amount and (2) giving cus-

tomers printed receipts as proof of sale. Other examples of internal control procedures are restricting entry and exit routes of employees, requiring all employees to take their vacations and assigning another person to do their jobs while they are away, surveillance cameras, sur-