Prentice Hall's one-day MBA in finance & accounting (44 page)

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
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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 straightforward concept, there are several technical problems in calculating earnings per share. Actually, two EPS ratios are needed for many businesses—basic EPS, which uses the actual number of capital shares outstanding, 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 business 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 businesses 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. Businesses 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 forgiving 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 emphasizes that the amount recorded in the accounts or on the books of a business 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 capital 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 important effect or result of something. Not many accounting-based terms have found their way into everyday language, but this is one that has.

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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 investment. 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 allocated among the various capital investment opportunities of a business.

The term sometimes is used interchangeably with the analysis techniques 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 capital for these expenditures from debt and equity sources.

capital investment analysis
Refers to various techniques and procedures used to determine or to analyze future returns from an investment 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 prefer) 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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capital recovery
Refers to recouping, or regaining, invested capital over the life of an investment. The pattern of period-by-period capital recovery 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 relatively easy if you use a spreadsheet model for capital investment analysis. 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 business 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 features 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 outlay 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.

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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 operating 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 business, classifies cash flows into three types: those from operating activities (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 depreciation 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 business’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 difficult 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 revenue 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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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 overhead costs of products. The cost of raw materials used to make products is not included in this concept. Generally speaking, this is a rough measure 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 compare 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, inventories, 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.