Prentice Hall's one-day MBA in finance & accounting (46 page)

prise counts of cash and inventory, and rotation of duties. Internal con-

trols should be cost-effective; the cost of a control should be less than the potential loss that is prevented. The guiding principle for designing internal accounting controls is to deter and detect errors and dishon-

esty. The best internal controls in the world cannot prevent most fraud by high-level managers who take advantage of their positions of trust and authority.

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internal rate of return (IRR)
The precise discount rate that makes the present value (PV) of the future cash returns from a capital investment exactly equal to the initial amount of capital invested. If IRR is higher than the company’s cost-of-capital rate, the investment is an attractive opportunity; if less, the investment is substandard from the cost-of-capital point of view.

inventory shrinkage
A term describing the loss of products from inventory due to shoplifting by customers, employee theft, damaged and spoiled products that are thrown away, and errors in recording the purchase and sale of products. A business should make a physical count and inspection of its inventory to determine this loss.

inventory turnover ratio
The cost-of-goods-sold expense for a given period (usually one year) divided by the cost of inventories. The ratio depends on how long products are held in stock on average before they are sold. Managers should closely monitor this ratio.

inventory write-down
Refers to making an entry, usually at the close of a period, to decrease the cost value of the inventories asset account in order to recognize the lost value of products that cannot be sold at their normal markups or will be sold below cost. A business compares the recorded cost of products held in inventory against the sales value of the products. Based on the lower-of-cost-or-market rule, an entry is made to record the inventory write-down as an expense.

investing activities
One of the three classes of cash flows reported in the statement of cash flows. This class includes capital expenditures for replacing and expanding the fixed assets of a business, proceeds from disposals of its old fixed assets, and other long-term investment activities of a business.

management control
This is difficult to define in a few words—indeed, an entire chapter is devoted to the topic (Chapter 17). The essence of management control is “keeping a close watch on everything.” Anything can go wrong and get out of control. Management control can be thought of as the follow-through on decisions to ensure that the actual outcomes happen according to purposes and goals of the management decisions that set things in motion. Managers depend on feedback control reports that contain very detailed information. The level of detail and range of information in these control reports is very different from the summary-level information reported in external income statements.

mark to market
Refers to the accounting method that records increases and decreases in assets based on changes in their market values. For
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example, mutual funds revalue their securities portfolios every day based on closing prices on the New York Stock Exchange and Nasdaq. Generally speaking, however, businesses do
not
use the mark-to-market method to write up the value of their assets. A business, for instance, does not revalue its fixed assets (buildings, machines, equipment, etc.) at the end of each period—even though the replacement values of these assets fluctuate over time. Having made this general comment, I should mention that accounts receivable are written down to recognize bad debts, and a business’s inventories asset account is written down to recognize stolen and damaged goods as well as products that will be sold below cost. If certain of a business’s long-term operating assets become impaired and will not have productive utility in the future consistent with their book values, then the assets are written off or written down, which can result in recording a large extraordinary loss in the period.

market capitalization,
or
market cap
Current market value per share of capital stock multiplied by the total number of capital stock shares outstanding of a publicly owned business. This value often differs widely from the book value of owners’ equity reported in a business’s balance sheet.

negative cash flow
The cash flow from the operating activities of a business can be negative, which means that its cash balance decreased from its sales and expense activities during the period. When a business is operating at a loss instead of making a profit, its cash outflows for expenses very likely may be more than its cash inflow from sales. Even when a business makes a profit for the period, its cash inflow from sales could be considerably less than the sales revenue recorded for the period, thus causing a negative cash flow for the period.
Caution:
This term also is used for certain types of investments in which the net cash flow from all sources and uses is negative. For example, investors in rental real estate properties often use the term to mean that the cash inflow from rental income is less than all cash outflows during the period, including payments on the mortgage loan on the property.

net income
(also called the
bottom line, earnings, net earnings,
and
net
operating earnings
) This key figure equals sales revenue for a period less all expenses for the period; also, any extraordinary gains and losses for the period are included in this final profit figure. Everything is taken into account to arrive at net income, which is popularly called the
bottom
line.
Net income is clearly the single most important number in business financial reports.

net present value (NPV)
Equals the present value (PV) of a capital investment minus the initial amount of capital that is invested, or the entry cost
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of the investment. A positive NPV signals an attractive capital investment opportunity; a negative NPV means that the investment is substandard.

net worth
Generally refers to the book value of owners’ equity as reported in a business’s balance sheet. If liabilities are subtracted from assets, the accounting equation becomes: assets − liabilities = owners’ equity. In this version of the accounting equation, owners’ equity equals net worth, or the amount of assets after deducting the liabilities of the business.

operating activities
Includes all the sales and expense activities of a business. But the term is very broad and inclusive; it is used to embrace all types of activities engaged in by profit-motivated entities toward the objective of earning profit. A bank, for instance, earns net income not from sales revenue but from loaning money on which it receives interest income. Making loans is the main revenue operating activity of banks.

operating cash flow
See
cash flow from operating activities.

operating leverage
A relatively small percent increase or decrease in sales volume that causes a much larger percent increase or decrease in profit because fixed expenses do not change with small changes in sales volume. Sales volume changes have a lever effect on profit. This effect should be called
sales volume leverage,
but in practice it is called
operating leverage.

operating liabilities
The short-term liabilities generated by the operating (profit-making) activities of a business. Most businesses have three types of operating liabilities: accounts payable from inventory purchases and from incurring expenses, accrued expenses payable for unpaid expenses, and income tax payable. These short-term liabilities of a business are non-interest-bearing, although if not paid on time a business may be assessed a late-payment penalty that is in the nature of an interest charge.

operating profit
See
earnings before interest and income tax (EBIT).

overhead costs
Overhead generally refers to indirect, in contrast to direct, costs. Indirect means that a cost cannot be matched or coupled in any obvious or objective manner with particular products, specific revenue sources, or a particular organizational unit. Manufacturing overhead costs are the indirect costs in making products, which are in addition to the direct costs of raw materials and labor. Manufacturing overhead costs include both
variable costs
(electricity, gas, water, etc.), which vary with total production output, and
fixed costs,
which do not vary with increases or decreases in actual production output.

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owners’ equity
Refers to the capital invested in a business by its shareowners plus the profit earned by the business that has not been distributed to its shareowners, which is called
retained earnings.
Owners’

equity is one of the two basic sources of capital for a business, the other being borrowed money, or debt. The book value, or value reported in a balance sheet for owners’ equity, is not the market value of the business.

Rather, the balance sheet value reflects the historical amounts of capital invested in the business by the owners over the years plus the accumulation of yearly profits that were not paid out to owners.

present value (PV)
This amount is calculated by discounting the future cash returns from a capital investment. The discount rate usually is the cost-of-capital rate for the business. If PV is more than the initial amount of capital that has to be invested, the investment is attractive. If less, then better investment alternatives should be found.

price/earnings (P/E) ratio
This key ratio equals the current market price of a capital stock share divided by the earnings per share (EPS) for the stock. The EPS used in this ratio may be the basic EPS for the stock or its diluted EPS—you have to check to be sure about this. A low P/E may signal an undervalued stock or may reflect a pessimistic forecast by investors for the future earnings prospects of the business. A high P/E

may reveal an overvalued stock or reflect an optimistic forecast by investors. The average P/E ratio for the stock market as a whole varies considerably over time—from a low of about 8 to a high of about 30.

This is quite a range of variation, to say the least.

product cost
This is a key factor in the profit model of a business. Product cost is the same as purchase cost for a retailer or wholesaler (distributor). A manufacturer has to accumulate three different types of production costs to determine product cost: direct materials, direct labor, and manufacturing overhead. The cost of products (goods) sold is deducted from sales revenue to determine gross margin (also called
gross profit
), which is the first profit line reported in an external income statement and in an internal profit report to managers.

profit
The general term
profit
is not precisely defined; it may refer to net gains over a period of time, or cash inflows less cash outflows for an investment, or earnings before or after certain costs and expenses are deducted from income or revenue. In the world of business, profit is measured by the application of generally accepted accounting principles (GAAP). In the income statement, the final, bottom-line profit is generally labeled
net income
and equals revenue (plus any extraordinary gains) less all expenses (and less any extraordinary losses) for the period. Inter-

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nal management profit reports include several profit lines: gross margin, contribution margin, operating profit (earnings before interest and income tax), and earnings before income tax. External income statements report gross margin (also called
gross profit
) and often report one or more other profit lines, although practice varies from business to business in this regard.

profit and loss statement (P&L statement)
This is an alternative moniker for an income statement or for an internal management profit report.

Actually, it’s a misnomer because a business has
either
a profit
or
a loss for a period. Accordingly, it should be profit
or
loss statement, but the term has caught on and undoubtedly will continue to be profit and loss statement.

profit module
This concept refers to a separate source of revenue and profit within a business organization, which should be identified for management analysis and control. A profit module may focus on one product or a cluster of products. Profit in this context is not the final, bottom-line net income of the business as a whole. Rather, other measures of profit are used for management analysis and decision-making purposes—such as gross margin, contribution margin, or operating profit (earnings before interest and income tax).

profit ratios
Ratios based on sales revenue for a period. A measure of profit is divided by sales revenue to compute a profit ratio. For example, gross margin is divided by sales revenue to compute the
gross margin
profit ratio.
Dividing bottom-line profit (net income) by sales revenue gives the profit ratio that is generally called
return on sales.

property, plant, and equipment
This label is generally used in financial reports to describe the long-term assets of a business, which include land, buildings, machinery, equipment, tools, vehicles, computers, furniture 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).