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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 measure 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 management decision-making analysis. (These expenses are not disclosed separately 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 current 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 transactions affecting owners’ equity. This statement (schedule) is very helpful when a business has more than one class of stock shares outstanding
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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 volume 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.

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variable expenses
Expenses that change with changes in either sales volume 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.

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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

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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

Sales revenue “negatives”

17.1

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,

13.2, 16.3, 16.4

Service businesses

16.1

Spreadsheet model (for capital

14.2, 14.3, 14.5, 15.1,

investment analysis)

15.2, 15.3

Stockholders’ equity, statement of

4.4

TEAMFLY

changes in

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Team-Fly®

I N D E X

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

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Capacity, 112–113, 130, 133,

Contribution margin, 31, 33,

150, 170, 239, 260.
See

35–36, 111, 132, 143, 152,

also
Production capacity

236–237, 255, 260

Capital, sources of, 67–69, 76,

Control.
See
Management control

99, 100, 191–192, 227

Corporation (type of business

Capital budgeting, 210

entity), 85–86

Capital expenditures, 98, 100,

Cost allocation, 171–172, 262,

103, 271

266–270, 280

Capital invested in assets, 80,

Cost driver, 140n, 268–269

95, 99, 100, 165, 192,

Cost of capital, 192–195, 206,

202–203

210, 214, 215, 218, 219,

Capital investment, 191–192,

224–227

195–199, 213, 215–224

Cost of equity capital, 194

Capitalization of costs,

Cost of goods sold, 17, 28, 29,

280–281

30, 77, 140, 182–183,

Capital needs planning, 97,

232–233, 234, 241, 258,

99–105, 165

259, 278n

Capital recovery (return of

Cost/sales volume trade-offs,

invested capital), 199–206,

164–165, 167–169

220, 221, 223

Current assets, 55–56

Capital stock (shares, or units of

Current liabilities, 55–56

ownership), 85–86

Current ratio, 55–56

Capital structure (capitalization),

Current replacement value of

82–83, 192, 193, 206,

assets, 40

214

Capital structure model, 88

Debt (interest-bearing liabilities),

Cash dividends.
See
Dividends

20, 55, 68, 76, 79, 81–84,

Cash flow, 3, 7, 251

92, 94, 95, 98, 192, 193,

Cash flow breakeven volume,

226, 227

119–120

Debt-to-equity ratio, 57, 206

Cash flow from operating activi-

Depreciation expense, 20, 24,

ties (also called
cash flow

33, 40, 70, 73, 103–104,

from profit, and operating

113–115, 129, 146,

cash flow
), 14, 16–17, 23,