Book: Financial Intelligence

Question 1

Contribution margin

Answer 1

Contribution margin indicates how much profit you are earning on the goods or services you sell, without accounting for your company’s fixed costs. To calculate it, just subtract variable costs from sales.

Question 2

Accruals

Answer 2

An accrual is the portion of a revenue or expense item that is recorded in a particular time span. Product development costs, for instance, are likely to be spread out over several accounting periods, and so a portion of the total cost will be accrued each month. The purpose of accruals is to match costs to revenues in a given time period as accurately as possible.

Question 3

Allocations

Answer 3

Allocations are apportionments of costs to different departments or activities within a company. For instance, overhead costs such as the CEO’s salary are often allocated to the company’s operating units.

Question 4

Depreciation

Answer 4

Depreciation is the method accountants use to allocate the cost of equipment and other assets to the total cost of products and services as shown on the income statement. It is based on the same idea as accruals: we want to match as closely as possible the costs of our products and services with what was sold. Most capital investments other than land are depreciated. Accountants attempt to spread the cost of the expenditure over the useful life of the item.

Question 5

Goodwill

Answer 5

Goodwill comes into play when one company acquires another company. It is the difference between the net assets acquired (that is, the fair market value of the assets less the assumed liabilities) and the amount of money the acquiring company pays for them. For example, if a company’s net assets are valued at $1 million and the acquirer pays $3 million, then goodwill of $2 million goes onto the acquirer’s balance sheet. That $2 million reflects all the value that is not reflected in the acquiree’s tangible assets—for example, its name, reputation, and so on.

Question 6

Fiscal year

Answer 6

A fiscal year is any twelve-month period that a company uses for accounting purposes. Many companies use the calendar year, but some use other periods (October 1 to September 30, for example). Some retailers use a specific weekend, such as the last Sunday of the year, to mark the end of their fiscal year. You must know the company’s fiscal year to ascertain how recent the information you are looking at is.

Question 7

Balance sheet

Answer 7

The balance sheet reflects the assets, liabilities, and owners’ equity at a point in time. In other words, it shows, on a specific day, what the company owned, what it owed, and how much it was worth. The balance sheet is called such because it balances—assets always must equal liabilities plus owners’ equity. A financially savvy manager knows that all the financial statements ultimately flow to the balance sheet.

Question 8

Cash

Answer 8

Cash as presented on the balance sheet means the money a company has in the bank, plus anything else (like stocks and bonds) that can readily be turned into cash. Really, it’s that simple. Later we’ll discuss measures of cash flow. For now, just know that when companies talk about cash, it really is the cold, hard stuff

Question 9

The matching principle

Answer 9

The matching principle is a fundamental accounting rule for preparing an income statement. It simply states, “Match the cost with its associated revenue to determine profits in a given period of time—usually a month, quarter, or year.” In other words, one of the accountants’ primary jobs is to figure out and properly record all the costs incurred in generating sales.

Question 10

Cost of sales

Answer 10

Cost of sales includes actual product cost, the cost of transportation to the Company’s warehouses, stores and clubs from suppliers, the cost of transportation from the Company’s warehouses to the stores and clubs and the cost of warehousing for our Sam’s Club segment and import distribution centers.

Question 11

Sales

Answer 11

Sales or revenue is the dollar value of all the products or services a company provided to its customers during a given period of time.

Question 12

Income statement

Answer 12

The income statement shows revenues, expenses, and profit for a period of time, such as a month, quarter, or year. It’s also called a profit and loss statement, P&L, statement of earnings, or statement of operations. Sometimes the word consolidated is thrown in front of those phrases, but it’s still just an income statement. The bottom line of the income statement is net profit, also known as net income or net earnings.

Question 13

Operating expenses

Answer 13

Operating expenses are the costs required to keep the business going from day to day. They include salaries, benefits, and insurance costs, among a host of other items. Operating expenses are listed on the income statement and are subtracted from revenue to determine profit.

Question 14

Capital expenditures

Answer 14

A capital expenditure is the purchase of an item that’s considered a long-term investment, such as computer systems and equipment. Most companies follow the rule that any purchase over a certain dollar amount counts as a capital expenditure, while anything less is an operating expense. Operating expenses show up on the income statement, and thus reduce profit. Capital expenditures show up on the balance sheet; only the depreciation of a piece of capital equipment appears on the income statement.

Question 15

One big rule about income statements

Answer 15

Remember that many numbers on the income statement reflect estimates and assumptions. Accountants have decided to include some transactions here and not there. They have decided to estimate one way and not another.

Question 16

Earnings per share

Answer 16

Earnings per share (EPS) is a company’s net profit divided by the number of shares outstanding. It’s one of the numbers that Wall Street watches most closely. Wall Street has “expectations” for many companies’ EPS, and if the expectations aren’t met, the share price is likely to drop.

Question 17

Cost of Goods Sold (COGS) and Cost of Services (COS)

Answer 17

Cost of goods sold or cost of services is one category of expenses. It includes all the costs directly involved in producing a product or delivering a service.

Question 18

Above the Line, Below the Line

Answer 18

The “line” generally refers to gross profit. Above that line on the income statement, typically, are sales and COGS or COS. Below the line are operating expenses, interest, and taxes. What’s the difference? Items listed above the line tend to vary more (in the short term) than many of those below the line, and so tend to get more managerial attention.

Question 19

Operating Expenses (Once More)

Answer 19

Operating expenses are the other major category of expenses. The category includes costs that are not directly related to making the product or delivering a service. . .

Question 20

Noncash expense

Answer 20

A noncash expense is one that is charged to a period on the income statement but is not actually paid out in cash. An example is depreciation: accountants deduct a certain amount each month for depreciation of equipment, but the company isn’t obliged to pay out that amount, because the equipment was acquired in a previous period.

Question 21

Profit

Answer 21

Profit is the amount left over after expenses are subtracted from revenue. There are three basic types of profit: gross profit, operating profit, and net profit. Each one is determined by subtracting certain categories of expenses from revenue.

Earnings before interest and taxes (EBIT) is an indicator of a company’s profitability.

Question 22

Gross profit

Answer 22

Gross profit is sales minus cost of goods sold or cost of services. It is what is left over after a company has paid the direct costs incurred in making the product or delivering the service. Gross profit must be sufficient to cover a business’s operating expenses, taxes, financing costs, and net profit.

Question 23

Operating Profit, or EBIT

Answer 23

Operating profit is gross profit minus operating expenses, which include depreciation and amortization. In other words, it shows the profit made from running the business.

Question 24

Net profit

Answer 24

Net profit is the bottom line of the income statement: what’s left after all costs and expenses are subtracted from revenue. It’s operating profit minus interest expenses, taxes, one-time charges, and any other costs not included in operating profit.

Question 25

Equity

Answer 25

Equity is the shareholders’ “stake” in the company as measured by accounting rules. It’s also called the company’s book value. In accounting terms, equity is always assets minus liabilities; it is also the sum of all capital paid in by shareholders plus any profits earned by the company since its inception minus dividends paid out to shareholders. That’s the accounting formula, anyway. Remember that what a company’s shares are actually worth is whatever a willing buyer will pay for them.

Question 26

“Smoothing” earnings

Answer 26

You might think that Wall Street would like a big spike in a company’s profits—more money for shareholders, right? But if the spike is unforeseen and unexplained—and especially if it catches Wall Street by surprise—investors are likely to react negatively, taking it as a sign that management isn’t in control of the business. So companies like to “smooth” their earnings, maintaining steady and predictable growth.

Question 27

Acquisitions

Answer 27

An acquisition occurs when one company buys another. Often you’ll see in the newspaper the words merger or consolidation. Don’t be fooled: one company still bought the other. They just use a more neutral-sounding term to make the deal look better.

Question 28

Intangibles

Answer 28

A company’s intangible assets include anything that has value but that you can’t touch or spend: employees’ skills, customer lists, proprietary knowledge, patents, brand names, reputation, strategic strengths, and so on. Most of these assets are not found on the balance sheet unless an acquiring company pays for them and records them as goodwill. The exception is intellectual property, such as patents and copyrights. This can be shown on the balance sheet and amortized over its useful life.

Question 29

Capital

Answer 29

The word means a number of things in business. Physical capital is plant, equipment, vehicles, and the like. Financial capital from an investor’s point of view is the stocks and bonds he holds; from a company’s point of view it is the shareholders’ equity investment plus whatever funds the company has borrowed. “Sources of capital” in an annual report shows where the company got its money. “Uses of capital” shows how the company used its money.

Question 30

Dividends

Answer 30

Dividends are funds distributed to shareholders taken from a company’s equity. In public companies, dividends are typically distributed at the end of a quarter or year.

Question 31

Owner earnings

Answer 31

Owner earnings is a measure of the company’s ability to generate cash over a period of time. We like to say it is the money an owner could take out of his business and spend for his own benefit. Owner earnings is an important measure because it allows for the continuing capital expenditures that will be necessary to maintain a healthy business. Profit and even operating cash flow measures do not. More about owner earnings in the toolbox at the end of this part.

Question 32

Financing a company

Answer 32

How a company is financed refers to how it gets the cash it needs to start up or expand. Ordinarily, a company is financed through debt, equity, or both. Debt means borrowing money from banks, family members, or other creditors. Equity means getting people to buy stock in the company.

Question 33

Buying back stock

Answer 33

If a company has extra cash and believes that its stock is trading at a price that is lower than it ought to be, it may buy back some of its shares. The effect is to decrease the number of shares outstanding and hence to increase the possibility that the price will rise.

Question 34

Reconciliation

Answer 34

In a financial context, reconciliation means getting the cash line on a company’s balance sheet to match the actual cash the company has in the bank—sort of like balancing your checkbook, but on a larger scale.

Question 35

Return on investment

Answer 35

Why isn’t ROI included in our list of profitability ratios? The reason is that the term has a number of different meanings. Traditionally, ROI was the same as ROA: return on assets. But these days it can also mean return on a particular investment. What is the ROI on that machine? What’s the ROI on our training program? What’s the ROI of our new acquisition? These calculations will be different depending on how people are measuring costs and returns.

Question 36

Opportunity cost

Question 37

Working capital

Answer 37

Working capital is the money a company needs to finance its daily operations. Accountants usually measure it by adding up a company’s cash, inventory, and accounts receivable, and then subtracting short-term debts.