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Financial Accounting Glossary by Lie Dharma Putra [Part 4]



INVENTORY TURNOVER RATIO – This ratio equals the cost of inventories divided into the cost of goods sold expense for a period [usually one year]. The ratio depends on how long products are held in stock on average before they are sold. Managers should closely monitor this ratio to tell if products are being held too long before being sold.

INVENTORY WRITE-DOWN – This term refers to making an accounting entry, usually at the close of a period, to decrease the cost value of the business’s inventory asset account in order to recognize loss of value due to products that cannot be sold at their normal mark-ups or that 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 decrease inventory and to record an expense. [An inventory write-down entry is also recorded for inventory shrinkage].



INVENTORY SHRINKAGE – This term refers to the loss due to customer shoplifting; employee theft; and damage, breakage, spoilage, and obsolescence of products while being handled, moved, or stored in a warehouse; it is also due to accounting errors in recording the purchase, manufacture, and sale of products. A business should make regular physical counts and inspections of its inventory to determine this loss.

INVESTING ACTIVITIES – This term refers to 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 longterm investment activities of a business.


LAST-IN, FIRST-OUT [LIFO] – One of the two popular accounting methods to measure cost of goods sold during a period and the cost of ending inventory. It is both an expense measurement and an asset-valuation method; you can’t separate these two aspects. The last, or most recent, costs of purchasing or manufacturing products are the first costs charged out to record cost of goods sold expense. Thus, the oldest costs of acquisition remain in the inventories asset account. To offer a simple example, suppose a business bought two units of a new product during the year. The first unit cost $100 and the second unit, which was purchased sometime later, cost $105. The business sold one of the two units. LIFO assigns $105 to cost of goods sold expense and $100 to the cost of ending inventory. See also first-in, first-out [FIFO—which uses the same facts but gives different results].

MANAGEMENT CONTROL – This term is difficult to define in a few words. The essence of management control is keeping a close watch on everything. Anything can go wrong and can get out of control. Management control can be thought of as the follow-through on strategy and policy decisions, to make sure that the actual outcomes are going according to the purposes and goals of the earlier decisions that set things in motion. Managers depend on feedback reports to know what’s going on; and they compare actual outcomes against the plans, goals, and budgets for the period, which focus on major variances and deviations.


MARK-TO-MARKET – This term refers to the accounting method that actually records increases and decreases in assets based on changes in the assets’ market values. For example, mutual funds revalue their securities portfolios every day based on closing prices on the New York Stock Exchange and the Nasdaq. Generally speaking, businesses do not use mark-to-market methods for 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, we should mention that accounts receivable are written down to recognize bad debts, and a business’s inventory 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 tangible and intangible long-term operating assets become impaired and will not have utility in the future consistent with their book values, then the assets are written down.

MARKET CAPITALIZATION [OR MARKET CAP] – This amount equals the 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 could 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 less than the sales revenue recorded for the period, thus causing a negative cash flow for the period. Caution: This term is also 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, net earnings, net operating earnings, or just earnings] – This key figure equals sales revenue for a period less all expenses for the period; 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] – This figure equals the present value [PV] of a capital investment minus the initial amount of capital that is invested, or the entry cost of the investment. A positive NPV signals an attractive capital investment opportunity; a negative NPV means that the investment is substandard from the cost of capital point of view.

NET WORTH – Generally, this term refers to the book value of owners’ equity as reported in a business’s latest 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 – This term refers to the sales and the expense activities of a business, both those that sell products and those that sell services. The term 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 liabilities] – These are the short-term liabilities generated by the operating [profit-making] activities of a business. Most businesses have three types of operating liabilities: [1] accounts payable from inventory purchases and from incurring expenses that are bought on credit; [2] accrued expenses payable for unpaid expenses; and [3] income tax payable. These short-term liabilities of a business are noninterest-bearing.


OPERATING PROFIT – See earnings before interest and income tax [EBIT] overhead costs This term generally means 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, or specific revenue sources, or a particular organizational unit. Production overhead costs are the indirect costs of manufacturing products. The direct costs of manufacturing products are raw materials and production-line labor. Manufacturing overhead costs include variable costs [such as electricity, gas, and water that vary with total production output] and fixed costs [that do not vary with increases or decreases in actual production output].

OWNER’S EQUITY – This term refers to the capital invested in a business by its shareowners plus the profit earned by the business that has not been distributed to them, which is recorded in an account called retained earnings. Owners’ equity is one of the two basic sources of capital to 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 by the owners over the years in a business plus the accumulation of yearly profits that were not paid out to its 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, then the investment is attractive. If PV is less, then better investment alternatives should be looked for.

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 may reflect an optimistic forecast by investors. The average P/E ratio for the stock market as a whole varies considerably over time.


PRODUCT COST – This is a key factor in the profit model of a business. Product cost is purchase cost for a retailer or a 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.

Other glossaries:

[Financial Accounting Glossary Part 1 – ACCOUNTING]
[Financial Accounting Glossary Part 2 – CAPITAL]
[Financial Accounting Glossary Part 3 – DIVIDEND PAYOUT RATIO]
[Financial Accounting Glossary Part 5 – PROFIT]

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