Financial Accounting Glossary by Lie Dharma Putra [Part 5]

PROFIT – The general term profit is not precisely defined; it may refer to net gains over a period of time, or to cash inflows less cash outflows of an investment, or to earnings before or after certain costs and expenses are deducted from income or revenue. In the business world, profit is measured by the application of generally accepted accounting principles [GAAP]. In the income statement, the final or bottom-line profit is generally labeled net income or net earnings. It equals revenue [plus any extraordinary gains] less all expenses [and less any extraordinary losses] for the period. Internal management profit reports may 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 REPORT [P&L] – 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. It would be better called the profit or loss report, but the term has caught on and won’t change.

 

PROFIT RATIOS – These ratios are 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 [PP&E] – This title, or label, is generally used in financial reports for 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.

 

QUICK RATIO – [See acid test ratio].

RETURN ON ASSETS [ROA] – Although practice is not uniform for calculating this ratio, most often it equals operating profit [earnings 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.

 

RETURN ON EQUITY [ROE] – This key ratio equals net income for the year divided by owners’ equity and is expressed as a percent. ROE should be higher than a business’s interest rate on debt because the owners take more risk.

RETURN ON INVESTMENT [ROI] – This very general concept refers to some measure of income, or earnings, or 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 see.

 

RETURN ON SALES – This ratio equals net income divided by sales revenue.

REVENUE-DRIVEN EXPENSES – These are those operating expenses that vary with 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 a key variable in a profit model. Segregating these expenses from other types of expenses that behave differently is essential for profit analysis. [These expenses are not disclosed separately in externally reported income statements]. Securities and Exchange Commission [SEC] This federal agency 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 has supervisory responsibility for the recently established Public Company Accounting Oversight Board, created by the Sarbanes-Oxley Act of 2002. The SEC has the primary jurisdiction over 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 – This term refers to the ability of a business to pay its liabilities on time when they come due for payment. A business may be in-solvent, which means that it is not able to pay its liabilities and debts on time. The current ratio and the acid test ratio are used to evaluate the short-term solvency prospects of a business. Also, the liabilities of a business can be compared with its cash flow from operating activities for a rough indication of its debt-paying ability.  Stockholder’s equity, statement of changes in Although often referred to as a financial statement, this is more in the nature of a supporting schedule that summarizes in one place the various changes in the owner’s 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 and when a variety of events occurred during the year that changed its owners’ equity accounts. Also, generally accepted accounting principles allow that certain events that have a positive or a negative effect on owners’ equity can bypass the income statement and be reported only in this statement.

STRAIGHT-LINE DEPRECIATION – This depreciation method allocates a uniform amount of the total costs of long-lived operating assets [fixed assets] to each year of use. It is the alternative to accelerated depreciation. When using the straight-line method, a business may adopt a longer life estimate for depreciating a fixed asset as compared with 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 – This is a cost is 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 spilt milk. Usually the term refers to the recorded value of an asset that has lost its value to 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. Sunk costs are irrelevant and 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 – This is the ratio that tests the ability of a business to make interest payments on its debt. It 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 one.

 

VARIABLE EXPENSES – These are operating expenses that vary with changes in either sales volume or sales revenue, in contrast with fixed expenses that remain the same over the short run, not fluctuating in response to changes in sales volume or sales revenue. See revenue-driven expenses and volume-driven expenses.

VOLUME-DRIVEN EXPENSES – Those expenses that vary with changes in total sales volume [total quantities, or units 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 a key factor in a model for profit behavior analysis. Segregating these expenses from other types of expenses that behave differently is very useful for management analysis and control. The cost of goods sold expense depends on sales volume and is a volume-driven expense. Product cost [i.e., the cost of goods sold] is such a dominant expense that it is treated separately from other volume-driven operating 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 a business’s debt and on the return on equity [ROE] goal established by a business. This is a return on capital rate and can be applied either on a before-tax basis or on 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.

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 4 – INVENTORY TURNOVER RATIO]

Author: Lie Dharma Putra

Putra is a CPA. His last position, in the corporate world, was a controller for a corporation in Costa Mesa, CA. After spending 15 years as a nine-to-five employee, he decided to serve more companies, families and even individuals, as a trusted business advisor. He blogs about accounting, finance and tax, during his spare time, and helps accounting students (around the globe) to understand the subject matter easier , faster. Follow him on twitter @LieDharmaPutra or add him to your circle at Google Plus Lie+

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