There’s More to know about that Balance Sheet
This Week’s Chapter “Fixed Assets’ Quirkiness” or how much is the Coca-Cola brand worth?
We will continue to examine your company’s balance sheet this week with a definition of Fixed Assets. Fixed assets are long-term assets and have a useful life of more than one year. They are usually anything that can be depreciated or amortized.
Fixed Assets are relatively illiquid and include Land, Buildings, Trucks, Equipment, and other long-term investments. Fixed Assets are recorded at the original historical cost of the asset (the book value) not the current market value. For example, if a company purchased the property 10 years ago for $750,00, and did nothing to it, if the land is now worth $4,500,000, it will still be listed at the original purchase price of $750,000. Land is not depreciated because it doesn’t wear out.
Other fixed assets will be depreciated over their useful life so that costs are spread over the years the asset will be used. For example, the company purchased a truck, and the cost will be depreciated over several years (or faster, depending on permissible acceleration schedules as determined by your accountant.) By matching the expense of the asset to the time it will be used to generate income, the operating income will more accurately match revenue to expense.
Depreciation is a non-cash charge used to match the expense with the revenue in a period. It is the allocation of past expenses to future time periods to match revenues and expenses. Your CPA will calculate the depreciation to be taken on a particular asset using the asset’s useful life, its salvage value, and the method of allocation to be used. There is more than one method of calculating depreciation, including straight line and accelerated depreciation. The method used will affect your bottom-line earnings.
Depreciation will impact the taxes the company will pay. Companies often use the most rapid method of depreciation over the shortest useful life of the asset (allowed by the IRS and state tax regulators) so that current taxes are minimized. Companies often keep two sets of financial records – one for managing the company and one for calculating the tax bill.
What to Watch – Measures of Efficiency and Productivity related to Assets
Example Company: Total Sales $5,400,000; Total Assets $2,200,000, Net Profit $590,000
Total Asset Turnover = Revenue/Total Assets =5400/2200 = 2.45
This result tells the owner how efficiently all the assets are being used. The owner can improve results (increasing the total asset turnover) by reducing inventory, reducing the average receivables, OR increasing sales revenue while total assets are held constant or increased at a slower rate. Some of the industry benchmarks of in the past few years (NALP and others) would indicate that a range of 2.6 to 2.7 turnover is within the target range. Our example shows us that $2.45 of sales is generated from every dollar of assets. We should investigate whether an improvement could be made in the asset composition or if we need to increase sales to become more profitable.
Return on Assets (ROA) = Net Profit/Total Assets = 590/2,200 = 27%
ROA tells the owner how productive the total amount invested in assets is. It is the percentage of every dollar invested in assets that is returned as profit. The total assets (fixed plus current assets) are used in this calculation. In our example, the ROA is 27%, which is near the average for all landscaping companies from the previously referenced NALP study. Those results ranged from 19.9% to 45% for the highest-profit companies. Note that a “too high” ROA number compared to the industry norms might indicate that the company isn’t renewing its asset base for the future. If that’s the case, the company may have long-term issues, all things being equal.
Unlisted Assets – How much is the Coca-Cola brand worth?
Intangible assets are assets that do not have a physical presence and cannot be touched. Intangible assets like goodwill, your brand, and intellectual property will not be listed on your balance sheet and have no recorded book value. They will be valued if you sell the company. The difference between the net assets the buyer acquires, and the amount paid for them will be the “goodwill” on the buyer’s balance sheet. Note that if a company is creating a new software program or pursuing a patent, it may be booked as an intangible asset and amortized over the life of the revenue stream it generates.
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The Asset “Subworld” of Market Valuation*
When calculations are made to provide the “value” of your business, the difference between the market value of your assets and the reported book value on your balance sheet will need to be calculated. If your buyer is coming from the “asset subworld” and not relying on the company’s earnings stream to calculate value, the company’s assets and liabilities will be adjusted to fair market value before calculating the net asset value. These fair market values for the company’s assets and liabilities are appropriate if they can be sold as an ongoing business. (Otherwise, liquidation values are used). *
*Source, Robert Slee, Private Capital Markets, Second Edition