When we are looking at a company’s tangible assets we have a number of concerns:
● Is the company replacing them?A company can make its ratios look very good in the short term by not replacing its assets, but in the longer term it will lose business as its machin- ery wears out and becomes unreliable.
● Is it replacing them with the right fixed assets?Additional fixed assets should lead to addi- tional profits. Either the fixed assets are being bought to increase capacity, and the addi- tional sales will lead to additional profits, or they are purchased as part of a cost reduction programme.
●
Asset replacement
Companies will normally disclose their capital expenditure in the operating review, if not it will be found in the additions line in the note on fixed assets. On the same note, they will disclose the depreciation that has been charged in the year. One way of checking whether the company is replacing its machinery is to compare the capital expenditure and the depre- ciation charge. We would expect capital expenditure to be much greater than depreciation, as depreciation is based on historical costs and technologies. This can be measured by the following ratio:
Capital expenditure x 100 Depreciation
Like all ratios, this is pretty meaningless in isolation; you would need to have a number of years to establish whether the company has a problem. It also needs to be considered in the light of the probable age of the assets. This can be roughly guessed by comparing the book value of the assets with the cost. For example, if a company’s plant and machinery, origi- nally costing £1 million, had depreciated by £800 000 to give a current book value of
£200 000 they are 80 per cent through their life. If we know the asset life for plant and machinery we could work out an average age. Unfortunately, most companies disclose asset lives in bands, but even so we have some useful information. If the assets are 80 per cent through their life, the company should be replacing them at a much faster rate than one where the assets are only 20 per cent through their life.
8 The fixed asset ratios
12 Tangible fixed assets Industrial Retail Plant &
property property machinery Total
Whitbread Group £m £m £m £m
Cost or valuation 25 February 1995 100.6 2,053.3 773.2 2,927.1
Foreign exchange movements – 3.1 1.1 4.2
Businesses acquired 0.4 269.8 43.4 313.6
Additions 2.1 224.3 128.5 354.9
Interest capitalised – 3.4 0.3 3.7
Disposals (2.5) (68.5) (53.6) (124.6)
Provision for permanent diminution – (4.2) – (4.2)
Revaluation (1.3) 14.7 – 13.4
Reclassifications 1.0 8.0 (9.0) –
Cost or valuation 2 March 1996 100.3 2,503.9 883.9 3,488.1
Depreciation 25 February 1995 (5.8) (30.7) (426.0) (462.5)
Foreign exchange movements – (0.7) (0.8) (1.5)
Businesses acquired – (8.2) (16.6) (24.8)
Depreciation for the year (2.7) (8.5) (82.1) (93.3)
Disposals – 5.9 47.1 53.0
Revaluation (0.1) (0.6) – (0.7)
Reclassifications – (4.5) 4.5 –
Depreciation 2 March 1996 (8.6) (47.3) (473.9) (529.8)
Net book amounts 2 March 1996 91.7 2,456.6 410.0 2,958.3
Net book amounts 25 February 1995 94.8 2,022.6 347.2 2,464.6
A provision of £4.2m has been made for a permanent diminution in the value of properties which have been identified for sale. This has been charged to the profit and loss account.
It is the group’s policy to revalue approximately 20% of its UK properties in each year, so that each property will be revalued once every five years. Breweries are valued on a depreciated replacement cost basis and all other properties are valued at open market value for the purpose of their existing use. During 1995/96 the directors carried out a revaluation in accordance with this policy in conjunction with the group’s own professionally qualified staff and external chartered surveyors, principally Gerald Eve. The revaluation in 1995/96 was £3.3m above book value. Incuded within the net surplus are individual diminutions relating to properties identified for sale. £0.5m of these diminu- tions, representing the deficit below historical cost, has been charged to the profit and loss account. The remaining net surplus of £3.8m has been added to the revaluation reserve. In addition, adjustments have been made to previous years’ revaluations with the result that the net book amount has been increased by a further £9.4m. This has also been added to the revaluation reserve.
If this and previous revaluations had not taken place, the net book amounts of fixed assets would have been:
Industrial Retail Plant &
property property machinery Total
£m £m £m £m
Cost 79.4 1,901.6 883.9 2,864.9
Depreciation (31.9) (87.4) (473.9) (593.2)
Net book amounts 2 March 1996 47.5 1,814.2 410.0 2,271.7
Net book amounts 25 February 1995 51.2 1,387.2 347.2 1,785.6
Long Short
Freehold leasehold leasehold Total
Net book amounts of properties £m £m £m £m
2 March 1996 2,024.2 429.8 94.3 2,548.3
25 February 1995 1,827.7 215.1 74.6 2,117.4
1996 1995
Cost or valuation of properties £m £m
As valued 1995/96 363.2 –
As valued 1994/95 364.4 366.3
As valued 1993/94 369.1 377.0
As valued 1992/93 777.0 1,122.1
As valued 1988/89 6.4 8.7
As valued 1984/85 1.9 3.2
At cost 722.2 276.6
2,604.2 2,153.9 Capital expenditure for which no provision has been made
Commitments 49.1 33.4
Authorised, not committed 215.4 132.6
264.5 166.0
ANALYSIS OF FIXED ASSETS (WHITBREAD) Extract 8.3
●
Asset utilisation
Increasing fixed assets should lead to increased profits, although there may be a time lag between the two. Profits can be increased by increasing sales or increasing margins.
Increasing sales
The sales can be simply measured:
...Turnover...
Tangible fixed assets
This can either be left as a number showing you how many pounds of sales the business generates for every pound invested in tangible assets, or expressed as a percentage. If it is left in pounds it is referred to as the tangible asset turn. If this is increasing, it may be that the com- pany is becoming more efficient or had excess capacity in earlier years, but it may mean nothing. Beware of this ratio, as like many others, the results can be misleading.
To illustrate this we will consider a company with sales of £1000 and fixed assets of £500.
Inflation is running at 3 per cent and sales increase in line with inflation. The fixed assets are depreciated at £50 a year, and the company buys no new fixed assets during the next five years.
If we look at the tangible asset turn we get some interesting and totally misleading results:
Year 1 Year 2 Year 3 Year 4 Year 5
Sales 1000 1030 1061 1093 1126
Tangible assets 500 450 400 350 300
Tangible asset turn 2.00 2.29 2.65 3.12 3.75
The business appears to have a significant increase in its operating efficiency, but the truth is that by not replacing its assets, it is storing up problems for the future! We could solve this problem by:
● making some adjustment for inflation over the five-year period;
● using the cost of fixed assets rather than the book value (I have yet to see an analyst do this, but you could be the first!)
Increasing profit margins
Many companies buy new fixed assets in an attempt to reduce their costs. If they are suc- cessful there should be an increase in their operating profit margins.
We need to see whether the company is replacing its fixed assets, and whether those fixed assets are improving the company’s profitability. Companies’ capital expenditure should be greater than the depreciation charge, as the depreciation charge reflects historical costs and historical technologies.
The tangible asset turn tells us how many pounds of sales have been generated for each pound invested in tangible assets. However, we should be careful in interpreting this ratio as it is easily distorted by inflation and depreciation.
Operating margins should improve if the company has justified its replacement of fixed assets through cost reduction.
SUMMARY
8 The balance sheet: tangible fixed assets The annuity method A method of depreciation that produces a depreciation charge that reflects a
constant cost of capital.
Book value/carrying value The net book value of an asset at the balance sheet date. It will be the cost/valuation less the accumulated depreciation to date.
Capital grant A grant to enable the company to buy an asset.
Finance lease A lease that transfers most of the risks and rewards of ownership to the lessee.
Operating lease This is defined by default, as it is a lease other than a finance lease.
Reducing-balance method The depreciation charge is based on a fixed percentage that is applied to the reducing value of the asset. Using this method gives higher depreciation charges in the early years and lower charges in later years.
Revenue grant A grant relating to either the company’s activities or to a specific period.
Straight-line method The depreciation charge is calculated at a constant amount each year.
Sum of the digits A method of depreciation, often used by leasing companies, that produces a depreciation charge similar to, but not as extreme as, the reducing-balance method.
JARGON