Impairment is accounting write off of a company’s asset, which can be an intangible asset as well as a fixed asset. An impairment loss is incurred when the fair value of the asset is lower than the carrying value in the balance sheet.
Alternatively, impairment charges can be incurred when the recoverable value of the asset is lower than the book value. Impairment charges are recorded in the income statement of the company as an expense.
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A widespread economic crisis is followed by a recession, which usually impacts the value of assets held by a company. Such events force companies to test the value of assets in the balance sheet, and this often leads to an impairment charge.
IFRS accounting standards ensure that a company’s carrying value of assets depicts a value which is not in excess of the recoverable amount.
As per the accounting rules, a business is often measured by its book value of assets. Specifically, the assets of the company carry the capability to generate future cash flows for the firm.
When the ability of an asset to deliver expected future returns is hampered, the value of assets is decreased. Therefore, it becomes an ethical responsibility of the companies to show a fair picture of the assets.
Goodwill generated at the time of business combination is required to be tested for impairments annually. Companies are required to assess any indication that could cause a potential devaluation to the asset.
When a company is holding intangible assets with an indefinite life, they are required to test the assets for impairments annually.
Cash generating units are often valued on the discounted value of future cash flows. Consequently, when market interest rates are rising, it impacts the discount rate used in estimating the recoverable amount.
Assets can be impaired because of other reasons as well. Suppose the plant and machinery of the company were damaged due to earthquake, it would result in a reduction in the value of an asset or even full write-off of the asset.
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Companies often avail consulting services to improve the performance of the business. Consultants may advise companies to shut down operations at any plant, which could result in the sale of the asset at a consideration lower than carrying value.
Oftentimes, internal reporting of the companies indicate that the performance of the asset may not yield expected benefit. This would force the management to undertake impairment testing for the asset.
Amortisation is a systematic decrease in the value of an intangible asset. Amortisation of intangible assets is a process of capitalising the expense incurred on the acquisition of the asset, and then periodically recording the expense on the income statement.
Impairment, on the other hand, is an irreversible decrease in the value of the asset, which is shown as an expense in the income statement. It is charged when the recoverable amount from the asset is lower than the carrying value of the asset.
Depreciation is a periodic devaluation of fixed assets. It is undertaken by the companies to account for the wear and tear caused to the asset during its useful life. When a firm seeks to sell an existing asset, the buyer of the asset will deduct the depreciation from the cost of the asset before adding any premium or discount to the value for arriving at the purchase price.
Impairment on fixed assets could be related to an unusual fall in the fair value of the asset. For instance, the fair value of the machinery could be impacted significantly when a new and more efficient machine is available in the market. Similarly, an earthquake or fire can also devalue the value of the fixed asset in the balance sheet.
Under the reversal of impairment loss, the approach used to determine reversal is similar to the approach used in identifying the impairment loss. Reversal of impairment loss cannot be undertaken for goodwill, and it is prohibited.
Companies assess whether any impairment loss recognised in the prior periods may no longer exist or have decreased. Impairment losses can only be reversed when the estimates used in determining recoverable amount are changed.
Previously incurred impaired individual asset can be reversed only when the estimates used in calculating the recoverable amount have changed. For instance, the changes in market interest rates could impact the discount rates used in calculating the recoverable amount.
Unless the reversal relates to a revalued asset, the reversal of impairment loss is recognised in the income statement. The revalued asset should not be more than depreciated historical cost without impairment.
In a cash-generating unit, the reversal of impairment loss is allocated on a pro-rata basis with the carrying amounts of the assets. The carrying value of an asset must not be increased above the lower of:
What is EBITDA? Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA) is a widely used financial metric in evaluating cash flows and profitability of a business. Market participants closely track EBITDA and apply it in decision making extensively. Although conventional investors like Charlie Munger had raised concerns over the use of EBITDA, it is very popular in markets, and M&A transactions are mostly priced on EBITDA-based valuation like EV/EBITDA (x). EBITDA is not recognised by IFRS and GAAP but is used extensively in the Corporate Finance world. It is now a mainstream financial metric that companies look to target. EBITDA depicts operational cash generation capacity of a firm in a given period. It acts as an alternative to financial metrics like revenue, profit or earnings per share. EBITDA allows to evaluate a business operationally and outcomes of operating decisions. Non-operating items are excluded to arrive at EBITDA. EBITDA excludes the impact of capital structure or debt/equity, and non-cash expenses like depreciation and amortisation. A particular criticism of EBITDA has been the inappropriate outlook of capital intensive businesses, which incur large depreciation expenses. Business with large assets incurs substantial costs related to repair and maintenance, which are not captured in EBITDA because depreciation expenses are accounted to calculate EBITDA. Meanwhile, EBITDA can paint an appropriate picture for asset-light business with lower capital intensity. While revenue, profit and earning per share remain sought-after headline generators for corporates, EBITDA has also found its growing application in the corporate finance world and is now a mainstream metric to evaluate a business financially. Perhaps the growth of asset-light business models has also added to the use of EBITDA. Its debt-agnostic approach to evaluate businesses has given reasons to investors, especially for high growth firms during capital expenditure cycles. But EBITDA has been present for close to four decades now. In the 1980s, the growth in corporate takeovers through leverage buyout transaction was on a boom. EBITDA grew popular to value heavy industries like broadcasting, telecommunication, utilities. John Malone is credited for coining this term. He was working at TCI- a cable TV provider. Since EBITDA has remained an important metric to determine purchase price multiples and is highly used in M&A transactions. EBITDA’s application in large businesses with capital intensive assets that are written down over a long period has been a source of concern for many investors. Although EBITDA is an effective metric to evaluate the profitability of a firm, it does not reflect actual cash flow picture of a firm during a period. Also, it does not account for capital expenditures of the firm, which are crucial in successfully running a business. EBITDA does not give a fair cash flow position because it leaves out crucial items like working capital, debt and interest repayments, fixed expenses, capital expenditure. At the outset, there can be times when EBITDA may overstate performance, value and ability to repay debt. How to calculate EBITDA? NPAT: Net Profit after tax is the amount reported by a firm in the given period. It is present on the income statement of the firm and is used in the calculation of earnings per share of an entity. To calculate EBITDA, interest expense, tax, depreciation and amortisation are added to NPAT. Interest Expense: Firms can employ debt in their capital structure, and interest expense is funds paid to lenders as interest costs on principal debt. Most companies have different financing structure, and excluding interest payments enable comparing firms on operating grounds through EBITDA. Tax: Firms also pay income tax on profits. Excluding taxes gives a fair picture of the operating performance of the business since tax vary across jurisdictions, and sometimes according to size of business as well. Depreciation: Depreciation is the non-cash expense to account for the steady reduction in value of tangible assets. Firms can incur depreciation expense on machinery, vehicles, office assets, equipment etc. Amortisation: Amortisation is the non-cash expense to account for the reduction in the value of intangible assets like patents, copyrights, export license, import license etc. Operating Profit: Operating profit is the core profit of a firm generated out of operations. It includes cash and non-cash expenses of a firm, excluding income tax and interest expenses. Operating Profit is also called Earnings Before Interest and Tax (EBIT). Read: EBIT vs EBITDA What is TTM EBITDA and NTM EBITDA? Trailing Twelve Months (TTM) or Last Twelve Months (LTM) EBITDA represents the EBITDA of the past twelve months of the firm. It allows to review the last operation performance of the business. Whereas NTM EBITDA represents 12-month forward forecast EBITDA of the firm. NTM EBITDA is also one-year forward EBITDA. Market participants are provided with consensus analysts’ estimates for a firm, which also include NTM EBITDA, NTM EPS, NTM Net Income or NPAT. What is EBITDA margin? EBITDA margin is the percentage proportion of a firm EBITDA against total revenue. It indicates the operational profitability of the firm and cash flows to some extent. If a firm has a higher margin, it means the level of EBITDA against revenue is higher. It is widely used in comparing similar companies and enable to evaluate businesses relatively. If a firm has a total revenue of $1 million and EBITDA is $800k, the EBITDA margin is 80%. What is adjusted EBITDA? Adjusted EBITDA is calculated to provide a fair view business after adding back non-cash items, one-time expenses, unrealised gains and losses, share-based payments, goodwill impairments, asset write-downs etc.
Return on Equity (ROE) is a popular financial metric used in assessing investment decisions. It tells you how much income the business is generating relative to shareholders’ equity. Investors use ROE to evaluate capital allocation decisions of firms. Companies with high ROEs tend to get higher valuation as compared to companies with lower ROEs. Read: Are These Businesses Benefiting From A Good Return On Equity Ratio? – CSL, MFG, AMC, LOV, SYD Companies can increase ROE either by increasing net income, by improving sales and profitability, or by decreasing shareholders equity by share buybacks. However, for management, it is not just about generating high Return on Equity but achieving an optimal level of capital structure and returns to complement sustainability. They can hit high ROEs by loading an unusual amount of debt at high intensity compared to equity and increase their sales. Debt can manipulate ROEs and capital intensive businesses ought to have long debt cycles, therefore it is perennial to look at business models and take appropriate measures. Market participants also compare ROEs of comparable companies to get better answers to divergences. Good read: Understanding Operating Leverage and Five Financial Stocks Investors consider ROEs as one of the measures to evaluate the performance of a bank. The spread between ROEs and banks cost of equity has served as an indicator of profitability for market participants. Besides, the benchmark ROEs for banks is dependent on business cycle, time period, and interest-rates. The A2 Milk Company Limited ROE Calculation, Image Kalkine (Data Source: 2020 Annual Report) Net Income or Net Profit After Tax is given in the income statement of the company, and shareholders’ equity is reported in the balance sheet. Shareholders’ equity is taken as an average of beginning and ended. Should there be a large equity issue or buyback of similar scale, the ending amount of shareholders’ equity will give a better picture. What are the limitations of using ROE? Debt: Return on Equity is calculated without incorporating the debt in the balance sheet, meaning that the increase in net income is perhaps driven by debt funding as well. Even the companies with massive debt and relatively lower equity capital can boast high ROEs. A massive debt could be a problem for businesses, and a high ROE may give a false picture. Companies with high debt to equity ratio could report optically high ROE figures. Depreciation: Depreciation is an expense that is recorded in the income statement of the company. It is incurred on the assets held by the business like plant and machinery, factory, trucks. A business in a growth stage can have addition of large assets, which would result in lower-income over the future due to increased depreciation. Write downs: Assets of the company are also valued to determine any changes to the fair value of assets. The companies charge impairments to assets when current valuation is lower than the previously reported amount, which lowers assets value booked on the balance sheet. Buybacks: Companies can also show better ROEs after buying back a lot of shares of the company, which reduces the shareholders’ equity. A lower amount of shareholders’ capital denotes that Return on Equity must have been higher. Profits: Business with inconsistent profit-making ability lower the shareholders’ equity as loss are recorded as a retained loss in the balance sheet. After a period of losses, the deterioration in shareholders’ equity can cause ROE to be extremely high when a company swings back into profits. Comparing two businesses within same industry with different capital structure becomes a challenge. Thus, analysts also use other ratios such as ROCE – Return on Capital Employed. What is DuPont Model? DuPont, a chemical company, introduced a method to calculate ROE and broke the equation into three parts: asset efficiency, leverage and operating efficiency. The method has three separate calculation of Net Profit Margin, Total Asset Turnover and Equity Multiplier. Net Profit Margin allows testing the operating efficiency by calculating the net profit relative to the net sales in percentage terms. Total assets turnover helps to determine the asset efficiency by dividing sales by total assets. Equity Multiplier is determined by dividing Total Assets by Common Equity, representing financial leverage. Read: Return on Assets ROE = Net Profit Margin x Total Assets Turnover x Equity Multiplier Where, Net Profit Margin = Net Profit/Sales Total Asset Turnover = Sales/ Total Assets Equity Multiplier = Total Assets/Common Equity A high ROE driven by an improvement in Net Profit Margin and Asset Turnover signals a positive sign for the business, but a rise in equity multiplier may indicate that business is taking further risks. When a business has sustainable leverage similar to its industry, it shows efficient management of capital sources. Even if the increase in Return on Equity is driven by leverage along with deterioration in other parameters, it would indicate that business has maintained its ROE largely due to an increase in leverage. 5-Step DuPont Model A five-step DuPont Model is a further extension of the basic DuPont model. This model argues that an increase in leverage may not always mean an increase in ROE. It was created to further segregate the net profit margin, allowing to assess the impact of interest payments of debt on net profit margins. ROE = (Tax Burden) x (Interest Burden) x (Operating Margin) x (Asset `Turnover) x (Equity Multiplier) Where, Tax Burden = Net Income/EBT Interest Burden = Earnings Before Taxes/Earnings Before Interest & Taxes Operating Income Margin = EBIT/Sales Asset Turnover = Sales/Total Assets Equity Multiplier = Total Assets/Shareholders’ Equity Do read: Interpreting ROE: A Quick look at Dupont Analysis
What is Free Cash Flow? Free Cash Flow (FCF) is a widely used financial metric used to gauge the company’s cash standing post taking the Capital Expenditure into consideration. Free cash flow is considered in valuation of an investment, entity or project. It is the amount of cash an enterprise is generating after incurring cash costs and cash investments for future growth. As the name suggests ‘Free’, it is the residual amount of cash left with the company after paying for taxes, inventory, plant and machinery, buildings etc. Investors prefer using this measure due to its effectiveness in assessing business operationally. It is calculated by deducting Capital Expenditure of the firm from Cash From Operations. CapEx includes the amount spent by the business in maintaining and growing asset base. Another way of calculating FCF requires the below equation. FCF = Net Profit After Tax + Non-cash Expenses - Changes in Working Capital - Capital Expenditure While general equation is: FCF = Cash From Operations - CapEx Non-cash expenses are included in the income statement, hence included in net income. The accounting principles/standards mandate to incur non-cash expenses like depreciation and amortisation of assets, stock-based payments, goodwill impairments etc. Since these expenses are non-cash, the total amount is added to net income of business to arrive at core cash generation by the enterprise. Changes in working capital reflect the transactions by a business in its core operations. Changes in Working Capital = Operating Working Capital (Previous) - Operating Working Capital (New) The difference between Operating Working Capital (OWC) and Working Capital (WC) is that OWC only includes items related to core operations like payments to suppliers, receipts from customers, inventory, prepaid expenses, deferred revenue. Moreover, cash movement on these items is yet to be realised, therefore it also referred to as Non-cash working capital. Operating Working Capital = Operating Current Assets - Operating Current Liabilities Operating current assets comprise accounts receivable, prepayments, inventory and some certain type of current assets in the balance sheet. Likewise, operating current liabilities include accounts payable, deferred revenue, income tax payable, accrued expenses. Change in working capital allows to determine the movement of operating current assets and liabilities. When the change in working capital is negative, it indicates a change in operating current assets is greater than operating current liabilities – cash was used, thereby reducing Free Cash Flow. Whereas a positive change in working capital implies operating current liabilities have increased more than operating current assets; cash application was limited, which increases Free Cash Flow. Moreover, if a change in working capital is negative, it suggests that the business needs further capital to grow as a result its working capital needs are growing. Likewise, when it’s positive, it means the business is able to fund its operations at a lower working capital intensity, possibly due to its bargaining power with suppliers, therefore working capital needs are depleting. Capital Expenditure is an expenditure that is capitalised on the balance sheet, and expenses are incurred in succeeding years and recorded in income statement. It includes the expenses incurred in maintaining and expanding asset base of the firm. Cash From Operation is available on the statement of cash flows. It means the net operating cash generation by the business. It includes payments to suppliers, receipts from customers, taxes paid, interest cost etc. Good Read: Importance of Free Cash Flow; Glance at 3 Companies with Consistent Free Cash Flow What does FCF imply? A negative Free Cash Flow is a common feature in small and growing firms since they are at a stage wherein cash burn intensity is higher due to a range of factors, including growing customer base, executing agreements with suppliers, stacking-up inventory, product development, expenses in research and development. Read: Galaxy to Slash Total Mined Material By 40 per cent to Prevent Intensive Cash Burn Small and growing enterprises boast high capital needs and often seek funding from markets. Put another way, new businesses monetise their negative cash flows by additional funding from investors or lenders. But how long investors or lenders can fund the business? It becomes crucial for enterprises to enter a cash flow positive state, which further stems the belief of expected future cash flows from the firm. Raising equity also means a dilution of interest in the company, and excessive use of debt capital increases bankruptcy risk. Watch: Car Rental Giant filed for Bankruptcy | ASX Market Update When businesses are incurring CapEx, the intent is to generate future cash flows and earnings through the use of asset for purposes like expanding product line, new variants of products, setting up a new factory. It is also important to study the growth plan of the business and expected need for capital over the investment cycle. Meanwhile, a company with preceding periods of positive FCF can record negative FCF due to high CapEx. However, if a business is not able to generate FCF over a long term period, it can be a problem for investors. A common investor expects companies to be cash generating machines, which also mean incremental earnings over time. Strong cash flows ensure higher probability of getting dividends. More on Dividends: Annual Dividend Yield It often becomes prelude for investors to select companies with a positive FCF. But investors also like businesses with high expectation of future cash flows due to numerous factors, including position in the industry, disruptive technology, innovative products, first-mover advantage. FCF of a firm also indicates the ability of the firm to meet its obligations like interest payments and potential need of capital over the near-term. What are the types of Free Cash Flows? Free Cash Flows to Equity or Levered Free Cash Flow Free Cash Flow to Firm or Unlevered Free Cash Flow Free Cash Flows to Equity: Free Cash Flows to Equity is calculated by adding issued debt and repaid debt to Free Cash Flow. It gives the amount of cash available with the company for shareholders and doesn’t indicate the amount distributed to shareholders. Free Cash Flow to the Firm: Free Cash Flow to the Firm refers to the amount of funds available for the shareholders and lenders/bondholders after incurring the cost of doing business, improvements to assets (capital expenditures), and investments in working capital.
What is Amortisation of Intangibles? Amortisation of an asset refers to an accounting process of spreading cost of an intangible asset over its useful life. Amortisation is applied alongside Depreciation to expense the cost of capital investments made in assets that are capitalised on balance sheet. Similar to Depreciation, it allows businesses to lower the tax liability since it is recorded on income statement as an expense. Intangible assets are recognised when cost of the asset is measurable, and future economic benefits are likely. A business should be able to measure cost of intangible asset to capitalise on balance sheet. Despite no physical substance, it should have legal rights over the asset and ability to transfer ownership. Intangible assets are expected to generate future economic benefits for an enterprise. Future economic benefits such as an expected increase in operating revenue of the company. Consider ABC Ltd has a five-year license to export specific goods in Japan, therefore ABC Ltd can generate sales through the license. But sometimes firms can develop intangible assets internally. Generally, it is research and development. Firms cannot capitalise expenses of a potential asset during the research, and expenses are recorded in income statement. During the development phase, firms can capitalise the expenses after: Internally generated goodwill is never capitalised, and goodwill can only be recognised during a business combination. Firms may generate intangible assets internally, but they should be able to measure cost to capitalise it. How are intangible assets measured? An enterprise can separately purchase an intangible asset, which is recorded at cost. Internally generated assets should be able to meet above criteria (image), and others are mostly measured at fair value. Cost of the asset includes the purchase price of the asset including any non-refundable expenses and excluding discounts. It also includes directly attributable expenses such as delivery and handling costs, installation costs, consulting fee etc. Costs will be capitalised when firms acquire asset or internally generate an asset through above criteria (image). A firm is also required to measure the asset in subsequent periods. Cost and revaluation models are applied to measure intangible in subsequent periods. In cost model, the asset is recorded at cost less accumulated amortisation and any impairment loss. In revaluation model, the asset is recorded at fair value minus accumulated amortisation and any impairment loss. Revaluation model is used when the firm can measure the fair value of the asset, which can only be measured in case of an active market for the asset. How are intangibles assets amortised? Intangible assets are amortised over the useful life. The amount of amortisation allocated to each year is the cost of the asset less residual value. It is important to have a useful life for the asset to allocate amortisation expense each year. After arriving at the useful life of the asset, firms may use any method of amortising an asset like the straight-line method, accelerated method or units of production method. The expected life of the asset can be estimated by assessing the longevity of the asset to produce gains for the firm. Businesses are also required to test the useful life of the asset each year since developments in the ecosystem could impact the life of the asset. For instance, a significant deterioration of a brand’s market share. What about indefinite life of intangible assets? Firms do not amortise assets that have an indefinite life, which are tested for impairments each year, and impairments are charged over the asset when required. In the event of sale of an intangible asset, it can be derecognised. Firms can also derecognise intangible asset when future economic benefits are not viable. Amortisation of goodwill – the debate continues IAS 38 says that internally generated goodwill should not be recognised as an asset since it is not identifiable and measurable. But goodwill arising due to business combinations is recognised and capitalised under IFRS 3 Business Combinations. IFRS 3 roughly says that goodwill is measured as the difference between consideration of the business and fair value of separable net assets acquired during the transaction. Just like intangibles with an indefinite life are tested annually for any potential impairments, purchased goodwill is also subject to annual impairment testing. Stakeholders and investors have been critical of the annual impairment approach used by corporations to evaluate accumulated goodwill. They noted that businesses are recognising impairment losses ‘too little, too late’. Consider a distressed business is acquired by a high performing business, the subsequent impairment test will be conducted on the combined entity, resulting in higher levels of internally generated goodwill. Although internally generated goodwill is not recognised in the balance sheet, it creates a premium as a difference between the book value of the net assets of combined entity compared to market value of combined business. Since combined entity has higher internally generated goodwill, there is no impairment charged, but the combined entity also has a distressed business in its books. The topic is also getting attention as impairment testing requires significant estimates and judgements that includes measurement of future cash flows. Management can also influence the timing and scale of impairment. In 2004, the impairment approach to goodwill valuation was introduced. Before that, goodwill used to be amortised, assuming that life is not more than 20 years. It was also required to test goodwill for impairment purpose under certain circumstances. Proponents of amortisation of goodwill say that using amortisation allows to avoid complexities involved in impairment testing and provide a steady decline in the recorded value of goodwill. Likewise, a steady charge to goodwill would alleviate the fluctuations of reported profits. The International Accounting Standards Board is conducting 2020 agenda consultation, and responses are welcomed by the body until 31 December 2020.