© 2000 John Petroff
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© 2000 John Petroff |
There are generally three lines of inquiry pertaining to fixed assets: turnover, rate of return and relative size. Each may reveal some problem. But, given the gross distortion that one can expect in the accounting numbers, as just discussed above, not much significance should be placed on the first two. A fourth approach is based on the income statement expenses to evaluate management care for their fixed assets.
1)- Efficiency:
To verify that the firm does not use excessive amounts of fixed assets to conduct its business, a fixed assets turnover ratio FAT is calculated
This ratio is compared over several years and with other companies in the industry. Likewise, the total assets turnover ratio TAT should confirm the assessment of efficiency with FAT ratio; if it doesn't, then one should look into the size of intangible assets and the level of current assets.
This approach is often conducted in the context of the DuPont break out [or in the context of the pyramid of coefficients, as it is known in Russia].A low ratio compared to prior years and other firms in the industry may be indicative of inefficiency (i.e. the company may have assets that are fully utilized). A high ratio compared to industry or prior years may be indicative of excessive use of assets that may result in breakdowns.
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Let us first calculate Timken Total Assets Turnover ratio for 1999. From Table T-6.2, The Timken Company - Balance Sheets 1998-99, we find that total assets in 1999 are $ 2,441.3 millions, and from Table T-6.1, The Timken Company - Income Statements 1998-99, sales for 1999 are $ 2,495 millions. TAT ratio is, therefore TAT = 2,485 / 2,441.3 = 1.02 as can be verified from the spreadsheet of ratios in Table T-5.16 ,The Timken Company - Ratios, which also reveals that TAT dropped slightly from 1998 when it was 1.09. If we compare these TAT values to industry statistics we find that Timken's TAT ratio is somewhat lower than the lower quartile values for the different industries to which Timken belongs: 1.1 for steel mills (SIC #3312) and 1.3 for motor vehicle parts (SIC# 3714), compared to 1.02 for Timken. This indicates that 75% of similar firms generate more sales per dollar of assets than Timken does. Now, let us calculate Timken Fixed Assets Turnover ratio for 1999. From Table T-6.2, The Timken Company - Balance Sheets 1998-99, we find that fixed assets in 1999 are $ 1,381.5 millions, and, as before, from Table T-6.1, The Timken Company - Income Statements 1998-99, sales for 1999 are $ 2,495 millions. FAT ratio is FAT = 2,485 / 1,381.5 =1.81 as can be verified from the spreadsheet of ratios in Table T-5.16 ,The Timken Company - Ratios, which also shows that this ratio decreased from 1998 figure of 1.99. Timken's FAT ratio is also lower than the lower quartile of comparable industries: 2.0 for steel mills and 3.1 for motor vehicle parts, compared to 1.81 for Timken. This ratio confirms that Timken has excessive assets compared to sales volume, and this excess is precisely in fixed assets. |
See review questions Q-10C1.1 through Q-10C1.5.
Return on assets will be extensively analyzed in Chapter 13 for its impact on profitability. Here, it is analyzed for an assessment of the adequacy of fixed assets. Return on assets can be calculated for fixed assets only ROFA or for total assets ROTA:
ROFA = Net after tax profit / Fixed assets
ROTA = Net after tax profit / Total assets
Return on assets is somewhat more informative than asset turnover because it incorporates expenses. A firm that has higher expenses, and thus a lower return on assets, can be generally considered less efficient. But, such conclusion can be erroneous in certain circumstance, as shown below.
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Let us take Delta Air Lines as an example for the calculation of these ratios. To calculate return on total assets, we take 1999 net profit after tax of $ 1,101 millions from Table T-6.11, Delta Air Lines Income Statement, and 1999 total assets of $ 16,544 millions from Table T-6.12, Delta Air Lines Balance Sheets. This give a ROFA of ROFA = 1,101 / 16,544 = 0.07 or 7% which can be verified in the ratios spreadsheet in Table T-5.21, Delta Air Lines Ratios. We note from the ratios spreadsheet that ROFA is exactly the same in 1999 and 1998. To judge Delta's performance we compare to ROFA ratios of other air carriers. AMR Corporation (i.e.American Airlines) had net earnings of $ 1,314 millions in 1998 on total assets of $ 22,303 millions for a ROFA of 0.06. UAL ROFA was also 0.06 (i.e. 1,235 / 20,963) in 1998. US Airways had a ROFA of 0.07 (i.e. 538 / 7,870). Comparing now to foreign air carriers: KLM had a 1998 ROFA of 0.03 (207/6300), and so did Air Canada ( 152 / 6,422). This indicates that Delta Air Lines slightly outperformed its domestic competitors, and did much better than its foreign competitors. For a more complete picture, it is necessary to compare Delta's ROFA to the entire industry. To do that we must use the RMA format which is built with profits before tax instead of profit after tax. Delta's profit before tax in 1999 was $ 1,826 as shown in Table T-6.11. This gives a ratio of profit before tax/total assets of PBT/TA = 1,826 / 16,544 = 0.11 or 11% The median RMA ratio for Profit before tax/Total assets for air transportation (SIC#4512) was only 2.5% and the highest quartile 9.2% for the entire industry. This shows that Delta had a very good year in 1999. Yet, there were many comparable firms that did even better: among the very large air carriers included in RMA statistics (i.e. 17 firms with sales in excess of $ 25 millions) 25% had profit before tax/total assets exceeding 16.6%. We continue with Delta Air Lines to illustrate the calculation of ROFA. We use the profit after tax of $ 1,101 millions from Table T-6.11, and we obtain the fixed assets of $ 11,467 from Table T-6.11.The ratio of profit after tax / fixed assets for 1999 is ROFA = 1,101 / 11,467 = 0.096 or 9.6% In 1998, Delta's ROFA was even better at 0.107 (i.e. 1,001/9,321). Once again, Delta's performance was better than AMR Corporation with ROFA of 0.091 (i.e. 1,314 /14,386) and UAL with 0.083 (i.e. 1,325/14,865), but not US Airways with ROFA of 0.147. However, US Airways reports no flight equipment under capital lease which all the other airlines do, and a note to the financial statements shows a liability under capital lease of only $27 millions. Yet, in current liabilities, US Airways reports Accrued aircraft rent of $ 166 millions, which suggests that off balance sheet rental does not allow comparison of US Airways fixed assets with that the other air carriers. See further discussion of airline industry comparison in Chapter 13. |
See review questions Q-10C2.1 through Q-10C2.3.
3)- Comparing size of fixed assets and size of equity:
A firm would be forced out of business if it had to liquidate fixed assets in order to repay debts. This implies that fixed assets must be financed with permanent capital: long term debt or equity. To verify that this is so, one can look at a common-size balance sheet and verify that the fixed assets represent a smaller proportion of total assets than the proportion of the total of long term debt plus equity in the balance sheet. This inquiry is a mirror image of the net working capital analysis, which also demands that a portion of current assets be financed by permanent capital (i.e. not current liabilities).
The proportion of fixed assets in total assets can also be compared between companies. If a company has a significantly smaller proportion of fixed asset to total asset, one would normally conclude that the firm is more efficient than the others. This could, however, be indicative that a company has an insufficient proportion of fixed assets to conduct its operations, or maybe the assets are old and fully depreciated. On the contrary, if, in conjunction with other ratios, it is shown that the company has too much capital tied up in fixed assets, one would conclude that the firm is inefficient. Remembering the likely distortions in these numbers, it would be strongly recommended that questions be asked of management, if at all possible, rather than relying of balance sheet numbers alone.
| To illustrate how fixed assets and debt proportions are compared, let us turn to Bell Atlantic. From Table T-5.8 Bell Atlantic Corporation - Normalized Balance Sheets, we note that, in 1998, 84% of assets are non-current (i.e. 67% fixed assets, plus 17% other non-current). This must be compared to long term debt of 32%, plus equity of 24%, deferred tax of 4% and other non-current liabilities of 21%, for a total of only 81% of non-current sources of funding compared to the 84% of non-current assets. This means that a portion of fixed assets is financed by short-term debt, which is clearly dangerous. By comparison, the non-current assets of companies in telephone communication (SIC# 4813) amounted to 57% of total assets (i.e. 39.9% of fixed assets, plus 5.5% of intangibles and 11.6 of other non-current assets), whereas non-current funding represented 62.3% of its total funding needs (24.6% of long term debt, 1.7% of deferred taxes, 31.3% of equity and 4.7% of other non-current liabilities), as reported in RMA 2000. In other words, fixed assets for most companies are covered by permanent funds. Not at Bell Atlantic. |
See review questions Q-10C3.1 and Q-10C3.2.
4)- Income statement expenses used to assess balance sheet fixed assets:
The indirect approach to studying management's strategy pertaining to fixed assets can be much better than looking at the fixed assets amounts themselves. First in line are maintenance and repair expenses. From a production manager's point of view, such expenses must be considered mandatory. Note that because they are stated in current monetary units, they are not distorted by inflation the way fixed assets and depreciation are. Expense data is therefore reliable. If these maintenance and repair expenses increase at a faster rate than all other items of the income statement and balance sheet, or if they are much larger than in other companies of the industry, there can be some problem. The problem can be that the equipment is getting too old, and its constant repair is expensive. In such a case, management must be asked why the equipment is not replaced in a timely fashion or with a better quality equipment. When clients are not served because of equipment failures, sales are lost. (Remember, sales must not be missed!)
If, on the contrary, maintenance and repair expense drops off in the current year, or if it is much smaller than in other companies in the industry, then a different problem is suggested. The company may try to save on this expense in order to boost its profit image. It should be obvious that skimping on maintenance is counterproductive: equipment will deteriorate faster in the future. However, fewer repairs can also be the result of better equipment. This is the type of inquiry that can only be answered by a physical inspection of an expert in the field. The analysis of repair and maintenance will be taken up again in Chapter 13, but whether maintenance and repair is too big or too small must naturally be studied in conjunction with the size of fixed assets components in the total assets of the firm, which is discussed in the next section. This relative size of fixed assets can be judged with such expenses as insurance.
See review questions Q-10C4.1 through Q-10C4.3.
See research assignment R-10C.1.
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