Development of a basic financial model – Part VI – Long-term assets

Continuing our series on fundamental financial modeling concepts, and after taking a short break to discuss the cash conversion cycle, I will now move on to another initial step in understanding how to forecast financial information. It is important for the reader to be familiar with the three main financial statements (income statement, balance sheet, and cash flow statement) that I covered in the previous three articles. If not, please read them first before proceeding.

long-term assets

The most common long-term asset for many industrial or manufacturing companies is property, plant and equipment (“PP&E”), also sometimes called fixtures, fittings, fixtures and equipment. PP&E is a category on the balance sheet that typically captures large pieces of equipment used to produce products. For example, a car manufacturing would include all assembly line equipment such as conveyors, robotic arms, electric drills and lifts, etc. in this category. Computers, desks, chairs, leasehold improvements, land, and buildings would also be included in PP&E. In most financial statements, a company lists both gross PP&E and net PP&E. The gross amount is the actual total dollar amount a business paid for all of its equipment, and the net amount represents the book value of those same items after including depreciation.

What is depreciation? Depreciation is a means of trying to establish the useful life of various assets based on both accounting standards and the tax code, which have different approaches. For example, a computer may have an asset life of five years for accounting and tax purposes, but a company car may be depreciated over 10 years for accounting purposes and five years for tax purposes. It is not uncommon to have asset classes with disparate terms between GAAP and tax methods. The Financial Accounting Standards Board regulates GAAP, which is the rules for accounting methods, and the IRS is the regulatory agency behind the tax code. These two entities have different rules to govern depreciation methods and a general understanding of the differences is important before developing a financial model. Additionally, some analysis can go into a very complex understanding of the tax code, so if your project requires a deep dive into the tax impact of decisions, you should have a resource to address those questions. However, in many cases of simple financial models, the book method and the tax method are left the same and many of the aforementioned differences become moot.

To keep things simple, financial modelers will take the full net amount of PP&E and use what’s called “straight-line” depreciation, or subtract the same amount of PP&E depreciation each year. For example, if the starting total was $100,000,000 and accounting rules dictate that the assets are depreciable over a 20-year period, the depreciation would be $5,000,000 per year, if there is no “salvage value” residual or salvage value, refers to the amount one thinks an asset would be worth at the end of its useful life to a business and this value does not exist for tax purposes). If there is a residual value of $20,000,000, you would depreciate $80,000,000 over a 20-year period, or $4,000,000 of depreciation expense per year. From a modeling perspective, it is easy to make an explicit depreciation calculation based on accounting terms.

Companies build the PP&E category through capital expenditures (“CapEx”). Capital expenditures can be upgrades to existing equipment or purchases of new equipment. To determine the amount of forecasted CapEx, there are two methods: explicit time horizon or index. Under the explicit time horizon, the financial modeler would have specific information about a company’s spending needs. For example, suppose the management team must spend $30 million in equal parts over the next three years to upgrade existing equipment. In this case, you know that $10 million per year will be spent. If you don’t know the exact amount, you would use a ratio to determine the total CapEx, as a percentage of revenue. Suppose that in recent years a company has spent 5% of total sales on CapEx. Barring some specific future news, you can assume that the 5% ratio will hold for the foreseeable future. Another way that some financial modelers will forecast CapEx, particularly for a company in the mature stage of the business, is to have CapEx equal to depreciation. In this way, the net PP&E will remain the same during the forecast horizon. Whichever method you choose to use, it should make sense based on an analysis of historical performance, as well as incorporate future expectations.

Another common long-term asset is goodwill, which is an intangible asset. Goodwill arises when a company buys another company for more than the net asset value. This “extra” value is presumably related to the positive intangible aspects of running a successful business, and the amount is placed on the balance sheet as goodwill. Current accounting standards for goodwill dictate that the total amount be periodically evaluated for possible decreases in value. If the goodwill account is determined to be higher than it should be, the goodwill is considered impaired and write-off is required. For financial models with a short forecast horizon (three to five years), goodwill is rarely adjusted. Other intangible assets include patents, trademarks, copyrights, etc. and there are specific time periods for which these categories are amortized (amortization is depreciation but for intangible assets). Patents are generally amortized over their legal life, trademarks, although technically indefinite, are amortized over their useful life, and copyrights are amortized over a period of time that reflects the costs to obtain such copyrights. From a financial modeling perspective, the accounts are very straightforward and require little or no adjustment over the forecast horizon.

There are other long-term assets, such as deferred taxes, long-term investments, and various prepayment rights. However, the category that spends the most time correcting is PP&E. It is critical that you have a basic understanding of depreciation methodologies and the CapEx rationale to correctly forecast PP&E. The vast majority of other long-term assets are much easier to model, and once the PP&E calculations are mastered, the rest of the long-term assets will seem like child’s play.