| In continuing in our series of fundamental | | | | depreciate $80,000,000 over a 20-year period, or |
| concepts of financial modeling, and after taking a | | | | $4,000,000 depreciation expense per year. From |
| quick break to discuss the cash conversion cycle, | | | | a modeling perspective, it is easy to do an explicit |
| I will now turn to another initial step of | | | | depreciation calculation based on the accounting |
| understanding how to forecast financial | | | | timeframes. |
| information. It is important that the reader has | | | | Companies build up the PP&E category |
| some familiarity of the three major financial | | | | through capital expenditures ("CapEx"). CapEx can |
| statements (income statement, balance sheet and | | | | either be improvements to existing equipment or |
| cash flow statement) that I covered in the prior | | | | new equipment purchases. To determine the |
| three articles. If not, please read those first prior | | | | amount of forecasted CapEx, there are two |
| to continuing. | | | | methods: explicit time horizon or ratio. Under the |
| Long-Term Assets | | | | explicit time horizon, the financial modeler would |
| The most common long-term asset for many | | | | have specific information on the spending needs |
| industrial or manufacturing companies is property, | | | | of a company. For example, assume that the |
| plant and equipment ("PP&E"), also referred | | | | management team must spend $30 million equally |
| to in certain cases as fixtures, furniture, fixtures | | | | over the next three years to upgrade existing |
| and equipment. PP&E is a category on the | | | | equipment. In this case, you know that $10 million |
| balance sheet that typically captures large pieces | | | | per year will be spent. If you do not know the |
| of equipment used to generate products. For | | | | exact amount, you would use a ratio to |
| example, a car manufacture would include all of | | | | determine total CapEx, like a percentage of |
| the assembly line equipment like conveyor belts, | | | | revenue. Let's assume that over the past few |
| robotic arms, power drills and lifts, etc., in this | | | | years a company has spend 5% of total sales in |
| category. Also computers, desks, chairs, leasehold | | | | CapEx. Barring some specific news of the future, |
| improvements, land and buildings would be included | | | | you might assume that the 5% ratio would hold |
| in PP&E. In most financial statements, a | | | | for the foreseeable future. Another way some |
| company lists both gross PP&E and net | | | | financial modelers will forecast CapEx, particularly |
| PP&E. The gross amount is the actual totally | | | | for a company in the mature stage of business, is |
| dollar amount a company paid for all of its | | | | to have CapEx equal depreciation. This way, the |
| equipment and the net amount represents the | | | | net PP&E will stay the same over the |
| book value of those same items after | | | | forecasted horizon. Whichever method you |
| depreciation is included. | | | | choose to use should just make sense from an |
| What is depreciation? Depreciation is a means to | | | | historical performance analysis as well as |
| try to establish useful lives for various assets | | | | incorporating future expectations. |
| based on both accounting standards and the tax | | | | Another common long-term asset is goodwill, |
| code, which have different approaches. For | | | | which is an intangible asset. Goodwill arises when |
| example, a computer may have a five-year asset | | | | one company buys another company for a value |
| life for both accounting and tax purposes, but a | | | | that is in excess of the net asset value. This |
| company car might be depreciated over 10 years | | | | "extra" value is, presumably, related to the |
| for accounting and five years for tax purposes. It | | | | positive intangible aspects of running a successful |
| is not uncommon to have assets classes with | | | | business, and the amount is placed on the balance |
| disparate timeframes between GAAP and tax | | | | sheet at goodwill. The current accounting rules for |
| methods. The Financial Accounting Standards | | | | goodwill dictate that the total amount be |
| Board regulates GAAP, which constitutes the rules | | | | evaluated periodically for potential decreases in |
| for accounting methods and the IRS is the | | | | value. If there is a determination that the goodwill |
| regulatory agency behind the tax code. These | | | | account is higher than it should be, the goodwill is |
| two entities have different rules for governing | | | | considered impaired and a write-down is required. |
| depreciation methods and a general understanding | | | | For financial models with a short forecast horizon |
| of the differences is important prior to developing | | | | (three to five years), the goodwill is rarely |
| a financial model. Further, some analyses may get | | | | adjusted. Other intangible assets include patents, |
| into very complex tax code understanding, so if | | | | trademarks, copyrights, etc. and there are specific |
| your project calls for a deep dive into the tax | | | | time periods by which these categories are |
| impact of decisions, you should have a resource | | | | amortized (amortization is depreciation but for |
| to address those questions. In many instances of | | | | intangible assets). Patents are generally amortized |
| simple financial modeling, however, the book | | | | over their legal life, trademarks, while technically |
| method and the tax method are left the same | | | | indefinite, are amortized over their useful lives, |
| and much of the aforementioned differences | | | | and copyrights are amortized over a time period |
| become moot. | | | | reflective of the costs to obtain such copyright. |
| To keep everything simple, financial modelers will | | | | From a financial modeling perspective, there |
| take the entire net PP&E amount and use | | | | accounts are very straightforward and require |
| what is called "straight line" depreciation, or | | | | little to no adjustment over the forecast horizon. |
| subtract the same depreciation amount from | | | | There are other long-term assets, like deferred |
| PP&E each year. For example, if the | | | | taxes, long-term investments and various prepaid |
| beginning total was $100,000,000 and accounting | | | | rights. The category most spend time getting |
| rules dictate that the assets are depreciable over | | | | right, however, is PP&E. It is of paramount |
| a 20-year period, the depreciation would be | | | | importance that you have a basic understanding |
| $5,000,000 per year, if there is no "residual value" | | | | of depreciation methodologies and CapEx rationale |
| (residual value, or salvage value, refers to the | | | | in order to correctly forecast PP&E. The |
| amount one thinks an asset would be worth at | | | | vast majority of the other long-term assets are |
| the end of the useful life to a company and this | | | | much easier to model and once the PP&E |
| value does not exist for tax purposes). If there is | | | | calculations are conquered, the rest of the |
| a residual value of $20,000,000, you would | | | | long-term assets will seem like child's play. |