Developing a Basic Financial Model - Part VI: Long-Term Assets

In continuing in our series of fundamental concepts of financial modeling, and after taking a quick break to discuss the cash conversion cycle, I will now turn to another initial step of understanding how to forecast financial information. It is important that the reader has some familiarity of the three major financial statements (income statement, balance sheet and cash flow statement) that I covered in the prior three articles. If not, please read those first prior to continuing.

Long-Term Assets

The most common long-term asset for many industrial or manufacturing companies is property, plant and equipment ("PP&E"), also referred to in certain cases as fixtures, furniture, fixtures and equipment. PP&E is a category on the balance sheet that typically captures large pieces of equipment used to generate products. For example, a car manufacture would include all of the assembly line equipment like conveyor belts, robotic arms, power drills and lifts, etc., in this category. Also computers, desks, chairs, leasehold improvements, land and buildings would 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 totally dollar amount a company paid for all of its equipment and the net amount represents the book value of those same items after depreciation is included.

What is depreciation? Depreciation is a means to try to establish useful lives for various assets based on both accounting standards and the tax code, which have different approaches. For example, a computer may have a five-year asset life for both accounting and tax purposes, but a company car might be depreciated over 10 years for accounting and five years for tax purposes. It is not uncommon to have assets classes with disparate timeframes between GAAP and tax methods. The Financial Accounting Standards Board regulates GAAP, which constitutes the rules for accounting methods and the IRS is the regulatory agency behind the tax code. These two entities have different rules for governing depreciation methods and a general understanding of the differences is important prior to developing a financial model. Further, some analyses may get into very complex tax code understanding, so if your project calls for a deep dive into the tax impact of decisions, you should have a resource to address those questions. In many instances of simple financial modeling, however, the book method and the tax method are left the same and much of the aforementioned differences become moot.

To keep everything simple, financial modelers will take the entire net PP&E amount and use what is called "straight line" depreciation, or subtract the same depreciation amount from PP&E each year. For example, if the beginning 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 "residual value" (residual value, or salvage value, refers to the amount one thinks an asset would be worth at the end of the useful life to a company 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 depreciation expense per year. From a modeling perspective, it is easy to do an explicit depreciation calculation based on the accounting timeframes.

Companies build up the PP&E category through capital expenditures ("CapEx"). CapEx can either be improvements to existing equipment or new equipment purchases. To determine the amount of forecasted CapEx, there are two methods: explicit time horizon or ratio. Under the explicit time horizon, the financial modeler would have specific information on the spending needs of a company. For example, assume that the management team must spend $30 million equally over the next three years to upgrade existing equipment. In this case, you know that $10 million per year will be spent. If you do not know the exact amount, you would use a ratio to determine total CapEx, like a percentage of revenue. Let's assume that over the past few years a company has spend 5% of total sales in CapEx. Barring some specific news of the future, you might assume that the 5% ratio would hold for the foreseeable future. Another way some financial modelers will forecast CapEx, particularly for a company in the mature stage of business, is to have CapEx equal depreciation. This way, the net PP&E will stay the same over the forecasted horizon. Whichever method you choose to use should just make sense from an historical performance analysis as well as incorporating future expectations.

Another common long-term asset is goodwill, which is an intangible asset. Goodwill arises when one company buys another company for a value that is in excess of 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 at goodwill. The current accounting rules for goodwill dictate that the total amount be evaluated periodically for potential decreases in value. If there is a determination that the goodwill account is higher than it should be, the goodwill is considered impaired and a write-down is required. For financial models with a short forecast horizon (three to five years), the goodwill is rarely adjusted. Other intangible assets include patents, trademarks, copyrights, etc. and there are specific time periods by which these categories are amortized (amortization is depreciation but for intangible assets). Patents are generally amortized over their legal life, trademarks, while technically indefinite, are amortized over their useful lives, and copyrights are amortized over a time period reflective of the costs to obtain such copyright. From a financial modeling perspective, there accounts are very straightforward and require little to no adjustment over the forecast horizon.

There are other long-term assets, like deferred taxes, long-term investments and various prepaid rights. The category most spend time getting right, however, is PP&E. It is of paramount importance that you have a basic understanding of depreciation methodologies and CapEx rationale in order to correctly forecast PP&E. The vast majority of the other long-term assets are much easier to model and once the PP&E calculations are conquered, the rest of the long-term assets will seem like child's play.