In the previous article of this series of basics of investing in equities, we took a look at one of the components of a balance sheet - 'Source of funds' and what its key constituents are. In the next few articles, we will take a look at the other component of the balance sheet - 'Application of Funds' and some of its key constituents.
In the previous article of this series of basics of investing in equities, we took a look at one of the components of a balance sheet - 'Source of funds' and what its key constituents are. In the next few articles, we will take a look at the other component of the balance sheet - 'Application of Funds' and some of its key constituents. As mentioned earlier, 'Sources of Funds' indicates the total financing that a company has done. In simple terms it shows how a company has got the funds which it has used to purchase its assets.
As such, Total assets = Shareholders' equity + total liabilities
Assets are resources owned by a company that help in generating cash flows. Broadly, assets are of two types- tangible and intangible. Tangible assets are assets that have a physical form. They can be seen or touched. Such assets include fixed assets and current assets. Intangible assets on the other hand are assets that have an economic value to an organisation but do not have a physical nature. A classic example of an intangible asset would be ‘brand value’. Some other examples that can be included in this list are goodwill, software and technical know-how.
In today's article, we will focus mainly on fixed assets. In the next few articles, we will take a look at the other components of 'Application of Funds' side of the balance sheet- current assets, current liabilities, investments and miscellaneous items.
What are fixed assets?
Fixed assets are assets that help companies reap economic benefits over a period of time. Assets such as land, building, plant and machinery are all fixed assets. Fixed assets cannot be liquidated easily. This is quite apparent when compared to current assets such as cash and bank account and inventories, which can be liquated or converted into cash relatively easily. It may be noted that intangible assets can also be part of this head as they benefit companies over a long period of time. More examples include trademarks, designs and patents.
Assets overtime lose their productive capacity due to reasons such as wear and tear, obsolescence, amongst others. As a result, their values deplete. Companies need to account for this depletion in value on a yearly basis. This amount is called as a 'depreciation expense' and is shown in the profit and loss account. It may be noted that it only represents deterioration in value and is not a direct cash expense. In due course of time, assets lose their value on account of depreciation on a year on year basis. As such, these amounts are accumulated and are reduced from cost of the asset.
Let us take up an example to understand the concept better. Below is the fixed assets schedule from Nestle's annual report for CY11. We can see three columns- gross block, depreciation and net block.
Gross block is the total value of all of the assets that a company owns. The value is determined by the amount it costs to acquire these assets. Any addition made to this gross block is what companies call as 'capital expenditure' or 'capex'. Deletions and other adjustments are largely on account of sale of fixed assets. As companies buy and sell assets on a regular basis, the gross block figures change every year.
In Nestle's case, gross block as 31st December 2011 (being a calendar year ending company) stood at Rs 25.5 bn. At the end of CY10, i.e. as on 31st December 2010, the company has a gross block of Rs 18.5 bn. As such, we can see that the company incurred a capex of about Rs 7.3 bn (excluding asset deletions and adjustments), which was largely expended towards plant & machinery (Rs 5.5 bn) and buildings (Rs 1.1 bn).
Sourced from Nestle's CY11 annual report
Now, on subtracting the depreciation amount from the gross block, we get what we call as the 'net block'. From the above table we see a figure of Rs 8.4 bn, which is the total accumulated depreciation as of 31st December 2010 (or at the end of CY10). This increased to Rs 9.76 bn by the end of CY11. If we take the difference of the two figures we get an amount of Rs 1.345 bn. It may be noted that this includes the accumulated depreciation amount of those assets that have been sold during the year. On adding the amount back, the total would go up to Rs 1.637 bn (including the impairment loss on fixed assets). An impairment loss is a nonrecurring charge that is taken to write down an asset with an overstated book value. As such, the actual amount that was added to the accumulated depreciation figure during the year stands at Rs 1.533 bn. This has also been reported in its profit and loss account during the year.
You will also find the term capital work-in-progress (CWIP) in companies' balance sheets. This is usually mentioned below the net block. In simple terms, CWIP is work that has not been completed but has already incurred a capital investment. For example - a building under construction, purchase of plant and machinery but not yet commissioned or capital advances. This amount (CWIP), when added to the net block amount gives the total fixed assets of a company for a year. In case of Nestle, during CY11 it had a net block of Rs 29.9 bn.
Equitymaster.com is India`s leading independent equity research initiative