Asset / Asset life cycle management
Encyclopedia of Business Terms and Methods, ISBN 978-1-929500-10-9. Copyright © 2011 by Marty J.Schmidt. Revised 13 january 2012.
The Meaning of Asset
An asset is an item of value owned or controlled by the entity, which was acquired at a measurable cost. Major kinds of assets described in this entry include:
• Asset focused financial metrics (ratios) | • Indefinite life intangibles |
The total book value of an entity's assets are one side of the so-called balance sheet equation:
Assets = Liabilities + Owners Equities
Assets are what the entity has to work with to make money. Liabilities are what the entity owes, and equities are what the entity owns outright.
In business, company management and stockholders expect assets to justify their existence by producing value for the company, that is, assets are supposed to earn "returns." Financial statement metrics such as inventory turns, total asset turnover, or return on assets (ROA) use income statement and balance sheet entries to measure the efficiency and productivity of the company's assets in this way. Assets that sit idle or are otherwise unproductive are candidates for elimination.
The entire practice of acquiring, using, and getting rid of assets is known as asset life cycle management. The specific activities and goals involved in life cycle management differs among different kinds of assets, but generally asset life cycle management makes use of best practice methods for planning, accounting, deployment, usage, and maintenance, in order to reach these objectives for the organization's collection of assets:
- Ensure asset availability where and when needed.
- Minimize the risk of asset failure or breakdown before the end of asset economic life.
- Maximize the return (gains) from the asset.
- Ensure that assets are used productively throughout the asset's economic life, and they are not wasted or idle. This may involve working with other management to improve or re-design processes that impact asset utilization and asset productivity.
- Sell or otherwise divest the organization of assets that are idle or unproductive.
- Set priorities for asset acquisition and replacement and plan future expansion or reduction of the asset base.
Reaching these objectives requires good knowledge of
- Expected gains or returns from the asset.
- Asset life cycle total cost of ownership, including maintenance costs and operating costs.
- Advancements and the current state of technology for the asset class. This is obviously true for computing assets, of course, but is also important for
- Any major asset class based on constantly improving technologies, such as medical or laboratory equipment.
- Assets subject to changing requirements for fuel efficiency or emissions.
- Asset reliability and or/risks to asset availability.
- Available choices in asset leasing vs. buying, and the implications of each approach in terms of upgrade/replacement flexibility, responsibility for maintenance, position either on or off the balance sheet, and potential tax liabilities and tax savings.
- The asset's depreciable life and its economic life.
- The method of depreciation appropriate for the asset and whether or not other depreciation methods are permitted.
- The asset's fair market value at all time and its salvage value (residual value).
• Categories of Assets Explained
Capital Asset
Fixed Asset
Current Asset
Tangible Asset
Intangible Asset
Wasting Asset
• Assets on the Income Statement and Balance Sheet
• Example Income Statement With Asset Depreciation Expense
• Example Balance Sheet With Accumulated Depreciation For Assets
• Asset Focused Financial Metrics
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Categories of Assets Explained
For accounting purposes, important asset categories include
Capital Asset
The term capital asset is sometimes used interchangeably with fixed asset) A capital asset is a long-lived asset, usually a tangible asset. These items go on the company’s balance sheet (they are "capitalized"), are usually paid for out of a capital budget, and are approved for purchase through a capital review process. In order to qualify as a capital asset, the item may have an acquisition cost above a specified value, and it may need to have a useful life of more than one year. In balance sheet accounting, capital assets/fixed assets are reported separately from current assets. Fixed assets are considered less liquid than current assets (i.e., capital assets would be more difficult to convert into cash in the short term).
Fixed Asset
The term fixed asset is sometimes used interchangeably with capital asset or non current assets. These assets are tangible property owned by the corporation or entity, that is not used up, consumed, or converted into cash during normal business operations. Factory machinery, buildings, and large computer systems are typical fixed assets. In balance sheet accounting, capital assets/fixed assets are reported separately from current assets, sometimes in a category called "Property, Plant and Equipment."
Current Asset
Current assets include cash and other assets that are expected to be (or could be) converted into cash or used up in the near future, usually within a year. Accounts receivable and finished goods inventory, for instance, are often classified as current assets. Other kinds of current assets may include short term notes receivable, prepaid expenses, and deferred taxes.
In balance sheet accounting, current assets are reported separately from capital assets/fixed assets. Current asset figures from the balance sheet contribute to liquidity metrics for the company, such as the acid-test ratio, current ratio, and working capital.
Tangible Asset
A tangible asset is an asset with physical substance, such as land, buildings, computing equipment, or cash (and often, accounts receivable, even though it could be argued that they have no physical existence. "Tangible" simply means there is something there that can be touched. This contrast with intangible asset (below).
Intangible Asset
An intangible asset, like other assets, is an item of value owned or controlled by the entity, which was acquired at a measurable cost. Intangible assets, however, have no physical substance and are by definition not "touchable." Monetary assets such as cash or accounts receivable are generally not included in the category intangible assets. Even though they have no physical substance, intangible assets can and often do appear on the balance sheet.
Intangible assets are sometimes categorized in different ways:
- Purchased intangibles vs. internally created intangibles
A patent (the intangible asset), for instance, might result from the company's own internal research and development activities, or the right to use a patented design might be purchased from another owner. By accounting standards (such as GAAP in the United States), purchased intangibles are usually easier to value and establish as assets in financial reports than are internally developed intangibles. Internally developed intangibles are generally not subject to depreciation. - Legal intangibles vs. competitive intangibles
Legal intangibles are sometimes referred to as intellectual property, including such things as trade secrets, proprietary knowledge (such as a proprietary soft drink formula), patents, trademarks, and copyrights. Intellectual property rights for such assets are legally defensible in courts of law.
Competitive intangibles are intangible assets that enable the company to compete effectively, ranging from such things as human capital—the skill and experience of the company's employees—to company reputation or brand recognition, to the establishment of collaborative activities and business partnership agreements. Competitive intangibles are generally not legally defensible (in contrast with legal intangibles). - Limited life intangibles vs. indefinite life intangibles
A company's brand recognition (a competitive intangible, above) is generally considered an indefinite life intangible asset, because it is expected to remain with the company indefinitely. By contrast, where there is a purchased right to use a patent for a specified period of time, the intangible asset (right to use the patent) is a limited life intangible..
Wasting Asset
Wasting assets include assets that are "used up" as well as assets that otherwise lose value after a specific time period. Assets in the first category include natural resources, such as timber, or oil, which are consumed or used up in the course of business. Assets in the second category include stock options which either expire at a certain date or, due to changing market conditions, become worthless (become "out of the money").
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Assets on the Income Statement and Balance Sheet
The acquisition and use of assets impacts both the company's income statement and balance sheet reports.
Income statement: An asset's full purchase cost generally does not go onto the income statement as an expense item, at least not all in one year. Instead, the accounting practice of depreciation provides a way to account for the purchase of long-lasting assets over a period of years. The idea is that assets have a useful life (depreciable life), over which they are used up or worn out, and that the owner receives the tax benefits of paying for the asset over those years instead of all at once. Each year of the useful life, a specified percentage of the purchase price is charged against income as a depreciation expense (the percentage is determined primarily by the depreciation schedule used for the asset). This lowers the company's reported income across a number of years and creates a tax savings for the company.
The example income statement below shows how depreciation expense can appear on an income statement. For a more complete coverage of the subject, see the encyclopedia entry on depreciation.
Balance Sheet: The balance sheet reports the book value of the company's assets. For most assets, this is the acquisition cost less accumulated depreciation for the asset, through the end of the current year of depreciable life. Each year of the asset's depreciable life, its book value decreases by the amount of depreciation (or amortization) expense, until it reaches its residual value.
The example balance sheet below shows how accumulated depreciation for several asset classes is subtracted from the initial cost of these assets, to result in the balance sheet book value.
The financial statement impacts described above refer most directly to situations involving capital assets and fixed assets. Note that the other categories of assets may also create income statement expenses and have their book value decreased annually, but with some differences:
- When the asset is an intangible asset with a limited life (e.g., the purchased right to use a patent for a specified period of time), the process of reducing its book value and charging an expense against income is called amortization instead of depreciation. Amortization expenses of this kind are usually derived with the straight line method applied across the asset's limited life.
- Indefinite intangible assets may also create an income statement expense and reduce in book value, but the reduction in value must usually be demonstrated by probing, or testing the current value. Damage to the company's brand recognition (if carried as an indefinite intangible asset) would represent such an impact, if the resulting damage to the company's ability to compete is demonstrated.
- Current assets (including cash, accounts receivables, and inventories) are generally not depreciated.
- Land assets are generally not subject to depreciation.
- Wasting assets may sometimes be depreciated according to a usage-based depreciation schedule rather than a time-based schedule. That is, depreciation expense as a percentage of acquisition cost is estimated by the percentage of the asset used up or depleted during the reporting period.
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Income Statement With Asset Depreciation Expense Example
The example income statement below shows the appearance of asset depreciation expenses in three categories, one above the gross Profit line, and two below the gross profit line. The depreciation expense location on the income statement, in other words, depends on where and how the assets are used: Assets used for product production contribute depreciation expense to cost of goods sold (and thereby impact gross profit). Below the gross profit line, assets used in selling (e.g., store equipment) appear under "Selling Expenses," while general administrative assets (such as computer systems) appear under "General and Administrative Expenses."
Grande Corporation Gross sales revenues.................33,329 Gross profit.................................10,940 Operating expenses Operating income before taxes............... 3,130 Financial revenue & expenses Income before tax & extraordinary items..... 2,737 Extraordinary items Net Income (Profit).......................... 2,126 |
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Balance Sheet With Accumulated Depreciation For Assets Example
Below is an example of one company's balance sheet, showing a number of different asset categories. Note that asset categories may sometimes be listed in terms of asset categories listed above (e.g., Current Assets), sometimes in terms of what the asset is used for (e.g., Store equipment), and sometimes simply in terms of what the asset is ( e.g., Computer systems).
Grande Corporation Assets Liabilities Owners Equity |
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Asset Focused Financial Metrics (Ratios)
Management and investors will want to be assured that the company has the assets it needs to operate and grow. They will also want to be assured that the company is using its assets productively. To address these issues, analysts turn to financial statement metrics that attempt to measure the company's asset resources and their utilization.
Below are just a few examples of asset focused financial metrics of this kind.
Does the company have the assets it needs to operate and grow? One way this question is addressed is through so-called liquidity metrics, which focus on the short term. The three most commonly used liquidity metrics are current ratio, working capital, and the quick ratio (acid-test ratio). All three take their input data from balance sheet entries (the full balance sheet from which these entries are taken is presented in the section above, Sample Balance Sheet).
Working Capital
Working capital is a figure in currency units (e.g., $, €, £ or ¥) showing the difference between current assets and current liabilities:
Working capital = Current assets – Current liabilities
= $9,609 – $5986 = $3,623
How much working capital is sufficient? Company management will attempt to address that question by projecting their current liabilities for the next year and the expected cash inflows for the next year.
Current Ratio
The current ratio metric is built from the same input data as the working capital metric, except that here a ratio is produced by dividing current liabilities into current assets:
Current ratio = Current assets / Current liabilities
= $9,609 / $5986 = 1.61
This company's current ratio may be cause for concern among analysts, because a current ratio value of 2.0 is a generally used "rule of thumb" requirement for healthy liquidity. (While a current ratio under 1.0 might be considered cause for alarm).
Quick Ratio / Acid-Test Ratio
The most severe liquidity test of the three presented here is the quick ratio, or acid-test ratio. This ratio is similar to the current ratio, except that the inventories figure is subtracted from current assets before performing division. The idea is that inventories are the least liquid of the current assets components:
Quick ratio = (Current assets – Inventories) / (Current liabilities)
= ($9,609 – $3,464) / $5986 = 1.03
Here, too, this company's acid-test ratio might be cause for concern. Analysts generally consider an acid-test ratio of about 1.1 as a minimum healthy level.
Other metrics focus on efficiency of asset utilization, or asset productivity, by computing ratios from data taken from both the income statement and balance sheet.
Inventory Turns
Inventories, like other assets are supposed to produce returns and not sit idle on the shelf. The Inventory turns metric uses an income statement item (Net sales revenues for the year) and a balance sheet item (Inventories) to approximate the number of times per year the company "turns" over its inventories. A higher number of turns is generally preferred, because (a) the storage and care for inventories is costly, and removing items from inventory completely means they have been sold, and (b) inventories tie up funds that might otherwise be used for some other means of producing revenue.
For this example, assume that Grande Corporation's net sales revenues for the year were $32,983, and that its balance sheet entry for total inventories was $5,986.
Inventory turns = (Net sales revenues) / (Inventories)
= $32,986 / $5,986 = 5.5 turns / year
Management may set specific target turn rates, and the value of reaching these targets can be readily calculated.
Total Asset Turnover
Companies acquire assets in for the purpose of generating revenues. Total asset turnover compare directly the revenue "returns" from the company's assets (sales revenues) to the book value (balance sheet value) of the assets. The higher the asset turnover rate, the shorter the time required for assets to generate their own value in sales. This example uses the same net sales figure ($32,983) as the previous, along with the sample balance sheet total assets figure of $22,075.
Total asset turnover = (Net sales revenues) / (Total assets)
= $32,983 / $22,075 = 1.49 turns/year
If the company's turn rate is out of line with industry standards, analysts will want to know why. (Companies in the same industry sometimes do have quite different business models, and this could account for the difference between one company's metric and the rest of the industry).
Return on Total Assets
The most wide ranging asset-focused metric is simply return on total assets. This is simply the company's net income for the year (bottom line of the income statement) divided by total assets from the balance sheet.
Assuming that Grande Corporation reported a net income (profit after taxes) of $2,126 for the year, and the balance sheet total assets were $22,075, Return on Total Assets (ROA) is:
Return on total assets = (Net Income) / (Total Assets)
= $2,126 / $22,075 = 9.6%
Investors and senior management will compare this ROA with other companies in the same industry, with year to year changes in this company's ROA, and with other opportunities for earning returns from the same value assets.
For more coverage of these and dozens of other financial metrics, along with working examples and templates, see Financial Metrics Pro.
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