When we look at a business’ balance sheet as analysts, we like to see that there are significant assets which, we think, give us some comfort should things go wrong later down the line. We especially place reliance on the non-current assets. But should we be so comfortable really?
The accounting equation
As a starting point in evaluating a business’ assets, we should keep in mind the accounting equation;
Assets = Equity plus Liabilities
The reason we should think about this equation is so that we fully understand that all assets have to be funded somehow. That funding could come from the owners/shareholders in the form of equity. Or it could come from funds borrowed from creditors in the form of liabilities.
Either way, it implies that holding assets comes with a cost to the business. So it makes sense that a business should have as few assets as possible while optimising its operations. That enables it to avoid incurring unnecessary costs in funding redundant assets.
That being the case, our desire to see significant assets in the balance sheet might be misplaced.
There are two major types of business assets; non-current assets and current assets and our approach to their evaluation differs depending on the type. In this article I will focus on the non-current assets and look at the current assets in a separate article.
What are non-current assets?
Typically, businesses that require non-current assets would have the following in their balance sheets;
- Property, plant and equipment (can include motor vehicles, furniture). These are sometimes called “fixed assets” or “tangible assets” because they are real and can be seen and touched.
- Intangible assets such as goodwill, patents, trademarks etc. These are invisible assets and so are quite difficult to value and may have no value in a liquidation.
- Investments (usually in subsidiaries and associates but could also be long-term financial investments)
The difference between non-current assets and current assets
The key difference between non-current assets and current assets is the role they play in the business’ operations and the reason the business acquired them initially. Non-current assets tend to be held for the long-term. They’re not expected to be converted to cash within the 12-months following the date of the balance sheet.
But that doesn’t mean they don’t have value. Or that they couldn’t be converted to cash quickly if the business needed cash desperately. Simply that it is not expected for that to happen.
The business acquired the assets initially to help make the business more productive over the long-term through their use. For example, machinery used in a manufacturing process. Or vehicles used in a transport company.
How do we evaluate non-current assets?
Each type of asset is viewed differently in an analysis. Our usual approach is to consider these assets from three perspectives;
- Are any of them possible sources of good collateral?
- Could the business sell some of the assets to raise cash in an emergency?
- What would they be worth if the bank had to liquidate the business and sell the assets to get repayment of its outstanding debt?
Evaluating property, plant and equipment
What must be remembered is that the fixed assets (property, plant and equipment) appear on the balance sheet at their original cost and not at their current values. With the possible exception of property, they will almost certainly have been depreciated from those cost values. So the figure on the balance sheet is not a good guide to their true worth.
With property it’s relatively easy to get a current valuation. Obviously, the thing to watch for here is the existence of any existing mortgages or legal claims or restrictions against the property.
Be careful with any property revaluation that is apparent on the balance sheet. This happens sometimes when a property has been owned for a number of years and the value is thought to have appreciated from that shown on the balance sheet.
The question that you have to ask is “who did the revaluation?” If it was done by an independent valuer, then you can assume the new valuation to be reasonably correct (although remember who paid the valuer to do the work). If the revaluation was done by the directors, beware. You can place no reliance on that valuation.
Plant and equipment is a little more difficult to evaluate as there may not be a ready market for used equipment even though it may be in good condition.
If the plant and equipment is very specialised or could become technologically obsolete very quickly, it would be safer to assume no value.
As a general guide with the plant and equipment assets, you might consider asking a local auctioneer to give you a view on what the assets might sell for at auction.
Remember too that the accounting rules may require that leased assets are brought on to the balance sheet. While there may be a value shown, there will be a corresponding lease commitment outstanding in the liabilities.
Example of virtually worthless fixed assets
A perfect example is the situation that Emirates Airlines finds itself in with its fleet of Airbus A380 planes. It has been the world’s biggest purchaser of the plane. But due to Covid-19 and the ensuing drop-off in air travel, the planes are no longer economically viable.
The reported plan is to reduce the fleet of 115 A380s by around 40. But other global airlines are in the same position so they’re not interested in buying them from Emirates. Each A380 costs in the region of US$430m and their depreciated value will appear on the balance sheet. But, in reality, they’re basically worthless if they can’t be used and no-one will buy them.
Evaluating intangible assets
This is always challenging because of the nature of the assets. How these values get into the balance sheet is a long story so I’m not going into that here. Suffice it to say that getting an independent valuation or a liquidation value is virtually impossible.
For that reason, most analysts would take the conservative approach and apply no value to intangible assets. Even though that may not be true in reality.
This too can be tricky to evaluate. If the investment is a financial one in something like government bonds, shares in listed companies or other long-term investments of that nature, the valuation is easy to ascertain from the market. Also, the asset’s value on the balance sheet will be its market value on the day the balance sheet was prepared as such investments are “marked to market” to reflect their true market values at the time.
On the other hand, if the investment is in a subsidiary or associate company which are not publicly listed, you would have to obtain the financial statements of that company to determine how likely it would be that the investment could be realised if necessary. That’s never going to be easy because you’ll always be working with historical financial information. So getting a clear picture of the value of the investment is very difficult in practice.
Generally, for these types of investments, you would be working with a consolidated balance sheet anyway so your concern would only be with investments in associates. On that basis, and assuming the balance sheet values are not significant, it might be best to ignore them in your evaluation.
A problem with fixed assets
Having said all that, it’s clear that the fixed assets, the property, plant and equipment, is where we can find most value. The problem with those assets is that they have often been acquired using debt. That debt would have to be settled first in a liquidation.
So, for us, the value that we really want to find is the current market value of the assets less the current debts/liabilities. You should be able to find that figure in the balance sheet as the total of long-term liabilities plus the current portion of long-term liabilities (found in the current liabilities section).