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How sound are a company's assets?

Getting behind a company's balance sheet and checking out the quality of its assets is one of the most powerful and revealing bits of research an investor can do
July 25, 2019

Investors tend to spend a lot of time looking at a company’s profits and sometimes its cash flows. Yet often the condition of its balance sheet and particularly the assets on it are not given enough attention. Checking out the soundness of a company’s assets can give you a great insight into the quality of its profits and can be a good way of keeping you away from bad businesses.

I’ve always maintained that a company’s annual report is the best piece of information on a business that an investor can get their hands on. They are freely available to everyone, yet very few investors read them and even fewer of them try to get the best out of them.

Looking at the condition of a company’s assets is a great example of what you can do with the numbers buried in the notes of a company’s accounts. I am going to show you how to look at a company’s stocks, debtors and fixed assets using these numbers and what they can tell you about how well a company is doing and how well it might do in the future.

 

Stock 

Sometimes called inventories, retailing and manufacturing companies need stock to run their day-to-day activities. They need to have enough stock to make their goods and keep their customers happy, but not so much that valuable cash resources are taken up by it and that prices have to be slashed to get rid of it, which can blow a hole in profits.

Stock tends to come in three different categories:

  • Raw materials - needed to make products.
  • Work in progress - goods that are being made but are not finished yet
  • Finished goods - products that are ready to sell.

By looking at these three categories of stock, but particularly finished goods, an investor can get a real insight into the health of a business. 

One of the first and most common tests of a company’s stock position is to compare it with its revenues or sales. A rising ratio of stock to sales can be a sign of a weakening business. Too much stock leaves a company vulnerable to a big profits hit as it might have to cut selling prices to bring stock levels down. A good example of this at the moment is fashion retailer Ted Baker (TED).

As we can see, its ratio of stock to sales has increased significantly over the past decade and particularly in the past couple of years. As always when looking at any ratio, you should look at its trend rather than any one year in isolation. Ted Baker clearly warrants closer inspection.

If you get a copy of Ted Baker’s annual report and go to the financial statements section you will see a number on its balance sheet for stock or inventories. Next to that number will be another number referring to a note in the accounts where you will find more information on its stock position. As with many things with analysing accounts, the notes are where the most revealing information can be found.

 

Ted Baker stock

£m

Raw materials

Work in progress

Finished goods

Total inventories

Sales

% sales

Finished goods as a % of sales

2019

9.0

1.1

215.8

225.8

617.4

36.6%

36.6%

2018

8.2

1.2

177.8

187.2

591.7

31.6%

31.6%

2017

6.4

1.3

150.8

158.5

531.0

29.9%

29.9%

2016

7.2

1.0

117.2

125.3

466.2

26.9%

26.9%

2015

6.8

1.4

102.9

111.1

387.6

28.7%

28.7%

2014

5.7

0.9

73.8

80.4

321.9

25.0%

25.0%

Source: Annual reports

 

We can see that most of Ted Baker’s stock is made up of finished goods and this has risen from 25 per cent of sales in 2014 to 36.6 per cent of sales in its last financial year. This is a big number in absolute terms and a big jump upwards in the trend. By looking more closely at the notes within the accounts we can find out that the losses from stock being written off has been getting bigger in recent years.

 

Ted Baker stock write-offs

£m

Stock w/offs

Operating profit

% of Operating profit

2019

11.8

57.3

20.6%

2018

8.5

70.9

11.9%

2017

8.5

67.0

12.7%

2016

4.2

59.4

7.0%

2015

6.0

50.4

11.9%

2014

2.3

40.6

5.7%

Source: Annual reports/Investors Chronicle

 

Only £2.3m was being lost to stock write-off in 2014. In 2019, this had increased to £11.8m. The risk is that with such a big stock position these losses could get bigger. The company issued a profit warning in June, and I see its rather ugly stock position as a source of further profit warning risk in the months ahead.

Doing similar analysis on other companies can reveal positive developments in a business and confirm that stock control is getting better. This seems to be the case with steam heating technology and pumps company Spirax-Sarco (SPX).

 

Spirax-Sarco stock position

£m

Raw materials

Work in progress

Finished goods

Total inventories

Sales

% sales

Finished goods as a % of sales

2018

53.0

25.7

81.9

160.6

1153.3

13.9%

13.9%

2017

47.9

24.0

73.5

145.4

998.7

14.6%

14.6%

2016

38.4

15.5

58.6

112.5

757.4

14.9%

14.9%

2015

30.6

13.3

48.6

92.5

667.2

13.9%

13.9%

2014

35.4

15.0

47.7

98.1

678.3

14.5%

14.5%

2013

35.8

15.6

52.8

104.2

689.4

15.1%

15.1%

Source: Annual reports/Investors Chronicle

 

The make-up of Spirax-Sarco’s stock position is slightly different to Ted Baker’s. Finished goods is still the biggest component, but there are significant raw material and work in progress components as well. The company’s stock position has been getting better as finished goods and stock in total has been declining as a percentage of sales.

 

Debtors

Debtors on a company’s balance sheet represent money that is owed to the company at the balance sheet date. By far the most significant component of debtors for most companies is trade debtors. This is money that has been booked as revenue – and profit – but where the money has not yet been received at the balance sheet date. It represents trade credit that is given to the company’s customers.

Some companies are very reliant on trade credit to grow their sales and profits. The danger is that they become too reliant and that some of their customers cannot pay their bills. Those debtors then turn bad and reduce a company’s profits.

One company that uses credit as a core part of its business strategy is retailer Next (NXT). Its online Directory business is very dependent on the credit it gives to its customers for sales, while the interest charged on it is a significant source of profits.

I have estimated the revenues and profits that are coming from a combination of its online business and interest income from credit (most of which I have assumed will come from the online business). You can see that Next is making some chunky profits here.

 

Next online revenues, profits and interest income

Year £m

2014

2015

2016

2017

2018

2019

Retail sales

1222

1374

1466

1515

1665

1918.8

Interest income

151.8

166.4

192.5

213.7

223.2

250.3

Total sales

1374

1541

1659

1729

1888

2169

       

Operating profit

358.5

376.8

405.2

444.1

461

513.9

Margin

26.1%

24.5%

24.4%

25.7%

24.4%

23.7%

Source: Annual reports

 

But is the company becoming too reliant on credit? As with stock, you should look at the relationship between trade debtors and sales. This has been trending upwards for Next in recent years.

Heading into the notes of Next’s accounts you can see that the amount of debtors that have been turning bad – and reducing profits – has been going up.

Next has one of the best annual reports out there and is very open with investors about what is going on with its bad debt position. It has a provision for bad and doubtful debts that make up its trade debtor position. 

The provision is netted off the gross debtor position to give a net debtor position. Every year the provision moves due to three main things:

  • The increase in debts that become doubtful. This is also expensed as a cost in the income statement and reduces profits.
  • The debts that cannot be collected and are written off.
  • The debts that are collected and reduce the provision.

At the end of January 2019, Next had £166m of doubtful debts, the highest figure since 2007. The amount by which profits were reduced also increased substantially and has exceeded the amounts seen in the last recession.

 

Next provision for bad and doubtful debts (£m)

Year

Opening

Charge to P&L

w/off

Recovered

Closing

2019

138.8

59.6

-25.5

-6.9

166

2018

137.8

28.5

-23.3

-4.2

138.8

2017

162.5

35

-52.8

-6.9

137.8

2016

140.8

28.7

-4.9

-2.1

162.5

2015

124.4

24

-5.2

-2.4

140.8

2014

125.6

29

-25.6

-4.6

124.4

2013

113.7

28.3

-11.7

-4.7

125.6

2012

108.8

29.9

-19.9

-3.3

113.7

2011

123.7

33.1

-42.3

-5.7

108.8

2010

117.2

38.2

-24.1

-7.6

123.7

2009

110.2

40.7

-26.7

-7

117.2

2008

106

40.1

-31.4

-4.5

110.2

2007

82.8

51.2

-25.3

-2.7

106

Source: Annual reports

 

Crunching the numbers further and looking at the hit to profits, we can now see that the reduction in profits as a percentage of Next’s total profits are now at levels seen in 2008 and 2009. Could they get worse?

 

Next bad debt expenses as a percentage of profits

Year

Charge to P&L

Recovered

Net profit fall

Directory/Online profit

Total profit

% of Online/Directory

% Total

2019

59.6

-6.9

52.7

513.9

761.9

10.25%

6.92%

2018

28.5

-4.2

24.3

461.2

780.2

5.27%

3.11%

2017

35

-6.9

28.1

429.5

849.1

6.54%

3.31%

2016

28.7

-2.1

26.6

405.2

880.7

6.56%

3.02%

2015

24

-2.4

21.6

376.8

825.7

5.73%

2.62%

2014

29

-4.6

24.4

358.5

756.9

6.81%

3.22%

2013

28.3

-4.7

23.6

302.1

677.9

7.81%

3.48%

2012

29.9

-3.3

26.6

262.6

622.2

10.13%

4.28%

2011

33.1

-5.7

27.4

221.9

586.5

12.35%

4.67%

2010

38.2

-7.6

30.6

183.6

550.8

16.67%

5.56%

2009

40.7

-7

33.7

157.6

493.3

21.38%

6.83%

2008

40.1

-4.5

35.6

164.4

545.7

21.65%

6.52%

2007

51.2

-2.7

48.5

143.9

518.9

33.70%

9.35%

Source: Annual reports/Investors Chronicle

 

Fixed assets

The other vitally important check on the soundness of a company’s assets is the condition of its fixed assets – assets such as plant and machinery and fixtures and fittings that are used in the business to generate revenues and profits.

Investors can check these out and answer some very important questions such as:

  • Is a company depreciating these assets at the right amount?
  • Are the assets being replaced?
  • How worn out are the assets?
  • How long are they expected to last?
  • How old are they?

You will find a great deal of information on a company’s fixed assets in the notes to its accounts that will help you answer these questions. I have shown the numbers for fixtures and fittings from JD Wetherspoon’s (JDW) accounts here. The company’s fixed asset balance is based on its gross asset value less their accumulated depreciation.

 

JD Wetherspoon Fixtures & Fittings £'000

2012

2013

2014

2015

2016

2017

2018

Opening

355963

389730

428075

481925

520781

541125

561801

Additions

40964

40881

58278

53108

37870

45473

56650

Disposals

-6245

-2536

-4429

-5989

-15926

-26266

-7187

Other

13929

13090

19784

6458

4240

1469

6536

Closing

389730

428075

481924

520781

541125

561801

617800

Average

372847

408903

455000

501353

530953

551463

589801

        

Depreciation

       

Opening

253772

270876

295738

321346

352014

374377

390380

Charge for the year

23633

25850

28887

33851

35881

37658

41524

Disposals

-5660

-2179

-3792

-5090

-12686

-20456

-6508

Impairments

-209

1191

137

2278

954

1272

1119

Other

-660

  

-371

-1786

-2471

-163

Closing

270876

295738

320970

352014

374377

390380

426352

        

Net book value

118854

132337

160954

168767

166748

171421

191448

        

Depreciation % of Avg

6.34%

6.32%

6.35%

6.75%

6.76%

6.83%

7.04%

Depreciation as % of starting

6.64%

6.63%

6.75%

7.02%

6.89%

6.96%

7.39%

Capex to Depreciation

173.33%

158.15%

201.74%

156.89%

105.54%

120.75%

136.43%

NBV as % of Gross BV

30.50%

30.91%

33.40%

32.41%

30.82%

30.51%

30.99%

% written down from cost

69.50%

69.09%

66.60%

67.59%

69.18%

69.49%

69.01%

Estimated life

15.8

15.8

15.8

14.8

14.8

14.6

14.2

Estimated age

11.5

11.4

11.1

10.4

10.4

10.4

10.3

Source: Annual reports/Investors Chronicle

 

Once you have these numbers you can do the following calculations:

  • Depreciation rate = annual depreciation charge/average original cost of asset

This tells us how quickly an asset is being depreciated. Short-life assets should have higher depreciation rates than long-life assets.

You take the annual depreciation rate and divide by the average of the opening and closing cost of the assets. For JD Wetherspoon, the current rate on fixtures and fittings is 7.04 per cent a year. Assuming zero scrap value, this implies that the assets are being depreciated over a life of just over 14 years (100/7.04)

  • Asset age = accumulated depreciation/annual depreciation charge

An ageing asset base can be a sign that a company has been cutting back on investing, which might have to be put right with a large replacement spending plan in the future. 

The average asset age is estimated at 10.3 years.

  • Cumulative depreciation ratio = accumulated depreciation/original cost

Alternatively, you can calculate the percentage of the original cost that has been written off as a way of seeing how worn out a company’s assets might be. JDW’s fixtures and fittings are just over 69 per cent depreciated.

  • Capex to depreciation ratio = additions/annual depreciation charge

Generally speaking, companies need to spend (known as capital expenditure or capex for short) at least their depreciation expense on replacing assets to keep their revenue-generating capabilities in good shape. A company that is investing to grow will spend much more. A declining business or one in difficulty will spend less. JDW spent 1.36 times its depreciation expense in 2018.

Like many financial ratios, they are more informative if compared over a reasonable period of time and with similar companies.

Depreciation is often dismissed as a non-cash expense, but it is a real cost. Manipulating depreciation can be a way for a company to boost its profits and can be spotted by a reduction in a company’s depreciation rate over a number of years. A declining rate can be explained by a number of factors:

  • Management extend the useful life of the asset. This is acceptable if the asset life was too low, but extending asset lives can be a source of profit manipulation by lowering depreciation expenses.
  • An increase in the amount of fully depreciated assets. This happens when the original cost number of assets contains some that have been fully depreciated. They are in the denominator of the depreciation rate ratio, but there is no depreciation on them in the numerator. This depresses the ratio. Large amounts of fully depreciated assets will need to be replaced and so a falling depreciation ratio due to this can be a sign of a big capex bill on the way. 
  • Estimates of residual value are increased. When it comes to pub fixtures and fittings this is unlikely, in my view.

JD Wetherspoon has one of the lowest depreciation rates in the UK quoted pub sector and looks to have a lot of worn-out assets. Is it manipulating its profits and flattering them with highly depreciated assets?

It’s easy to come to this conclusion, but a closer inspection of the business suggests this is not true. The company spends significant amounts of money each year on maintenance and repairs – which reduce profits – which goes a long way to explaining why it thinks its assets can last for longer. So when depreciation and repairs expenses are combined it does not seem to be flattering its profits. This is an example of the type of further analysis you can do when doing asset analysis and highlights how useful the exercise can be.