Straight line depreciation and crooked line depreciation

Depreciation is one concept that allows a lot of creative management to do a lot of creative accounting. They are so creative that when they sit in front of the PC, the sound card leaps out of the motherboard and give them bearhugs.

Just to mention a few ways how depreciation can help make really ugly no.s look like The Swan, here are the popular tricks:

1) Increasing or reducing the depreciation life
2) Using crooked line depreciation
3) Depreciate things that are not supposed to be depreciable

Let's use the previous analogy of Ah Gou, the rogue taxi driver to see how each trick works.

In 1), Ah Gou decides that his taxi (which cost S$1000) can actually last 20 yrs, so assuming he still earns S$200, instead of booking only S$100 of profit, he can now book S$150 of profit, and the value of his taxi only drop to S$950 instead of S$900.

In 2), Ah Gou still depreciate over 10yrs, but he can depreciate the taxi less for the 1st few years, say, $80 for the 1st year, again he can book a higher profit of S$200 - S$80 = S$120. (In real life, usually company front-load depreciation so that subsequent years will look good, or so that they can sell their assets and book profits, like what SIA does with its planes)

In 3), say Ah Gou bought a phone for his personal use, but his clients got the no. and started calling him up to book his taxi. (Ok, mobile phones are not invented yet, but just an example ok?) He depreciate this cost of the phone (S$100) for 10yrs as well, so bcos of the phone, he earns more, say $250, but he only book the total depreciation of S$100 (car) + S$10 (phone) = S$110. And his profits increased to $140.

So as you can see, it is up to creative management and accountants what they want to do right? In the 3 examples, profits was easily increased by 20%-50% ($100->$120, $140, $150). Welcome to the World of Wall StreetCraft, where investors are the lowest lifeform and cannot help but fall into the ubiquitous booby traps.

See also Asset Turnover
and Fixed Asset and Depreciation

Fixed Asset and Depreciation

Fixed Asset refers to asset that are fixed. (that was helpful wasn't it.) They include stuff like

1) Property, Plant and Equipment
2) Building and Structure
3) Furniture and Fixture
4) Land

Basically they are assets that are held by the company for its business operations and are not intended for sale and are held on for the long term.

Different industries will require different amount of fixed asset (heavy industries like automakers, or transportation sector like railway will need a lot of fixed asset but online co.s will require minimal fixed asset) but recently the general trend is for corporates to reduce fixed asset.

Fixed assets are usually depreciated over 10-30 years to determine its cost impact on the business operation. The value of the fixed asset is then reduced by the amount that was depreciated.

Ok, analogy time. Imagine in the 60s, when policemen still wear shorts, and anyone can buy a car and use it as a taxi, let's say that Ah Gou bought one such car for S$1000 and decided to be a rogue taxi driver for 10 yrs.

So after 1 yr, assuming straight line depreciation and assuming he earned $200 in 1 yr, he would have booked a profit of S$200-S$100 = S$100 of profit (assuming no other costs) and his taxi would be worth S$900.

And after 2 yrs, the taxi will be worth S$800 and by the tenth yr it will be zero. That's straight line depreciation, where the depreciation cost per yr is the same.

See also Crooked Line Depreciation
and Why does the balance sheet balance?

Asset Turnover

Asset Turnover is probably one of the most important ratios that Wall Street invented but ironically also the most overlooked because it's regarded as not-so-sexy and desperately needs some extreme makeover.

If Asset Turnover is so ugly then why is it important then? Well, Greenspan is ugly too in case you didn't notice. But his fart affects the lives of millions, if not billions.

Asset Turnover measures the revenue that can be generated by $1 of the firm's asset. i.e. how much money can be made from $1 of asset. It is calculated by dividing Sales over Total Assets. Do not under-estimate significance of this ratio. If only you knew its power...

Ok, so much so for the lousy parody. To increase the firm's Asset Turnover while keeping Asset constant requires operational efficiency improvement. This cannot be done if the company is slack or has a lousy management.

This ratio also has some weight partly because both its components no.s are large no.s and large no.s are not easy to manipulate. (e.g. you can make your OP increase by 50% easily by pushing back some costs, but you cannot increase your sales 50% or decrease your assets 50% overnight.)

But this also means that comparison between different companies gets tricky. You get into situations when you try to compare Asset Turnover of Firm A at 1.0614x vs that of Firm B at 1.0615x. So which is better? You can't really say for sure, unless you are a Nobel Laureate for Applied Rocket Science for Not-So-Meaningful Financial Ratio Calculation.

Hence Asset Turnover may be useful only for historical comparison. If the Asset Turnover of a company has improved from 0.9x to 1.1x, you know that it has successfully generated more sales for every dollar of asset. This no an easy feat, especially if companies are already operating at full capacity. If they can increase Asset Turnover while at full capacity, it means that they somehow can make their existing facilities work harder (by streamlining processes or making existing pool of workers work harder etc) to generate the extra revenue.

However Asset Turnover cannot be used for companies that does not generate its revenue from tangible assets. (e.g. online businesses with no assets to speak of.) In such cases, we have no choice but to return to more popular measures like ROE or OP margin

See also Fixed Asset and Depreciation

and Components of the Balance Sheet