Depreciation: Case study

The various financial statements are of critical importance to investors and financial managers alike. Depreciation is not a cash expense like Labor and material costs; it is simply a bookkeeping entry on the Balance Sheet and on the Income Statement. Depreciation is deducted when computing net income, but it is not an actual cash outflow. Thus, we add it back to net income when determining the amount of cash the firm has generated.

For a case study, we will use PT XL axiata as an example. PT XL Axiata Tb (EXCL) is a telecommunications services and/ or telecommunications networks company. The Company commenced its commercial operations in 1996. The Company’s majority shareholder, Axiata Investments (Indonesia) Sdn. Bhd., is a wholly owned subsidiary of Axiata Investments. With the market value of 21.352 billion IDR, PT XL Axiata is the second largest Telecommunication provider in Indonesia.

From an investment standpoint, there is important trait that the telecommunication industries have,It has a virtual surety of tremendous growth ahead. Here is an area where annual growth rates are maintained year after year that elsewhere in the financial world would be incredible But as in the fierce competitive struggle in a tropical jungle, many of these exotic
growths can fade about as quickly as they bloom.

During 2007 to 2009, PT XL axiata was going through transformation to upgrade existing telecommunication signal capacity and coverage and investment in data transmission technology.

After  a few years, this company took the lead in the commercial development of the
telecommunication service provider. 

 

Table above shows the income statement for a PT XL axiata.  During 2008 period, the company managed to had its revenue and EBITDA increase 46%. But after EBITDA had adjusted for other other sources of income or expenses, the company had -15 billion IDR net income.

The company used depreciation methods to add the depreciation back to net income, therefore the company managed to have 3,379 billion IDR amount of cash which enable them to invest on data transmission technology and took the lead in Indonesian commercial telecommunication service provider.

 

Keep Them "Barefoot and Pregnant"

 

Indonesia's economic is currently facing the downturn. Its steady economic growth over the past five years has tapered off recently . Most of the price of stocks in Indonesia have escalated compare to its asset values and other earning assets which were exhibited by the high earning/ price ratios over the past five years now begin to fell sharply.

Indonesia's economic decline were caused by several major factors such as corruption, overregulation , inefficiencies of labor supply, etc. But above all of that, the author believes that there were systemic flaws occurred on the indonesia market which leads to highly inflated stock prices over the past years.

This escalated prices were caused by lack of law enforcement in Indonesian securities markets, lack of accountable financial education, and irrational investor sentiment which were propagated mainly by media or the other parties which have the access to the news.

All of the above factors have made "overpriced" equities which will leads to bubble that will burst eventually. The extreme case was the Indonesian economic crisis in 1997 which were mainly caused by the excessive private foreign debt and eventually lead the banking system in Indonesia into demise.

Whilst the government has always careful in managing government debt, 85% of Indonesia's foreign debt increase comes from private loans, and by December 1997 the number of debts to be repaid in private sectors in less than one year amounted to U.S. $ 20.7 billion (World Bank 1998).

This lead to private banks bail out and assets seizure by the Indonesian government which were financed by Indonesian recaps obligation. Up until now the the recaps obligation payment have yet not settle and most of the Indonesian people still have to pay the obligation.. While most of the bankers who received the bail-out had run away with the money or able to buy back its assets long after the crisis with deflated prices.

In this blog, the author hope to give a little contribution for a better Indonesian market with his naive financial opinion rather than keep them "bare foot and pregnant".

Depreciation

Depreciation in the Income Statement is a charge against income based on an estimate of the percentage of the original cost for fixed assets that has been used up in the production process during the period covered by the Income Statement.

Depreciation is not a cash expense like Labor and material costs; it is simply a bookkeeping entry on the Balance Sheet and on the Income Statement. The cash expense for fixed assets is incurred at the time of purchase.

On the Balance Sheet, Gross Fixed Assets (capitalized purchases of property, plants, and equipment) are listed at their purchase price. Accumulated Depreciation (sum of all depreciation charges over the life of the assets currently on the company's Balance Sheet) is deducted to arrive at Net Fixed Assets. Net Fixed Assets can be considered as an estimate of the value of those assets for the remainder of their useful lives.

On the Income Statement, the total Depreciation for the period for all Capitalized Assets is deducted from earnings as an Operating Cost.

For example, the piece of equipment may have an estimated useful life of five years and, therefore, will have no value at the end of the five years. Using a straight-line depreciation method, the annual amount that the company may deduct is ($500,000 - $0) / 5 yrs. = $100,000. There are several different depreciation methods and any accounting text can provide a more detailed discussion of their calculations and uses.

Income Statement

The Income Statement provides a summary of a company's operations and profitability over a given period of time. The income statement or statement of financial performance lists the firm’s revenues and expenses over a period of time. It shows the value of the products and services sold by the company for the reporting period, the costs incurred in achieving those sales, and the distribution of the residual income. The Income Statement provides an analyst with clues about the profitability of a company's operations. A typical Income Statement is shown below

Description of accounts

Whereas the balance sheet shows the firm’s assets and liabilities at a given point in time,

the income statement shows the flow of revenues and expenses generated by those assets
and liabilities between two dates.

Gross Profit. The first two lines of the income statement list the revenues from sales of products and the costs incurred to make and sell the products. Cost of sales shows costs directly related to producing the goods or services being sold, such as manufacturing costs. 

Operating Expenses.  These are expenses from the ordinary course of running the business that are not directly related to producing the goods or services being sold. They include administrative expenses and overhead, salaries, marketing costs, and research and development expenses. The third type of operating expense, depreciation and amortization, is not an actual cash expense but represents an estimate of the costs that arise from wear and tear or obsolescence of the firm’s assets.

Net income. represents the total earnings of the firm’s equity holders. It is often reported on a per-share basis as the firm’s earnings per share (EPS), which we compute by dividing net income by the total number of shares outstanding.

Capital Structure

The companies with the greatest growth prospects were under tremendous pressure on their need for funds and their ability to use funds productively.

The cost of developing the new products followed by the heavy marketing needed to introduce them to the customer was just the first heavy drain on capital needed to finance growth.

One of the fundamental questions in corporate finance is how a firm should choose the set of securities it will issue to raise capital from investors. This decision determines the firm’s capital structure, which is the total amount of debt, equity, and other securities that a firm has outstanding. The relative proportions of debt, equity, and other securities that a firm has outstanding constitute its capital structure. 

Consider the following investment opportunity. For an initial investment of $500 this year, a project will generate cash flows of either $1100 or $600 next year. The cash flows depend on whether the economy is strong or weak, respectively. Both scenarios are equally likely. Due to the project cash flows depend on the overall economy, they contain market risk. Suppose the current risk-free interest rate is 5%, and the market risk of the investment the appropriate risk premium is 10%.

The expected cash flow in one year is 1/2($1100)+1/2($600)=$850.

The net present value would be NPV = -500 + 850/(1 + 0.15) = 239.1
Thus, the investment has a positive net present value.

If this project is financed using equity alone, how much would investors be willing to pay for the firm’s shares? the market value of the firm’s equity today will be

PV (equity cash flow) = $850/ 1.15 = $ 739.1

The company can raise $739.1 by selling the equity in the firm. After paying the investment cost of $500, the entrepreneur can keep the remaining $239.1 as a profit.

Given equity’s initial value of $ 739.1 shareholders’ returns are either $ 360.9 or - $ 139.1.

The strong and weak economy outcomes are equally likely, so the expected return on the unlevered equity is 1/2($ 360.9 )+1/2 (- $ 139.1 )= 180.45 -69.55 = 110.9.

Financing the firm exclusively with equity is not the company’s only option. The company can
also raise part of the initial capital using debt. Suppose the company decides to borrow $500 initially, because the project’s cash flow will always be enough to repay the debt, the debt is risk free. Thus, the firm can borrow at the risk-free interest rate of 5%, and it will owe the debt holders 500 * 1.05 = $525 in one year.

Financial Statement Analysis part 2

 

Liabilities (Debt) and Equity

Current liabilities
This includes all current liabilities which thecompany is obligated to pay within the next 90 days
· ACCOUNTS PAYABLE – amount owed by the company for materials they have purchased on credit
· NOTES PAYABLE – amount the company has borrowed from banks in the form of short-term loans
· ACCRUED WAGES AND TAXES – for wages, the amount of wages earned by the employees, but not yet paid by the company; for taxes, the amount of taxes incurred by the business, but not yet paid to the respective governments by the company.

Long-term liabilities
These accounts include:
· LONG-TERM DEBT – amount the company has borrowed in the form of bonds sold to investors or banks
· PREFERRED STOCK – amount paid by investors to the company wanting a priority claim on the assets of the company
· COMMON STOCK – amount paid to the company by investors in exchange for a claim on the ownership of the company. Often, the number of outstanding shares is included on this line.
· RETAINED EARNINGS – value of the assets of the company in excess of the claims upon those assets (liabilities and stockholders' ownership). This does not represent cash held in the company.

The stockholders' (common) equity, also known as net worth, is the residual between the value of the assets and the value of the liabilities.
Assets - Liabilities = Common Equity (Net Worth)

Financial Statement Analysis part 1

Public companies are often widely held with investors ranging from individuals who hold one share to large financial institutions that own millions of shares.It  means that stock ownership is most investors’ sole tie to the company. How, then, do investors learn enough about a company to know whether or not they should invest in it? One way firms evaluate their performance and communicate this information to investors is through their financial statements

Companies use financial statements to record their asset investments, report their profitability, and describe their cash flow. There are three types of financial statements:
· Balance Sheet
· Income Statement
· Cash Flow Statement

A typical Balance Sheet looks like the example.

Assets

Assets are used to produce the products or generate the services that are sold by the company. Although all assets are stated in monetary terms, only cash represents actual money.

Some asset accounts represent the current (short-term) assets of Corporation. They include

· CASH – amount of cash held by the company in liquid bank accounts

· MARKETABLE SECURITIES – value of short-term investments held by the company
· ACCOUNTS RECEIVABLE – amount owed to the company by its customers who have purchased their products or services on credit terms
· INVENTORIES – amount of money the company has invested in raw materials, work-in-progress, and finished goods available for sale
· PREPAID EXPENSES – amount of expenses paid by the company before the expense is incurred. One example is rent on an office building paid at the beginning of the year for the entire year.
· OTHER CURRENT ASSETS – any other item related to production that does not fit into the above classifications.

Corporation also has long-term investments for the operation of its business. These asset accounts include:

· GROSS FIXED ASSETS – amount that the company paid for its property, manufacturing plants, and equipment when it acquired those assets at some time in the past
· DEPRECIATION – total amount of money that the company has charged as an expense for using the plants and equipment. Since this account is a deduction from an asset account, it is referred to
as a contra-asset account

· NET FIXED ASSETS – difference between GROSS FIXED ASSETS and DEPRECIATION. This is often called the book value of the fixed assets.

PROGRESS CHECK

1. Suppose that $1.2 million worth of equipment damaged before the company was able to package them. What asset account would be affected?
a) Cash
b) Accounts Receivable
c) Raw Goods Inventory
d) Prepaid Expenses
e) Gross Fixed Assets

2. What should the correct amount be for the Balance Sheet to be correct?
a) 319.4 million
b) 11.12 million
c) 55.93 million
d) 11.55 million
e) 3.545 million

3.  A customer  is no longer able to pay its bills. The amount to be written off as a loss is $1.9 million. What will the new ACCOUNTS RECEIVABLE amount be?

4.  This event will also affect an account on the other side of the Balance Sheet. What is this account?
a) Accounts Payable
b) Notes Payable
c) Long-term Debt
d) Preferred Stock
e) Retained Earnings