How can the value of fixed assets affect a company's value, dividends, financial performance and, as a result, cash flow? This article summarizes information on determining the fixed asset value threshold, what can be the sources of fixed asset financing, what is the importance of the balance sheet in determining the company's value, and how the company's value is evaluated by third parties - banks, investors and partners.
Fixed assets are the part of the company that is not intended for sale, but will be used for more than one year, performing economic and financial activities. Long-term investments consist of intangible investments, fixed assets and financial investments.
According to MK regulations No. 877 "Regulations for bookkeeping" and MK regulations No. 775 "Regulations on the application of the law on annual reports and consolidated annual reports", the company must determine the value of fixed assets and keep their records. It is also necessary so that in case of sale, liquidation or reorganization of the company, it is possible to distribute the property belonging to the company. It should be noted that the company's investment in fixed assets affects the company's value and financial results.
The Law on Annual Reports and Consolidated Annual Reports defines what is a fixed asset and what are the criteria for determining it, but the value of fixed assets from which an inventory item can be considered a fixed asset is determined by the company manager. Therefore, the manager, evaluating the type of operation, financial indicators and development of his company, can determine the value threshold of fixed assets himself.
By determining the value threshold, the company can decide on the source of financing for the purchase of fixed assets, e.g.
- the existing funds of the company;
- financial investment in the capital;
- borrowing from credit institutions;
- production of fixed assets; financing of the support fund.
By carefully evaluating the economic situation in the country, the financial results of the company, as well as the available funds, the company can evaluate which of the financing sources will be more beneficial for it. If a company evaluates its operations, including how efficiently it uses working capital and what its cash flow cycle is, it can determine whether an investment in fixed assets with the company's funds will have a positive or negative cash flow effect on the company. Examples in practice show that there may also be situations in which it is more profitable for the company to purchase fixed assets with borrowed funds. Therefore, when investing in the purchase of new fixed assets, the company must be guided by the principles of prudence.
Interaction of indicators
The balance sheet and enterprise value should be analyzed in an overview with other items and indicators. Fixed assets should be given such a return that it could ensure economic activity, help the company operate in competitive conditions, generate positive cash flow and bring profit.
It is not possible to unambiguously evaluate only the item of fixed assets separately. The company's investment in fixed assets must be evaluated together with the sources of financing, for example, whether the company has invested only its own funds, whether it has taken loans from credit institutions and what impact it has had on the company's cash flow.
The company should regularly analyze indicators that indicate the success of economic activity, for example:
- profitability of the company;
- liquidity for companies;
- discounted cash flow;
- reason/s for turnover increase/decrease;
- reason/s for profit increase/decrease;
- total solvency ratio.
In order to monitor and control the company's economic activity, the long-term investment section is also used in various calculations, which also includes fixed assets. So, for example, to calculate the company's ability to pay off its total debts, the total solvency ratio can be used when selling current and fixed assets. Also, the composition of the long-term investment is used in the turnover ratio of the long-term investment. If the turnover indicators are calculated in days, it indicates the return of money invested in fixed assets to the company in the form of income. The smaller the number of days, the more efficiently long-term investments are used.
Third party vision
The value of the company is important not only for its management, but also for third parties, such as commercial banks, cooperation partners and investors. One of the most well-known criteria evaluated by the financial sector is the result of the company's own capital. If it is close to zero or negative, it will be more difficult for the company to attract additional financing from banks - negative equity indicates difficulties in the company's operation.
Banks regularly maintain data on the results or rating of their customers, so it would be valuable for the company to conduct research and compare the balance sheet results with the leading companies in their industry. It would also be useful to compare the structure of the balance sheet items, for example, what are the long-term investments, the composition and ratio of assets and liabilities. By finding out information about other companies in the industry, the entrepreneur can also evaluate his balance sheet and determine whether it is necessary to improve one of the evaluation indicators, for example, the profitability result. In this way, the company can also analyze the structure of the long-term investment composition of companies in the industry, that is, whether the companies have easily reprofiled production equipment, or whether the composition of fixed assets is small and the company is operating successfully.
If the company wants to attract investors, attention should be drawn to the fact that the financial calculations made (liquidity, profitability and other indicators) are current only on the specified date and their results change every day. Basically, the balance sheet records historical provisions as of a certain date. Therefore, investors will often conduct in-depth research (due diligence) in order to evaluate an investment object. During it, not only the results shown in the balance sheet will be evaluated, but also:
- strategy, business plan and its viability;
- cooperation agreements with customers and suppliers;
- structure of fixed assets;
- return on capital; cash flow;
- knowledge and qualifications of the company's employees;
- other off-balance sheet assets and liabilities.
An important aspect when evaluating the company's financial statements is whether the annual the report is prepared according to local or international standards. This is important because the annual report, which is prepared according to international standards, reveals wider and more detailed information about the company's financial position, especially in the context of leased fixed assets.
Therefore, the entrepreneur, when reorganizing - merging with another company or attracting investors - should conduct thorough research, taking into account a wider range of data and values. If an investor wants to invest in a company or an entrepreneur wants to sell it, there is a chance to get an expert assessment. The valuation will analyze all the internal and external factors that make it possible to determine the value of the company.
Accounting nuances
In practice, there are companies whose fixed asset position has a relatively small share in the balance sheet, but it continues to do business successfully. When determining the value of a company, it is wrong to be guided only by whether the company's balance sheet contains fixed assets. In order to evaluate the economic activity of the company, the company can prepare a business plan, in which all financial indicators are reviewed and analyzed in detail. Based on the business plan, it is possible to assess the dynamics of the company's financial indicators and the importance of capital investments.
The manager of the company should regularly assess the threshold from which the value of fixed assets is determined, because it may change as the company develops. Likewise, it would not be desirable for companies to set one general limit of the value of fixed assets, as it is set for economic activity performers. Since the sizes and development of companies are different, only the manager of the company can determine what threshold of fixed assets is optimal for the company.
If the changes that affected economic operators were to be applied to companies as well, only the position of the inventory object would change in the balance sheet. When a company purchases a material object that is planned to be used in the long term, it also needs to be listed for control purposes. This should be done in the list of low-value inventory and not fixed assets. If an item of inventory is purchased that does not meet the fixed asset value threshold, it should still be accounted for because it has value (and sometimes even a warranty) and will also be used by the business for more than a year.
Investments in fixed assets should be evaluated more critically especially for newly founded companies, because in the first years they will face significantly more purchases than in the following years of operation. Other companies may consider investing in fixed assets now or wait until a better offer comes along.
Companies should carefully evaluate the purchase value of fixed assets and review what costs should be included in the original value of fixed assets. The initial value of the fixed asset purchased for payment is the sum of the actual costs of the economic activity performer for the purchase, assembly or production of the fixed asset, minus value added tax (VAT).
Costs may include:
- sums paid to the supplier in accordance with the contract or invoice;
- additional compensation paid by the economic operator for the performance of work (separately concluded contractor agreement);
- various registration fees, state fees (including customs fees) and other similar payments made in order to purchase ownership rights to the inventory object (for example, the paid fee for registering property rights in the land book);
- costs associated with the delivery, assembly or installation of the fixed asset so that the fixed asset is in working order and ready for use in economic activity;
- calculated interest on borrowed funds, if any incurred until the fixed asset object is put into operation;
- other, not yet mentioned, expenses that are directly related to the purchase or production of the fixed asset.
It is important that the inventory object can also be a set of connected objects. It is one or more items that are intended for one or different purposes and have a common control, mounted on a common foundation. Thus, an item in a set can perform its functions only in a set with another item, but not independently.
If the objects are independent of each other (they can be used separately) and also have different periods of useful life, they are considered separately, permanently usable fixed assets.
When purchasing new fixed assets, a company or an economic operator should evaluate whether a set is being purchased that could be considered as one fixed asset. In the event that a set of fixed assets has been purchased, if one of the components breaks down, the company must replace the entire set of fixed assets. If one of the components is no longer usable, but its absence does not affect the operation of other objects, the set of fixed assets cannot be considered as a set.
Also, companies should remember that if it is not registered in the register of VAT payers, then the VAT calculated for the purchased inventory item must be included in the initial value of the fixed asset.
The impact created
According to the report "Latvian Economic Development Report" prepared by the Ministry of Economy for 2022, consumer prices in November 2022, compared to December 2021, increased by 21.4%. This is the fastest increase from January to November since 1994. That is why the increase in the prices of inventory objects was also observed.
Before purchasing a fixed asset, especially fixed assets whose value is significantly high, all influencing factors and risks should be taken into account. Determining the value of the fixed asset (1,000 euros) for all merchants could increase costs, but investments should also be evaluated in the context of external influencing factors.
- What is the general economic situation in the country?
- Is there a rapid increase/decrease in prices; is there stability?
- What is the situation in the foreign markets?
- What is the market supply / demand?
- Will it be possible to sell the fixed asset in case of an unsuccessful investment?
- Competitiveness of the company, create a positive cash flow and generally promote successful business.
The management of the company should carefully decide on the increase in the value of the fixed assets, because the value of the company is determined by various factors on the balance sheet and off the balance sheet. Also, the company must familiarize itself with its financial indicators, assess the impact of the purchase of fixed assets and define with which financial means the company intends to purchase the fixed asset. However, the most important thing would be to find out whether the return on fixed assets will be significant for the company and increase its competitiveness in the market.