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Investment

Understanding accounts series

Introduction

This is all about investment. However, if you got here and want to know what is a good safe bet on the stock market, you’re definitely in the wrong place. I’m going to be talking about investment in things called assets, which will yield some sort of return in your business in future years. Stocks and shares are similar in that you hope that they will give you a certain return in the future both in terms of their increasing value and in terms of income by way of dividends. My kind of investment – assets – is normally going to go down in value every year, and won’t usually produce an identifiable cash return.

What do we consider is an asset?

There is a technical definition and it talks broadly about an asset being an item of expenditure which produces economic benefits for the firm in the future. A bit jargony! Here’s an example – you make biscuits, you buy a biscuit-wrapping machine that has an operating life of 20 years. Over those years it is going to save you a packet (pun intended!) because it is going to do the hard work, meaning fewer workers, fewer broken biscuits and faster production. Economic benefits clearly. Twenty years is certainly the future. So our biscuit-wrapping machine is an asset. You could probably have reached that conclusion without my help, but it shows that there are very clear ways of describing what an asset is, that leave you in no doubt. Notice too that it doesn’t mention anything about its (the asset’s) value. So when you next invest in a new laptop, consider whether and what economic benefits you will get from it. To make the investment “worth it” it is going to have to generate extra savings or income for you over and above what the old one does. Most people just buy one because they want a new toy or because the old one’s broken. Vanity is nothing to do with accounts; and if the old one’s broken, you need to replace it, so actually it’s not really “new investment”. But supposing the laptop you have works fine, is coping with everything you are throwing at it. Do you really need a new one? Assets come in all shapes and sizes and range from cars, vans, buildings, computers, printers, furniture, cat5 cabling, advertising signs and personal number plates to factory equipment, boilers, heating systems, lifts and toilets. These are all tangible assets. You can touch them and see them: they exist physically in our world, in your business. The other main category of asset is intangible assets. You generally can’t see touch or feel these. By definition they are “untouchable”. These still have the same economic qualifier as the tangible assets (this used to be called fixed assets); the only difference is you can’t see them. Intangible assets include intellectual property, goodwill and brands. Very difficult to value, and apart from goodwill, few small businesses have intangible assets. Strange as it may seem, you may have been in business for years, have many customers who come back again and again, have a reputation that is second to none and yet have no goodwill in your accounts. It’s really only when you sell your business that the goodwill can be seen to exist because someone is prepared to pay more than the other assets themselves are worth. That extra is for goodwill. So the new business owner would have your goodwill in his business until it is eventually replaced by his (or her) own.

Depreciation

Assets usually wear out over time – they become less economically valuable. Accountants measure this wearing out by using a technique called depreciation and you’ll find more about that in a separate factsheet.

In the accounts

You won’t see asset investment anywhere in the profit and loss account because the money that is used to acquire assets is retained profits. Retained profits are those left after paying tax, so all you’ll see in the accounts is a lower bank balance – because you’ve spent the money – and a higher value of assets in the business. If your business is big enough to have to produce a statutory cashflow statement, you’ll see investment mentioned there.

Investment allowances

Tax rules vary widely when it comes to assets – what counts and what doesn’t, what tax relief you get and over how long, so I can’t really condense about 50 pages of rules into a single paragraph. However, the easiest investment allowance to get to grips with is the … Annual investment allowance Recently increased to £100,000, this lets you get tax relief on the first £100,000 of investment in tax qualifying assets every year. And if you really need to spend more than £100,000, there are ways of increasing it beyond £100,000 legitimately. Of course there are more rules about these allowances too though not quite as many as 50 pages worth. One automatic result of the annual investment allowance is an increase in deferred tax values. Please see the relevant factsheet for information about what deferred tax is and how it works.

How do we measure our return on assets?

The main performance ratio is the asset turnover ratio. There is another, return on capital employed (ROCE), although this latter ratio uses other numbers and is not exclusively an assets ratio. We will not be considering ROCE here. Asset turnover measures the number of times the sales figure can be divided by the net asset value. The higher this ratio, the higher the work rate of the asset. The underlying assumption is that £1 of asset produces £1 of sales and so if a business had an asset turnover ratio of just 1.0, it would be assumed that the equipment is not exactly working flat out! However, one with a turnover ratio of 10.0, could on the face of it, be working 10 times harder.

What things will affect the ratio?

First of all, how much you spent on the assets and how old they are now. For example, a machine that is five years old and still going strong will have a low asset value and be generating (hopefully) good sales and so a higher ratio. Secondly, the sale value of your product and the volume of sales every year. Thirdly, the rate of innovation in your market – new products may need new machines every year to cope and you would hope that the higher margin available to new entrants to new markets would compensate for the higher investment budgets Fourthly, whether your business operates 24 hours or just eight. Is the demand for the finished product strong enough? Remember this would also squeeze more efficiency out of your property costs as well if you were working two or three shifts! As with many ratios, there is no right answer. All you can do is calculate it and track changes in it over time and see if you are improving (becoming bigger than 1) or worsening (getting closer to or below 1).

Disclaimer

The information contained within this factsheet is factual but may contain opinion and express different ways of considering the topic. No responsibility is accepted by NGM Accountants for any losses or profits foregone by acting on or refraining from acting on any information contained within this factsheet or any factsheets to which this refers. Before making any decisions concerning the accounts of your business or enterprise, you should consult a professionally qualified accountant. Return to Advice page.