Cash profit margin can't measure correct operating performance

ACCOUNTANCY

The figure of profit or loss provided in the financial reports of a firm is essential for evaluating the performance of its management in its stewardship function. Its computation is, however, complicated by the fact that while the economic life of a firm unfolds continuously over time, accounting periods chop up this continuous flow at arbitrary points.

Therefore, it will almost certainly be the case that the benefit of certain expenditures and the sources of certain revenues will overlap across the boundaries of accounting periods. In accounting, we adjust for this overlap through the process of depreciation.

Assets that provide benefits for more than one accounting year are classified as fixed assets. They include tangible property, plant and equipment and intangible assets such as goodwill, brand and software for use in production or administration. Their cost of acquisition must be allocated over their entire useful life.

If the company expects to realise a part of the total cost on disposal of the asset when it will be retired permanently from use, only the net cost, which is the acquisition cost less the residual value, is allocated over the useful life of the asset. The net cost is known as depreciable amount. The residual value of an intangible asset is usually considered zero.

With certain exceptions such as quarries and sites used for landfill, land has an unlimited useful life. Therefore, it is not considered a depreciable fixed asset. All other items of property, plant and equipment are depreciable assets. Depreciation of intangible assets is called amortisation.

The useful life of a depreciable fixed asset is the period over which the entity intends to use the fixed asset. The technical or physical life is the period over which the asset is expected to produce the intended result. Economic life is the period over which use of the asset makes economic sense. Technical and economic lives are specific to the asset. The useful life is specific to the enterprise.

Determination of the useful life of intangible assets is tricky. For some assets, it is difficult, if not impossible, to estimate the useful life with reasonable accuracy. For those assets, there is no foreseeable limit to the period over which the asset is expected to generate net cash inflows to the enterprise. International Financial Reporting Standards (IFRS) and US GAAP classify those assets as "intangible assets with indefinite useful life".

An example of intangible assets with indefinite useful life is a licence which, in practice, is renewable automatically on payment of a nominal fee. Suppose the government grants a licence to private radio operators on payment of a lump sum fee initially for five years.

Subsequently, the licence is renewed at an interval of five years on payment of a nominal amount subject to satisfactory performance in the previous five-year period. Here, it is appropriate to say there is no foreseeable limit to the period over which the asset is expected to generate net cash inflows to the enterprise.

Accordingly, the licence should be classified as an intangible asset with indefinite useful life. On the other hand, if the government distributes the licence through auction, the licence has a finite useful life, which is five years. Other examples of intangible assets with indefinite useful life are patents or brands acquired from another enterprise and trade marks.

If the useful life is finite, the enterprise should assess the useful life and allocate the depreciable amount over the useful life of the asset. Under IFRS and US GAAP, acquisition cost of assets with indefinite useful life are not amortised, they are tested for impairment annually.

Indian GAAP (AS-26) does not recognise the concept of an intangible asset with indefinite useful life. However, there is a rebuttable presumption that the useful life of intangible assets cannot exceed 10 years from the date it is available for use.

Therefore, intangible assets for which there is no foreseeable limit to the period over which the asset is expected to generate net cash inflows to the enterprise are amortised over a period not exceeding 10 years.

Companies have the option to select the depreciation method to be used to depreciate plant, property and equipment. They may select the straight-line method or any of the accelerated depreciation methods such as reducing balance method.

A company may use different methods for different classes of assets or for assets located at different locations. In practice, most companies use the straight-line method of depreciation. Intangible assets are also amortised using the straight-line method.

Under the Companies Act, 1956, in order to calculate divisible profit and directors' remuneration, depreciation should be provided at the rates provided in Schedule XIV of the Act. The schedule provides depreciation rates for both written-down value (reducing balance) and straight-line methods. The Act allows charging depreciation at rates different from principal rates specified in Schedule XIV, provided the fact is disclosed in financial statements.

According to the pronouncement of the Institute of Chartered Accountants of India, the amount of depreciation calculated according to the rates specified in Schedule XIV of the Companies Act, 1956, should be considered as the minimum amount of depreciation to be provided by a limited company.

The view has been supported by the Department of Company Affairs of the Union government. The provision in the Companies Act protects investors from unscrupulous managers. If a company charges lower than appropriate depreciation, it overstates profit. On expiry of the useful life, the asset will appear in the book, although it will not generate cash flow. Therefore, the law requires minimum depreciation to be provided while calculating the divisible profit.

Income tax law provides depreciation rates for charging depreciation on plant, property and equipment for computing taxable income, which forms the basis for determining tax liability. It prescribes the reducing balance method for charging depreciation.

The government uses depreciation under the income tax law as a tool to induce companies to invest in certain types of assets. Use of high depreciation rates results in deferment of tax liability. Companies do not use depreciation rates and methods stipulated in the income tax law for the preparation and presentation of financial statements.

Some analysts use "earnings before interest, tax, depreciation and amortisation" (EBITDA) to sales ratio, called cash profit margin, to measure operating performance. They prefer to use EBITDA margin because they believe that it focuses on cash operating items.

However, this assumption is not correct and is misleading because sales, cost of sales, and other operating expenses (other than depreciation and amortisation) often include non-cash items. Moreover, depreciation is a real operating expense, and it, to some extent, reflects consumption of resources. Therefore, cash profit margin is misleading and fails to measure the operating performance appropriately.

Some companies use "free cash flow" as a metric to measure operating performance. Free cash flow is calculated by adding depreciation to operating profit and deducting increase in investment in fixed assets and working capital. Free cash flows form the basis for estimating the intrinsic value of the company. A company that focuses on the intrinsic value of the company does not focus on the free cash flow from year to year.

A company may have low or negative cash flows in the initial years due to heavy investments that are expected to generate high free cash flow in subsequent years. Those companies use 'value' as the measurement metric. They compare intrinsic value at the end and at the beginning of the year.

The writer is prof, finance and control, at IIM-C