Woolworths* is once again impairing the value of David Jones, this time by AU$437.4m. I want to dig into not only what this means, but why a company may decide to impair an asset it recently bought.
When an asset is purchased, it is automatically recorded on the asset side of the balance sheet, albeit in various pieces. For example, the value can be classified as cash, property, plant and equipment (PPE), inventories and the like. There is, of course, also goodwill. Determining this requires a complex calculation, but a good proxy for finding this value is calculating the difference between the purchase price and the net asset value (NAV) of the business being bought. NAV is calculated as all assets less all liabilities.
Goodwill always worries me. While it is real in that it was paid for, it provides no real benefit compared to the other assets of the business. That said, in a sense goodwill represents the potential the business has for making a profit in the future – and when we buy a business, we’re truly just buying future profits.
Then, when the purchase goes wrong, this new shiny asset (in this case David Jones) may be impaired.
Impairing an asset is essentially reducing its value on the balance sheet. This will not reflect in the company’s (in this instance Woolies’) headline earnings per share (HEPS), but it will reflect in earnings per share (EPS) due to how accounting rules work. (HEPS excludes one-off events, which ideally is what an impairment would be.)
Further, management will often claim that shareholders shouldn’t worry, as an impairment is not a cash event in that the reduction in value doesn’t involve actual cash movements, just an accounting treatment. They are correct but, as I always point out, it certainly was a cash event when the asset was purchased using cash, and then recorded on the balance sheet.
But then why impair an asset at all?
Many asset values decrease anyway because, due to its finite lifespan, PPE will depreciate over time as it gets used.
But remember the equity value that comes out of the balance sheet: NAV (which is all assets less all liabilities). This is also known as shareholder equity, as this is the breakup value of the business if it goes bust.
Now, a number of other ratios that are used by management and investors for analysis purposes use this equity. For example, a very popular one is return on equity (RoE), which is very useful for determining the net income being generated from equity. Return on assets (RoA) is another useful financial indicator often used by those valuing a business. It’s calculated by dividing a company’s net income by its total assets. I must also point out that these ratios are also often used when determining director and management bonuses.
Let’s use an example of a business with assets of, say, R750 and liabilities of R500. This would leave equity of R250. Then let’s say net income is R50, making for a RoE of 20% (R50 net income on R250 equity). The RoA would be 6.7%.
But what if we impaired the assets by, say, R100 to R650 because we bought a dud business? Assets are now R650, while liabilities remain exactly the same, and equity is now only R150. Net income remains R50, as this impairment is just an accounting transaction, not operational. RoE is now 33.3%, instead of 20%, and RoA is 7.7%.
Boom. A simple accounting trick and the financial ratios (and maybe bonuses) suddenly look a lot better. Nothing illegal, but the hard truth remains: Management wildly overspent on an asset, and shareholders are left paying for it. And this impairment is seemingly much easier than actually buying a good asset at a good price.
*The writer owns shares in Woolworths.