As an investor, financial statement forms the most important source of information for getting details about the company, its operations and profitability. Financial statements are prepared in compliance with accounting standards. However, generally accounting standards are prescribed from an accounting perspective and not a businessman perspective.
Most of the investors ignore what is written in company’s accounting policy. But there are few interesting things that an investor should keep in mind while analyzing financial statements of company.
In this article we are trying to bring out one interesting accounting policy which inflates profit of the company by inflating cost of fixed asset. That accounting policy is related to capitalization of borrowing cost on qualifying assets.
As per Accounting Standard 16 – Borrowing Cost,
Borrowing costs are interest and other costs incurred in connection with the borrowing of funds. Borrowing costs directly attributable to the acquisition, construction or production of qualifying assets, which are assets that necessarily take a substantial period of time to get ready for their intended use sale, are added to the cost of those assets, until such time as the assets are substantially ready for their intended use or sale.
The accounting policy simply states that a company can add finance cost to the cost of asset if the asset is going to take more than 1 year to construct. (We don’t have to get into details of qualifying asset etc.).
From the point of view of Accountant, there is nothing wrong with this accounting policy. But as an investor, we must look at the financial statement from Businessmen’s angle and not from accounting angle.
Let us understand implication of this accounting standard with a case study
Case study of Black rose Industries Limited (A small cap company with market capitalization of approx. 700 Crs.)
Black Rose Industries undertook to build a manufacturing unit through borrowing. Interest pertaining to borrowing utilised for project amounting to Rs. 188 Lakhs & 100 Lakhs was capitalized in fixed assets in FY 2012-13 & FY 2011-12 respectively.
What are implication of this accounting policy on financial statement?
- Profit and Loss statement – As interest is not charged to P&L, profit will increase by Rs. 188 lakhs even though interest cost is payable and is a charge to the company.
- Balance sheet – Cost of fixed asset (Property, Plant and Equipment) will increase by Rs. 188 Lakhs even though interest cost will not add any real value to the asset.
- Cash Flow – Cash flow from investing activities will increase since the interest cost is added in the cost of asset. (Though will not have any impact on total cash outflow)
Ratios which could get affected by this accounting treatment?
- Net profit margin Ratio (Profit After Tax/Sales) – Since the interest cost is not being charged to P&L, this ratio will look inflated. (Capitalized Interest cost will be charged to P&L over the life of asset through depreciation). (FY 2012-13 – Actual 1.9% Vs. Adjusted 0.6%)
- Interest Coverage Ratio (EBIT/Interest Cost) – Investor needs to add interest cost capitalized in the total interest cost while calculating interest coverage ratio as the main purpose of this ratio is to understand whether its earnings are sufficient to pay its interest obligation. (FY 2012-13 – Actual 2.83 Vs. Adjusted 1.27)
- Fixed Asset Turnover Ratio (Sales /Fixed Asset) – As interest cost is added to the cost of asset, this ratio may look depressed. (FY 2012-13 – Actual 3.29% Vs. Adjusted 3.55%)
- Projected Sales (Sales Turnover * Fixed asset addition) – While projecting sales, interest cost will have to be deducted from fixed asset as interest cost will not fetch additional economic value from the asset. If the same is not adjusted, investor may end up projecting higher sales and it will affect its future cash flow projection and thereby valuation (Projected sales – Rs. 12,868 Lakhs Vs. if Adjusted projected sales would be Rs. 11,925 Lakhs)
There are many companies which are currently capitalizing interest cost in accordance with this standard. However, investors need not be cautious about it while analyzing every company as the impact would be very significant only in companies where there is high capex with borrowings. It needs specific attention only while analyzing financials of a company, which have done heavy capitalization with borrowings in a particular year relative to its existing fixed assets.