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Section 179 election – Immediate tax deduction for asset purchases

In financial accounting, when you purchase a long-term asset you will depreciate the cost over time.  However, for tax purposes you may expense some or all of the acquisition costs for property immediately.  One way of deducting the property is the section 179 election.  This election allows you to immediate expense up to $500,000 in qualifying purchases of long-term assets.

What property qualifies?
If you received the property by purchase for business use, it will generally be deductible.  It also does not matter if the equipment was new or used when you purchased it.  The property must be eligible, and this includes:

  • Tangible personal property, or non-real property (machines, office equipment, vehicles, livestock, etc.).  Investments and royalty-providing properties are not included.  Rental is excluded if you are not in the business of renting.
  • Off-the-shelf software (easily purchased by the general public, not substantially modified, nonexclusive license).
  • Qualified real property (beyond the scope of this post).

What property does not qualify?
Property that does not typically qualify includes land and improvements, some leased items, property used in lodging, heating and air conditioning units, items used primarily outside the United States, and energy property.

There are also restrictions on items acquired from related persons (either individuals or businesses).

How much of the property purchase may I deduct?
If the property is used 100% for business, you may deduct all of it.  If the property is not used exclusively for business:

  • It is only eligible if it is used above 50% of the time for business.
  • If it meets the 50% threshold, multiply the cost of the item by the percentage used for business.  Eg. a laptop costing $750 that is used only 80% of the time for business:  $750 x 80% = $600 allowed expense

Also, you will begin phasing out the deduction when it is applied to property that costs more than $2,000,000.  You will reduce the section 179 deduction dollar-for-dollar that the property cost exceeds $2,000,000.  For example, if you choose to apply section 179 to property costing $2,050,000, you must reduce the section 179 deduction by $50,000 (2,050,000 – 2,000,000 = 50,000).

You may also only use the election up to the amount of your taxable income.  If you have $400,000 worth of qualifying property, but only $29,000 in taxable income, you may only deduct up to $29,000 for section 179.

Planned use of section 179

  • You are not required to use all of the election.  You may have $500,000 or more of eligible property, but you may expense less than the section 179 limit.
  • You are not required to completely expense the total cost of an elected item.  If you have a $1,500 computer, you may only elect $750 if you would like.
  • You may split the deduction between different items.

On what form will section 179 deductions be reported?
When you have elected to apply section 179 to certain property purchased during the year, you will report the necessary data on Form 4562 – Depreciation and Amortization.

From period to period – Horizontal analysis

What is horizontal analysis?

Horizontal analysis is the comparison of a single financial statement item over a period of time.  Visually, if you were to lay out the income statements of a business side-by-side for the last five years, and you were to examine, for example, the net income for each of those years, you are “horizontally” examining a business.  The analyst needs to choose a reasonable baseline period according to the scope and requirements of a project or venture, and then compare each successive year with that base.

Horizontal analysis using financial statements

Suppose you are a manager, and you receive direction from the Senior Manager that you have a target goal of increasing net sales by 10% in 5 years.  After five years elapse, you sit down with the Senior Manager and examine the year-end results:

Base year – $10,000
Year 2 – $10,500
Year 3 – $11,200
Year 4 – $10,900
Year 5 – $12,300

How much has the company grown in sales each year?  Let’s take the same numbers and put them in percentage format, substituting 100% for the base year:

Base year – 100%
Year 2 – 105%
Year 3 – 112%
Year 4 – 109%
Year 5 – 123%

Since the base period year, you have increased sales by 23%.  You made your goal!

Horizontal analysis of ratios

Horizontal analysis is also useful in examining ratio trends.  What if you want to evaluate the performance of a stock over a period of time?  You might use earnings per share (net income / number of shares of common stock = earnings per share).

Base period – 42.17
Period 2 – 39.10
Period 3 – 37.77
Period 4 – 36.12
Period 5 – 36.86

This trend would indicate that, over time, the value earned per issued share is diminishing.

How about the price/earnings ratio?

The price/earnings ratio tells you what an investor is willing to pay per dollar of current earnings.  The higher the ratio, the more confident investors feel that the company will produce future growth (1).  Investors will also consider whether the stock is going to experience growth in dividends (2).  Thus, the P/E ratio is a reflection of whether investors feel that they will get their investment back in a reasonable time.

This is calculated as market value of share / earnings per share (1).

Base period – 21.2
Period 2 – 26.7
Period 3 – 23.5
Period 4 – 20.2
Period 5- 18.1

For the base period, for $1 of current earnings, an investor is willing to pay $21.20; in the second period, $26.70.  At the fifth period, it’s floating at a low $18.10.

What could you learn from this trend?  From the base period to the second period, it seems that investors began to have more confidence in the investment.  However, in period 3 and onward, the confidence began to wane.

Context

Now I will shake up the example.

Suppose that the following was the industry average for the P/E ratio:

Base period – 18.5
Period 2 – 18.2
Period 3 – 18.1
Period 4 – 19.2
Period 5 – 18.1

For the first four periods, it appears that the company is ahead in its industry for earnings.  Even when it stabilized, you cannot say that they are doing worse than their competitors.

How about we put this in graph form?

PE Comparison Chart
Now that you have the history of the company based on this ratio, you can see not only the trend of investor confidence of future returns, but you can discern that, generally, they felt more optimistic about the future earnings of the company over most of its competitors.

Another key indicator of the value of a share lies in how high the P/E ratio is currently when compared to the past. The higher the P/E ratio at the end of a horizontal examination range, the higher chance there is that the stock is overvalued.  Companies in a growth phase tend to have higher P/E ratios than mature companies do (2).  Given these thoughts, the sample company above might have been in a growth phase for the first few periods, but finally settled in maturity.

As always, it is important to study the whole context.  Analysis tools are only one face of the diamond.

(1) Price-earnings ratio (n.d.).  Investopedia.  Retrieved July 4, 2013 from http://www.investopedia.com/terms/p/price-earningsratio.asp

(2) Profit with the power of P/E ratio (n.d.).  Retrieved July 4, 2013 from http://www.investopedia.com/articles/basics/10/profit-with-pe-power.asp

Happy Independence Day!

Today is America’s Independence Day.  237 years ago now, the Declaration of Independence was authored by our would-be third president, Thomas Jefferson, and was signed on July 4, 1776 by representatives from the thirteen colonies in North America.  One of the signors, John Hancock, was so bold as to write his name in large enough letters that the King of England would not need his spectacles to read it.

Can you guess which country was the first to officially recognize our independence as a nation?

Morocco.  That’s right, Morocco.  They signed a Treaty of Friendship and Cooperation with us in 1787.  Wikipedia tells us far more than we really need to know.

Be thankful for your freedom, work to preserve it, and remember that you have many rights and privileges that others in the world do not have.  You are uniquely blessed.

For example, how many people can write a letter to the IRS and dispute the penalty and interest on their taxes?  Not many.

Mind the context (Financial reporting, analysis, and Lockheed Martin)

When you first approach financial analysis, you are tempted to think that financial ratios are the catch-all tool for determining the economic health of a company or project.  Financial ratios are insightful, and you can discern patterns in a business using horizontal, vertical, and comparative analyses that otherwise would not have surfaced.

Still, ratios have their weaknesses.  No one ratio tells all, and they must be used conjointly.  Even then, the ratios are only one part of the story.

For example, Company A has a debt-to-equity ratio of 0.7, while Company B has a debt-to-equity ratio of 1.  If this is all the information you have, which would you think is the healthier company?

Let’s add more information:

  • The companies are in separate industries
  • The industry average DTE ratio for Company A’s industry is 0.5, while for Company B’s industry it is 2.1
  • Company A has reached a steady state, while Company B is obtaining investments for future growth
  • Company A is known to put high pressure on management and employees for good performance numbers, while Company B is less rigorous and works to bring the best out of their employees

Does the analysis seem as simple now?  If all you had was a ratio, then it would seem simple; but now that you have context, you have different perspectives on Companies A and B.  A business is a whole business, and financial ratios do read vital signs, but not all of them.

If you check the annual reports for publicly-traded companies, you find that they discuss more than their financial statements.  For example, examine the latest Annual Report published by Lockheed Martin to its shareholders.  Their report to the shareholders, in addition to financial statements, includes:

  • Descriptions of their business divisions, including each segment’s percentage of consolidated net sales
  • Overview of 2012 accomplishments (eg. development of the United States’ third littoral combat ship, developing the protective aeroshell for the Mars Science Lab called Curiosity)
  • Their industrial liabilities (heavy dependence on U.S. government contracts, budget constraints influencing contracts, business risks not covered by insurance)
  • The unqualified audit opinion of Ernst & Young concerning their internal controls for financial accounting and reporting

These are just as important as the financial ratios or comparative analyses when deciding if you would like to invest in Lockheed Martin.

(And I promise, one day I will write a positive article about financial ratios)

Company liquidity – Net working capital

In an earlier entry I talked about liquidity, and how some liquid assets are not optimally liquid because you have restrained access to them.  In review, one measure of company liquidity is your current assets divided by your current liabilities; but those current assets include accounts receivables and inventory, which are poor substitutes for needed cash.  What also matters is how quickly you can collect on the receivables and sell the inventory items so that you have cash.  If you have an emergency, no one is going to accept $50,000 in accounts receivables or $20,000 in inventory as a payment.  We examined the cash conversion cycle, and looked at how it includes the element of time so a business owner or decision-maker may know when the less liquid current assets will finally become cash.

Still, no one ratio tells the whole story, and no ratio should be examined apart from a context.  Accounts receivables and inventory are liquid assets.  They are liquid because within a year’s time they will be cash (1, p. 72).  At some point the value of these assets will be usable for meeting obligations.  Over the course of business, the receivables will all be collected, and the inventory will be converted to sales.  Thus, the current ratio is a good general picture of a company’s operating position.

The current ratio has another weakness: it is not a dollar amount.  A decision-maker may look at the current ratio and see there is room to expand using their current capital, but then they need to decide how much they can spend.  The number that the decision-maker wants then is “net working capital.”

Net working capital is current assets minus current liabilities (p. 72). Assuming a positive amount, these are the assets that are not allotted to paying off your obligations, and the value of most of these assets may be quickly applied to the business operations. Net working capital can be safely spent on business activities without a conflicting claim against it.  Still, not all current assets are equal.

The next question is this:  Which current assets and current liabilities relate to cash flow?  Also, how are they related?

We know, for example, that accounts receivables relate to cash flow because they will be converted to cash before the year is over.  However, prepaid insurance does not create cash flow (seeing as you’ve paid for it already), yet it’s a current asset (p. 72).  I can’t imagine a scenario where you would use your prepaid insurance to pay off a vendor.  Thus, prepaid insurance cannot be used to calculate working capital.  The proper definition for net working capital is more restrained than current assets minus current liabilities.  The formula is as follows (p. 72):

Net working capital = Current Assets + Accounts Receivables + Inventory – Accounts Payable

Now the decision-maker knows how much in cash or cash-convertible assets he has leftover after accounting for debts owed.  For example, suppose he knows that he has $25,000 in cash, $12,000 in accounts receivables, $19,000 in inventory, and $39,000 in current liabilities.  That leaves him with $17,000 in net working capital.  He now has more useful information.

So then, how does knowledge of working capital relate to a business?

Working capital is one indicator of the season of a business.  When a company has low net working capital it may mean, for example, that sales have been short, that they are in their slow season, or are able to do little more than meet current obligations.  At this point, a business has few resources of its own to take on new business ventures, and an emergency could put the company in a bind.  A business with low net working capital is restrained to “business as usual,” and perhaps has to move forward with very fine movements (unless they manage to obtain financing to increase capital).  However, a high amount of working capital means resources available for growth, expansion, new projects, product development, etc.

It is also possible for a business to have negative net working capital.  When a company has negative net working capital, it means that every dollar of current assets is “tied” to an obligation somewhere (2), and most of the company’s energies are probably involved in keeping up with the demands already laid on it.

While the current ratio will tell you the proportion of current assets to current liabilities, the net working capital will tell you how much usable capital you have that is not already obligated to a liability, and gives needed information for present and future spending decisions.

(1) Friedlob, George T., & Schleifer, Lydia L.F. (2003).  Essentials of Financial Analysis.  John Wiley & Sons, Inc.  Hoboken, New Jersey.

(2) Keythman, Bryan (n.d.).  How to calculate and interpret a company’s net working capital.  The Houston Chronicle.  Retrieved June 28, 2013 from http://smallbusiness.chron.com/calculate-interpret-companys-net-working-capital-16051.html

Winning at networking: Give, don’t take!

I came across an interview presented by Knowledge@Wharton with Wharton management professor Adam Grant on networking.  He divides all networkers into three categories:  The Taker, the Matcher, and the Giver.

  • Taker – Only networks to get, and gives as little as possible, believing that this is the way to achieve their goal
  • Matcher – Tries to strike a balance between giving and taking to achieve fairness
  • Giver – Less concerned about receiving, and wants to help who they can

Grant made the following observations concerning network sizes:

  • Takers have very broad networks, because they are constantly burning bridges
  • Matchers have very narrow networks, restricted to those that have either helped them, or can help them, and so have the fewest opportunities
  • Givers have a broad network because they are always helping, and so they build goodwill that will blossom into reward in the future

Who is it that comes out on top, and who comes in at the bottom?  Some will say that givers end up on the bottom because they risk burnout and exploitation.  Others say that takers are at the bottom because they burn their bridges, and it’s the matchers that are the most successful because they know how to give and protect their own interests (1).

According to Grant, both statements are wrong.  Givers, if naive and unwise, are targets for the takers; but takers fail to build long-term trust; matchers, however, have narrowed their opportunities by restricting their network; and a good networking giver knows how to maximize giving at the lowest cost to self, and in the long-term rises to the top (1).

That is the balance:  Maximizing giving at the lowest cost to self.  Anyone who is a pure giver is at risk of burnout because they lose time, energy, and resources.  A balanced networking giver still keeps their own interests in view.  If they keep a generous attitude with a steady eye on their own interests, they actually increase their ability to give to others (1).

I am a frequenter of the Netweavers meetings in the Dallas Metroplex area.  Jeff McKissack, who manages the Uptown AM Netweavers Express, frequently emphasizes that people do business with those that they know, like, and trust.  Even if a taker succeeds in reaching their goal, and even if they can be known and liked (for a time), eventually they will lose the trust.  However, a giver makes the effort to build trust, and maintains it longer.  They give leads and potential business, and people in gratefulness return favors to them.  Takers that come to the group will usually not succeed, because they do not want to take the time (and yes, it takes time) to become trusted.  Givers who stay around, and take the time to be trusted, will increase their long-term business opportunities.

I can name a few individuals at these Netweavers meetings whom everybody likes and trusts.  They are trusted because they always seem to have a connection that someone needs.  They receive multiple public thank-you’s from other networkers, and everyone notices their absence.  They are as (if not more) interested in becoming your friend and acquaintance as becoming your next business connection.

In the interview, Adam Grant makes another interesting observation:  The taker is not always openly self-centered.  The common stereotype is that the taker is always publicly putting their best foot forward.  That may be true for some, but some are takers in the passive sense.  Sometimes being a taker means that you never give credit where credit is due.  The taker is not always the one who boasts about their role in a successful project, but doesn’t acknowledge that other people have worked as hard; or they are unaware of what their teammates have done, and never give credit because of ignorance.  The result, as with other takers, is that no one wants to work with them (1).

In your networking efforts, suppose you give and you haven’t increased your business, at least not immediately, haven’t you at least increased your circle of friends?

For more good information, go watch the interview or read through the transcript.

PS – At the time that I authored this article, I did not realize that there was a book out on the market by Adam Grant.  “Give and Take:  A Revolutionary Approach to Success.”

(1) Givers vs. takers: the surprising truth about who gets ahead (2013, 10 Apr.).  Knowledge @ Wharton.  Retrieved June 20, 2013 from http://knowledge.wharton.upenn.edu/article.cfm?articleid=3224&goback=%2Enmp_*1_*1_*1_*1_*1_*1_*1_*1_*1_*1%2Egde_4625137_member_246832688

When liquid assets are not all that liquid

If you have any background in financial analysis, you probably learned that Current Assets / Current Liabilities = Current Ratio, which helps measure your ability to meet short-term obligations with current assets.  A variation on this formula is the Acid-Test Ratio, which is (Cash + Accounts Receivable + Inventory) / Current Liabilities.  In other words, out of your most liquid assets, can you pay your debts?

If Company A has a current ratio of 2.1, while Company B has a current ratio of 0.97, you would probably assume that Company A is in good condition to meet short-term obligations, while Company B is struggling.

It looks that way… if that’s all the information that you have.

However, simple business experience tells you that neither accounts receivable nor inventory are as liquid as cash.  The more closely convertible to cash an asset is, the more liquid it is, but no vendor would accept your accounts receivable as a payment, nor would they take any of your inventory in a like-kind exchange.  What they want is cash.

Let’s go back to Company A and Company B, and add a new layer of facts:

  • Out of Company A’s current assets, $1,300 of it is cash, $4,500 of it is accounts receivables, and $4,200 of it is in inventory.  It takes Company A at least 25 days to collect cash for its accounts receivables, and an average of 30 days for an inventory item to leave the warehouse through a sale.  On average, a company payable is paid off no more than 5 days after receiving the invoice.
  • Out of Company B’s current assets, $4,500 is in cash, $4,200 is in accounts receivables, and $1,300 is in inventory.  It takes Company B no more than 9 days to collect payment for an accounts receivable, and no more than 12 days for an inventory item to leave the warehouse through the sale.  A company payable on average is paid off 15 days after receiving the invoice.

Based on the information, who do you think has more true liquidity?  Company A has little cash compared to its accounts receivables and inventory, and pays off its debts quickly.  Company B’s current assets, however, has more cash than either inventory or receivables, and the company has more time to pay its debts.

Suppose the owner of Company A is sitting in the conference room with the bank Vice President and wants to take out a loan to finance a new business venture.  The business owner explains the venture, gives an overview of the business plan, and then hands over the compiled financial statements to the Vice President.  As the Vice President looks them over, he notices that the amount of cash on Company A’s financial statements is only 13% of the current assets, while accounts receivable and inventory together make 87%!  The VP is hesitant, but then asks, “Well, how long does it take for you to collect on a receivable?”

“About twenty-five days,” the business owner answers.

“And how quickly can you turn an inventory product into a sale?”

“That takes about thirty days.”

“Okay, how long on average does it take you to pay your invoices?”

“I usually have to pay it off within about five days to avoid trouble.”

The Vice President leans back and thinks to himself, “He may have all these current assets and comparatively little debt, but if a crisis comes up, he might not be able to collect cash fast enough to recover.  Not only that, but others will be collecting on him too.  I am at risk of never seeing this loan again.”

Do you see the picture?  If you would have looked at the current and acid-test ratios alone, you would have assumed that Company A was thriving and Company B was struggling; but with this new information, Company A has setbacks that Company B does not.

This all comes from an article I found on the Cash Conversion Cycle (CCC):  “Analyzing liquidity using the cash conversion cycle.”

A basic course on finance will teach you about the current ratio and the acid-test ratio, and give you guidelines on interpreting those ratios.  However, there is an inherent weakness with ratios in general.  For one, most of them are static, meaning they only present the condition of the company on the date of the financial statement.  The ratio may not have been the same the day before the statement.  The element of time is missing (1).

The other weakness is that ratios are easily manipulated.  It is possible for a company to engage in transactions the day before the filing of the financial statements that would make ratios appear a certain way (1).  To build off of an example from the article, suppose on December 31, a business has $1.5 million in current assets, and $1 million in current liabilities, for a current ratio of 1.5.  What if they use their current assets pay off about $0.5 million of their debt the day before they officially close the books for the year?  With current assets of $1 million and current liabilities of $0.5 million, they now have a current ratio of 2!  The ratio is only indicating what is technically true at that moment about the company’s working capital.

One weakness of the current ratio in particular is that it “flattens out” the current assets as though they were all the same, but in reality inventory and accounts receivables are only good for paying off obligations once they become cash (1).  As discussed earlier, a vendor is not going to accept accounts receivables or inventory for payment as though they were cash.  They want cash.  If you do not have enough cash to pay your obligation, then you are in trouble with them, regardless what you have in other assets.

However, the Cash Conversion Cycle adds that missing element of time.

The Cash Conversion Cycle is formulated as follows:  Days Inventory Outstanding + Days Receivables Outstanding – Days Payables Outstanding (1).

With the CCC, you are able to measure just how liquid your current assets are.  How long is it before an inventory item will leave as a sale?  How long is it before the cash due from the receivable generated by that sale is collected?  How long does the company take in paying vendors (1)?

The CCC formula provides important clues to those questions.  For example, a high Days Inventory Outstanding would reveal that the company is stocking up inventory and not moving it out quickly enough, and therefore bringing in cash slowly.  The current ratio will not tell you this.  Likewise, if a company became more flexible in its collection policies, the Days Receivables Outstanding would increase, and therefore receivables will convert to cash more slowly.  Again, the current ratio will not reveal this (1).

The Days Payables Oustanding reveals the quality of the working capital.  If a company can further delay payment to a vendor without damaging the business relation, this means more working capital is immediately available for use by the company for other purposes.  However, the current ratio would not have considered this, but would have reflected badly on the company whether or not they had a lengthy period of time to pay off their obligations (1).

This of course does not mean that the CCC is a replacement for liquidity ratios.  Static ratios have the advantage of being easy to calculate and do indicate the general impact of current assets on current liabilities, but they are not to be used exclusively.  The CCC formula has its weaknesses as well.  For example, it does not account for tax, payroll, or interest. These formulas should be used in conjunction with each other (1).

If you want a good example of this concept, access the article and read about the application of the current ratio and the CCC to Best Buy and its bankrupt competitor Circuit City.

I can offer one graduate story of the limits of financial ratios.

When I was in my last semester of graduate courses I took part in an automobile industry simulation project.  We divided the class into teams and each team was its own automobile producer.  The simulation would run over ten successive periods, and in each period the teams would have to make decisions on what kinds of cars to produce, what prices to set, whether to obtain financing, etc.  In the simulation, we had access to all the financial statements of each team.  The project required that we perform ratio analysis on our own company and on the competing companies’ statements.  I set up a workbook in Excel and measured every company by several different ratios. After running the analysis I found that, like this article stated, a high current ratio does not mean financial health.  Our company began with the highest current ratio, but we were trailing in the market.  After a little investigation, I saw that the reason we were trailing was because we had too much working capital that we were not using.

My partner and I decided that we were going to think long-term: in the present we would use our resources to invest heavily in the vehicles through upgrades and new technologies, and we would open up more dealerships; and then once the upgrades, technologies, and dealerships begin to take effect, we would see greater sales and get ahead in the market.  One move we took was to issue a high amount in bonds, which at that point boosted up our current ratio to 5 (you can see here that the current ratio wasn’t an indicator of health, but of high activity).  When the investments matured and the investors collected on them, we trailed behind other companies in our current ratio.  With each period the profits were diminishing, and our instructor suggested we might want to try a different strategy.

When the fifth period rolled in, the intense application of the working capital paid off.  The upgrades fully developed, the technologies were implemented,  and the profits poured in.  They also continued to build in every period following.  We led in each one of our markets.

In this case, the current ratio did not indicate a healthy or prosperous company; instead, it indicated that the company was not using what it had.

(1) Cagle, Cory S., Campbell, Sharon N., & Jones, Keith T. (2013, May).  Analyzing liquidity using the cash conversion cycle.  Journal of Accountancy.  Retrieved May 30, 2013 from http://www.journalofaccountancy.com/Issues/2013/May/20126764.htm