The Meaning of Asset and Life Cycle Management
Encyclopedia of Business Terms and Methods, ISBN 978-1-929500-10-9. Revised 2013-12-03.
An asset is an item of value owned or controlled by the entity, acquired at a measurable cost. This entry defines asset and explains related concepts in asset management and accounting.
The total book value of an entity's assets are one side of the so-called balance sheet equation:
Assets = Liabilities + Owners Equities
- Assets are resources the entity owns or controls, to work with to make money.
- Liabilities are what the entity owes.
- Equities are what the entity owns outright.
In business, company management and stockholders expect assets to justify their existence by producing value for the company, that is, they are expected to earn "returns." Financial statement metrics such as inventory turns, total asset turnover, or return on assets (ROA) use income statement and balance sheet entries to measure the company's efficiency and productivity in using them. Assets that sit idle or are otherwise unproductive are candidates for elimination.
The entire practice of acquiring, using, and getting rid of assets is known as life cycle management. The specific activities and goals involved in life cycle management differ among different kinds of assets, but generally life cycle management makes use of best practice methods for planning, accounting, deployment, usage, and maintenance, in order to reach these objectives for the company's assets:
- Ensure their availability where and when needed.
- Minimize the risk of failure or breakdown before the end of their economic life.
- Maximize the return (gains) from them.
- Ensure they are used productively throughout their economic life, and they are not wasted or idle. This may involve working with other management to improve or re-design processes that impact their utilization and productivity.
- Sell or otherwise divest the organization of those that are idle or unproductive.
- Set priorities for their acquisition and replacement and plan future expansion or reduction of the asset base.
Reaching these objectives requires good knowledge of asset ...
- Expected gains or returns.
- Life cycle total cost of ownership, including maintenance costs and operating costs.
and the current state of technology. This is
obviously true for computing technology, but is also important
- Any major asset class based on constantly improving technologies, such as medical or laboratory equipment.
- Those subject to changing requirements for fuel efficiency or emissions.
- Reliability and or/risks to availability.
- Available choices in leasing vs. buying, and the implications of each approach in terms of upgrade/replacement flexibility, responsibility for maintenance, position either on or off the balance sheet, and potential tax liabilities and tax savings.
- Depreciable life and economic life.
- The appropriate method of depreciation and whether or not other depreciation methods are permitted.
- The fair market value at all times and its salvage value (residual value).
• Categories of assets explained
• Placement on the income statement and balance sheet
• Example income statement with depreciation expense
• Example balance sheet with accumulated depreciation
• Asset focused financial metrics
Categories of assets explained
For accounting purposes, important asset categories include:
The term capital asset is sometimes used interchangeably with fixed asset. A capital item is long-lived and usually tangible. These items go on the company’s balance sheet (they are "capitalized"), are usually paid for out of a capital budget, and are approved for purchase through a capital review process. In order to qualify as a capital resource, the item may have an acquisition cost above a specified value, and it may need to have a useful life of more than one year. In balance sheet accounting, capital items are reported separately from current assets. Fixed items are considered less liquid than current items because capital items would be more difficult to convert into cash in the short term.
The term fixed asset is sometimes used interchangeably with capital or non current assets. These are tangible resources owned by the corporation or entity, that are not used up, consumed, or converted into cash during normal business operations. Factory machinery, buildings, and large computer systems are typical fixed items. In balance sheet accounting, capital and/or fixed items are reported separately from current items, sometimes in a category called "Property, Plant and Equipment."
Current assets include cash and other items that are expected to be (or could be) converted into cash or used up in the near future, usually within a year. Accounts receivable and finished goods inventory, for instance, are often classified as "current." Other kinds of current items may include short term notes receivable, prepaid expenses, and deferred taxes.
In balance sheet accounting, current assets are reported separately from capital and/or fixed items. Figures for current items from the balance sheet contribute to liquidity metrics for the company, such as the acid-test ratio, current ratio, and working capital.
A tangible asset is an item with physical substance, such as land, buildings, computing equipment, or cash (and often, accounts receivable, even though it could be argued that they have no physical existence). "Tangible" simply means there is something there that can be touched. This contrast with intangible asset (below).
An intangible asset, like others, is an item of value owned or controlled by the entity, which was acquired at a measurable cost. The intangible kind, however, have no physical substance and are by definition not "touchable." Monetary items such as cash or accounts receivable are generally not included in this category .
Even though they have no physical substance, intangible assets can and often do appear on the balance sheet.
Intangible assets are sometimes categorized in different ways:
- Purchased intangibles vs. internally created intangibles
A patent (the intangible), for instance, might result from the company's own internal research and development activities, or the right to use a patented design might be purchased from another owner. By accounting standards (such as GAAP in the United States), purchased intangibles are usually easier to value and include in financial reports than are internally developed intangibles. Internally developed intangibles are generally not subject to depreciation.
- Legal intangibles vs. competitive intangibles
Legal intangibles are sometimes referred to as intellectual property, including such things as trade secrets, proprietary knowledge (for example, a proprietary soft drink formula), patents, trademarks, and copyrights. Intellectual property rights for such things are legally defensible in courts of law.
Competitive intangibles are intangibles that enable the company to compete effectively, ranging from such things as human capital—the skill and experience of the company's employees—to company reputation or brand recognition, to the establishment of collaborative activities and business partnership agreements. Competitive intangibles are generally not legally defensible (in contrast with legal intangibles).
- Limited life intangibles vs. indefinite life intangibles
A company's brand recognition (a competitive intangible, above) is generally considered an indefinite life intangible, because it is expected to remain with the company indefinitely. By contrast, where there is a purchased right to use a patent for a specified period of time, the intangible (right to use the patent) is a limited life intangible.
Wasting assets include items that are "used up" as well as other items that otherwise lose value after a specific time period. Those in the first category include natural resources, such as timber, or oil, which are consumed or used up in the course of business. Assets in the second category include stock options which either expire at a certain date or, due to changing market conditions, become worthless (become "out of the money").
Placement on the income statement and balance sheet
The acquisition and use of assets impacts both the company's income statement and balance sheet reports.
Income statement: An asset's full purchase cost generally does not go onto the income statement as an expense item, at least not all in one year. Instead, the accounting practice of depreciation provides a way to account for the purchase of long-lasting items over a period of years. The idea is that these items have a useful life (depreciable life), over which they are used up or worn out, and that the owner receives the tax benefits of paying for these items over those years instead of all at once. Each year of the useful life, a specified percentage of the purchase price is charged against income as a depreciation expense (the percentage is determined primarily by the appropriate depreciation schedule used for the class of item). This lowers the company's reported income across a number of years and creates a tax savings for the company.
Balance sheet: The balance sheet reports the book value of the company's assets. For most items, this is the acquisition cost less its accumulated depreciation through the end of the current year of depreciable life. Each year depreciable life, its book value decreases by the amount of depreciation (or amortization) expense, until it reaches its residual value.
The example balance sheet below shows how accumulated depreciation for several asset classes is subtracted from their initial cost, to result in the balance sheet book value.
The financial statement impacts described above refer most directly to situations involving capital and fixed items. Note that the other categories of assets may also create income statement expenses and have their book value decreased annually, but with some differences:
- For intangibles with a limited life (e.g., the purchased right to use a patent for a specified period of time), the process of reducing its book value and charging an expense against income is called amortization instead of depreciation. Amortization expenses of this kind are usually derived with the straight line method applied across the limited life.
- Indefinite intangible assets may also create an income statement expense and reduce in book value, but the reduction in value must usually be demonstrated by probing, or testing the current value. Damage to the company's brand recognition (if carried as an indefinite intangibles) would represent such an impact, if the resulting damage to the company's ability to compete is demonstrated.
- Current assets (including cash, accounts receivables, and inventories) are generally not depreciated.
- Land owned is generally not subject to depreciation.
- Wasting items may sometimes be depreciated according to a usage-based depreciation schedule rather than a time-based schedule. That is, depreciation expense as a percentage of acquisition cost is estimated by the percentage used up or depleted during the reporting period.
For a broader discussion of the structure of a company's base in these categories, see the encyclopedia entry asset structure.
Income statement with depreciation expense example
The example income statement below shows asset depreciation expenses in three categories, one above the Gross profit line, and two below the gross profit line. The depreciation expense location on the income statement, in other words, depends on where and how the items are used: Those used for product production contribute depreciation expense to cost of goods sold (and thereby impact gross profit). Below the gross profit line, those used in selling (e.g., store equipment) appear under "Selling Expenses," while items used for general administrative purposes (such as computer systems) appear under "General and Administrative Expenses."
Balance sheet with accumulated depreciation example
Below is an example of one company's balance sheet, showing a number of different asset categories. Note that these may sometimes be listed in terms of general categories (e.g., Current assets), sometimes in terms of what the items are used for (e.g., Store equipment), and sometimes simply in terms of what the items are ( e.g., Computer systems).
Asset focused financial metrics (Ratios)
Management and investors will want to be assured that the company has the assets it needs to operate and grow. They will also want to be assured that the company is using them productively. To address these issues, analysts turn to financial statement metrics that attempt to measure the company's resources and their utilization.
Below are just a few examples of asset focused financial metrics of this kind.
Does the company have the resources it needs to operate and grow? One way this question is addressed is through so-called liquidity metrics, which focus on the short term. The three most commonly used liquidity metrics are current ratio, working capital, and the quick ratio (acid-test ratio). All three take their input data from balance sheet entries (for the full balance sheet with these entries, see the Sample balance sheet in this entry).
Working capital is a figure in currency units (such as dollars, pounds, euro, or yen) showing the difference between current resources and current obligations:
Working capital = Current assets – Current liabilities
= $9,609 – $5986 = $3,623
How much working capital is sufficient? Company management will attempt to address that question by projecting their current liabilities for the next year and the expected cash inflows for the next year.
The current ratio metric is built from the same input data as the working capital metric, except that here a ratio is produced by dividing current liabilities into current assets:
Current ratio = Current assets / Current liabilities
= $9,609 / $5986 = 1.61
This company's current ratio may be cause for concern, because a current ratio value of 2.0 is a generally used "rule of thumb" requirement for healthy liquidity. (While a current ratio under 1.0 might be considered cause for alarm.
Quick ratio / Acid-test ratio
The most severe liquidity test of the three presented here is the quick ratio, or acid-test ratio. This ratio is similar to the current ratio, except that the inventories figure is subtracted from the "current" total before performing division. The idea is that inventories are the least liquid of the current components:
Quick ratio = (Current assets – Inventories) / (Current liabilities)
= ($9,609 – $3,464) / $5986 = 1.03
Here, too, this company's acid-test ratio might be cause for concern. Analysts generally consider an acid-test ratio of about 1.1 as a minimum healthy level.
Other metrics focus on efficiency of asset utilization or productivity, by computing ratios from data taken from both the income statement and balance sheet.
Inventories, like other assets are supposed to produce returns and not sit idle or unproductive. The Inventory turns metric uses an income statement item (Net sales revenues for the year) and a balance sheet item (Inventories) to approximate the number of times per year the company "turns" over its inventories. A higher number of turns is generally preferred, because (a) the storage and care for inventories is costly, and removing items from inventory completely means they have been sold, and (b) inventories tie up funds that might otherwise be used for some other means of producing revenue.
For this example, assume that Grande Corporation's net sales revenues for the year were $32,983, and that its balance sheet entry for total inventories was $5,986.
Inventory turns = (Net sales revenues) / (Inventories)
= $32,986 / $5,986 = 5.5 turns / year
Management may set specific target turn rates, and the value of reaching these targets can be readily calculated.
Total asset turnover
Companies acquire resources for the purpose of generating revenues. Total asset turnover compare directly the revenue "returns" from the company's resources, to the book value of these resources. The higher the turnover rate, the shorter the time required for these resources to generate their own value in sales. This example uses the same net sales figure ($32,983) as the previous, along with the sample balance sheet total assets figure of $22,075.
Total asset turnover = (Net sales revenues) / (Total assets)
= $32,983 / $22,075 = 1.49 turns/year
If the company's turn rate is out of line with industry standards, analysts will want to know why. (Companies in the same industry sometimes do have quite different business models, and this could account for the difference between one company's metric and the rest of the industry.
Return on total assets
The most wide ranging asset-focused metric is simply return on total assets (ROA). This is simply the company's net income for the year (bottom line of the income statement) divided by total assets from the balance sheet.
Assuming that Grande Corporation reported a net income (profit after taxes) of $2,126 for the year, and the balance sheet total assets were $22,075, ROA is:
ROA = (Net Income) / (Total Assets)
= $2,126 / $22,075 = 9.6%
Investors and senior management will compare this ROA with other companies in the same industry, with year to year changes in this company's ROA, and with other opportunities for earning returns from the same value resources.
For more coverage of these and dozens of other financial metrics, along with working examples and templates, see Financial Metrics Pro.