Capitalization of Interest, Non-operating Income (Q&A)

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The current article in this series provides responses related to:

  • Capitalization of interest and other costs
  • CFO vs PAT
  • Non-operating income

 

Query 

Hello Vijay,

Could you please explain to me why the companies capitalise their interest cost to fixed asset? What will be the benefit to companies? Is it to show-off bigger profits to investors? How retail shareholders get affected by this?

Regards

Author’s Response:

Hi,

Thanks for writing to me!

Interest cost along with other costs of creating the plants/fixed assets like land, building, machinery, logistics etc. are capitalized. The logic is that even though these costs are incurred in the year in which the plant/fixed asset is created, however, the plant runs a longer life and keeps on producing goods for many years. Therefore, the total cost of the plant including the interest cost on the debt taken to build the plant is not recognized as an expense in the profit & loss statement (P&L) in the year in which such costs are incurred. These costs are recognized as a cost in the P&L over the life of the plant as depreciation.

Read: Understanding the Annual Report of a Company

The underlying logic of capitalization is that for any year the P&L should have revenue and the cost related to the items which are sold in any particular year. If we show all the cost of the plant as the cost within one year, then it would distort the principle of related recognition of revenue and costs in P&L. As in such a scenario, the cost of the plant, which would have been related to the goods, which it would produce in future, has also been recognized in the current year.

Investors should note that recognition of the cost of the plant including the interest cost of the debt taken to build the plant, has no relation to the cash outflow/timing of the cash to be paid by the company for the plant. The costs of the plant including the interest cost need to be paid when they become due: monthly for interest payment and as per terms with the seller for the machinery etc. Cash outflow has no relation to the recognition of cost. The bank would ask for interest payment every month irrespective of the fact that the company might expense this plant in P&L over 10 years.

Therefore, investors should estimate the total interest outgo that the company might need to make including the interest which is expensed in the P&L as well as the interest, which is capitalized and then calculate the interest coverage etc.

Read: How to do Financial Analysis of Companies

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr. Vijay Malik

 

Query

Dear Dr. Malik,

  1. While calculating return on capital employed (roc) should be taken CFO (post tax)/ (gross assets+ working capital)*100 as cash flows from operations are not depreciation adjusted. So both denominator and numerator are equal in treatment.
  2. As the depreciation is an accounting measure to reduce the tax burden and charges may not accurately picture the life of the asset and its life cycle, shouldn’t this charges be viewed separately and not mixed in calculations all together while calculating different ratios?
  3. If cCFO >> cPAT, does it mean that excess cash is advances from customers and if cCFO << cPAT then payments are due from customers? And these differences should match up with receivables and payables.

Regards

Author’s Response:

Hi,

Thanks for writing to me!

1) We do not use ROCE in our stock assessment. You may find our reasons for the same in the following article:

Read: Why Return on Equity (ROE) is not meaningful for Stock Market Investors!

Moreover, as stated above, we suggest that investors should keep on tweaking the financial ratios to see if the new measure does a better job. Therefore, we suggest that you work further with CFO as part of ROCE and see if it does a better job.

2) Depreciation is a real expense. It is the adjustment of the cash outflow that the company had in the year of plant setup, however, this cash outflow was not shown in P&L as an expense as the asset would be used for many years. If the investor does not reduce this cash outflow of establishing the plant in the year of plant setup and also does not allow depreciation expense, then the cumulative PAT is going to be grossly inflated.

3) Apart from customer advances, receivables and payables, the CFO is also impacted by inventory and depreciation and other non-operating income & expenses. To understand the relationship between PAT and CFO, I would suggest you read the cash flow statement in the annual report of any company, which would show step by step calculation of CFO from PAT/PBT.

This calculation would clearly show how the profits/funds get stuck in or get released working capital and the impact of depreciation. It would be a good learning exercise for you to understand in which cases PAT would be higher than CFO and in which cases it would be lower.

In case after reading and analysing the cash flow calculation of company from its annual report, you have any query, then I would be happy to provide my inputs on your analysis and query resolution.

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr. Vijay Malik

 

Query

Dear Sir,

I have a query regarding a publishing company Hindustan Media Ventures Ltd.

Read: Analysis: Hindustan Media Ventures Limited

In 2016 Company’s Net Profit was Rs. 197.17 Cr. including Other Income of Rs. 83.89 Cr., which was coming from various Current and Non-Current Investment. Could you please explain, this kind of huge Other Income from investment in Bonds & Mutual Funds is reliable or not? And how much Other Income percentage in Net Profit are acceptable for investment in any Company. Are these worrying signs? And how important is it from investors’ perspective?

Author’s Response:

Hi,

Thanks for writing to me!

There is no fixed rule/parameter about the levels of the income from investments (other income) etc. One need to see the level of investments held by the company and then see if the other income is sufficiently explained by the level of investments. For example, if a company has ₹1000 cr. in current investments and the general interest rate prevailing in the economy is about 10%, then an investor should expect that it should have about ₹100 cr. (₹1000 cr. * 10%) as other income.

There is no such benchmark level about other income being a percentage of net profits.

An investor should keep it in mind that the company should not hold cash unnecessarily for long periods of time. The company should either deploy the cash for future growth opportunities or return it to shareholders by dividend/buyback or repay the debt if it has.

Read: 7 Steps to find out whether a Company is cooking its Books

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr. Vijay Malik

P.S.

 

DISCLAIMER

  • The above discussion is only for educational purpose to help the readers improve their stock analysis skills. It is not a buy/sell/hold recommendation for the discussed stocks.
  • I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013.
  • Currently, I do not own stocks of the companies mentioned above in my portfolio.

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