Understanding Capitalization of Interest & Other Expenses

The current article in this series provides responses related to:

• Capitalization of interest and other costs and how it shows up in the balance sheet and the profit & loss statements
• Is interest expense in P&L equal to the total interest outflow of the company? If not, then how to calculate total interest outflow?
• Does capitalization apply to inventory as well?
• CFO vs PAT
• Non-operating income

Capitalization of interest and other costs

Hello Vijay,

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

Further advised reading: How Companies Inflate their Profits

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr Vijay Malik

How does capitalization show on the balance sheet and P&L?

Dear Sir,

I am a premium member of Peaceful Investing – Workshop Videos. In the video of profit & loss (P&L) statement, you have said that the debt of ₹1,000 crores plus ₹200 crore interest becomes the value of the fixed asset as ₹1,200 crores after capitalization.

My question is in the liability section of the balance sheet we will mention ₹1,000 crores as debt whereas we are mentioning in the asset section of the balance sheet as ₹1,200 crores of the fixed asset. How to match the gap of ₹200 crores between liability and asset?

Author’s Response:

Hi,

Thanks for writing to us!

We need to understand it by combining both the balance sheet (B/S) and the profit and loss (P&L) statement. When we capitalize interest (₹200 cr), then first, we increase the value of the fixed assets by the value of interest (₹200 cr) and second we do not deduct this interest amount in the P&L as an expense. Therefore, we increase the profit before tax (PBT) by an amount equal to the capitalized interest (₹200 cr).

Let us assume a hypothetical case where there are no taxes applicable to the company. In this case, the assets will increase by the amount of capitalised interest (₹200 cr) and the liabilities will increase by the increase of ₹200 cr in reserves and surplus because the entire increase in PBT (₹200 cr) will be added to the reserves and the two sides of the balance sheet will match.

If there are taxes applicable, then let us assume that increased profits of ₹200 cr involve a 30% tax i.e. ₹60 cr. In this case, the liabilities will increase only by ₹140 cr as an increase in the reserves because the net profit after tax (PAT) will be ₹200 – ₹60 = ₹140 cr. On the assets side, the fixed assets will increase by ₹200 cr (the capitalised interest); however, there will be a decline of the cash by ₹60 cr (the payment of taxes to the income tax department). So, effectively, the assets side of the balance sheet will also increase by ₹140 cr only and the two sides of the balance sheet will match.

You may extend the logic of tax deduction to other payments like dividends as well. If the company pays dividends out of the ₹200 cr of inflated profits, then the liability side will see an equal reduction in reserves and the assets side will see an equal reduction in the cash & equivalents and the two sides of the balance sheet will match.

Hope it answers your query.

All the best for your investing journey!

Regards,

Dr Vijay Malik

Is interest expense in P&L equal to the total interest outflow of the company?

How to calculate total interest outflow?

Q. 1)

Hi Vijay,

I observed that in your excel template the interest expense and interest outgo are differing. What is the reason behind it?

How are you calculating the Cash + Investment in the same excel?

Thanks

Q. 2)

Dr Vijay,

Good morning. How to calculate Interest outgo. What are the parameters used for Interest Outgo?

Thanks

Author’s Response:

Hi,

Thanks for writing to us.

1) 

The interest expense in the P&L is net of capitalized interest. Therefore, to calculate the overall interest outflow (including the P&L interest expense and capitalized interest), we have assumed an interest rate of 12% and then calculated the total interest outflow.

In the Screener export to excel “Data Sheet”, it provides the data for “Cash & Bank” and “Investments”. We sum these two items in the datasheet to arrive at Cash & Investments.

2)

Interest outgo can be calculated as total debt * interest rate

Total debt can be calculated from the annual report as short-term debt + Long-term debt + current maturity of long-term debt

Further advised reading: Understanding the Annual Report of a Company

Total debt is also available in the datasheet of the Screener export to excel as “Total borrowings”.

You may get the interest rate from the annual report in the detailed notes to financial statements.

All the best for your investing journey!

Regards

Dr Vijay Malik

Does capitalization mean that a company does not need to pay interest to lenders?

Gulshan Polyols Limited (Read – Analysis: Gulshan Polyols Limited)

Sir, If Gulshan Polyols Limited is capitalizing the interest amount, wouldn’t it require paying it sometimes in future? How can debt providers allow company to escape paying interest? Please explain for my/our knowledge.

Also, do you think that Gulshan Polyols Limited is doing interest capitalization just to show-off bigger profits to investors in this Bull Run? Or can there be any other reason?

Author’s Response: 

Gulshan Polyols Limited is capitalizing interest because the accounting rules allow it to. It is paying this interest as you would understand that banks will not allow it to escape interest. However, it is not mentioning the interest on debt taken for any new plant/fixed assets in the P&L.

Banks would never defer interest payments. It has to be paid monthly, irrespective of whether you show it in P&L or CWIP.

It is increasing the value of new plant/fixed assets by the amount of interest it pays on its loan for this asset. This is allowed by accounting rules.

However, we must factor this interest as well while calculating the total interest outgo of any company.

An investor can get the amount of total interest paid by any company in the cash flow from financing section of the cash flow statement in the annual report. However, she must keep in mind that many companies show capitalized interest as a part of the increase in fixed assets under cash flow from investing activity. Therefore, many times, the interest outflow in cash flow from financing activities may not represent the total interest paid by the company during the year.

Hope it helps!

Related Query

My specific questions are the following:

Why would a company raise debt and hide it in the Capital Work in Progress (CWIP) and not pay the interest on the debt and thereby reduce its taxes:

• I believe that one reason could be to show to the investors that the company has strong Net Profit Margin (NPM), which otherwise would look terrible. Is that correct?
• Also, how can the company not pay interest on the debt raised or is it possible by deferring the interest liability for the gestation period of the new projects?

Thank you.

Author’s Response:

Thanks for writing to me!

Debt is not hidden in CWIP. Debt details are there in the balance sheet in the liabilities section (Non-Current Liabilities and Current Liabilities). It is the interest cost that is added to CWIP and not deducted from sales while calculating net profits. It is legal as per accounting standards.

Only thing is that an investor should know that ₹3,500cr debt would never have only ₹25 cr of the interest cost. The actual interest paid in a year, which should be about ₹350cr considering 10% rate of interest.

The total amount of interest paid by a company would be visible in the cash flow statement under cash flow from financing (CFF). However, she must keep in mind that many companies show capitalized interest as a part of an increase in fixed assets under cash flow from investing activity. Therefore, many times, the interest outflow in cash flow from financing activities may not represent the total interest paid by the company during the year.

Read: Understanding Annual Report of a Company

Banks would never defer interest payments. It has to be paid monthly, irrespective of whether you show it in P&L or CWIP.

All the best for your investing journey.

Regards,

Does capitalization apply to inventory as well?

Dear Doctor,

Thanks for your in-depth analysis. We understand that the companies capitalize the interest and other related costs while setting up a plant or machinery.

Is such an application of “capitalization” limited only to plant creation? Or similar mode of treatment can be applied to other “operational expenses “as well, like procurement of raw materials, as indicated in below mentioned hypothetical scenarios.

Scenario 1

A company in anticipation of a price hike of raw material costs in the forthcoming years accumulates bulk of quantities in advance. However, the realization of lower prices is likely to be at a later stage only. Does the company show such cost in the P&L statement of the same financial year or recognize it in the balance sheet, till it realizes (similar to the treatment of CWIP/fixed asset)? If the company mentions it as one time cost, then does it distort the principle of accounts?

Scenario 2

Another instance is that of the recent quarterly result of Purvankara Limited, which shows a substantial increase in the land purchase cost, compared to the previous quarters in the P&L Statement (presumably as raw material, considering the kind of business they execute). Does this figure of ₹168 Cr, arrive on account of the transaction carried out during the third quarter or derived from the same principle of capitalization?

Appreciate your input, when time permits.

Regards,

Author’s Response:

Hi,

Thanks for writing to us! We are happy to see that you are doing your own equity analysis and spending time and effort to understand different concepts.

We believe that any definite answer to your queries may be provided only by a chartered accountant. However, we would attempt to provide our views:

The concept of capitalization is applicable to fixed assets, which lead to the generation of economic value to the firm for more than one financial year. Such fixed assets include plant & machinery, which once created, keep on producing economic value for many years to come.

The concept of capitalization is not applicable to inventory/raw material. The purchase cost of raw material during a quarter is deducted in the P&L during the period it is incurred as “purchase of raw material”. However, if a company has purchased excess inventory than what it could use during the period, then it deducts the purchase cost of such excess inventory from the “purchase of raw material” under the head “increase in inventory” in the P&L. In such cases, you would appreciate that the amount of inventory in the balance sheet increases by the amount, which is deducted from P&L under “Increase in inventory”. This treatment ensures that the purchase cost of only that raw material is deducted from the income, which is used during the period to produce finished goods.

Further advised reading: Understanding the Annual Report of a Company

In the case of the example cited by you, it seems that the land purchase cost is the cost incurred during the reported period. You may also notice the impact of the reduction of “increase in inventory” in the example cited by you.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik

Query

Dear Dr Malik,

1. While calculating return on capital employed (ROCE) 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 the 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 the 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, the company’s net profit was ₹197.17 Cr. including other income of ₹83.89 Cr., which was coming from various current and non-current investments. 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 the net profit is 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 needs 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 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

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Disclaimer

Registration status with SEBI:

I am registered with SEBI as a research analyst.

Details of financial interest in the Subject Company:

I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.