Equine Business - November 2009
Mind Your Own Business:
Think - plan - organize - execute - make/save money
In this column we will discuss identifying specific fixed asset accounts that reflect how we want to measure our assets to make them more productive. I am going to start by repeating the introduction in my last article, but with an emphasis on fixed assets.
In previous columns we have discussed primary account categories that are used in a business's financial statements and to a limited extent, the type of information that is contained in these categories. It is now time to get specific about fixed assets so we know how we are investing our money, what we are investing it in, if we are getting the Return On Investment (ROI) we expect and if not, how we can make improvements. Having this detail will let us know what changes we need to make, if any, to better manage our business assets to make them more productive.
Fixed Assets are generally BIG capital expense items and therefore, consume a lot of cash. Unlike Current Assets, Fixed Assets are not expected to be turned into cash in the next twelve months. Purchases that fall into the fixed asset category are horses used in production (breeding and lessons), vehicles, equipment (tractors, ATV's), Buildings, etc. You need to make sure all your fixed assets are producing, and furthermore producing at a level where they are providing you with a Return on Investment (ROI). Before a fixed asset is purchased you should determine the ROI that is acceptable to you. If the asset is not meeting your expectations, then you need to solve the problem or sell it. Fixed Assets that are not working for your business are a financial burden no different than cash tied up in inventory. Fixed assets cost money to keep and if the fixed asset isn't producing it is cash at rest. You will not be able to make that determination without setting up your system to measure the assets productivity.
Return On Investment is a versatile and simple way to measure if a Fixed Asset is going to be productive. That is, if an investment does not have a positive ROI, or if there are other opportunities with a higher ROI, and your cash is limited, then the Fixed Asset should be not be purchased. To calculate ROI, the business benefit of an investment is divided by the cost of the investment. The result can be expressed as a percentage or a ratio.
The Return On Investment (ROI) formula is:
|ROI = (Gain from an Investment - Cost of The Investment) / Cost of The Investment|
Return On Assets is a broader asset measurement that indicates how profitable your business is relative to its total assets. ROA gives an idea as to how efficient you are at using your assets to generate earnings. To calculate ROA you divide your businesses annual earnings by its total assets. The result can be displayed as a percentage.
The Return On Assets (ROA) formula is:
|ROA = Net Income / Total Assets|
Fixed Assets generally fall into the following categories: Furniture and Fixtures; Equipment; Vehicles; Buildings; Land; Horses and Accumulated Depreciation. There may be other Fixed Asset categories that better define your business, but no matter the category the productive asset rule still applies. 'If it isn't productive, fix it or sell it' - and if you decide to sell it, hopefully not at a loss.
Fixed Assets are capitalized. Capitalization is an accounting method used to delay the recognition of an assets expense by recording the expense over a period of time. The periodic expense is called depreciation. The period of time is the useful life of the Asset. For example, currently the IRS allows a 10 year capitalization period for a horse. Remember, horses produced to sell are inventory. Horses used in your business are Fixed Assets. Equipment, vehicles, fencing, barns etc, all have their own capitalization periods. Always check with your accountant when setting up the capitalization period for any of your fixed assets. In general, capitalizing assets is beneficial. Acquiring new assets with a long-term lifespan can spread out the cost over a specified period of time. The purchase of a new asset deducted over the long term does not have an immediate (time of purchase) negative effect on your revenues and is beneficial to your free cash flow. We will discuss free cash flow when we cover the Use Of Cash and Cash Flow Statement in a future article.
Accumulated Depreciation is considered a Fixed Asset because it is subtracted from the original purchase price of an asset to determine the assets remaining financial value for reporting purposes. Depreciation in accounting is an expense recorded to allocate an asset's cost over its useful life. Depreciation is a non-cash expense because you have already used your cash to purchase the asset. However, the accumulated depreciation is reported on your income statement decreasing your reported earnings. This doesn't mean that when an asset is fully depreciated that it has no value to the business. The longer you can keep a fixed asset producing for your business the greater the asset's contribution to your business.
My observation is that the majority of financially successful horse businesses rarely have new trucks and horse trailers. Remember why you need a truck and trailer before you spend your precious cash. A truck and trailer only needs to get you and your horses from point 'A' to point 'B' safely and free of problems. Ego and self-image have a terrible ROI.
There are times when it is difficult to calculate an asset's ROI. There are some Fixed Assets that are necessary in the course of conducting business, but don't have an ROI that is easy to measure. A good example is furniture and fixtures. If your horse business needs a comfortable place for you to conduct business and/or your customers to relax, furniture and fixtures are probably a necessity. A boarding business would be a good example. I would caution you not to spend a lot of money on furniture and fixtures. Anything to do with horses seems to have a shortened useful life.
Items that were considered Fixed Assets several years ago are not capitalized today. The increase in cost over the last several years has raised the capitalization threshold required by the IRS. For example, a few years ago if you purchased a computer you were required to depreciate its cost over several years. Today a typical computer system can be expensed. It is a good idea to always check with your accountant to see if an asset needs to be capitalized and depreciated.
When purchasing more costly assets you need to take into consideration not only the initial cash impact on your business, but also the depreciation impact on your net profit. You may have a loan against you business that is tied to net profit. Depreciation is deducted on your income statement after your operating profit is calculated; therefore it is best if a loan's covenant is tied to operating profits. We will cover depreciation schedules and their impact on business management decisions in a future article.
One last consideration in being able to measure the productivity of a Fixed Asset is to be able to account for individual assets within an asset category. For example, if you have more than one vehicle I suggest you measure each vehicle separately. Measuring each vehicle separately will enable you to calculate their respective ROI's. This will help you in any business management decisions that need to be made about a vehicle. Which one do you sell if you have to sell one? Which one is more productive in different ways the vehicles are used?
In our next column we will work on defining the accounts and subaccounts associated with Income. Keeping track of your Fixed Assets can be beneficial even in a hobby business. In a hobby business you are allowed to write off expense against income. Depreciation is an expense. I suggest you list all your fixed assets by category. Then think about the ROI associated with each one. Is there anything that can be done to make them more productive? Is there any of your fixed assets that should be sold? Remember, spending your time and money wisely may provide the opportunity to enjoy your business more while making more money or at least having more fun with your horses. Think - plan - organize - execute - make/save money.
'If you can't measure it, you can't manage it.'
Bob Valentine, Ph.D.
GenieCo, Inc. was founded by Bob Valentine, Ph.D. Dr. Valentine has been breeding Arabian horses since 1971. He is also a professor at Colorado State University where he teaches Equine Business Management to graduating seniors in the Equine Science Department. In addition, Dr. Valentine writes a monthly equine business column titled: 'Mind Your Own Business: Think - plan - organize - execute - make/save money'.
GenieCo, Inc. is a Colorado Corporation and a member of the Rocky Mountain Innovation Incubator (RMI2). GenieCo Inc. specializes in providing Intelligent Business Systems for individuals and small to large business owners.