How does a company or a business grow? Simple- the employees and the employers work tirelessly and continuously to come up with new ideas, products and designs to shine in the market. But then there is another approach to become bigger. By acquiring smaller companies and merging them with your own to increase your profits. Investors acquire a lot of companies and keep growing smoothly. But occasionally, you end up buying a rotten apple don’t you? Or you unknowingly end up with a bunch that soon goes bad?
 |
| Image Credit - Moneycontrol |
It is not a huge mistake but one that could end up costing investors a lot. It is quite common for public companies to grow through acquisitions. This is due to the fact that it is easier to get hold of an already flourishing or at least built company than building one from the ground up. But there are good investments and there are bad investments. In time, a lot of acquired company’ valuation goes up and that means the investment was a good one.
Impaired assets and the bad purchase
But there are times when a company’s value goes down than its book value (the value at what it was bought) and this a bad investment. This is where the bought company becomes an impaired asset. This impaired asset’s market value is lesser than the value listed on the company's balance sheet. This asset also occurs when the parent company after a certain time lowers the value of those assets (bad ones). This is how you know you made a bad purchase.
 |
| Image Credit - cbc.ca |
Let’s see this through with an example. But before we do that is is important to know that Generally Accepted Accounting Principles (GAAP) need companies to "test" goodwill of their assets every year for impairments. Now let’s say that Company GHI purchases Company XYZ. The book value of XYZ is $10million but due to certain calculated reasons, GHI buys it for $15million, that is $5million above its marker value. Now GHI will record these $5million of goodwill as an asset on its balance sheet.
Now a year has passed and it is time to review and look for impairments. When the gains and financial statements from XYZ are looked upon (as it is now a subsidiary of GHI), it is found that its sales fell by 40% due to certain reasons (now XYZ has a market value of $8million) Maybe the new product line by GHI did not gather popular support or the services were at fault or the competitors came up with a better line. It can be anything. If the fair value of XYZ comes to be lesser than the carrying value, as in if GHI sells XYZ today, it won’t get the the same value it bought it for but lesser, then company GHI has an impairment.
While making records, GHI would compare XYZ’s current market value of $8million plus $5 million of goodwill assets recorded earlier (total $13million) with the actual price it bought it for i.e., $15million. The difference between the two comes to be $2million, and GHI has to now reduce the goodwill on its books by this number. The goodwill entry goes down and the total assets fall accordingly.
Why does recording the new goodwill entry matter?
Well, when a company marks an asset impairment on its balance sheet, it is letting the market know that its acquired asset (here company XYZ) is now valued at a lower price than what it was originally bought at.
Impairment not to be confused with depreciation
Everything that companies buy, all their assets have a life span. When machineries are bought, they are expected to become less useful and less valuable over time. They depreciate over time. This depreciation’s value is often always calculated by the investor/ parent companies and are managed accordingly. This gradual loss of value is recorded in financial statements.
A machinery bought for $20million will e recorded at the same value in the first year but its price will keep getting smaller every year due to its depreciation. The major difference between depreciation and impairment is that depreciation is a calculated investment and risk. Whereas, an impairment is totally unexpected. A company can flourish too giving the owner company huge profits. A machine cannot magically become new.
A note for the investors and the apprentices
When such major acquisitions occur, it is important to take a note of them. When companies get impaired assets at the end of their financial year, they usually write down their assets value. That means they make its book value lesser than it used to be, the value they bought the company for.
A company can still be thriving this way when it has a lot of impaired assets hanging by its side. Because it has written down its assets and it is in general growing its parent company. If you want to understand a company’s actual financial status, read its balance sheets and financial statements, you will see profits to.
However, if you are thinking of investing, then a company having a lot of impaired assets being written down should definitely be avoided. For it just means they are making a lot of bad purchases and this will obviously affect business results in the long run.
Be wise!!
Stay away from the already rotten apple!!
