Synonyms: Fixed Assets; Plant and Equipment; Machinery; Vehicles; Delivery Equipment; Furniture and Fixtures
All businesses need some form of Property, Plant, and Equipment (PP&E) to operate. The exact type of PP&E varies across industries. The list includes buildings, manufacturing equipment, warehouse facilities, trucks, ships, aircraft, delivery vehicles, computer servers, computer equipment, printers, television sets, furniture (office tables, chairs, etc.), cooking equipment, transmission towers, power plants, bulldozers, medical equipment, x-ray machines, microscopes, etc. When businesses acquire PP&E, it’s part of what’s known as a “capital expenditure (capex) program”.
Keep in mind a few important points about PP&E:
- These are expensive items. The decision to acquire PP&E goes through a complicated internal vetting process called “capital budgeting”, which involves justifying that the benefits outweigh the costs (usually in monetary terms). It’s a lengthy vetting process that can take several months and requires prudent forward-looking analysis of the company’s prospects. If you’re a bit confused, think of it this way: what is your thought process if you are deciding whether or not to buy a regular cheeseburger for lunch from your favorite fastfood joint? How about if you are deciding whether or not to buy a brand new car? Which decision is easier to make?
- Knowing that the PP&E acquisition could require lots of money, the next obvious question is “how will the acquisition be financed?” Does the company have sufficient cash on hand? Does the company need to tap external sources of funding? If the company needs external funding, will it be in the form of debt or equity? For that matter, will it be a bank loan, bond issuance, common stock, preferred stock, or some other type of financing mechanism? The answers to these questions are important because the capital structure (i.e. proportion of debt vs. equity in the balance sheet) of the company will be affected. Too much debt in the balance sheet is not good. However, too little debt may not be good also. (I won’t dwell on the pros and cons of capital structure theory…there are many sources out there that discuss the topic adequately.)
- “Capital budgeting” is important because it is not easy to correct an incorrect decision to acquire PP&E. If you bought a cheeseburger and halfway through eating it decided that you didn’t like it, you could easily leave it on the table and walk away. However, if you just bought a new car and after a month decided that you didn’t like it, how do you walk away from it? Now imagine if a company spent USD 10 million or PHP 500 million to buy manufacturing equipment, only to realize after six months that they didn’t need it. How do the CEO and CFO walk away from it? Either they find a way to make the equipment useful, or they sell it (which may not be an easy process).
- Business expansion often entails acquiring new PP&E. Well-planned and well-executed expansions are often rewarded with higher stock prices.
- Maintaining business performance also entails acquiring new PP&E and discarding old, worn-down equipment. This is sometimes called “replacement capex”.
- Certain types of assets are consumed or used up or transformed during the day-to-day operations: ballpens and papers are used; inventory is sold and converted to cash (or receivable); receivables are collected and converted to cash; prepaid insurance is used up as time goes by; etc. Other types of assets such as PP&E do not disappear during the day-to-day operations. Instead, PP&E are objects that stay as they are and enable the company to carry out the day-to-day operations. Buildings, vehicles, and laptops don’t disappear…however they eventually get worn out as they are used. In fancy accounting jargon, this is called “depreciation expense”.
The Income Statement is nothing more than “Sales – Expenses = Profit or Loss”. Depreciation expense arises from the normal use of PP&E and is a legitimate expense item in the Income Statement. However, depreciation is a non-cash expense item that distorts the cash profile of the “Profit or Loss”. Impairment loss is another form of non-cash expense item related to PP&E. For many companies, depreciation and impairment form a significant chunk of expenses.
It would be worthwhile to keep in mind these important points about PP&E so that you can better appreciate the value of the ROIC (Return on Invested Capital) analysis.
