CHAPTER 9: BALANCE SHEET – MEASUREMENT OF FINANCIAL HEALTH

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Goodwill
– Why Would a Company Pay Higher than the Net Asset of the Acquired Company?
Inventories
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Goodwill
 
Unlike the general term which refers to the value of the brand generated by a company, in accounting terms, goodwill exists when the company acquires another company at a price higher than the fair value of the Net Asset Value of the acquired company. The difference is recognised as “goodwill” in the Balance Sheet of the acquirer.

The value of goodwill will not increase. In fact, the value of goodwill is subject to annual impairment tests to determine if the value of the goodwill is still valid. If the value has reduced, the company would need to reduce the goodwill and recognise impairment of goodwill as an expense in the income statement. In TexCycle’s case, the methodology for its annual impairment is stated in page 98 under Notes to the Accounts No. 16.

When the purchase price is less than the net asset value of the acquired company, a negative goodwill scenario will emerge.
 
[1]. Why Would a Company Pay Higher than the Net Asset of the Acquired Company?
 
Some companies have value that is not in tangible forms, such as brand name. In such cases, the acquiring company could be willing to pay more than what the target company has in tangible forms, as the brand value is intangible. Other intangible items that could be valuable to the acquiring company include technology, patent, or even the rights to certain products.

Or it could be simply a bad decision.

Take this example: Company A is an investment holding company with RM100 million in cash. Company A then acquires Company B for RM100 million. However, Company B’s net asset is only RM80 million. Thus, goodwill from acquisition of RM20 million has to be recognised in Company A’s balance sheet. What actually happens is: due to the acquisition, the net assets of Company A before the acquisition, i.e., RM100 million, has dropped to RM80 million post acquisition – simply because Company A paid more than what Company B has in terms of net assets.

Disasters from overpayment are very common in the corporate world. Without a doubt, one of the most famous blunders was from Time Warner’s acquisition of America Online which involved a “goodwill” worth US$100 billion, which was subsequently written off.

The reality is, unlike the name, goodwill may not be of any good.

Goodwill is important for investors to take note in that some listed companies do carry a substantial amount of goodwill in its balance sheet. And in times when the goodwill needs to be impaired, it will cause a hit to the net profit. However, on the other hand, one may also take the view that since impairment of goodwill is a non-cash and non-core item to the business, one can adjust it by calculating core earnings. However, substantial goodwill may indicate that the company may have (stressing on the word “may”) bought certain white elephants.
 
Inventories
 
Inventories are simply the stocks or assets that the company holds which are intended for sale. Under Note 17 in page 98, TexCycle disclosed that its inventories are made up of recycled products (RM0.18 million) and finished goods (RM0.54 million). The company also recognised an allowance for slow-moving inventories amounting RM0.50 million, which reduced the value of the inventories to RM0.22 million (RM0.18 million + RM0.54 million – RM0.50 million).

Inventories are also an indication of sales trend. Take Visdynamics Holdings Bhd (“VIS”) as an example. VIS designs and builds back-end semiconductor equipment and high-speed transfer and inspection machines. VIS is conservative in its revenue recognition methodology, as in VIS will only recognise sales when the customers have tested and accepted the equipment, and not when the equipment is shipped to customers.

The resulting impact is though the equipment may have been delivered to the customer’s site, until the customer has signed the acceptance, the equipment will still be recognised as inventories in VIS’s balance sheet.
 
Figure 3 shows the revenue and inventories level reported by VIS in its quarterly result announcement to Bursa Malaysia. What is obvious is that VIS’s inventory level is a good indication of the sales direction in the subsequent quarters.
 

In the next posting, we will discuss about Cash & Bank Balances, Issued Capital & Treasury Shares, and Deferred Tax Liabilities. Do not miss it.