Question

You have been asked to provide some guidance to the management team of OHYA Corporation with respect to their asset management.

After reviewing their accounting policies, you notice a few items:

1. OHYA has replaced much of their equipment over the past fiscal year as they felt the old machinery was not as efficient. They believe the new equipment will increase output. Many of OHYA’s competitors use older machinery which has not been replaced for many years.
2. OHYA has decided to use a diminishing balance method of depreciation for this equipment, whereas most of OHYA’s competition uses a straight line method

（Question）Management has asked you to prepare them for their annual investor call where many analysts will be in attendance.

1. What financial performance ratios may be in question based on the transactions and decisions OHYA has made related to their PP&E this year?
2. Which financial ratios would you expect to have positive result / negative result compared to OHYA’s competitors based on this information?
3. How would you explain the performance to an analyst?

Answer 1

The reason why management replaced the old machinery was because they believed it was inefficient.

The new machinery will boost efficiency which will give the firm an advantage against its peers

The first question they will ask is why did you chose the diminishing balance method ? In this method, The depreciation is calculated at a certain percentage each year on the value of the asset which is brought forward from the previous year. The depreciation charges in the initial periods or at the beginning period is higher than those in the later period. The reason is that since most of the efficiency gains would happen at the start, it is fair to be charged more depriciation at the start.

I believe due to the Capex incurred, the following ratios might come under the scanner in the investor conference call

1) Gross Margin - since the machine is now more efficient, the same raw materials would give a better yield and thus improving our Gross Margins

2) Maintenance Cost / Expenses - Since the old machine was aged it would have costed more to maintain, the new machine would bring down the maintenenace cost and positively impact the ratio

3)Contribution margin - It measures the % of revenue that is attributed to fixed cost, now since the efficiency is set to increase, contribution margin will improve

4) Capex/ Sales = This ratio is said to increase since the company has undertaken a significant capex for the new machines

5) Capex/ Operating Cash = This ratio will increase since the new capex will be more than the operating cash flows

To basically sum it up for an analyst, the key takeaways are that the new macinery will increase the sales yield, which will kick in the operating leverage thus increase the companies margin profile. To add to these margins, the maintenance cost of the firm will go down as new machine is much more efficient