Question

Please offer an explanation and example of the below statement.

As a general statement in computing all the profitability ratios, the analyst must be sensitive to the age of the assets. Plant and equipment purchased 15 years ago may be carried on the books far below its replacement value in an inflationary economy. A 20 percent return on assets purchased in the early 1990s may be inferior to a 15 percent return on newly purchased assets.

Answer 1

The historical cost of an asset is presented on the balance sheet and it will not be correctly represented in an inflationary economy, because when the inflation rates are going to go up, the value of the assets are also going to go up.

Hence, when there would be an inflationary economy, it will mean that the value of the Asset which had been purchased fifteen years back will be carried below the replacement cost in its books of accounts because it will be recorded at the historical cost.

For example, when we will be purchasing the assets 15 years back the value of money due to time value concept would have been very low and in today's scenario the value of money will be higher due to inflation.

20% of return on assets which are purchased in early 1990 will be lower than 15% of return of newer asset because there will be a depreciation element which will be attached to assets which has been purchased, so overall rate of return when it will be discounted with the depreciation would be much lower and hence the 15% rate of return on the new asset will be looking Higher.