VOLUME 1
Chapter 10 - A capital asset
"Capital is money, capital is commodities. By virtue of it being value, it has acquired the occult ability to add value to itself. It brings forth living offspring, or, at the least, lays golden eggs."
Karl Marx, Das Kapital (1867)
Geronimo spends the next day building a new fruit stall for Ursulina. He creates some lockable storage compartments in the back for unsold oranges and to save them the trouble of packing it up and taking it home every day, he buys a chain and padlock to secure it to a nearby tree. Meanwhile, dazzled by the possibilities of Moisture Control Technology, Ursulina invests in a portable refrigerator that they can run off their car battery. Their total investment in this equipment corresponds to several weeks’ sales of oranges and although they pay for it by credit card, they will have to repay this debt from their bank account at the end of the month. How can we represent this in the Business Flight Simulator?
Figure 10.1: Model 107 - Fixed Assets
In Figure 10.1 I have introduced a new box called Fixed Assets to represent this activity. Into it flows a new pipe called Capital Expenditure and out of it runs a new (rather thin) pipe called Depreciation. To make the model more complete I have also added a new pipe called Expenses. It is easiest to explain the operation of all these when the simulation is running, so please go to www.amplifying-intuition.com and choose Model 107 (or click on the diagram).
If you now click on Start you will notice that you are prompted for some Capital Expenditure via the highlighted slider. You will also see a prompt in the top left of the simulator, and if you point to it with your mouse a more detailed explanation will appear. Since these capital items can be bought on credit, move the Payment Delay slider to a suitable value and also set a few days of History.
You are now ready to invest in some fixed assets. Drag the Capital Expenditure slider towards the middle of its range and then release it. This will cause the Fixed Assets box to register this expenditure, while the Creditors box indicates that the business now owes this money to its suppliers. But notice that after your decision, the Capital Expenditure slider immediately returns to the zero setting, as if it were attached by an elastic band.
This is deliberate. Your other slider settings determine a daily value, but clearly Capital Expenditure does not happen every day, only from time to time. So this ‘one-off’ slider handle is coloured differently, to distinguish it from the others which operate continuously. Usually such ‘one-off’ sliders are coloured black and ‘continuous’ sliders white, but you may be able to change these colours when using the online model.
The Fixed Assets box now displays the amount of money that has been spent on these capital items. But will the new fruit stall and the portable refrigerator last for ever? Almost certainly not: indeed one day they will be worthless. You can decide how long you think they will last using the Depreciation slider, which can be adjusted from 2 to 10 years. This pipe can be thought of as a continuous leak from the Fixed Assets box, reducing its level gradually over the prescribed period until there is nothing left.
But what happens to the other end of this pipe? After all, it has to go somewhere; remember the notice board at Figure 3.1: ‘Closed System - No pipes lead outside the bathroom’.
Hitherto Ursulina and Geronimo have been able to calculate the business’s profit by simply subtracting the cost of the oranges from the day’s sales. But now they have spent the equivalent of several weeks’ worth of orange sales in a single day. Does this reduce their profit dramatically on that one day? That would seem somewhat extreme: after all, the fruit stall and refrigerator are expected to last for a few years before needing to be replaced. Since we are already calculating a small daily reduction in the Fixed Asset box to correspond with the slow deterioration in the value of this equipment, isn’t that a more realistic figure to deduct from their daily Gross Profit so as to form the resulting Operating Profit?
It sounds plausible, doesn’t it? So plausible in fact that it represents standard accounting practice world-wide. But we must also recognise that this idea of Depreciation introduces some arbitrary and potentially misleading judgements into the diagram. For a start, we don’t know how long this equipment will last: we can only guess. If it breaks down sooner than anticipated, then with the benefit of hindsight we will see that we have been calculating too low a Depreciation charge and thereby overstating our Operating Profit figures - for several years. Likewise if the equipment lasts longer than expected, we will have been charging too high a Depreciation figure and under-estimating our Operating Profit figure.
Is there a right answer to this conundrum? Yes, there is, but it is somewhat unexpected. Remember the equation:
Estimated Profit = Measured Cash Flow + Assumed Asset Increase
We can retain our composure by noting that the write-off period that we choose for Depreciation will have no effect at all on our Measured Cash Flow. It will simply affect the level of the Assumed Asset Increase and hence the level of Estimated Profit. And since we are not clairvoyant, we can never choose exactly the right value for the Depreciation write-off period in advance, because we cannot know how long the equipment will last.
It follows inexorably from this observation that our Estimated Profit and Assumed Asset Increase values will almost always be incorrect, or to put it more specifically: the probability of determining the right values for them is negligible because we don’t know how long these capital items will last.
The right answer to this conundrum is therefore to understand that declarations of profit and asset valuation by companies are always estimates. They may not be massively incorrect, but they are most unlikely to be perfectly accurate. But perhaps counter-intuitively, even though neither Estimated Profit nor Assumed Asset Increase can be correctly measured, the difference between them can, because it is called Measured Cash Flow. The pragmatic reality of cash flow might therefore strike us as rather a good place to start when assessing the performance of a company, as opposed to the metaphysical minefield of estimated profits and assumed assets.
Notwithstanding these difficulties, Geronimo now reminds Ursulina of some of the additional costs involved in running their business. He has been filling up the car with petrol every few days and so this expense also needs to be recorded. The petrol station proprietor lets him pay for this at the end of each month and so we can identify this with the Expenses slider at the bottom of the diagram. This enables you to set a daily level of expenditure which has the effect of increasing the amount owed to Creditors and decreasing the Operating Profit.
Figure 10.2: Expenses and Operating Profit
On the diagram you will see that the Purchases slider is prompting you to obtain some Stock to sell, so set a value on that slider as appropriate. Now it is time to choose values for the remaining sliders - Sales, Gross Profit % and Receipts delay - and watch your business spring into life. In my case you can see the results in Figure 10.2, where I seem to have built a business with a healthy bank balance, plenty of undistributed profits owed to the shareholders, and relatively modest Stock, Debtors, Creditors and Fixed Assets. If only real life were this simple.
