Why We Exclude Intangible Assets in Credit Analysis
Introduction: See Me, Feel Me?
In an earlier post on Linkedin, I explained the role of tangible net worth as a measure of a borrower’s financial strength.[i] “ Tangible net worth (TNW) is a calculation of the value of a company that excludes any value derived from intangible assets such as copyrights, patents, trademarks, goodwill, and intellectual property. Intellectual property includes things such as proprietary technology or designs. ??TNW is what remains after deducting total liabilities from tangible assets, and it is a key component to the TNW/Total Debt leverage ratio where a ratio value of 1.0x or more indicates that the firm has the ability to pay off all its liabilities. Some readers of that post asked me to write a follow-up to the TNW piece concentrating on intangible assets and their lack of value.?
For What It’s Worth Right Now
When the Who sang in 1969 about their blind, deaf pinball wizard Tommy, “See me, feel me, touch me, heal me . . . ,[ii] they probably did not realize that they had created the perfect theme song for intangible assets.? What does intangible mean?? Merriam-Webster defines intangible as “ incapable of being touched : having no physical existence : not tangible or corporeal. “[iii]? When intangible is applied to balance sheet assets, these are assets incapable of being touched because they have no physical existence.? After all, when a lender is sizing up a borrower’s ability to repay from its cash flow, the lender likes to have alternate repayment sources, i.e., the borrower’s assets as collateral, especially collateral assets that can be liquidated at prices close to their current purchase prices, e.g., marketable securities, receivables and inventories.? Consequently, assets with no discernable value are excluded from tangible assets, e.g., copyrights, patents, trademarks, and goodwill. Why such harsh treatment?
Intangible assets are difficult to quantify? because they are usually ?dependent on future external events. Indeed, how does an analyst estimate ?the value of goodwill or a patent? It is extremely difficult because their actual value depends on external context, which may rapidly evolve.? For example, a patent may have some value for a few months but become obsolete overnight. The value of goodwill may vary depending on many criteria: competitive environment, market growth, and positioning.? Because of this subjectivity, the valuation of intangible assets ultimately varies with the success of the borrower’s business strategy.? For example, a major computer software firm may possess valuable intangible assets in its ?intellectual property that could continue to increase as software updates roll out.? Consider how much Microsoft’s windows software has ?risen in value over the years.? But if Microsoft failed, what would happen to the value of its software or the Microsoft trademark with no more improvements?? ??
?A trademark's value is the amount a non-owner would be willing to pay for it, and it is based on the goodwill associated with the trademark. The value of a trademark can be difficult to determine because it depends on many factors, including:
·?????? Brand recognition: How well the brand is recognized
·?????? Market demand: How much demand there is for the brand's products or services
·?????? Competitive landscape: The state of competition in the brand's industry
·?????? Intellectual property protection: The strength of the brand's intellectual property
·?????? Brand reputation: The reputation of the brand
·?????? Sales revenue: How much revenue the brand generates
·?????? Market conditions: The state of the market
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·?????? Expected future earnings: How much the brand is expected to earn in the future[iv]
Failed enterprises are unlikely to continue to generate revenues and profits, and the public’s memory of a brand fades over time—remember any of these—Eastern Airlines, Pan Am, Sharper Image, Toys-R-Us, K-Mart?? Nostalgia sometimes resuscitates a brand—Pan Am branded clothing and accessories—but not nearly enough revenues to bring a brand back to its previous value.? Trademarks illustrate the vulnerability of intangible assets.? Their value is highest when they represent a successful firm, but when its success fades, so does its value.
Further, the primary purpose of a credit analysis is to determine a company’s ability to pay its debts, e.g., its invoices and loans in the short term, perhaps a few weeks or even a few months. However, intangible assets are difficult to convert immediately into cash and, therefore, do not strengthen the liquidity of a company in the short run.? The purpose of TNW is not to deny the value of a company’s intangible assets, which, in most cases, do have some value, but to put them aside because they do not help the company immediately meet its debts.
Summary and Closing: Now Is Better than Later
Intangible assets foster long-term value by creating a market niche by increasing revenue and profits, but that may be too far in the future to realize any immediate cash flow now.? The economist John Maynard Keynes wrote in 1923:? “But this long run is a misleading guide to current affairs.? In the long run we are all dead.”? The comedian Steven Wright bragged:? “I plan to live forever, so far so good.”? So, look forward to intangibles later but bank on tangible assets now.
[i] See my LinkedIn post “Tangible Net Worth;? The Real Story.”
[ii] The Who—Tommy Lyrics and Track List, 1969” https://genius.com/albums/The-who/Tommy
[iii] Merriam-Webster Dictionary definition of intangible, at
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Bank of America Private Bank at Bank of America
3 周Insightful, as always!
Banker | Credit Expert | Customer Relationship Builder | Team Leader
3 周Well done Dev! I have always appreciated your style and humor!