All assets can be classified into two types:
- Performing Assets (PAs)
- Non-Performing Assets (NPAs)
Performing Assets (PAs): Are the assets that directly help in generating income.
Non-Performing Assets (NPAs): Are assets that indirectly help in generating income.
- Every organization is bound to posses NPAs.
- Non-performing does not necessarily mean non-essential or those that are not required.
- NPAs are those that do not directly generate income.
- Furniture in Café is essential but does not generate income. However, coffee machine is a performing asset.
- Office car given to CEO is a NPA, however if it is used as a taxi then it is a Performing Asset.
- PA v/s NPA ratio
- Let us assume the ratio to be 50:50. – Sometimes it might be 70:30 and sometimes 30:70. It is very subjective and varies from business to business. For this example we will assume it is 50%.
- The mistake can be avoided by generating $163,000 on an investment of $1,000,000.
- However 50% of assets are NPAs, so business has to generate $163,000 from $500,000.
- This now takes the targeted rate of return from 16.3% to 32.6%.
Question: Do PAs perform throughout the year?
No, it does not.
- It has been estimated that PAs effectively perform for two-thirds (2/3rd) of the year. You open your business in the morning and close in the evening. So, definitely business is not happening for 24 hours. Some business will be open on weekends and some stay off. Then you have public holidays and other holidays. Then you have seasonal variations. So it is estimated in general PAs perform only 2/3rd of the year.
- But liabilities perform throughout the year! The banker will not say that since it is a public holiday and you are not making money so do not bother me paying that day’s interest. That would not happen. You still will have to pay the full amount.
- So now assets are supposed to generate 32.6% which has to be achieved over 2/3rds of the year.
- The effective targeted annualized rate of return now goes up to 48.9%.This is because PAs perform 2/3rds of the year. So the Cost of Capital for this business is 48.9%.