Module 3: Financing Activities Analysis

Leases

"A lease is a con- tractual agreement between a lessor (owner) and a lessee (user). It gives a lessee the right to use an asset, owned by the lessor, for the term of the lease. In return, the lessee makes rental payments, called minimum lease payments (or MLP). Lease terms obligate the lessee to make a series of payments over a specified future time period. Lease contracts can be complex, and they vary in provisions relating to the lease term, the transfer of ownership, and early termination. 3 Some leases are simply extended rental contracts, such as a two-year computer lease. Others are similar to an outright sale with a built-in financing plan, such as a 50-year lease of a building with automatic ownership transfer at the end of the lease term." "capital lease. If classified as a capital lease, both the leased asset and the lease obligation are recognized on the balance sheet. All other types of leases are accounted for as operating leases. In the case of operating leases, Both types Operating only 39% the lessee (lessor) accounts for the minimum lease payment as a rental 55% expense (revenue), and no asset or liability is recognized on the balance sheet." "Lessees often structure a lease so that it can be accounted for as an operating lease even when the economic characteristics of the lease are more in line with a capital lease. By doing so, a lessee is engaging in off-balance-sheet financing. Off-balance-sheet financing refers to the fact that neither the leased asset nor its corresponding liability is recorded on the balance sheet when a lease is accounted for as an operating lease even though many of the benefits and risks of ownership are transferred to the lessee." "The decision to account for a lease as a capital or operating lease can significantly impact fi- nancial statements. Analysts must take care to examine the economic characteristics of a company's leases and recast them in their analysis of the company when necessary."

Lease Classification Reporting

"A lessee (the party leasing the asset) classifies and accounts for a lease as a capital lease if, at its inception, the lease meets any of four criteria: (1) the lease transfers ownership of the property to the lessee by the end of the lease term; (2) the lease contains an option to purchase the property at a bargain price; (3) the lease term is 75% or more of the estimated economic life of the property; or (4) the present value of the minimum lease payments (MLPs) at the beginning of the lease term is 90% or more of the fair value of the leased property. A lease can be classified as an operating lease only when none of these criteria are met. Companies often effectively structure leases so that they can be classified as operating leases."

Affirmative Covenants

"Affirmative covenants specify actions that management needs to take to keep the debt in good standing. An example of an affirmative covenant is the re- quirement that the company must file audited financial statements that are in accor- dance with GAAP within a specified time period. Failure to file audited financial state- ments gives lenders the legal authority to ask for immediate repayment of their loans." "Details of covenants are available in notes to the financial statements and also in the debt agreements or the prospectus to the debt issue."

Short Term Debt

"Companies also borrow money over the short term. In addition to its flexibility, short-term borrowing offers lower interest rates than long-term debt. However, short- term borrowing is riskier because of the need for repayment in the near term. Examples of short-term borrowing are revolvers, discounted bills, and commercial paper. Short- term debt is primarily used for financing working capital and other liquidity needs. Short-term borrowing is classified as a current liability and appears on the balance sheet as line items called bank borrowing, commercial paper, or short-term notes." Sometimes companies issue short term promissory notes from third parties (such as customers) to banks for immediate cash be- fore they become due, at a discount to the principal amount in the note. This is called bill discounting." "Also, large and well-reputed companies issue short-term unsecured notes to investors in the global credit markets. These notes are known as commercial paper."

Debt Related Disclosures

"Companies are required to report details regarding their long-term (and short-term) debt in notes to the financial statements. In addition to explaining the amount recog- nized on the balance sheet, the note disclosures provide other useful information. These include information regarding anticipated future maturities of the debt, details of con- tractual provisions such as collateral and covenants, unused balances in lines of credit, and any other pertinent information relating to a company's debt."

Long Term Debt

"Debt that has terms exceeding a year is called long-term debt. Examples of long-term debt are bonds, debentures, and notes issued to the public (public debt); and term loans and long-term notes (private debt)." "any portion of long-term debt that matures within a year of the balance sheet date is classified as a current liability and called current portion of long-term debt."

Equity

"Equity refers to claims of owners on the net assets of a company. Claims of owners are junior to creditors, meaning they are residual claims to all assets once claims of creditors are satisfied. Equity holders are exposed to the maximum risk associated with a company but also are entitled to all residual returns of a company. Certain other securities, such as con- vertible bonds, straddle the line separating liabilities and equity and represent a hybrid form of financing."

Unutilized Credit Lines

"Exhibit 3.2 reveals that Alliance One has $695 million of available credit lines. While this may indicate that the company has the ability to increase its borrowing significantly, in reality it is not so. All the available credit lines are in the form of short-term working cap- ital finance. Therefore, these credit lines can be used only to specifically finance Alliance One's working capital needs. Accordingly, the company can borrow only to the extent that it has current assets such as inventory and receivables. Besides, Alliance One's busi- ness is seasonal, and so it is possible that its working capital requirement could expand significantly during peak seasons, such that it fully utilizes the available credit lines. An analysis of the company's quarterly reports will confirm this conjecture."

Fair value accounting

"Fair value also reflects the present value of debt. However, fair values diverge from amor- tized cost because they reflect current interest rates, unlike amortized cost, which reflects interest rates at the time of issue. For example, Alliance One discloses that the fair value of its total long-term debt is $905 million, which is higher than its amortized cost of $885 million. Fair value accounting for debt is not currently required. However, US GAAP and IFRS encourage companies to recognize the fair value of debt on the balance sheet. At present, a number of financial institutions have chosen to report certain types of debt at fair value." "it is not clear whether fair value accounting improves the accounting for debt when companies are expected to hold the debt until maturity." "fair value accounting to debt can cause transitory unrealized gains or losses to creep into reported income. It is important for an analyst to identify these items and remove them when estimating sustainable income." "More crucially, it is pos- sible for companies to recognize a gain when its own credit quality deteriorates! That is, as a company's creditworthiness declines, the market value of its debt will decrease. Under fair value accounting, this will result in recording an unrealized gain in net in- come. Recently, a number of banks have recorded such gains. It is important for an an- alyst to exclude these gains when analyzing a company's income." "Probably the only situation where fair value accounting for debt makes sense is for financial institutions. Typically, banks have both assets and liabilities that are sensitive to economy-wide interest-rate movements, and it makes sense to "match" the values" of "assets and liabilities by marking both to market. A bank that has properly matched the maturity profile of its assets with those of its liabilities will have a stable debt-equity ratio when both sides of its balance sheet are marked to market, even though its assets' and liabilities' values may both display volatility related to interest-rate movements."

Amortization of bond premium

"First, consider the 6% interest-rate scenario. In this case, the present value of the bond at issue—which is represented by Year 0—exactly equals $100,000. 1 Because the company gets to raise exactly the face value, we say that the bonds were issued at par. In this scenario, interest expense (Effective interest rate * Beginning of period present value) also exactly equals the coupon payment of $6,000 (6% * $100,000) in each year. Now consider the case where the effective interest rate is 3%. The present value at the time of issue is now $108,486. Because the market values the bonds at their present value, the company gets to issue the bonds above the face value of $100,000, or at a premium of $8,486. Interest expense is now much lower than the coupon payment. For example, in Year 1 it is $3,255 (3% * $108,486). Therefore, when the company pays the $6,000 coupon to the lenders, it is as if the company is also returning principal to the tune of $2,745 ($6,000 - $3,255), which reduces the present value of the bond. We refer to this $2,745 as amortization of bond premium. Note that the interest expense and the amortiza- tion are not the same every year, but the two will always add up to the coupon payment."

Future Debt Retirement Forecasting

"It is important for an analyst to carefully examine the future debt payment schedule. At the outset, this helps with cash flow forecasting. At a deeper level, an analyst has to evaluate whether a company has the ability to repay its debt when it matures because an inability to do so could potentially lead to bankruptcy. Typically, companies tend to refinance maturing debt with fresh borrowing. However, an analyst cannot simply as- sume that the debt will be refinanced, especially for companies that are not in good fi- nancial health. Companies that are unable to refinance will often renegotiate with their bankers to extend the debt's maturity. Such renegotiations, however, involve significant costs, typically in the form of higher interest rates or payment of various penalties."

Lender Protections in Analysis

"Lenders often have explicit contracts with borrowing companies which helps the lenders protect the money they have loaned. Typically, there are three ways in which lenders protect themselves: (1) seniority, (2) collateral, and (3) covenants. Information in the notes to the annual report provides details about these protections. Understand- ing the nature of these protections and their implications is important in analysis, especially for firms that are in poor financial health."

Negative Covenants

"Negative covenants limit management behaviors that might be harmful to the lenders. Such covenants typically consist of two parts: (1) constraints, which specify when a com- pany has violated a covenant; and (2) penalties or restrictions that arise when a covenant has been violated. Typically, violating a covenant is grounds for technical default, which provides lenders legal rights to demand immediate repayment of their debts. While lenders rarely seek immediate repayment in practice, they may specify fresh conditions and constraints on the company as part of the renegotiation that occurs during technical default. Negative covenants may also impose restrictions on management behavior when a violation occurs. Such restrictions may include restrictions on dividend payment, restrictions on further borrowing, restrictions on issuing senior debt, restrictions on cap- ital expenditures, and restrictions on mergers and acquisitions. The objective of such re- strictions is to limit the dilution of net assets by constraining management's ability to dis- tribute assets to new or continuing shareholders or to new lenders. By doing this, current lenders ensure that the money they have loaned to the company is protected." "The constraints that specify when a company has violated a covenant are typically related to some form of financial health. Often these conditions are specified in terms of financial statement information. The most popular constraints link the amount of bor- rowing to various indicators of financial performance or financial position. Examples are covenants that specify a minimum amount of retained earnings, maximum debt-to- equity ratios, minimum coverage ratios, and maximum ratios of debt to EBITDA. Whenever a company's ratio crosses the minimum or maximum values specified, the company is said to have violated the covenant."

Lease amortization schedule example

"Over the entire five-year period, total expense for both methods is identical. However, the capital lease method reports more expense in the earlier years and less expense in later years. This is due to declining interest expense over the lease term. Consequently, net income under the capital lease method is lower (higher) than under the operating lease method in the earlier (later) years of a lease."

Revolving Lines of Credit

"Revolving lines of credit (or revolvers, for short) refer to short-term borrowing from banks that is used to finance working capital needs. A line of credit works somewhat like a credit card. That is, a company can borrow only what it requires as long as it is within the maximum borrowing limit and pays interest on only the amount borrowed. The maximum borrowing limit is determined by the contracted maximum line of credit and the value of existing current assets that serve as collateral for the loan."

Security (collateral)

"Security or collateral refers to assets that are set aside during dissolution to specifically satisfy a particular claim. A claim that is backed by collateral is called secured. In the event of dissolution of the company, the owners of these particular claims can sell the identified assets to satisfy their claims. The particular types of assets offered as collateral are laid down in the lending contract. For example, short-term finance is usually secured by current assets such as inventory. Alliance One's senior credit facility ("Revolver") is secured by current and certain non-current assets."

Seniority

"Seniority refers to the order in which different parties will be paid when a company's business is dissolved. Senior claims will be paid before junior claims. The seniority of certain claims is predetermined by law. For example, government dues, such as taxes payable, and employee dues, such as unpaid salaries, need to be settled before" "claims are handled. Also, equity holders can be paid only after all other claims are fully paid, and so common equity is the most junior of all claims. Within similar classes of claims—for example, within the broad classes of creditors—seniority can be determined explicitly by contractual provisions. For example, all the long-term debt of Alliance One is senior, which suggests that these claims will get preference over other claims, such as accounts payable."

fair value of a bond

"The fair value of the bond is the present value of the bond discounted at the current interest rate, rather than the rate at the time of issue." "For example, in our "discount" scenario, if the interest rate drops from 10% to 7% at the end of Year 1, the fair value of the bond at Year 1 end would be $98,192 (present value of the remaining two coupon payments and face value discounted at 7%). If the interest subsequently dropped to 3% by the end of Year 2, the fair value at Year 2 end would be $102,913 (present value of one remaining coupon payment and face value discounted at 3%)."

Short term debt accounting

"Unlike long-term debt, short-term debt is typically reported at face value. The reasoning behind reporting short-term debt at face value is that face values rarely diverge from present values given the short-term nature of the debt."

Capital Lease Vs Operating Lease Accounting EXTENDED

"We begin the analysis by preparing an amortization schedule for the leased asset as shown in Exhibit 3.3. The initial step in preparing this schedule is to determine the present (market) value of the leased asset (and the lease liability) on January 1, 2005. Using the interest tables near the end of the book, the present value is $10,000 (computed as 3.992 * $2,505). We then compute the interest and the principal amortization for each year. Interest equals the beginning-year liability multiplied by the interest rate (for year 2005 it is $10,000 * 0.08). The principal amount is equal to the total payment less inter- est (for year 2005 it is $2,505 -$800). The schedule reveals the interest pattern mimics that of a fixed-payment mortgage with interest decreasing over time as the principal bal- ance decreases. Next, we determine depreciation. Because this company uses straight line, the depreciation expense is $2,000 per year (computed as $10,000/5 years). We now have the necessary information to examine the effects of this lease transaction on both the income statement and balance sheet for the two alternative lease accounting methods." Income statement effects of alternative lease accounting methods-example image attached.

Long Term Debt Accounting

"We now examine the key features of accounting for long-term debt. First, long-term debt is always reported on the balance sheet at present value, not at the face value. This present value is known as amortized cost. For example, in the "discount" scenario of our illustration, the balance sheet will show $90,053 in Year 0, $93,058 in Year 1 and so on. Second, the income statement will reflect the interest expense and not the coupon payment. Again for the "discount" scenario, interest expense will be $9,005 in Year 1, $9,306 in Year 2, and so on. Third, the coupon payment of $6,000 is a cash outflow that reduces cash flow from operating activities. Fourth, the amortization of bond discount—$3,005 in Year 1—gets added to the carrying value of the bond so that the carrying value of the bond now reflects the updated present value. 2 In case of premium, the amortization of the premium is sub- tracted from the bond's present value. The accrual accounting identity works in the fol- lowing manner (the numbers below pertain to Year 1 for the "discount" scenario): Interest expense (reduce equity) $9,005=Cash outflow(reduce assets)($6,000)+ Amortization of bond discount (increase long-term debt) $3,005. These accounting rules are common to both US GAAP and IFRS. Similar rules also apply to both public and private debt. However, differences between coupon and effec- tive interest rates are rare in private debt, although they do happen occasionally. Be- cause of this, amortized costs rarely differ from face values for private debt." Both US GAAP and IFRS encourage—but do not require—companies to report long- term debt at fair value. When a company adopts fair value accounting, the balance sheet recognizes the current fair value of the bond and all changes in the fair value of debt during a period are included in net income as unrealized gain or loss on debt."

Capital Lease Vs Operating Lease Accounting

"When a lease is classified as a capital lease, the lessee records it (both asset and lia- bility) at an amount equal to the present value of the minimum lease payments over the lease term (excluding executory costs such as insurance, maintenance, and taxes paid by the lessor that are included in the MLP). The leased asset must be depreciated in a man- ner consistent with the lessee's normal depreciation policy. Likewise, interest expense is accrued on the lease liability, just like any other interest-bearing liability. In accounting for an operating lease, however, the lessee charges rentals (MLPs) to expense as they are incurred; and no asset or liability is recognized on the balance sheet." "The accounting rules require that all lessees disclose, usually in notes to financial statements: (1) future minimum lease payments separately for capital leases and operating leases for each of the five succeeding years and the total amount thereafter, and (2) rental expense for each period that an income statement is reported."

Amortization of bond discount

"When the interest rate is much higher than the coupon rate, then the mirror image of the "premium" scenario unfolds. The present value at issue is $90,053. Therefore, the company issues the bonds below face value or at a discount of $9,947. Every year, interest expense is higher than the coupon payment, and so it is as if the company is borrowing more every year, therefore increasing the present value of the bond. For example, in Year 1 this notional borrowing—which we call amortization of bond discount— is $3,005 ($9,005 - $6,000)."

Balance Sheet Effects of Capitalized Leases

"While the operating lease method is simpler, the capital lease method is conceptually superior, both from a balance sheet and an in- come statement perspective. From a balance sheet perspective, capital lease accounting recognizes the benefits (assets) and obligations (liabilities) that arise from a lease trans- action. In contrast, the operating lease method ignores these benefits and obligations and fully reflects these impacts only by the end of the lease term. This means the balance sheet under the operating lease method fails to reflect the lease assets and obli- gations of the company." "Note the leased asset is always lower than the lease liability during the lease term. This occurs because accumulated depreciation at any given time exceeds the cumulative principal reduction." Cash decreases Leased asset decreases by depreciation expense Leased liability decreases by principle reduction Equity and Expense accounts should equal in debts and credits on capital lease interest expense and depreciation expense = total expense. equity will be - so debit expense + credit?

Financing Liabilities

"are all forms of debt financing such as long- term notes and bonds, short-term borrowings, and leases." Also known as interest-bearing liabilities

Operating Liabilities

"are obligations that arise from operations such as trade creditors, and postretirement obliga- tions. Liabilities are commonly reported as either current or noncurrent—usually based on whether the obligation is due within one year or not." ie. accounts payables

Debt Financing: Private Debt

Corp borrows from financial institutions such as banks.

Debt Financing: Public Debt

Corp issues bonds directly to investors for financing

Credit Analysis

Senior Debt is less risky than junior debt because it gets paid first during company dissolution. "In the absence of seniority, the junior claimants would also get to share in the payoffs. Second, certain debts like unpaid taxes and wages get priority over all other claims. Therefore, even senior lenders could suffer if a company has large unpaid taxes or wages." "Secured debt is less risky because there are explicit assets (the collateral) that trans- fer to the holders of the secured debt during company dissolution." "First, the safety of secured debt crucially depends on the value of the collateralized assets." "For example, debt secured by inventory may not be protected if a firm is likely to go bankrupt because there is no demand for its products. Second, unsecured debt be- comes more risky in the presence of secured debt. This is because certain assets (the collateral) are removed from the common pool of assets that are used to pay common claims. Third, sometimes seniority—especially of the legal kind—can over- ride security." "Paradoxically, secured debt typically carries higher interest rates than unsecured debt, suggesting that it is more risky. This occurs because only the riskiest compa- nies issue secured debt. In most cases, the presence of secured debt is an indicator that the company is in poor financial health and cannot afford the extremely high interest rates that will be charged on its unsecured debt." "Not only should an analyst keep track of actual covenant violations, but he or she must also estimate covenant slack (or margin of safety), which is a measure of how close a company is to violating its covenants. Covenant slack can be estimated by calculating the particular ratios that are specified in the covenant using current financial statement information and then comparing these values to the value that will potentially trigger a violation."

Leasing( long term debt)

indirect form of long term borrowing is leasing. Companies especially certain industries such as airlines and retail acquire a majority of their assets through leases. Although structured to look like a rental agreement, leases are a major form of debt financing.