Liabilities

The value of a firm to equity investors risk V = D1/(1+r) + D2/(1+r)2 + D3/(1+r)3 ……. profitability 1 The value of a firm to creditors risk V = I1/(1+r) + I2/(1+r)2 + I3/(1+r)3 + P/(1+r)3 profitability Ii: interest revenues in period i P: return of principal 2 And our job is … Profitability analysis to predict the numerator, that is, the payoffs Risk analysis to predict the denominator, that is, the risk of the getting the payoffs 3 Understanding risk 1. Choosing a profession involves risk, the profession may turn out to be becoming extinct Choosing a restaurant involves risk, they may sell bad food Choosing a person to marry involves risk, he/she may lose interest in her/him Choosing this course involves risk, you may learn nothing Anything that is yet to happen involves risk 2. 3. 4. 5. We are pretty much all risk-averse (躲避风险）！ 4 Understanding risk But risk is good If you have a crystal ball (not necessarily being a witch), you see all your future, would you still live? If before you go into a restaurant, you already can feel the feel, taste the taste, would you like to eat? 5 Understanding risk For investing, risk means future returns to your investment is uncertain Your investment may make money, or lose money. We invest only because in our expectation, we will earn a certain level of expected return; Associated with the expected return comes the expected risk. Rational people endure high expected risk, only for high expected return. 6 Understanding upside risk 高考： 学生要在考试之前填报志愿学校。 如果一类第一志愿学校报高了，有上不了一类 其他好学校，而直接进了二类学校的风险 (downside risk)。 如果一类第一志愿学校报低了，有可能本来可 以进的好学校没有报的风险(upside risk)。 7 Understanding upside risk 买股票也是一样， 如果买的一个股票公司破产了，有损失(down side risk) 如果没有买的一个股票股价飙升了，你也有损 失(upside risk)。 8 Understanding Risk: a statistical presentation Low Risk High Risk Future Earnings 9 Understanding risk An ordering of risk levels: 1) Cash 2) Government bonds 3) Liquid tangible assets 4) Other tangible assets 5) Intangible assets 6) Corporate bonds 7) Preferred stocks 8) Common stocks 9) Private equity investment 10) Venture capital investment 10 Understanding risk Ex ante high expected risk does not guarantee ex post high realized returns, otherwise it will not be called risk; But on average, high risk instruments should earn high ex post returns than low risk instruments, otherwise no one would invest. 11 An example If you buy one share Sina stock today for 1 dollar, and expect to sell one year from now, with no dividend in between. You believe: if next year Chinese economy booms, the share will sell for 3 dollars; if next year Chinese economy bombs, the share will sell for 0.5 dollar. Investment risk means either state of the Chinese economy could happen, and as a result, your return of investment will differ. 12 Obligation A social, legal, or moral requirement, such as a duty, contract, or promise that compels one to follow or avoid a particular course of action. ( www.dictionary.com ) 13 Liability An obligation is a liability if: 1. It involves a probable future sacrifice of resources and the amount of the sacrifice can be reasonably precisely measured. 2. There is little or no discretion to avoid the transfer 3. The transaction or event that gives rise to the obligation has already occurred A liability is an obligation, but an obligation may not be a liability. 14 Liabilities: Recognized, Disclosed and Hidden Accounting items whose economic impact on the firm can be measured with reasonable precision, are recognized in the I/S or B/S. Accounting items whose economic impact on the firm can NOT be measured with reasonable precision, are sometimes disclosed in annual reports, such as contingency liabilities. Some other obligations are not shown on financial statements, but they have potential impact on the firm, so they are hidden. 15 Classifications of Accounting Liabilities by Degree of Certainty on repayment dates and repayment amounts 16 Contingencies: Potential Liabilities • Contingent liabilities are potential liabilities related to past events. • The more probable the potential to become a legal obligation, the greater the rationale for recognizing it as a liability. • Probability of a potential liability is very difficult to measure. • In general, an obligation should be recognized as a liability if it is probable that the firm will have make future sacrifices of resources. • Of course, the word probable is also difficult to measure. • Contingencies are normally disclosed in footnotes. • But, FASB and IASC require the recognition of a loss and a contingent liability, when, given past events, – It is probable that an asset has been impaired or a liability incurred, and – The amount of the loss can be reasonably estimated. 17 Liability Classification • Liabilities are separated into current and noncurrent based on the length of time that will elapse before the obligation must be fulfilled. • Current liabilities are obligations that must be fulfilled within the current operating cycle which is almost always one year. • Noncurrent liabilities are obligations that need not be fulfilled within the current operating cycle. • Obligations calling for periodic payments such as a mortgage may be noncurrent but have a current portion; that is, the payments due within the operating cycle are current but the remaining payments are noncurrent. 18 Current Liabilities a. Accounts payable b. Short-term notes and interest payable c. Wages, salaries and other payroll items d. Income taxes payable e. Deferred performance liabilities: advances from customers f. Deferred performance liabilities: product warranties 19 Long-Term Liabilities a. Bonds b. Mortgages 20 Bonds • Bonds are debt instruments sold to the investing public. • Some bonds carry no collateral（担保） and are called debenture bonds. • Bonds backed by collateral are called collateral trust bonds. • Bonds that can be converted to common shares of the issuing company are called convertible bonds. • Bonds are recorded as a long-term liability. • Bonds usually have a current portion, the interest that is due in one year 21 How to define a bond? 1. A piece of paper 2. Face value (or par value): for example $1,000 3. A nominal （名义上的） interest rate: for example 10% (the rate is annual rate if not stated otherwise. Semiannual rate is half of it at 5%). 4. Duration: number of years before the principle is due, for example, 5 years 5. Frequency of nominal interest payment in a year: annually pays once a year; semiannually pays twice a year (so a five-year bond would have ten semiannual periods) 22 How to define a bond? The definition of a bond is the pattern of its cash payments to the bondholders, nothing else (STOP: This is the first important concept in bond accounting, you must understand before you go on) $1,000 The bond in the previous slide is defined as: $50 $50 $50 $50 $50 $50 $50 $50 $50 $50 This bond is defined by ten $50 payments of nominal interests every half a year (semiannually); and a payment of par value $1,000 at the end of the fifth year. 23 How much will this bond sell for? Like any investment vehicles, the price of a bond is the net present value of its future cash payments (NPV) I assume you have learnt NPV calculations, and The use of present value tables. The bond price and the par value of the bond are totally two different things, they do not have to be the same. The previous bond can be sold more than or less than the par value $1,000. (STOP: This is the second important concept in bond accounting, you must understand before you go on) 24 How much will this bond sell for? The rate of return that we use to discount the cash flows to get NPV of the bond is called discount rate（折现率）. Discount rate is decided, at the time of the bond sale, by the risk associated with the bond. If it is more (less) likely for the bond seller to default in the future, the discount rate will higher (lower). Microsoft’s bond discount rate may be 4.8%, while a small food chain’s bond discount rate has to be 10.7%. Discount rate has nothing to do with the bond’s nominal interest rate; nominal interest rate only determines the cash payments ($50 each in this case).(STOP: This is the third important concept in bond accounting, you must understand before you go on) 25 How much will this bond sell for?-sold at par Let us assume the previous bond’s discount rate is 10% (this 10% has nothing to do with the 10% nominal interest rate). Then the bond price is = 50/(1+5%) + 50/(1+5%)2 + 50/(1+5%)3 + 50/(1+5%)4 + …… 50/(1+5%)10 + 1000/(1+5%)10 = $1,000 Why we use 5% discount rate not the 10%? Because the $50 nominal interest payment is for half a year. We use 10 periods because five years make up ten half-a-years. When bond price is equal to bond face value, we say it is sold at par. You should not rely on any calculator or tables to compute the bond price in the above equation. When nominal interest rate (5%) is the same as discount rate (5%), the bond is sold at par value. (STOP: This is the fourth important concept in bond accounting, you must understand before you go on) 26 How much will this bond sell for?-sold at premium Let us assume the previous bond’s discount rate is 8% (that is, it is less riskier than in the previous slide to lend to the company so a lower discount rate is used). Then the bond price is = 50/(1+4%) + 50/(1+4%)2 + 50/(1+4%)3 + 50/(1+4%)4 + …… 50/(1+4%)10 + 1000/(1+4%)10 = $50*8.11081 + $1,000*0.675562=$1,081 1 2 Stickney and Weil page 855, 4% at n=10 Stickney and Weil page 853, 4% at n=10 Premium = $1,081 – 1,000 = $81 When bond price is more than bond par value, we say it is sold at premium. 27 How much will this bond sell for?-sold at discount Let us assume the previous bond’s discount rate is 12% (that is, it is more riskier than in the previous two slide to lend to the company so a higher discount rate is used). Then the bond price is = 50/(1+6%) + 50/(1+6%)2 + 50/(1+6%)3 + 50/(1+6%)4 + …… 50/(1+6%)10 + 1000/(1+6%)10 = $50*7.36009** + $1,000*0.55839***=$926 ** *** Stickney and Weil page 855, 6% at n=10 Stickney and Weil page 853, 6% at n=10 Discount = $1,000 – 926 = $74 When bond price is less than bond par value, we say it is sold at discount. 28 How much will this bond sell for?-summary Sold at premium Nominal Interest rate Discount rate Bond Price (cash received by the bond seller) Sold at par 10% 10% $1,000 Sold at discount 10% 12% $926 10% 8% $1,081 Understand price differencetechnical In the bond price equation, compare to sold at par, the numerator is the same, but denominator is smaller, then the result gets larger When the market demands 8% (discount rate, rate of return) from the bond seller, the bond seller pays cash at 10% every year. So this bond is worth more than the par value. When the market demands 10% (discount rate, rate of return) from the bond seller, the bond seller pays cash at 10% every year. So this bond is worth its par value. In the bond price equation, compare to sold at par, the numerator is the same, but denominator is larger, then the result gets smaller Understand price differenceintuitive When the market demands 12% (discount rate, rate of return) from the bond seller, the bond seller pays cash at 10% every year. So this bond is worth less than the par value. 29 Bond’s real interest rate and interest expense The bond’s real interest rate is NOT the nominal interest rate; it is the discount rate. Nominal interest rate is only used to determine the pattern of future cash payments. Interest expense is the real interest rate times the balance of the bond payable (principle) account at the beginning of the period.. (STOP: This is the fifth important concept in bond accounting, you must understand before you go on) When the bond is sold at par, interest expense is the the same as cash payment (the $50). When the bond is sold at premium, interest expense is less than cash payment. The difference is a return (decrease) of principle (bond payable). When the bond is sold at discount, interest expense is more than cash payment, the difference increases the principle (bond payable) to the face value. In any case, at the end of the fifth year, after the last payment of $50, bond payable account should have a balance of $1,000 (par value), then the borrower pays the creditor $1,000 cash. 30 Bond accounting – an example $100,000 par value 12% nominal interest rate Five year duration Cash payments made semiannually Discount rate 14% Bond price then = $92,976. This is the amount of cash the bond seller receives from the bond sales. He then: Dr. Cash 92,976 Cr. Bond Payable 92,976 Note: at this time, the bond seller owes $92,976 (principle of the bond), not the $100,000 par value. (STOP: This is the sixth important concept in bond accounting, you must understand before you go on) 31 Bond accounting – an example On June 30 of year 1, the bond seller pays cash $100,000*0.06 = $6,000. This is NOT interest expense. Interest expense for the first half of year 1 = discount rate 7%*bond payable $92,976 = $6,508. Dr. Interest expense 6,508 Cr. Cash 6,000 Cr. Bond payable 508 Now bond payable account balance = $92,976 + 508 = $93,484 32 Bond accounting – an example On December 31 of year 1, the bond seller pays cash $100,000*0.06 = $6,000. This is NOT interest expense. Interest expense for the second half of year 1 = discount rate 7%*bond payable $93,484 = $6,544. Dr. Interest expense 6,544 Cr. Cash 6,000 Cr. Bond payable 544 Now bond payable account balance = $92,976 + 508 + 544 = $94,028 So on so forth, on December 31 of year 5, after pay cash of $6,000 for the 10th time, bond payable account has a balance of $100,000. Then pay cash of $100,000 to return the par value. Dr. Bond Payable 100,000 Cr. Cash 100,000 The bond is gone now!!! 33 This exhibit shows the calculation of interest expense and increase in bond payable over the five year duration period. It is called an amortization schedule because it looks like that the total discount, $7,024, has been amortized over these ten periods) 34 Bond retirement before maturity The balance of bond payable account is the book value of the bond. After the bond is sold, its book value will seldom equal the market value of the bond, in the same what that the book value of a building will seldom equal the market value of the building. Why market value of bond changes? Remember the cash flows in the bond price equation do not change, then the only thing that changes bond market value is the discount rate. The discount rate changes with 1) the company’s ability to pay off debts, 2) the country’s risk-free rate, and 3) inflation rate. 35 Bond retirement before maturity After the bond is sold, sometimes, the seller buys the bond back from the bondholder at market value. If market value is smaller than the book value, the seller realizes gains; if larger, the seller realizes losses. (remember this is liabilities not assets) To avoid companies using bond retirement to manage their earnings, GAAP requires the gains/losses from bond retirement to be shown in I/S as extraordinary items, which is included in net income, but not excluded from income from continuing operation. 36 Analysis of Risk • Questions or issues a. Can the firm pay short-term obligations like workers’ wages? That is, what are measures of short term risk? (liquidity risk流动性风险) b. Can the firm pay long-term obligations like debt? That is, what are long-term measures of risk? (insolvency risk偿债风险) 37 Liquidity risk Example: A company has a regular balance of short term liability payment of 5 million dollars. A company normally invests its idle cash in large-cap stocks, who liquidity of trading makes them easy to sell. At the beginning of 2001, A company invested 25 million dollars of idle cash in stock market and sell stock when the short term liability is due. But in 2001, stock market crashed and A company lost 24 million dollars on the 25 million investment in stocks. Unable to raise cash from elsewhere and no able to meet the 5 million short term liability payment, A company declares bankruptcy. 38 Liquidity risk In most cases, a short term liquidity problem does not mean bankruptcy if the firm does not have solvency problem. 1) Creditors may alter the terms of debt contract to delay payments, 2) Court may not allow bankruptcy, 3) Company may soon raise additional cash 39 Insolvency risk However, it is difficult for the firm to dodge insolvency risk 1) High liability build-up; 2) Even if assets still exceed liabilities, selling assets to repay liabilities mean the firm has nothing to operate on; 3) Investors, customers, suppliers etc. lost confidence on the firm’s survival. 40 The economics of bankruptcy 1. In some cases, it is not in creditors’ interest to force the firm into bankruptcy; keeping the firm alive may prove to be a turnaround; forcing it into bankruptcy may expedite the loss of value 2. But in other cases, if not forcing the firm into bankruptcy asap, firm may take on even riskier projects that harm creditors more. 3. Also consider other stakeholders of the firm in a bankruptcy: employees, local community, suppliers, customers, etc. 41 The rough procedure of bankruptcy protection (chapter 11) in the US 1. Creditors force the firm into chapter 11 protection; 2. A U.S. bankruptcy court takes over the firm and appoint a trustee and probably a new CEO; 3. Accountants, appraisers, lawyers and bankers are brought; 4. Restructuring plan is negotiated; 5. Several ways to settle the liabilities: waivers, converted into common shares, some cash payment; 6. The firm can still walk away from the negotiation by threatening going right into bankruptcy; 7. In the end, old shareholders lost everything, new shareholders are brought in. 8. The firm emerges out of bankruptcy protection as a new firm. 42 In one word… Bankruptcy is ugly!!! 43 Factors that affect risk of a firm – Economy-wide factors such as inflation – Industry-wide factors such as competition – Firm-specific factors such as potential for a labor strike, a weak market, key employee loss 44 Measures of Short-Term Risk • Measures of short-term liquidity risk • Current ratio – current ratio = (current assets)/(current liabilities) – Measure of ability of the firm to pay short-term liabilities on time • Quick ratio – (current highly liquid assets)/(current liabilities) – Current highly liquid assets are assets that are quickly and easily converted into cash – This includes bank accounts but not inventories 45 Measures of Short-Term Risk (Cont.) • Cash flow from operations to current liabilities ratio – (cash flow from operations)/(current liabilities) – Measures the ability of the firm to pay current liabilities without borrowing or additional investments. • Working capital turnover ratios – Working capital is a broad definition of cash that includes cash and other assets that are highly liquid such as marketable securities. – Ratios that use working capital show the short-term liquidity of the firm including near-cash assets. 46 Measures of Long-Term Risk • Debt-to-equity ratio – (total liabilities)/(total equities) – Percentage of total financing provided by debtors or creditors. – A firm is said to be highly leveraged when this ratio is large. • Cash from operations to total liabilities ratio – Measures the ability of the firm to pay all liabilities from cash without new debt or additional investment. 47 Measures of Long-Term Risk (Cont.) • Interest coverage ratio = (interest before interest and income tax) (interest expense) • Number of times interest is covered by income • Indicates the relative protection that operating profitability provides to debtors • Some analysts use cash flows instead of income 48 Forecasting tips 1. Time series analysis of ratios 2. Cross-sectional analysis of ratios 3. You have to know the average ratios of industries. 49 Limitations of Ratio Analysis 1. Ratios based on financial data share the same problems of financial data (such as timeliness). 2. Changes in many ratios correlate with other ratios so a direct interpretation of a change in a ratio is not always apparent. 3. Comparing ratios over time is complicated by the fact that economic conditions may change also. 4. Comparing ratios between two firms is complicated by the fact that the firms may have different economic environments or production technologies even though they produce the same product. 50 The Altman Z-Score: a Predictor of Bankruptcy Z = 0.72*X1 + 0.85*X2 + 3.11*X3 + 0.42*X4 + 1.0*X5 where X1 = (Current assets – current liabilities)/total assets X2 = Retained Earnings/total assets X3 = EBIT/total assets X4 = Market value of equities/total liabilities X5 = Revenues/Total assets 2.675 was the early cutoff point for bankruptcy discrimination; Z-score below 2.675 was considered risky. 51 The conceptual framework of Z-score development 1. The idea is to use financial data to predict the likelihood of bankruptcy; 2. It does not have to involve X1-X5; 3. Statistical tools are used to identify variables that have the highest predictive power; 4. Any model incurs type I and type II error, where type I error identifies a bankruptcy firm as nonbankruptcy and type II error identifies a nonbankruptcy firm as a bankruptcy one. 52 盈余的时间序列特性（二）： 企业风险评估与融资成本 • 财务汇报的透明性与融资成本(Lang and Lundholm, 1996) • 盈利波动性与融资成本(Gode and Mohanram, 2001；Gebhardt, Lee, and Swaminathan, 1999) • 分析师盈余预测分散性与股票回报（Diether, Malloy, and Scherbina, 2002） • 盈利波动性与“特殊处理ST”(姜国华，王汉生， 2005) 53 企业风险评估与融资成本 • 企业使用投资者的资金要支付使用价格，即资 本成本 • 资本成本的大小取决于投资者认为的企业经营 风险的高低 • 投资者认为的风险越高，资本成本越高，企业 的价值越低，投资行为越受限制 • 盈余汇报应该帮助投资者正确认识企业的风险， 尽量减低投资者要求的资本成本 54 企业风险评估与融资成本（续） • 增加财务汇报的透明度可以降低投资者 认为的风险，从而降低企业的资本成本 • 降低企业盈余的波动性可以起到同样的 作用 • 证券分析师在企业和投资者之间起着至 关重要的桥梁作用，他们对企业盈余汇 报的理解可以作为投资者理解的代表 55 财务汇报的透明性与分析师盈 余预测 因变量是分析企业的分析师数目；β4代表企业财务 汇报透明度指数对分析师数目的影响 56 财务汇报的透明性与分析师盈 余预测（续） 因变量分别是分析师盈余预测的分散性和准确度；β4代 表企业财务汇报透明度指数对分析师预测的影响 57 财务汇报的透明性与分析师盈 余预测（续2） • 结论： • 企业财务汇报透明度越高，越多分析师 预测企业的未来盈余 • 企业财务汇报透明度越高，分析师对企 业未来盈余的预测准确度越高，分析师 预测的分散性越小；两者都降低企业的 融资成本，提高企业价值 58 盈利波动性与融资成本 自变量是融 资成本，框 内是盈余波 动性对融资 成本的影响 59 盈利波动性与融资成本（续） 按盈余波动性把企业分成5组，从低到高各组企业资本成本中 风险溢价的平均数 60 分析师盈余预测分散性与股票 回报 按分析师对企业盈余预测的分散性分组，各组未来投资回报的 平均数 61 对财务汇报的启示（五） • 在不涉及企业商业秘密的情况下，增加 企业财务汇报的透明度可以降低企业的 融资成本 • 投资者（分析师）不喜欢企业盈余波动 大，所以，通过平滑企业的盈余能够降 低企业的融资成本 • 证券分析师作为投资者信息来源的重要 专家，应该成为投资者关系的重要对象 62 国际证券分析师预测什么样的中 国上市公司？ 63 盈余波动性与我国上市公司的退 市风险 • 企业亏损的概率是长期赢利能力/盈余波 动性的函数（盈亏稳定性） 64 盈余波动性与我国上市公司的退 市风险（续） 表一：盈亏稳定性及其连续亏损的概率 分位数 50% 45% 40% 35% 30% 25% 公司代码 65686Y10 33803220 盈亏稳定性 0.905 0.727 0.581 0.453 0.336 0.184 赢利能力 0.100 0.130 一年亏损 0.183 0.234 0.281 0.325 0.368 0.427 赢利波动率 0.547 0.704 两年亏损 0.033 0.055 0.079 0.106 0.136 0.182 盈亏稳定性 0.184 0.184 65 作业 产生一个spreadsheet，并命名为“风险分 析” 1）做出所有风险比率的时间序列分析 2）做出所有风险比率的配比公司对比分析 3）计算Altman Z-score 66