Liabilities Off Balance Sheet

Liabilities & Off Balance Sheet Graham - Buffett Concentration in Security Analysis 1 Current Liabilities Result of Operating Activities (carried at expected, undiscounted, cash flow) • Operating & trade liabilities (require future cash payment) • Customer advances, payments for services to be rendered (require future service or delivery of goods) Result of Financing Activities (carried at discounted cash flow) • Short term debt such as commercial paper and lines of credit • Current portion of LTD Graham - Buffett Concentration in Security Analysis 2 Long Term Debt • The initial liability reported is the money paid to issuer by the creditor • This will be the present value of the future payments “promised” to the creditor discounted at the risk adjusted discount rate which the creditor wishes to earn. • This might not be the par value (face value) of the debt • I.e., the initial liability might include a discount or premium from face value • You should understand the calculation of interest expense which accounts for the amortization of premiums and discounts using time value of money concepts, the “interest method”. Graham - Buffett Concentration in Security Analysis 3 Cash flow classification of debt payments is based on the coupon rate, not the interest rate Face value = $100,000, maturity = 3 years, Coupon rate = 10% (semiannual) Premium Bond YTM = 8% Discount Bond YTM = 12% Interest Expense Balance Sheet Liab Cash Flows Bond Issued at Year 1 2 3 Total Par Prem 10,000 8,388 10,000 8,256 10,000 8,114 30,000 24,758 Discnt 11,452 11,632 11,833 34,917 Bond Issued at Par 100,000 100,000 100,000 Prem 103,630 101,866 100,000 Discnt 96,535 98,167 100,000 Operations Finaning (for all cases) 10,000 10,000 10,000 100,000 30,000 100,000 2. Interest expense is actually at financing cash flow even though reported in CFO 1. The true interest cost is not shown in CFO 3. This is usually not a significant problem. 4 Graham - Buffett Concentration in Security Analysis Convertible Debt • When stock price is higher than “conversion price” per share and it is likely that management will force conversion by “calling” the bond, the convertible should be considered analytically as equity. -- exclude interest payment from “Times interest earned” calc’s -- include face value of debt as common equity • When the convertible is not likely to be converted in near future, it should be treated as straight debt in TIE and Debt to Equity ratios • The middle ground presents problems. There are conceptual ways of handling convertibles (Black-Scholes option pricing model). But it is difficult to apply to practical applications. Graham - Buffett Concentration in Security Analysis 5 Should Measures of Debt be at Market or Book • For many debt issues, it is difficult to find market values, even when traded. • Market values for privately placed debt and inactively traded bonds are difficult to estimate • Unless interest rates have moved significantly away from the coupon rate on the debt, the difference between the market and book value of debt is often trivial when compared with the market/book difference for equity • Thus, book value of debt is probably a reasonable estimate its arket value, don’t worry about the problem. Graham - Buffett Concentration in Security Analysis 6 Early Retirement of Debt Bonds that are called • Difference between book value of debt and price paid to retire the issue is treated as an extraordinary gain or loss on income statement • Usually this will be an accounting loss, even though the firm will not call a bond unless it is economically advantageous to do so (present value of after tax interest cost is greater than after tax costs of refinancing • Generally it is best to ignore such events when trying to analyze a firm’s past profitability for extrapolation of likely future profitability Graham - Buffett Concentration in Security Analysis 7 Leases: Why Lease an Asset You should have an understanding of the possible benefits of leasing an asset --Leasee gets better tax benefits from leasing than owning -- period of use is short relative to life of asset (disposal costs) -- Leasor has comparative advantage in selling the asset (same as above) -- debt covenants favor the use of a lease instead of buy/borrow -- management compensation programs might be tied to returns on “ reported invested capital” -- leasor has less risk of ownership than leasee -- leasor can maintain the asset at lower cost than leasee -- leasing might result in more favorable reported profits than buying Graham - Buffett Concentration in Security Analysis 8 Capitalized Lease Obligations SFAS 13 requires the capitalization (recognize an asset and liabilty on the balance sheet) if any one of the following is true: • The lease transfers ownership of the asset to leasee at the end of the lease term. • The lease contains a bargain purchase option. • The lease term is equal to 75% or more of the economic useful life of the leased asset (not applicable when the lease begins within the final 25% of the economic useful life of the asset). • The present value of the minimum lease payments equals or exceeds 90% of the fair value of the asset. -- The discount rate used in this calculation is the leasee’s incremental borrowing rate or implicit interest rate of the leasor, whichever is lower. You must know these Graham - Buffett Concentration in Security Analysis 9 Operating Leases • Leases which do not meet one or more of these conditions are treated as operating leases • They are not shown on the balance sheet but disclosed in the footnotes • Payments are treated as “Rental Expenses” Graham - Buffett Concentration in Security Analysis 10 Lease Illustration Noncancellable lease, beginning 12/31/x0, $100,000 minimum lease payment end of each year for 4 years Discount rate is 10% Operating Lease Treatment: • No entry at lease inception • Annual rental expense will be 100,000, charged to income and CFO Capital Lease Treatment: • At inception, an asset (leasehold asset) and liability (leasehold Liability) equal to present value of future MLP’s is recognized • Over life of lease 1. Annual rental cost of $100,000 will be allocated between interest and principal payments as shown on next slide 2. Cost of Leasehold Asset is depreciated (using an appropriate method) over term of the lease Graham - Buffett Concentration in Security Analysis 11 Capital Lease Calculations Leasehold Asset Value $316,986.5 = $100,000 + $100,000 + $100,000 + $100,000 1.1 1.12 1.13 1.14 Opening Closing Year Liability Interest Principal Liability 0 316,986.5 1 316,986.5 31,698.65 68,301.35 248,685.2 2 248,685.2 24,868.52 75,131.48 173,553.7 3 173,553.7 17,355.37 82,644.63 90,909.09 4 90,909.09 9,090.09 90.909.09 0 Yearly SL depreciation = 316,986.5 / 4 = 79,246.62 Graham - Buffett Concentration in Security Analysis 12 Balance Sheet Effects of Capitalized Lease Assets Leased Assets Accum Deprec 1 316,986 79,246 Net Leased Assets 237,740 Notice that CL increase 2 316,986 158,492 158,494 Current Portion to be paid 82,644 90,909 173,554 90,909 0 90,909 0 3 4 316,986 316,986 237,738 316,986 79,248 0 Liabilities Current Portion of Lease Obligation 75,131 Long-term debt: lease obligations 173,554 Total Liabilities 248,685 0 13 Graham - Buffett Concentration in Security Analysis Income Effects of Lease Classification Operating Lease Rent 1 100,000 2 100,000 3 100,000 4 100,000 Total 400,000 Capital Lease Depreciation Interest 79,246 31,698 79,246 24,868 79,246 17,355 79,246 9,090 316,986* 83,013* Capitalization results in higher “Operating Income” Total 110,944 104,114 96,601 88,336 400,000 Decreasing Higher in early years Level Expense Graham - Buffett Concentration in Security Analysis 14 Ratio Affects of Lease Classification • Operating leases tend to show -- higher times interest earned -- higher profit margins (for firms which are growing and using more leases) -- higher ROE again for growing firms) -- higher ROA (because reported assets are lower) Graham - Buffett Concentration in Security Analysis 15 Off Balance Sheet Items You should know what each of these are. Do not concern yourself with calculations necessary to capitalize them. • Take or Pay arrangements • Sale of Receivables • Finance Subsidiaries • Joint Ventures and Investments in Affiliates • Derivatives Graham - Buffett Concentration in Security Analysis 16