3. Financing
Companies operations are financed by various sources:
• Capital (Stockholders’ Equity)
• Liabilities
• Off balance sheet transactions
4. Shareholders’ Equity
Basics of Equity Financing
Equity Analysis — involves analyzing equity characteristics, including:
• Classifying and distinguishing different equity sources
• Examining rights for equity classes and priorities in liquidation
• Evaluating legal restrictions for equity distribution
• Reviewing restrictions on retained earnings distribution
• Assessing terms and provisions of potential equity issuances
Equity Classes — two basic components:
• Capital Stock
• Retained Earnings
Equity — refers to owner (shareholder)
financing; its usual characteristics include:
• Reflects claims of owners (shareholders) on
net assets
• Equity holders usually subordinate to
creditors
• Variation across equity holders on seniority
• Exposed to maximum risk and return
5. Equity Financing
• Book value of shareholders’ equity:
• The amount of shareholders’ equity reported in the balance
sheet.
• Is the investment base for equity/net assets used in profitability
analysis, risk analysis and residual income-based equity valuation.
• Shareholders’ equity is affected by:
• Investments by shareholders
• Distributions to shareholders
• Profitable operating and investing activities
6. Distributions to Shareholders:
Dividends
• Are simply a transfer (usually of cash) to shareholders of a
portion of what they really own, namely, net assets of the
firm.
• The declaration of dividends is formalized by three important
dates:
• Date of declaration
• Date of record
• Date of payment
7. Types of dividends
• Dividends are paid in the form of:
• Cash
• Scrip dividends (dividends with an interest-bearing promise to pay
dividends)
• Property dividends
• Stock dividends
• Liquidating dividends (where payments to shareholders exceed the
retained earnings balance)
8. Accounting for dividends:
Dividend Type
Total
Shareholder’s
Equity
Retained
Earnings and
Contributed
capital
Cash, Scrip, and
Property dividends
Reduces retained
earnings and
Reduces assets or
increases current
liabilities (if unpaid) Changes
Stock Dividends
As per accounting
rules and
jurisdictional legal
requirements No change
9. Summary and Interpretation
of Equity
• Market-to-Book Ratio = Market Price per Share/Book Value
per Share
• Generally, Market-to-Book Ratio >1 because book value is less
than market value due to
• Conservatism of accounting
• Non accounting for future growth opportunities
10. Debt Financing:
• Critical for understanding the profitability and risk of
the firm.
• Reporting for debt involves:
• Principles of Liability Recognition
• involves a probable future sacrifice of economic benefits.
• a present obligation.
• transaction or event has already occurred.
• Principles of Liability Valuation
• Application of Criteria for Liability Recognition
11. Important Features in
Analyzing Liabilities
• Terms of indebtedness (such as maturity,
interest rate, payment pattern, and amount).
• Restrictions on deploying resources and pursuing
business activities.
• Ability and flexibility in pursuing further financing.
• Obligations for working capital, debt to equity, and
other financial figures.
• Dilutive conversion features that liabilities are
subject to.
• Prohibitions on disbursements such as dividends.
12. Principles of Liability
Valuation
• Valuation for liabilities:
• Requiring future cash payments
• Requiring future delivery of goods or services
• Representing cash advances from customers
• Disclosure of the fair values of financial instrument as per U.S. GAAP
and optionally under FASB Statement No.159 or IASB IAS 39
14. Financing with Long-Term Debt
• In the form of:
• Notes payable (primarily to banks and other financial
institutions).
• Bonds payable (to any type of bondholder, including open-market
debt investors).
• Leases (entered into with property owners, equipment dealers, or
finance companies)
• Is evidenced by a bond indenture, promissory note, or lease
agreement.
15. Reducing Debt: Early Retirement
• Method of Reducing Debt
• Methods to retire early
• Accounting:
• Income statement:
• Realized Gain or Loss: The difference between the amounts used to
extinguish the debt and the book value of the debt.
• Cash Flows from financing activities: Cash flows used to reduce
debt.
16. Accounting for Troubled Debt
• Handling of troubled debt:
• From debtor’s perspective
• Settlement in cash or by issue of capital stock
• A gain on debt settlement: the difference between the book value of the debt
settled (principal plus any accrued interest) and the fair market value of the non-
cash asset or cash transferred to retire the debt.
• Modification of terms
• Accounting
• Is conservative
• Ignores the present value in restructuring model
17. AdditionalIssues: HybridSecurities(i.e.,
compound financing instruments)
• Securities have both debt and equity characteristics.
• Methods of recording conversion under U.S.GAAP & IFRS.
• Book Value Method
• Market Value Method (rarely used)
18. Accounting for Hybrid Securities
Preferred Stock U.S.GAAP IFRS
Mandatorily redeemable Liability Liability
Redeemable at firm’s option Equity Equity
Redeemable at holder’s
option
Mezzanine
section
Liability
Convertible Debt Financial
Liability
Debt and equity features
are distinguished and
valued at Fair Value
Bonds issued with
detachable warrants
Debt and equity features are
distinguished and valued at Fair Value
19. Off-Balance-Sheet Financing
Off-Balance-Sheet Financing is the non-recording of financing obligations
Motivation
To keep debt off the balance sheet—part of ever-changing landscape, where as one
accounting requirement is brought in to better reflect obligations from a specific off-
balance-sheet financing transaction, new and innovative means are devised to take
its place
Transactions sometimes used as off-balance-sheet financing:
• Operating leases that are indistinguishable from capital leases
• Through-put agreements, where a company agrees to run
goods through a processing facility
• Take-or-pay arrangements, where a company guarantees to pay
for goods whether needed or not
• Certain joint ventures and limited partnerships
• Product financing arrangements, where a company sells and agrees to
either repurchase inventory or guarantee a selling price
• Sell receivables with recourse and record them as sales rather than liabilities
• Sell receivables as backing for debt sold to the public
• Outstanding loan commitments
Basics of Off-Balance-Sheet Financing
GAAP
20. Off-Balance-Sheet Financing
Sources of useful information:
Notes and MD&A and SEC Filings
Companies disclose the following info about financial instruments with
off-balance-sheet risk of loss:
• Face, contract, or principal amount
• Terms of the instrument and info on its credit and market risk, cash
requirements, and accounting Loss incurred if a party to the
contract fails to perform
• Collateral or other security, if any, for the amount at risk
• Info about concentrations of credit risk from a counterparty or
groups of counterparties
Useful analyses:
• Scrutinize management communications and press releases
• Analyze notes about financing arrangements
• Recognize a bias to not disclose financing obligations
• Review SEC filings for details of financing arrangements
Analysis of Off-Balance-Sheet Financing
21. Off-Balance-SheetFinancing Arrangements
• Either or combination of approaches:
• Sale of an existing asset or sale-leaseback.
• Use of another entity (uncontrolled entity) to obtain financing.
• Ways to avoid consolidation:
• Joint venture
• SPE/ VIE
• Financial reporting does not recognized mutually unexecuted
contracts as liabilities they are mere promises.
22. Off-Balance-SheetFinancingArrangements
1. Leases
2. Sale of Receivables
3. Product Financing Arrangements
4. Use of Another Entity to Obtain Financing
5. Use of Joint Ventures or Research and Development Financing
Arrangements
6. Take-or-Pay or Throughput Contracts
(usually using non-consolidated Special Purpose Entity)
23.
24.
25. Leases
• Benefits to Lessees:
• Ability to shift the tax benefits
• Flexibility to change capacity
• Ability to reduce the risk of technological obsolescence.
• Ability to finance the “acquisition” of an asset.
• Accounting Methods
• Operating Lease Method
• Capital Lease Method
26. Choosing the Accounting
Method
• Conditions for a capital lease:
• Extends for at least 75 percent of the asset’s total expected
economic life.
• Transfers ownership to the lessee.
• The “bargain purchase” option will be used.
• The present value of the contractual minimum lease payments
equals or exceeds 90 percent of the fair market value of the asset
at the time of signing.
27. Converting Operating Leases to
Capital Leases
• By Analyst
• To avoid understating the short-term liquidity or long-term solvency
risk of the firm.
• For various firms’ cross-sectional comparisons.
• If the purpose appears to be financing rather than acquisition.
• Provides a more conservative measure of liabilities.
• Balance sheet restatements are more significant than income
statement restatements.
28. Impact of Accounting for Operating
Leases as Capital Leases
• Though individually impact is relatively small, cumulatively can
be significant.
• Thus, important for analyst:
• assessing the risk and accounting quality of a firm’s financial
statements.
• determining capital structure weights and debt costs for the
weighted average cost of capital calculations in entity valuation.
29. Contingencies and Commitments
Contingencies -- potential losses and gains whose resolution depends on one or
more future events.
Contingent liabilities -- contingencies with potential claims on resources
-- to record a contingent liability (and loss) two
conditions must be met:
(i) probable i.e. an asset will be impaired or a
liability incurred, and
(ii) the amount of loss is reasonably estimable;
-- to disclose a contingent liability (and loss) there
must be at least a reasonable possibility of
incurrence
Contingent assets -- contingencies with potential additions to resources
-- a contingent asset (and gain) is not recorded until
the contingency is resolved
-- a contingent asset (and gain) can be disclosed if
probability of realization is very high
Basics of Contingencies
Contingencies
should be . . .
30. Contingencies and Commitments
Sources of useful information:
Notes, MD&A, and Deferred Tax Disclosures
Useful analyses:
• Scrutinize management estimates
• Analyze notes regarding contingencies, including
•
Description of contingency and its degree of risk
•
Amount at risk and how treated in assessing risk exposure
•
Charges, if any, against income
• Recognize a bias to not record or underestimate contingent liabilities
• Beware of big baths — loss reserves are contingencies
• Review SEC filings for details of loss reserves
• Analyze deferred tax notes for undisclosed provisions for future losses
Note: Loss reserves do not alter risk exposure,
have no cash flow consequences, and do not
provide insurance
Analyzing Contingencies
31. Contingencies and Commitments
Commitments -- potential claims against a company’s resources due
to future performance under contract
Basics of Commitments
Analyzing Commitments
Sources of useful information:
Notes and MD&A and SEC Filings
Useful analyses:
• Scrutinize management communications and press releases
• Analyze notes regarding commitments, including
•
Description of commitment and its degree of risk
•
Amount at risk and how treated in assessing risk exposure
•
Contractual conditions and timing
• Recognize a bias to not disclose commitments
• Review SEC filings for details of commitments