ANALYZING FINANCING ACTIVITIES

Course Outcomes:
 Apply financial statement analysis tools and techniques to generate financial
data.
 Analyze and interpret financial data and relevant information taken from
financial statements necessary to make important business decisions
 Demonstrate knowledge of financial analysis and reporting through a case
analysis that shows ability to make financial decisions
ANALYZING FINANCING ACTIVITIES
 ANALYZING FINANCING ACTIVITIES

DEBT FINANCING
Debt, or financial liabilities, refers to funds that a company has explicitly borrowed
from various providers of capital. The company may borrow directly from investors
by issuing securities such as bonds; such borrowing is called public debt. The
company may also borrow from financial institutions, such as banks, in the form of
loans; such borrowing is called private debt.
Debt always has explicit borrowing costs, typically through payment of interest.
This is why financial liabilities are also called interest-bearing liabilities, which
distinguishes them from operating liabilities such as accounts payables, which in
most cases do not have explicitly contracted interest tied to the borrowing.
The other important feature of debt—which distinguishes it from equity—is that it
has a fixed term at the end of which the debt will mature. That is, the borrowed
amount, or principal, must be repaid at maturity.
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Accounting for Debt
Mechanics of Accounting for Long-Term Debt: An Illustration
Consider a company that issues bonds with a face value of $100,000 and a coupon rate of 6%
payable annually for a fixed term of three years. Face value refers to the amount that the
company promises to return to lenders at the end of the term. Coupon rate is the contracted rate
at which the company agrees to pay interest and the dollar amount of such payment is called the
coupon payment. In our example, the coupon payment is $6,000 per year.

The effective interest rate is the rate that the market assigns to the bond at the time of its
issuance. This rate determines the present value of the bond at the time of issuance, which
equals the cash proceeds that the company receives from the bond issue. The effective interest
rate is determined by the market after considering factors such as the prevailing risk-free interest
rate and the bond’s term and riskiness. There needs to be no relation be-tween the coupon rate
and the effective interest rate.
For example, companies issue zero coupon bonds, where the only payment to the investors is the
face value at the end of the term. Such bonds are also present valued by the market at some
effective interest rate.
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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 recognized on the balance sheet, the note disclosures provide other
useful information. These include information regarding
 anticipated future maturities of the debt,
 details of contractual provisions such as collateral and covenants,
 unused balances in lines of credit, and
 any other pertinent information relating to a company’s debt.
ANALYZING FINANCING ACTIVITIES
ANALYZING FINANCING ACTIVITIES
ANALYZING FINANCING ACTIVITIES
ANALYZING FINANCING ACTIVITIES
ANALYZING FINANCING ACTIVITIES
 ANALYZING FINANCING ACTIVITIES

Analyzing Debt Financing

Amortized Cost versus Face Value
Debt is typically reported on the balance sheet at amortized cost. This can differ
from the amount due at maturity (face value).
For example, the face value of Alliance One’s 10% senior notes is $635 million,
while the carrying value on the balance sheet is only $612 million. Assuming no
other differences, this suggests that the face value of Alliance One’s total long-
term debt is $908 million, compared with amortized cost of $885 million.
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LEASES
Leasing is a popular form of financing, especially in certain industries. A lease is a
contractual 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.
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Methods for lease accounting reflect the differences in lease contracts.

Capital lease - is a lease that transfers substantially all the benefits and risks of
ownership is accounted for as an asset acquisition and a liability incurrence by the
lessee. Similarly, the lessor treats such a lease as a sale and financing
transaction.
Operating leases, the lessee (lessor) accounts for the minimum lease payment as
a rental expense (revenue), and no asset or liability is recognized on the balance
sheet.
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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.
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Impact of Operating Leases
Lessees’ incentives to structure leases as operating leases relate to the impacts of operating
leases versus capital leases on both the balance sheet and the income state-ment. These
impacts on financial statements are summarized as follows:
 Operating leases understate liabilities by keeping lease financing off the balance sheet. Not
only does this conceal liabilities from the balance sheet, it also positively impacts solvency
ratios (such as debt to equity) that are often used in credit analysis. Operating leases
understate assets. This can inflate both return on investment and asset turnover ratios.
 Operating leases delay recognition of expenses in comparison to capital leases. This means
operating leases overstate income in the early term of the lease but understate income late
in the lease term.
 Operating leases understate current liabilities by keeping the current portion of the principal
payment off the balance sheet. This inflates the current ratio and other liquidity measures.
 Operating leases include interest with the lease rental (an operating expense).
Consequently, operating leases understate both operating income and interest expense.
This inflates interest coverage ratios such as times interest earned.
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CONTINGENCIES AND COMMITMENTS

Contingencies are potential gains and losses whose resolution depends on one or
more future events. Loss contingencies are potential claims on a company’s
resources and are known as contingent liabilities. Contingent liabilities can arise
from litigation, threat of expropriation, collectibility of receivables, claims arising
from product warranties or defects, guarantees of performance, tax assessments,
self-insured risks, and catastrophic losses of property.
A loss contingency must meet two conditions before a company records it as a
loss.
First, it must be probable that an asset will be impaired or a liability incurred.
The second condition is the amount of loss must be reasonably estimable.
 ANALYZING FINANCING ACTIVITIES

Commitments are potential claims against a company’s resources due to future

performance under contract. They are not recognized in financial statements since
events such as the signing of an executory contract or issuance of a purchase
order is not a completed transaction.

Off-balance-sheet financing refers to the nonrecording of certain financing

obligations (such in operating lease).
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SHAREHOLDERS’ EQUITY
Equity refers to owner (shareholder) financing of a company. It is viewed as reflecting the
claims of owners on the net assets of the company. Holders of equity securities are typically
subordinate to creditors, meaning that creditors’ claims are settled first. Also, typically
variation exists across equity holders on seniority for claims on net assets. Equity holders are
exposed to the maximum risk associated with a company. At the same time, they have the
maximum return possibilities as they are entitled to all returns once creditors are covered.
Analysis of equity must take into account several measurement and reporting standards for
shareholders’ equity. Such analysis would include:
 Classifying and distinguishing among major sources of equity financing.
 Examining rights for classes of shareholders and their priorities in liquidation.
 Evaluating legal restrictions for distribution of equity.
 Reviewing contractual, legal, and other restrictions on distribution of retained earnings.
 Assessing terms and provisions of convertible securities, stock options, and other
arrangements involving potential issuance of shares.
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It is important to distinguish between liability and equity instruments given their
differences in risks and returns. This is especially crucial when financial instruments
have characteristics of both. Some of the more difficult questions we must confront
are:
 Is a financial instrument such as mandatory redeemable preferred stock or a put
option on a company’s common stock—obligating a company to redeem it at a
specified amount—a liability or equity instrument?
 Is a financial instrument such as a stock purchase warrant or an employee stock
option—obligating a company to issue its stock at specified amounts—a liability or
equity instrument?
 Is a right to issue or repurchase a company’s stock at specified amounts an asset
or equity instrument?
 Is a financial instrument having features of both liabilities and equity sufficiently
different from both to warrant separate presentation? If yes, what are the criteria
for this presentation?
 ANALYZING FINANCING ACTIVITIES
Reporting of capital stock includes an explanation of changes in the number of capital
shares. This information is disclosed in the financial statements or related notes. The
following partial list shows reasons for changes in capital stock, separated according to
increases and decreases.
Sources of increases in capital stock outstanding:
 Issuances of stock.
 Conversion of debentures and preferred stock.
 Issuances pursuant to stock dividends and splits.
 Issuances of stock in acquisitions and mergers.
 Issuances pursuant to stock options and warrants exercised.
Sources of decreases in capital stock outstanding:
 Purchases and retirements of stock.
 Stock buybacks.
 Reverse stock splits.
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Contributed (or paid-in) capital is the total financing received from shareholders in
return for capital shares. Contributed capital is usually divided into two parts.
 One part is assigned to the par or stated value of capital shares: common
and/or preferred stock (if stock is no-par, then it is assigned the total financing).
 The remainder is reported as contributed (or paid-in) capital in excess of par or
stated value (also called additional paid-in capital ).
When combined, these accounts reflect the amounts paid in by shareholders for
financing business activities. Other accounts in the contributed capital section of
shareholders’ equity arise from charges or credits from a variety of capital
transactions, including (1) sale of treasury stock, (2) capital changes arising from
business combinations, (3) capital donations, often shown separately as donated
capital, (4) stock issuance costs and merger expenses, and (5) capitalization of
retained earnings by means of stock dividends.
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Treasury Stock. Treasury stock (or buybacks) are the shares of a company’s stock
reacquired after having been previously issued and fully paid for. Acquisition of
treasury stock by a company reduces both assets and shareholders’ equity.
Classification of Capital Stock
Capital stock are shares issued to equity holders in return for assets and services.
There are two basic types of capital stock: preferred and common. There also are
a number of different variations within each of these two classes of stock.
Preferred Stock. Preferred stock is a special class of stock possessing
preferences or features not enjoyed by common stock. The more typical features
attached to preferred stock include:
 Dividend distribution preferences including participating and cumulative
features.
 Liquidation priorities—especially important since the discrepancy between par
and liquidation value of preferred stock can be substantial.
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 Convertibility (redemption) into common stock—the SEC requires separate
presentation of these shares when preferred stock possesses characteristics of
debt (such as redemption requirements).
 Nonvoting rights—which can change with changes in items such as arrearages
in dividends.
 Call provisions—usually protecting preferred shareholders against premature
redemption (call premiums often decrease over time).

Common stock is a class of stock representing ownership interest and bearing

ultimate risks and rewards of company performance. Common stock represents
residual interests—having no preference, but reaping residual net income and
absorbing net losses. Common stock can carry a par value; if not, it is usually
assigned a stated value.
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Retained earnings are the earned capital of a company. The retained earnings
account reflects the accumulation of undistributed earnings (net income) of a
company since its inception. This contrasts with the capital stock and additional paid-
in capital accounts that constitute capital contributed by shareholders. Retained
earnings are the primary source of dividend distributions to shareholders.
Cash and Stock Dividends
A cash dividend is a distribution of cash to shareholders. It is the most common form
of dividend and, once declared, is a liability of a company. Another form of dividend is
the dividend in kind, or property dividend. These dividends are payable in the assets
of a company, in goods, or in the stock of another corporation. Such dividends are
valued at the market value of the assets distributed.
A stock dividend is a distribution of a company’s own shares to shareholders on a pro
rata basis. It represents, in effect, a permanent capitalization of earnings.
Shareholders receive additional shares in return for reallocation of retained earnings
to capital accounts.
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Liabilities at the “Edge” of Equity

Convertible Debt. Sometimes, companies issue debt that can be converted into
equity shares at maturity. Such debt is called convertible debt. Convertible debt is
the classic hybrid security as it is a combination of features of both debt and
equity. Usually, convertible debt allows the holder an option to convert at a fixed
price. Therefore, conversion will occur only if the share price is higher than the
conversion price at maturity. If it is not, the debt holders can ask for repayment of
principal.

Minority interest (also called noncontrolling interest ) refers to the portion of the
partially owned subsidiary’s shareholders’ equity that belongs to the minority
(outside) shareholders. It is truly an intermediate capital form.
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SHAREHOLDERS’ EQUITY REPORTING UNDER IFRS
Shareholders’ equity reporting requirements under IFRS are somewhat different from US
GAAP and need some discussion. Broadly, IFRS identifies three categories of share-
holders’ equity: issued capital, reserves, and accumulated profits/losses (retained earnings).
However, it allows considerable latitude in how the line items within shareholders’ equity are
reported, and so there is a wide variation in practice. Broadly, the following common patterns
can be observed:
 Share capital is reported as a separate line item.
 Most companies report retained earnings, but a few include retained earnings in reserves.
 Reserves includes accumulated other comprehensive income, option compensation,
share premium, and in some cases even retained earnings.
 Minority interest (noncontrolling interest) is shown separately from the parent company’s
shareholders’ equity but is included as part of total equity.
 Some companies report detailed components on the balance sheet, while others report
only aggregates for each category.
END OF ANALYZING
FINANCING
ACTIVITIES