Analysis of Financing Decisions

Contents

1. Financing liabilities
2. Leases
3. Contingent liabilities and commitments
4. Off-balance-sheet financing
5. Equity financing

1. Financing liabilities

Types of Liabilities

Our analysis starts distinguishing between two types of liabilities:

1. Financing liabilities: all forms of credit financing, such as bank loans, bonds, and leases.

2. Operating liabilities: obligations that arise from normal business operations, such as accounts payable, leases, accrued expenses, and taxes payable.

Of course, by traditional reporting purposes, liabilities are also classified as current or noncurrent, based on whether the obligation is expected to be satisfied within one year or the operating cycle, whichever is longer.

Let’s start by focusing on financing liabilities.

The impact of liabilities decisions

What is the impact on the financial statments of the following decisions? Consider that each decision is executed in January 1st.

Part 1: Borrowing $1,000,000 from a bank at 5% interest rate. Interest payments are due annually at January 1st, and the principal is due in 5 years.

Part 2:

1. Paying off the original loan in the 5th year.
2. Refinancing the previous loan but with a 10% interest rate (principal is not paid, debt restructure)

Compare a and b regarding their impact on liquidity (current and cash ratio), solvency (debt to assets), profitability (net profit ratio) during the transition from year 4 to year 5.

One could take the numbers from the financial statements and compute solvency ratios.

But a less naive approach should consider key information from:

The Notes:

• Interest rates, maturity dates, conversion privileges, and redemption clauses.

The Managerial report:

• Expectation of refinancing, debt covenants getting tight, and future financing needs.

With this additional information we can work on different scenarios:

• Refinancing: What would the current cost of refinancing be? Worse? Better? How much?
• Debt reduction: Does the firm have enough cash? Issuing new shares? Selling assets?

Once we have a better picture of how the debt structure would look in the near future, we can include the respective adjustments in the financial statements before jumping into the ratios.

• This is especially true when the last report available is from many months ago.

Credit Ratings

The credit rating of a bond is an external assessment of the issuer’s ability to make timely payments of interest and principal.

S&P Website

Bond valuation and credit ratings

Therefore, it is not surprising that the credit rate is a major determinant of

1. the interest rate that the issuer must pay for selling more bonds.
2. the fair value of the issued bonds in the market.

Let’s look at the financial obligations of Apple and Mercedes [10 min]

Links for the annual reports of Apple and Mercedes.

From the Balance Sheet, check the total amount on financial liabilities.

More advance: From the footnotes, collect the following information: type of instruments, maturities, interest rates, ranking/seniority, redemption, and covenants.

• Apple: Check Note “Debt”.
• Mercedes: Check “Combined Management Report>Refinancing”, and Notes “Management of financial risks” (liquidity runoff), “Financing liabilities”.

To Discuss:

• How is the debt distributed across maturities and amounts?
• What are the interest rates in these debt contracts? How is the market now?
• Is any big maturity coming up soon? News from rolling over?

2. Leases

Now we move into operating liabilities ground.

Definitions and key elements

• A lease is a contractual agreement between a lessor (owner) and a lessee (user) that gives the lessee the right to use an asset owned by the lessor for a specified period of time in exchange for periodic payments.

Contracting terms:

• Minimum lease payments (MLP), or Based Rent, are the fixed payments that the lessee is obligated to make over the lease term.
• Contingent rentals are payments that depend on the future performance of the leased asset.
  • Mileage for a car lease, sales performance for a retail store lease, etc.
• Residual value guarantees are guarantees that the lessee will pay the lessor a specified amount at the end of the lease term if the residual value of the leased asset is less than the guaranteed amount.

Capital vs. Operating Leases:

Finance Lease (formerly “Capital Lease”): A lease in which all risks and rewards of ownership are substantially transferred to the lessee.

• Recognition: Lessee records a right-of-use asset and a lease liability on the balance sheet, representing the leased asset and corresponding obligation to make lease payments.

Operating Lease: Prior to 2019, these leases were treated differently, as they didn’t meet the criteria for capital leases.

• Recognition under old standards: Only rental expenses were recognized, with no impact on the balance sheet.
• IFRS 16 update: Operating leases are now also recognized on the balance sheet as right-of-use assets and lease liabilities, eliminating off-balance-sheet treatment for most leases for the companies that adopted IFRS 16.

An illustrative example of the impact on the financial statements of capital vs. operating leases:

• A company leases an asset on January 1, 2005.
• The company has no other assets or liabilities.
• The estimated economic life of the leased asset is 5 years and no residual value is expected.
• The lease has a fixed noncancelable term of 5 years with MLP of $2,505 per year, payable at the end of each year.

Capital lease scenario:

• The interest rate on the lease is 8% per year.
• Depreciation is computed using the straight-line method.

Capital lease treatment:

First, let’s compute the present value of the MLP.

Remember that the PV of an annuity is given by \(P_0=\frac{1-1/(1+i)^n}{i}\). In this case, \(i=8\%\) and \(n=5\).

• \(P_0=\frac{1-1/(1.08)^5}{0.08}=3.9927\)
• Leased asset value = \(\$2.505\times 3.9927=10.000\)

Second, compute the interest expense and depreciation expense for each year. - notice that the interest expense is computed on the lease liability, which is updated yearly after the payment of the MLP.

Total expense is identical for both cases, but the timing is different: capital lease reports more expenses earlier.

But more importantly: the operating lease does not report any liability (nor asset) in the balance sheet.

However, lesses that already adopted IFRS 16 (2019) must capitalize most of the leases.

• recognition of the right-of-use asset and lease liability.
• leases that were previously classified as operating leases must be brought on the balance sheet.
• expense recognition: depreciation of the ROU asset (“Operating expense”) and interest expense (“Financial expenses”) on the lease liability.

The lessor’s accounting remains largely unchanged

Example Apple and Mercedes [10 min]

Apple: Note - Leases.

Mercedes: Notes - “Lease” “Equipment in operating leases”

1. Identify the type of assets being leased.
2. Identify where the lease asset and the lease liability are reported.
3. Identify the lease maturity schedule.

3. Commitments and contingent liabilities

Contingent liabilities

A contingent liability is a potential obligation that depends on the occurrence of a future uncertain event (e.g., legal disputes or warranties).

1. Probable Occurrence: The future event that would trigger the loss is more likely than not to occur (i.e., greater than 50% likelihood).
2. Reasonable Estimation: The amount of the loss can be reasonably estimated.

Reporting:

1. If the event is probable and the amount can be reliably estimated, the liability is recognized as a provision in the balance sheet.
2. If the event is possible but not probable, or the amount cannot be reasonably estimated, disclosure without recognition may be required.

Example:

A company is being sued for damages amounting to $5 million.

The company believes it is probable (chances >50%) that will lose the lawsuit.

It estimates the damages at $2 million (based on available evidence or legal counsel’s advice).

Under IFRS, the company will recognize a provision (i.e., a liability) of $2 million on the balance sheet and an expense in the income statement.

Commitments

A commitment is a firm agreement or contractual obligation to undertake a future action

Frequent commitments:

• Purchase equipment (before the reception)
• Licensing agreements (before the licensing period)

Reporting:

They are generally off-balance-sheet items and disclosed in the notes, explaining potential future obligations.

Example Apple and Mercedes [15 min]

Search: Balance sheet “Commitments and Contingencies.”

Apple: Note - “Commitments …” ” and “Item 3: legal proceedings”.

Mercedes: Notes - “Provisions for other risks”, ” Legal Proceedings”, “Contingent Liabilities”

1. What type of commitments the company has? (Apple: UPO!!)
2. What is the most important type of contingent liabilities?
   2.1) What do they report about legal contingencies (litigation)? cases? amounts? provisions?

4. Other Off-balance-sheet financing

It refers to the non-recognition of financing activities in the financial statements.

• Operating leases were the most common example before IFRS 16.
• Other cases: special purpose entities, joint ventures, limited partnerships, etc.

4.1 Joint Ventures

A joint venture is a business entity created by two or more parties that pool resources and shared ownership.

Objectives:

• Resource sharing
• Market entry and expansion
• Risk mitigation
• Access to new technologies
• Financing structuring

Typical financing strategy:

JVs are use to avoid recognizing liabilities on the parent company’s balance sheet.

• Non-consolidation: When the parent company holds less than 50% of the JV (or lacks control per IFRS 10), the JV’s assets and liabilities are not consolidated into the parent company’s financial statements. This keeps debt associated with the JV off the balance sheet of the parent company.

• Leaseback arrangements: A common tactic is for the JV to purchase assets financed by its own debt and lease/rent them back to the parent company. The parent gets to use the assets while keeping the debt off its balance sheet.

4.2 Special Purpose Entities (SPEs)

A special purpose entity (SPE) is a legal entity created to fulfill narrow, specific, or temporary objectives.

• Typically used by companies to isolate the firm from a specific financial risk. Example, securitization of receivables and trade-credit risk.

The typical structure of an SPE:

1. The company, called the sponsor, forms a separate entity and capitalizes it with equity investment, some of which must be from independent third parties.
   • the sponsor do not control the SPE to avoid consolidation.
2. The SPE issues debt and uses the proceeds to purchase earnings assets from or for the sponsoring company.
3. The sponsoring company receives the cash from the transaction and removes the earnings assets from its balance sheet.

Why SPEs are so popular?

1. They allow companies to obtain lower-cost financing.

• As SPEs are restricted to a single purpose, they are less risky than the sponsoring company.

2. They allow companies to avoid violating debt covenants.

• If structured properly, the SPE is not consolidated in the sponsoring company’s financial statements.

Reporting of Joint Ventures and SPEs:

• Very limited information in the annual reports:
  • Check Apple and Mercedes Benz
• In practice, it is more common to rely on specialized business databases like Orbis or Capital IQ.

5. Equity financing

Equity refers to the owners’ (shareholders’) financing of a company.

Commonly viewed as reflecting the claims of owners against the assets of the company.

Typically, holders of equity securities are subordinate to creditors in the event of liquidation.

5.1 Components of capital stock

1. Contributed/Share Capital: The amount of money raised by a company through the issuance of shares.

   • It represents the equity investment made by shareholders in exchange for ownership rights in the company.
   • One part is assigned to the par or stated value of capital shares (Common and/or Preferred Stock).
   • The remainder is reported as Additional Paid-In Capital (APIC).

Example:

• Company issues 1 million common shares at a par value of $1 each, with an issuance price of $1.5 per share.
• Total capital raised: $1.5 million, where $1 million goes to the common stock account and $500,000 to APIC.

2. Treasury stock (buybacks): The amount of capital stock repurchased by the company and kept in their own treasury.

   • Why? as an attempt to increase the share price or limiting dilution.

   • It reduces both contributed assets and total equity (contra-equity account).

   • Recorded at cost value.

3. Retained earnings: accumulated earnings of the company that have not been distributed to shareholders as dividends.
   • Covenants can create restrictions on the use of retained earnings (check Bond indentures and Loan agreements).
4. Other comprehensive income (OCI): unrealized gain and losses not recognized in the income statement.
5. Noncontrolling interest (NCI) or minority interest: equity interest in a subsidiary not attributable to the parent company.

Typical equity events:

The impact of equity decisions

What is the impact on the financial statments of the following financing decisions? Consider that the decision is executed the last day of the fiscal year.

1. Capital Increase of $1,000,000 from the same investors base.
   • no new shares (no dilution)
2. Paying $300.000 in dividends.

Classification of capital stock

1. Preferred stock
   • dividend distribution preferences (usually fixed)
   • liquidation priority
   • convertibility into common stock
   • non or limited voting rights
2. Common stock
   • voting rights
   • bear the residual risk and rewards of the company

Example:

First year of operations: What is the total equity of the company?

Pay special attention to capital stock dilution

Common variations in the capital stock:

• issuance of new stocks
• repurchase of stocks
• conversion of debentures and preferred stocks

Less common reasons to keep in mind:

• Stock options with compensation and bonus plans calling for the issuance of capital stock over some time at fixed prices (i.e., employee stock ownership plan)
• Commitments to issue capital stock in the future (i.e., stock warrants, or merger agreements)

Questions?

Check my website for an updated version of this presentation:

https://www.marceloortizm.com/

Based on:

• Subramanyam, K. R. (2014). Financial statement analysis. McGraw-Hill Education. Chapter 3.
• Steven M. Bragg (2022). IFRS Guidebook. Accounting Tools. Chapters 19 and 29.
• IFRS 16 Leases
• IAS 37 Provisions (IFRS) Contingent Liabilities and Contingent Assets
• IFRS 11 Joint Arrangements