Accounting Equation: Another Look

Everything we have came from somewhere.

Focuses on Liabilities

Liabilities

Line of credit needed--Quick borrowing power in cash for stressed times

 Interest expense non-value added to

customers, except for financial institution.

 No real excuse for running out of money—have a good cash plan.

Liabilities

Liabilities creates added risk High risk--agriculture, small business... little

debt (0-10%), need high equity Medium risk companies--large, service,

manufactures--modest debt (20-50%--no more than 60% of total assets), good equity

Low risk—utilities or financial can take on substantial debt (50%-80%), adequate equity  

SHORTAGE"Keep the wolf from the door."Schedule out receipts and payments

expected by day for the month.Sell something, if possible (often not)Borrow more, if possible (often not)

SHORTAGE

Examine contracts for advances possible on partial completion of work.

Opportunity to become more efficient quickly--cut all NVA activities.

Press late paying customers to pay on time.

Ethical Payments?Payments, in dire circumstances

Mail to vendor's place of businessMail on Mon. or Tues., not Fri.Use regular envelope, not vendor's

MORE DRASTIC ACTION Lengthen creditor terms--

unsecured first, “Lean on the Trade” If good customer, then they will lengthen If poor customer, suppliers often react with

COD terms. Restructure loans

Renegotiate loans with creditors Interest rates reducedPrincipal payments extended

Court Protection (almost over)

Voluntary bankruptcy procedure to give time to work out difficulties (Chapter 11), few survive this.Do not favor one creditor or make personal use of assets.If business cannot be turned around, then minimize losses/liquidate early. (Chapter 7)

Current Liabilities Current operating liabilities

Accounts payable Accrued liabilities

Current non-operating liabilities Short-term interest-bearing loans Current maturities of long-term debt

Terms

Accounts payable carry credit terms such as 2/10, net 30. These terms give the buyer, for example, 2% off the invoice price of goods purchased if paid within 10 days. Otherwise the invoice is payable in its entirely within 30 days.

Some customers lean too far—they take the discount and pay late anyway.

Uncertain Accruals

Specifically, if the obligation is probable and the amount estimable, then a company will recognize this obligation.

If only one of the criteria is met, the contingent liability is disclosed in the footnotes.

Misreporting of Accruals

The latitude in determining the amount and timing for recognition of accruals can lead to misreporting of income and liabilities.

If accruals are over (under) estimated, then liabilities are over (under) estimated, income is under (over) estimated, and equity (retained earnings) is under (over) estimated.

Short-term Interest-Bearing Loans

Companies generally finance seasonal swings in working capital with a bank line of credit.

Bond Pricing

There are two different interest rates you must understand before we can discuss the mechanics of bond pricing:1. Coupon (contract or stated) rate – the stated rate in the bond contract. It is used to compute the dollar amount of (semiannual) interest payments that are paid to bondholders during the life of the bond issue. 2. Market (yield) rate – the interest rate that investors expect to earn on the investment in the debt security. This rate is used to price the bond issue.

Cash Flows from Bonds

To illustrate, assume that investors wish to price a bond with a face amount of $10 million, an annual coupon rate of 6% payable semiannually (3% semiannual rate), and a maturity of 10 years.

Investors purchasing this issue will receive the following cash flows:

Coupon Rate vs. Market Rate

Bond Pricing:Coupon Rate = Market Rate (Par)

Company promises to pay 20 semiannual payments of $10 million (6%/2) = $300,000 each, plus the $10 million face amount of the bond at maturity, for a total of $16 million.

Assuming that investors desire a 6% annual market rate of interest (yield), the bond sells for $10 million:

Bond Pricing:Coupon Rate > Market Rate (Premium)

Assume that investors expect only a 4% annual yield (2% semiannual yield). Given this new discount rate, the bond sells for $11,635,129 – see below:

Bond Tombstone

Verizon’s Zero Coupon Debt

Bonds Sold at a Premium

Effective Interest Method (Premium Example)

Debt Ratings

Bond Interest Rates

Bond Ratings

Credit quality is related to default risk. Companies seeking to obtain bond financing

from the capital markets first seek a rating on the bond issue from one of several rating agencies such as Standard & Poor’s, Moody’s Investor Services or Finch.

The business of these rating agencies is to rate debt so that its default risk can be accurately determined and priced by the market.

Selected Financial Ratios for Various Bond Rating Classes