INSTRUCTIONAL MATERIAL

Treasury Management
(FIMA 40103)

WEEK 13
DEBT MANAGEMENT

Learning Objectives:

 Appreciate the role and importance of debt management for achieving stability and
growth
 Explain debt concepts and how capital markets can promote portfolio choice
towards achieving the appropriate cost and risk balance
 Make informed decisions on the costs and risk in debt and financial portfolios

The treasurer is usually called upon to either manage a company’ s existing debt or
procure new debt. In either case, this calls for a knowledge of the broad variety of debt instruments
available, as well as dealing with credit rating agencies. It may also be necessary to have a
working knowledge of the accounting, controls, policies, and procedures used to manage debt.

TYPES OF DEBT

 Commercial Paper – unsecured debt that is issued by a company and has a fixed maturity
ranging from 1 to 270 days. A company uses commercial paper to meet its short - term
working capital obligations. It is commonly sold at a discount from face value, with the
discount (and therefore the interest rate) being higher if the term is longer. A company can
sell its commercial paper directly to investors, such as money market funds, or through a
dealer in exchange for a small commission.
 Factoring – is a financial transaction in which a company sells its accounts receivable to
a finance company that specializes in buying receivables at a discount (called a factor).
Accounts receivable factoring is also known as invoice factoring or accounts receivable
financing.
 Field Warehouse Financing – uses a company's inventory as collateral for a loan. The
inventory to be used as collateral is segregated from the rest of the inventory by a fence,
and all inventory movements into and out of this area are tightly controlled. Alternatively,
the inventory may be stored in a public warehouse. State lien laws typically require that
signs around the segregated area clearly state that there is a lien on the inventory stored

Daren D. Cortez, CFMP, CATP, MBA

Department of Financial Management
College of Accountancy and Finance
Polytechnic University of the Philippines
 INSTRUCTIONAL MATERIAL
Treasury Management
(FIMA 40103)

inside. It is highly transaction intensive and recommended only for those companies that
have exhausted all other less expensive forms of financing.
 Floor Planning – is a method of financing inventory purchases, where a lender pays for
assets that have been ordered by a distributor or retailer, and is paid back from the
proceeds from the sale of these items. The arrangement is most commonly used when
large assets, such as automobiles or household appliances, are involved. The entity at
risk in this arrangement is the lender, which is relying upon the sale of the underlying
assets in order to be repaid. Accordingly, the lender may demand the following:
o That all assets acquired under the floor planning arrangement be sold at a price
that is no lower than its original purchase price.
o That the inventory of assets in stock is regularly counted and matched against the
records of the lender.
o That the inventory of assets in stock is regularly counted and matched against the
records of the lender.
o That the loan be paid back no later than a certain date, thereby avoiding the risk
of product obsolescence.
 Lease – covers the purchase of a specific asset, which is paid for by the lease provider
on the company’s behalf. In exchange, the company pays a fixed rate, which includes
interest and principal, to the leasing company. It may also be charged for personal property
taxes on the asset purchased.
o Capital Lease – is a lease in which the lessor only finances the lease, and all other
rights of ownership transfer to the lessee, resulting in the recording of the
underlying asset as the lessee's property in its general ledger. The lessee can only
record the interest portion of a capital lease payment as expense, as opposed to
the amount of the entire lease payment in the case of a normal lease.
o Operating Lease – under the terms of which the lessor carries the asset on its
books and records a depreciation expense, while the lessee records the lease
payments as an expense on its books. This type of lease typically does not cover
the full life of the asset, nor does the buyer have a small - dollar buyout option at
the end of the lease.
 Line of Credit – a commitment from a lender to pay a company whenever it needs cash,
up to a preset maximum level. It is generally secured by company assets, and for that
reason bears an interest rate not far above the prime rate. It is a flexible loan from a bank

Daren D. Cortez, CFMP, CATP, MBA

Department of Financial Management
College of Accountancy and Finance
Polytechnic University of the Philippines
 INSTRUCTIONAL MATERIAL
Treasury Management
(FIMA 40103)

or financial institution and a defined amount of money that you can access as needed and
then repay immediately or over a prespecified period of time. It will charge interest as soon
as money is borrowed, and borrowers must be approved by the bank.
 Loans
o Asset-Based Loans – is a loan that uses fixed assets or inventory as its collateral
is a common form of financing by banks. Loans may also be issued that are based
on other forms of collateral, such as the cash surrender value of life insurance,
securities, or real estate.
o Bonds – is a fixed-income instrument since bonds traditionally paid a fixed interest
rate (coupon) to debtholders. Variable or floating interest rates are also now quite
common. It is also referred to as a certificate of indebtedness.
 Collateral trust bond – a bond that uses as collateral a company’s security
investments.
 Convertible bond – a bond that can be converted to stock using a
predetermined conversion ratio. The presence of conversion rights typically
reduces the interest cost of these bonds, since investors assign some value
to the conversion privilege.
 Debenture – a bond issued with no collateral. A subordinated debenture is
one that specifies debt that is senior to it.
 Deferred interest bond – a bond that provides for either reduced or no
interest in the beginning years of the bond term, and compensates for it
with increased interest later in the bond term. Since this type of bond is
associated with firms having short - term cash flow problems, the full - term
interest rate can be high.
 Floorless bond – a bond whose terms allow purchasers to convert them
to common stock, as well as any accrued interest. The reason for its “death
spiral” nickname is that bondholders can convert some shares and sell
them on the open market, thereby supposedly driving down the price and
allowing them to buy more shares, and so on.
 Guaranteed bond – a bond whose payments are guaranteed by another
party. Corporate parents will sometimes issue this guarantee for bonds
issued by subsidiaries in order to obtain a lower effective interest rate.

Daren D. Cortez, CFMP, CATP, MBA

Department of Financial Management
College of Accountancy and Finance
Polytechnic University of the Philippines
 INSTRUCTIONAL MATERIAL
Treasury Management
(FIMA 40103)

 Income bond – a bond that pays interest only if income has been earned.
The income can be tied to total corporate earnings or to specific projects.
If the bond terms indicate that interest is cumulative, then interest will
accumulate during nonpayment periods and be paid at a later date when
income is available for doing so.
 Mortgage bond – a bond offering can be backed by any real estate owned
by the company (called a real property mortgage bond), or by company -
owned equipment (called an equipment bond), or by all assets (called a
general mortgage bond).
 Serial bond – a bond issuance where a portion of the total number of
bonds are paid off each year, resulting in a gradual decline in the total
amount of debt outstanding.
 Variable rate bond – a bond whose stated interest rate varies as a
percentage of a baseline indicator, such as the prime rate. Treasurers
should be wary of this bond type because jumps in the baseline indicator
can lead to substantial increases in interest costs.
 Zero coupon bond – a bond with no stated interest rate. Investors
purchase these bonds at a considerable discount to their face value in
order to earn an effective interest rate.
 Zero coupon convertible bond – a bond that offers no interest rate on its
face but allows investors to convert to stock if the stock price reaches a
level higher than its current price on the open market. The attraction to
investors is that, even if the conversion price to stock is marked up to a
substantial premium over the current market price of the stock, a high level
of volatility in the stock price gives investors some hope of a profitable
conversion to equity. The attraction to a company is that the expectation of
conversion to stock presents enough value to investors that they require
no interest rate on the bond at all, or at least will only purchase the bond at
a slight discount from its face value, resulting in a small effective interest
rate.
o Bridge Loans – is a form of short - term loan that is granted by a lending institution
on the condition that the company will obtain longer-term financing shortly that will
pay off the bridge loan. This option is commonly used when a company is seeking

Daren D. Cortez, CFMP, CATP, MBA

Department of Financial Management
College of Accountancy and Finance
Polytechnic University of the Philippines
 INSTRUCTIONAL MATERIAL
Treasury Management
(FIMA 40103)

to replace a construction loan with a long-term note that it expects to gradually pay
down over many years. This type of loan is usually secured by facilities or fixtures
in order to obtain a lower interest rate.
o Economic Development Authority Loans – usually extended by governments
to guarantee bank loans to finance a company’s working capital needs in
geographic areas to attain social improvement.
o Long-Term Loans – are highly desirable form of financing, since a company can
lock in a favorable interest rate for a long time, and keeps it from having to
repeatedly apply for shorter - term loans during the intervening years, when
business conditions may result in less favorable debt terms.
 Receivables Securitization – a well-established funding method whereby assets such
as trade receivables, credit card receivables, or other financial assets are packaged,
underwritten and sold in the capital markets in the form of asset-backed securities.
 Sale and Leaseback – an arrangement in which the company that sells an asset can
lease back that same asset from the purchaser. With a leaseback—also called a sale-
leaseback—the details of the arrangement, such as the lease payments and lease
duration, are made immediately after the sale of the asset. In a sale-leaseback transaction,
the seller of the asset becomes the lessee and the purchaser becomes the lessor.

CREDIT-RATING AGENCIES

A credit rating agency is a company that assigns credit ratings, which rate a debtor's ability
to pay back debt by making timely principal and interest payments and the likelihood of default.
An agency may rate the creditworthiness of issuers of debt obligations, of debt instruments, and
in some cases, of the servicers of the underlying debt, but not of individual consumers.

If a publicly held company issues debt, it can elect to have that debt rated by either
Moody’s, Standard & Poor’s, or Fitch. These are the three top – tier credit - rating agencies that
the Securities and Exchange Commission SEC allows to issue debt ratings. A debt rating results
in a credit score that indicates the perceived risk of default on the underlying debt, which in turn
impacts the price of the debt on the open market. Having a credit score is essentially mandatory,
since most funds are prohibited by their internal investment rules from buying debt that does not
have a specific level of credit rating assigned to it.

Daren D. Cortez, CFMP, CATP, MBA

Department of Financial Management
College of Accountancy and Finance
Polytechnic University of the Philippines
INSTRUCTIONAL MATERIAL
Treasury Management
(FIMA 40103)

Daren D. Cortez, CFMP, CATP, MBA

Department of Financial Management
College of Accountancy and Finance
Polytechnic University of the Philippines
 INSTRUCTIONAL MATERIAL
Treasury Management
(FIMA 40103)

If an agency issues a low credit rating or downgrades an existing rating, the best reaction
by the company is to not publicly challenge it. The only result of such action is that the company
has drawn attention to a negative opinion issued by a qualified third party, which may very well
reduce investor confidence in the debt price. However, a company may certainly appeal the rating,
usually by presenting new information to the agency.

If a company wants to improve its credit rating, then it must take specific steps to make its
financial structure more conservative, such as by issuing more stock and using the proceeds to
pay down debt. This requires the development of a plan to achieve the higher credit rating and
communication of this information to the credit rating agency.

DEBT-RELATED CONTROLS

The recordation of debt - related transactions is somewhat technical, and therefore subject
to some degree of calculation error. Several of the following controls are designed to verify that
the correct interest rates and calculation dates are used. In addition, there is some possibility that
the deliberate timing of gain and loss recognition related to debt transactions can be used to
manipulate reported earnings. Several of the following controls are used to detect such issues.
Finally, controls over the approval of debt terms, borrowings, and repayments are also described.

General Debt Transaction Controls

 Require approval of the terms of all new borrowing agreements

 Require supervisory approval of all borrowings and repayments
 Investigate the reasoning for revenue recognition related to attached rights that is not
recognized ratably
Interest Rate Calculations

 Require written and approved justification for the interest rate used to value debt
 Include in the month - end closing procedure a task to record interest expense on any
bonds for which interest payments do not correspond to the closing date
Extinguishment of Debt

 Include in the debt procedure a line item to charge unamortized discounts or premiums to
expense proportionate to the amount of any extinguished debt
 Report to the board of directors the repayment status of all debt

Daren D. Cortez, CFMP, CATP, MBA

Department of Financial Management
College of Accountancy and Finance
Polytechnic University of the Philippines
 INSTRUCTIONAL MATERIAL
Treasury Management
(FIMA 40103)

Convertible Debt

 Verify the market value of equity on conversion dates when the market value method is
used
 Verify the market value of equity on debt retirement dates when offsetting equity entries
are being reversed
 Include a review of accrued interest expense on all recently converted debt
 Verify expense calculations associated with any sweetened conversion offers

DEBT-RELATED POLICIES

The policies set forth in this section define the issuance and buyback of debt, control the
timing of expense recognition, the setting of interest rates used for expense calculations, and
similar issues. The intent of the bulk of these policies is to issue and buy back debt only when it
is in the best business interest of the company to do so, as well as to ensure that debt – related
transactions are recorded fairly.

General Debt Transaction Controls

 All notes and bonds shall only be issued subsequent to approval by the board of directors
 Debt sinking funds shall be fully funded on scheduled dates
 Recognition of unearned revenue for attached rights shall match offsetting discount
amortization as closely as possible

Extinguishment of Debt

 Debt shall not be extinguished early if the primary aim is to report a gain or loss on the
extinguishment.
 When interest rates allow, the company shall repurchase its debt with less expensive debt.

Convertible Debt

 Debt conversions to equity shall always be recorded using the book value method

Daren D. Cortez, CFMP, CATP, MBA

Department of Financial Management
College of Accountancy and Finance
Polytechnic University of the Philippines
 INSTRUCTIONAL MATERIAL
Treasury Management
(FIMA 40103)

DEBT-RELATED PROCEDURES

Daren D. Cortez, CFMP, CATP, MBA

Department of Financial Management
College of Accountancy and Finance
Polytechnic University of the Philippines
INSTRUCTIONAL MATERIAL
Treasury Management
(FIMA 40103)

Daren D. Cortez, CFMP, CATP, MBA

Department of Financial Management
College of Accountancy and Finance
Polytechnic University of the Philippines
 INSTRUCTIONAL MATERIAL
Treasury Management
(FIMA 40103)

Activities/Assessment: (CASE STUDY ANALYSIS)

Perform an exhaustive and in-depth analysis on the following cases:

1. The Vital Role of the Treasurer of the Philippines in Debt Management

2. The National Government Outstanding Debt Stock as of April 2022
3. Japan ranking 1st with the highest Debt-to-GDP Ratio
4. The Economic Crisis in Sri Lanka
5. World Bank’s International Debt Statistics 2022

Daren D. Cortez, CFMP, CATP, MBA

Department of Financial Management
College of Accountancy and Finance
Polytechnic University of the Philippines