Analyzing Financing

Activities

3
CHAPTER

McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved

 Liabilities
Classification
Current (Short- Noncurrent (Long-
term) Liabilities Term) Liabilities

Obligations whose
settlement requires use of Obligations not
current assets or the payable within one
incurrence of another year or the operating
current liability within one cycle, whichever is
year or the operating longer.
cycle, whichever is
longer.
 Liabilities
Alternative Classification
Obligations
Obligationsthat
thatarise
arisefrom
from
Operating
Operating operating
operatingactivities--examples
activities--examples
Liabilities are
areaccounts
accountspayable,
payable,unearned
unearned
Liabilities revenue,
revenue,advance
advancepayments,
payments,
taxes
taxespayable,
payable,postretirement
postretirement
liabilities,
liabilities,and
andother
otheraccruals
accrualsof
of
operating
operatingexpenses
expenses

Obligations
Obligationsthat
thatarise
arisefrom
from
financing
financingactivities--examples
activities--examples
Financing
Financing are
areshort-
short-and
andlong-term
long-termdebt,
debt,
bonds,
bonds,notes,
notes,leases,
leases,and
andthe
Liabilities
Liabilities the
current
currentportion
portionofoflong-term
long-termdebt
debt
 Liabilities
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.
 Leases
Leasing Facts

Lease – contractual agreement between a

lessor (owner) and a lessee (user or renter) that
gives the lessee the right to use an asset
owned by the lessor for the lease term

MLP – minimum lease payments

(MLP) of the lessee to the lessor
according to the lease contract
 Leases
Lease Accounting and Reporting
(1) Capital Lease Accounting For leases that transfer substantially all
benefits and risks of ownership—accounted for as an asset acquisition
and a liability incurrence by the lessee, and as a sale and financing
transaction by the lessor
A lessee classifies and accounts for a lease as a capital lease if,
at its inception, the lease meets any of four criteria:
(i) lease transfers ownership of property to lessee by end of the lease
term
(ii) lease contains an option to purchase the property at a bargain price
(iii) lease term is 75% or more of estimated economic life of the
property
(iv) present value of rentals and other minimum lease payments at
beginning of lease term is 90% or more of the fair value of leased
property less any related investment tax credit retained by lessor
 
(2) Operating Lease Accounting For leases other than capital leases—the
lessee (lessor) accounts for the minimum lease payment as a rental expense (income)
 Leases
Lease Disclosure and Off-Balance-Sheet Financing

Lease Disclosure
Lessee must disclose: (1) future MLPs separately for capital
leases and operating leases — for each of five succeeding
years and the total amount thereafter, and (2) rental expense
for each period an income statement is reported
 
Off-Balance-Sheet Financing
Off-Balance-Sheet financing is when a lessee structures a
lease so it is accounted for as an operating lease when the
economic characteristics of the lease are more in line with a
capital lease—neither the leased asset nor its corresponding
liability are recorded on the balance sheet
 Leases
Frequency of Capital and Operating Leases
 Leases
Accounting for Leases – An Illustration

Lease Facts
•  A company leases an asset on January 1,
2000 -- it has no other assets or liabilities
• Estimated economic life of leased asset
is 5 years with no salvage value -- company will
depreciate the asset on a straight-line basis over its life
• Lease has a fixed non-cancelable term of 5 years
with annual MLPs of $2,505 paid at the end of each year
• Interest rate on the lease is 8% per year
 Leases
Accounting for Leases – Illustration (continued)

Lease Amortization Schedule

Beg. Interest and Principal Year-
  Year Components of MLP end
Year Liability Liability
Interest Principal Total

2000 $10,000 $ 800 $ 1,705 $ 2,505 $8,295

2001 8,295 664 1,841 2,505 6,454
2002 6,454 517 1,988 2,505 4,466
2003 4,466 358 2,147 2,505 2,319
2004 2,319 186 2,319 2,505 0
Totals $2,525 $10,000 $12,525  

Beginning liability
PV of MLP = 3.992 x $2,505
Straight-line depreciation
$2,000 per year ([$10,000 - $0]/5 years)
 Leases
Accounting for Leases – Illustration (continued)
Income Statement Effects of Alternative Lease Accounting
Operating
Lease Capital Lease

Rent Interest Depreciation Total

Year Expense Expense Expense Expense
2000 $ 2,505 $ 800 $ 2,000 $ 2,800
2001 2,505 664 2,000 2,664
2002 2,505 517 2,000 2,517
2003 2,505 358 2,000 2,358
2004 2,505 186 2,000 2,186

Total $ 12,525 $ 2,525 $ 10,000 $ 12,525

 Leases
Accounting for Leases – Illustration (continued)
 

Balance Sheet Effects of Capitalized Leases

Leased Lease
Date Cash Asset Liability Equity
1/1/2000 0 $ 10,000 $ 10,000 $ -
12/31/2000 (2,505) 8,000 8,295 (2,800)
12/31/2001 (5,010) 6,000 6,454 (5,464)
12/31/2002 (7,515) 4,000 4,466 (7,981)
12/31/2003 (10,020) 2,000 2,319 (10,339)
12/31/2004 (12,525) 0 0 (12,525)
 Leases
Accounting for Leases – Illustration (continued)
 

Effects to Cash Flows

Operating lease Capital lease
CF Operations CF Operations CF Financing
2000 $ 2,505 $800 $1,705
2001 2,505 664 1,841
2002 2,505 517 1,988
2003 2,505 358 2,147
2004 2,505 186 2,319
Total $12,525 $2,525 $10,000
 Leases
Effects of Lease Accounting

Impact of Operating Lease When Capital Lease Is Apt:

• Operating lease understates liabilities—improves solvency ratios
such as debt to equity
• Operating lease understates assets—can improve return on
investment ratios
• Operating lease delays expense recognition—overstates income in
early term of the lease and understates income later in lease term
• Operating lease understates current liabilities by ignoring current
portion of lease principal payment—inflates current ratio & other
liquidity measures
• Operating lease includes interest with lease rental (an operating
expense)—understates both operating income and interest
expense, inflates interest coverage ratios,
understates operating cash flow, & overstates
financing cash flow
 Leases
Effect to Financial Statements: Summary
 
Financial Statement Impact
Financial Statement Capital Lease Operating Lease
Totals
Assets Higher Lower
Liabilities Higher Lower
Net Income (in early Lower Higher
years)
Cash flows from Higher Lower
operations
Cash flows from Lower Higher
financing
Total cash flows Same Same
 Leases
Effect to Financial Statements: Summary
 
Ratio Impact
Ratios Capital Lease Operating Lease
Current ratio (CA/CL) Lower Higher
Working Capital Lower Higher
Asset turnover Lower Higher
(Sales/TA)
Return on assets Lower Higher
(EAT/TA)
Return on Lower Higher
equity(EAT/TE)
Debt/equity Higher Lower
 Leases
Leases
Converting Operating Leases to Capital Leases
Determining the Present Value of Projected Operating
Lease Payments and Lease Amortization
 Recasting Best Buy’s
Income Statement
· Depreciation expense = $3,321/12 = $277
million
· Operating expenses decrease by $177 million
(elimination of $454 million rent expense
reported in 2004 and addition of $277 million of
depreciation expense)
· Interest expense increases by $193 million (to
$201 million)
· Net income decreases by $10 million [$16
million pretax x (1 - .35), the assumed marginal
corporate tax rate] in 2004.
 Recasting Best Buy’s
Balance Sheet

The balance sheet impact is more substantial.

· Total assets and total liabilities both increase
markedly—by $3.321 billion at the end of 2004,
which is the present value of the operating lease
liability.
· The increase in liabilities consists of increases in
both current liabilities ($261 million) and
noncurrent liabilities ($3.06 billion).
 Leases
Restated Financial Statements after Converting
Operating Leases to Capital Leases—Best Buy 2004
 

   
 Leases
Effect of Converting Operating Leases to Capital Leases on Key
Ratios-Best Buy 2004
 Shareholders’ Equity
Basics of Equity Financing

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

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
 Shareholders’ Equity
Reporting Capital Stock

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
• Purchases of treasury stock
• Reverse stock splits
 Shareholders’ Equity
Components of Capital Stock

Contributed (or Paid-In) Capital — total financing received

from shareholders for capital shares; usually consists of two parts:
 
• Common (or Preferred) Stock — financing equal to par or
stated value;if stock is no-par, then equal to total financing
 
• Contributed (or Paid-In) Capital in Excess of Par or Stated
Value — financing in excess of any par or stated value
 Shareholders’ Equity
Two Types of Capital Stock
Preferred Stock — capital stock with features not possessed by
common stock; typical preferred stock features include:
• Dividend distribution preferences
• Liquidation priorities
• Convertibility (redemption) into common stock
• Call provisions
• Sinking fund provisions
 
Common Stock — capital stock with ownership interest and
bearing ultimate risks and rewards (residual interests)
 Shareholders’ Equity
Basics of Retained Earnings
Retained Earnings — earned capital of a company; reflects
accumulation of undistributed earnings or losses since inception;
retained earnings is the main source of dividend distributions
 
Cash and Stock Dividends
• Cash dividend — distribution of cash (or assets) to shareholders
• Stock dividend — distribution of capital stock to shareholders
 
Prior Period Adjustments — mainly error corrections of prior periods’
statements
 
Appropriations of Retained Earnings — reclassifications of retained
earnings for specific purposes
 
Restrictions (or Covenants) on Retained Earnings — constraints or
requirements on retention of retained earnings
 Shareholders’ Equity
Shareholder’s Equity Section of Kimberly Corp. for
periods ending in Year 4 and 5
Year 5 Year 4

Prefered stock, 7% cumulative, par value

$100 (authorized 4,000,000; outstanding
3,602,811) $ 360,281,100 $ 360,281,100
Common Stock, par vaulue $16.67
(authorized 90,000,000 shares; outstanding
54,138,137 shares at December 31, Year 5
and 54,129,987 shares at December 31,
Year 4 902,302,283 902,166,450
Retained earnings 2,362,279,244 902,166,450
Total shareholder's equity $3,624,862,627 $ 2,220,298,288
*Note: Preferred stock is nonparticipating and callable at 105. Dividends for Year 5 are in arrears
 Shareholders’ Equity
Calculated Book Value per Share

Preferred Common Total

Preferred stock* (at $100 par) $ 360,281,100 $ 360,281,100
Dividends in arrears (7%) 25,219,677 25,219,677
Common stock $ 902,302,283 902,302,283
Retained earnings (net of amount attributed
to dividend in arrears 2,337,059,567 2,337,059,567
Total $ 385,500,777 $ 3,239,361,850 $ 3,624,862,627
Divided by number of shares outstanding 3,602,811 54,138,137
Book value per share $ 107.00 $ 59.84
*The call premium does not normally enter into computation of book value per share because the call
provision is at the option of the company
 Group Assignment
z This assignment is related to Chapter 4 Subramanyam book; so, read that
chapter thoroughly.
z Prepare analysis of investing activities of SMGR and INTP for the year of
2010 to 2012, related to investing in current assets and fixed assets.
• Use the following approach and ratios for analysis:
x Year-on- year analysis (related to current assets and fixed assets)
x Common size balance sheet (related to current assets and fixed assets)
x Inventory turnover ratio /days to sell inventory ratio
x Average age of plant and equipment
x Average remaining life of plant and equipment
x AR turnover ratio/average collection period
x Fixed asset turnover
x Total asset turnover
x Return on total assets
• Analysis should include performance of individual company and comparison
between two companies
• Draw conclusion about the two companies’ investing activities
z The paper will be submitted and presented on Tuesday, March 4, 2014.