On Balance Sheet Debt

On Balance Sheet Debt

Short and long-term

Introduction: Important issue in analysis of debt is to realize that not all items classified as debt are debt. Some items represent equity (raised from shareholders); others are equity by virtue of being unrecognized income (revenue).

At the same time, (certain) items classified as equity are perhaps better treated as debt.

Most importantly there exist numerous items not reported anywhere on the financial statements which should be reported as debt (off balance sheet debt).

Current liabilities: three classifications that should be treated differently:

Trade debt (A/P, accrued liabilities etc) – normal operating debt within firms operating cycle
Short-term debt (& current portion of Long-term debt) – loans , commercial paper – outside financing – care should be taken to ensure that firm is not shifting from trade to bank financing
Advance from customers – not a liability! (at least not in the amount listed). Unrecognized revenue – as advance from customer goes up, it is good sign---future income increases.

Long-term debt and equity

Nature of debt should be analyzed:

Convertible bondsDebt or equity? – portion debt and portion equity; one should examine strike price to assess this question (option pricing models may be appropriate.
Redeemable preferred shares: Equity or debt? Given its provisions, more than likely its debt and should be so treated. [SEC requires that it be reported above (but not as part of) equity.]

Market or Cost: (Carrying Value)

Difference between two affected by a function of three factors:

Terms of debt – fixed or variable (swaps)
Horizon – long or short
“Imbedded” rate versus change in interest rates

Debt denominated in foreign currency is adjusted for changes in exchange rates (not changes in interest rate)

Effect on Cash Flow Statement:

Per GAAP, coupon payments (“interest”) are treated as CFO; whereas Face Value (“principal”) is treated as CFF.

Distortion/Inconsistency

When bonds issued at premium – coupon payments include principal payment but reported as CFO
When bonds issued at discount – face value payments include interest but reported as CFF –

Consider Zero Coupon Bond: all payments are CFF, no CFO!

Bond Covenants

10-5

Selected Balance Sheet Data, December 31, 1987 to 1988 ($ in millions)

American AirlinesEastern Airlines

1987 1988 1987 1988

Cash and short-term investments $1,012.4 $1,286.6 $ 332.9 $ 402.3
Net receivables 729.2 833.6 463.1 396.5
Inventories 299.4 375.1 182.1 163.7
Other current assets 105.3 119.7 44.3 37.4

Current assets $2,146.3 $2,615.0 $1,022.4 $ 999.9

Accounts payable 560.4 710.4 267.2 242.7
Accrued liabilities 728.5 1,072.0 344.9 455.7
Air traffic liability* 577.0 800.0 390.5 302.4
Notes payable and current portion long-term debt 205.1 213.2 190.1 153.0

Current liabilities $2,071.0 $2,795.6 $1,192.7 $1,153.8

Net revenues $7,198.0 $8,824.3 $4,447.5 $3,806.1

*ForEastern Air Lines includes $7.8 million and 19.2 million in frequent flier miles for 1987 and 1988, respectively.

Source: American Airlines and Eastern Airlines, 1988 Annual Reports.

American Airlines / Eastern Airlines
1987 / 1988 / 1987 / 1988
Current assets
Current Liabilities
Net working
Capital
Current ratio
Quick ratio
Cash ratio / $2,146.3
2,071.0
$ 75.3
1.03X
0.84
0.49 / $2,615.0
2,795.6
$ (180.6)
0.94X
0.76
0.46 / $1,022.4
1,192.7
$ (170.3)
0.86X
0.67
0.28 / $ 999.9
1,153.8
$ (153.9)
0.87X
0.69
0.35
Adjusted Computations:
Current
liabilities
Air traffic
liability
Current liabilities
Net working
capital
Current ratio
Quick ratio
Cash ratio / $2,071.0
(577.0)
$1,494.0
652.3
1.44X
1.17
0.68 / $2,795.6
(800.0)
$1,995.6
619.4
1.31X
1.06
0.64 / $1,192.7
(390.5)
$ 802.2
220.2
1.27X
0.99
0.41 / $1,153.8
(302.4)
$ 851.4
148.5
1.17X
0.94
0.47

MICROSOFT

Balance Sheet (In millions)

June30 1998 1999

Assets

Current assets:

Cash and short-term investments $13,927 $17,236
Accounts receivable 1,460 2,245
Other 502 752
Total current assets 15,889 20,233
Property and equipment 1,505 1,611
Equity and other investments 4,703 14,372
Other assets 260 940
Total assets $22,357 $37,156

Liabilities and stockholders equity

Current liabilities:

Accounts payable $ 759 $ 874
Accrued compensation 359 396
Income taxes payable 915 1,607
Unearned revenue 2,888 4,239
Other 809 1,602
Total current liabilities 5,730 8,718
Commitments and contingencies
Stockholders’ equity:
Convertible preferred stock — shares authorized 100;
shares issued and outstanding 13 980 980
Common stock and paid-in capital — shares authorized 12,000;
shares issued and outstanding 4,940 and 5,109 8,025 13,844
Retained earnings, including other comprehensive income
of $666 and $1,787 7,622 13,614
Total stockholders’ equity 16,627 28,438
Total liabilities and stockholders’ equity $22,357 $37,156

Income Statement (In millions)

Year Ended June30 / 1997 / 1998 / 1999
Revenue / $ 11,936 / $ 15,262 / $ 19,747
Operating expenses:
Cost of revenue / 2,170 / 2,460 / 2,814
Research and development / 1,863 / 2,601 / 2,970
Acquired in-process technology / — / 296 / —
Sales and marketing / 2,411 / 2,828 / 3,231
General and administrative / 362 / 433 / 689
Other expenses / 259 / 230 / 115
Total operating expenses / 7,065 / 8,848 / 9,819
Operating income / 4,871 / 6,414 / 9,928
Investment income / 443 / 703 / 1,803
Gain on sale of Softimage, Inc. / — / — / 160
Income before income taxes / 5,314 / 7,117 / 11,891
Provision for income taxes / 1,860 / 2,627 / 4,106
Net income / $ 3,454 / $ 4,490 / $ 7,785

MICROSOFT

Notes To Financial Statements

UNEARNED REVENUE

A portion of Microsoft’s revenue is eamed ratably over the product life cycle or, in the case of subscriptions, over the period of the license agreement.

End users receive certain elements of the Company’s products over a period of time. These elements include browser technologies and technical support. Consequently, Microsoft’s earned revenue reflects the recognition of the fair value of these elements over the product’s life cycle. Upon adoption of SOP 98-9 during the fourth quarter of fiscal 1999, the Company was required to change the methodology of attributing the fair value to undelivered elements. The percentages of undelivered elements in relation to the total arrangement decreased, reducing the amount of Windows and Office revenue treated as uneamed, and increasing the amount of revenue recognized upon shipment. The percentage of revenue recognized ratably decreased from a range of 20% to 35% to a range of approximately 15% to 25% of Windows desktop operating systems. For desktop applications, the percentage decreased from approximately 20% to a range of approximately 10% to 20%. The ranges depend on the terms and conditions of the license and prices of the elements. The impact on fiscal 1999 was to increase reported revenue $170 million. In addition, the Company extended the life cycle of Windows from two to three years based upon management’s review of product shipment cycles. The impact on fiscal 1999 was to decrease reported revenue $90 million. Product life cycles are currently estimated at 18 months for desktop applications. The Company also sells subscriptions to certain products via maintenance and certain organizational license agreements. At June 30, 1999, Windows platforms products unearned revenue was $2.17 billion and unearned revenue associated with productivity applications and developer products totaled $1.96 billion. Uneamed revenue for other miscellaneous programs totaled $116 million at June 30, 1999.

Contingencies

The Securities and Exchange Commission is conducting a non-public investigation into the Company’s accounting reserve practices. Microsoft is also subject to various legal proceedings and claims that arise in the ordinary course of business.

Face Value / $100,000
Coupon / 10%
Mkt rate / 10% / Issued at Par
Opening / Interest / Change in / Closing
Balance / Expense / Payment / Principal / Balance
1 / $100,000 / $ 10,000 / $ 10,000 / $ - / $ 100,000
2 / $100,000 / $ 10,000 / $ 10,000 / $ - / $ 100,000
3 / $100,000 / $ 10,000 / $ 10,000 / $ - / $ 100,000
4 / $100,000 / $ 10,000 / $ 10,000 / $ - / $ 100,000
$ 40,000 / $ 40,000 / $ -
Face Value / $100,000
Coupon / 10%
Mkt rate / 8% / Issued at Premium / $106,624
Opening / Interest / Change in / Closing
Balance / Expense / Payment / Principal / Balance
1 / $106,624 / $ 8,530 / $ 10,000 / $ (1,470) / $ 105,154
2 / $105,154 / $ 8,412 / $ 10,000 / $ (1,588) / $ 103,567
3 / $103,567 / $ 8,285 / $ 10,000 / $ (1,715) / $ 101,852
4 / $101,852 / $ 8,148 / $ 10,000 / $ (1,852) / $ 100,000
$ 33,376 / $ 40,000 / $ (6,624)
Face Value / $100,000
Coupon / 10%
Mkt rate / 12% / Issued at Discount / $93,925
Opening / Interest / Change in / Closing
Balance / Expense / Payment / Principal / Balance
1 / $ 93,925 / $ 11,271 / $ 10,000 / $ 1,271 / $ 95,196
2 / $ 95,196 / $ 11,424 / $ 10,000 / $ 1,424 / $ 96,620
3 / $ 96,620 / $ 11,594 / $ 10,000 / $ 1,594 / $ 98,214
4 / $ 98,214 / $ 11,786 / $ 10,000 / $ 1,786 / $ 100,000
$ 46,075 / $ 40,000 / $ 6,075
Face Value / $100,000
Coupon / 0%
Mkt rate / 10% / Issued at discount / $68,301
Opening / Interest / Change in / Closing
Balance / Expense / Payment / Principal / Balance
1 / $ 68,301 / $ 6,830 / $ - / $ 6,830 / $ 75,131
2 / $ 75,131 / $ 7,513 / $ - / $ 7,513 / $ 82,645
3 / $ 82,645 / $ 8,264 / $ - / $ 8,264 / $ 90,909
4 / $ 90,909 / $ 9,091 / $ - / $ 9,091 / $ 100,000
$ 31,699 / $ - / $ 31,699

EQK REALTY

Zero Coupon Financing, Financial Statement Excerpts

Balance Sheet

Year Ended December 31 / 1991 / 1992
Liabilities
Mortgage note payable, net of debt discount of $392
Zero-coupon mortgage notes, net of unamortized discount of $9,574 / ------
$89,410 / $ 75,324
------

Statement of Cash Flows

Year Ended December 31 1992

Cash flows from operating activities

Net loss $ (8,850)
Adjustments to reconcile net loss to net cash provided by
operating activities
Amortization of discount on zero-coupon mortgage
notes 9,344
Other adjustments 7,574
Net cash provided by operating activities $ 8,068

Cash flows from financing activities

Prepayment of zero-coupon note $(23,038)
Other adjustments 1,572
Net cash provided by (used in) financing activities $(21,466)

Note 2: Debt Restructuring

In December 1992, the Company refinanced $75,689,000 representing the balance of its zero-coupon mortgage note that remained after reducing this indebtedness with the proceeds from the sale of properties. . . . The new financing, which is collateralized by first mortgage liens …. matures in December 1995.

Source:EQK Realty Investors, 1992 Annual Report.

EXHIBIT 10-13. NORAM ENERGY CORP.

Stockholders’ Equity and Debt Covenants

Condensed Shareholders’ Equity19941993

Capital Stock

Preferred$ 130,000 $ 130,000
Common stock including paid-in capital944,870 944,118
$1,074,870$1,074,118

Retained Deficit

Balance at beginning of year(366,080) (360,121)
Net income (loss)48,066 36,087
Cash dividends
Preferred stock, $3.00 per share(7,800) (7,800)
Common stock, $0.28 per share in 1994 and
$0.28 per share in 1993(34,265) (34,246)
Balance at end of year$ (360,079) $ (366,080)
Unrealized gain on Itron investment, net of tax2,586 ____

Total stockholders’ equity$ 717,377$ 708,037

Note 5: Restrictions on Stockholders’ Equity and Debt

Under the provisions of the Company’s revolving credit facility as described in Note 3, and under similar provisions in certain of the Company’s other financial arrangements, the Company’s total debt capacity is limited and it is required to maintain a minimum level of stockholders’ equity. The required minimum level of stockholders’ equity was initially set at $650 million at December 31, 1993, increasing annually thereafter by (1) 50% of positive consolidated net income and (2) 50% of the proceeds (in excess of the first $50 million) of any incremental equity offering made after June 30, 1994. The Company’s total debt is limited to $2,055 million. Based on these restrictions, the Company had incremental debt issuance and dividend capacity of $321.2 million and $43.3 million, respectively, at December 31, 1994. The Company’s revolving credit facility also contains a provision which limits the Company’s ability to reacquire, retire or otherwise prepay its long-term debt prior to its maturity to a total of $100 million.

Source: NorAm Energy, 1994 Annual Report.

Debt - 1