ANALYSIS OF FINANCING LIABILITIES

Financial Liabilities | Definition, Types, Ratios, Examples –

 Financial Liabilities for a business are like credit cards for an individual. They are very
useful in the sense that the company can use employ “others’ money” in order to finance its
own business related activities for some time period which lasts only when the liability
becomes due. However, one should be mindful that excessive financial liabilities can put a
dent on the balance sheet and can take the company on the verge of bankruptcy.

A financial liabilities definition

Any future sacrifices of economic benefits that an entity is required to make as a result
of its past transactions or any other activity in the past. The future sacrifices to be made
by the entity can be in the form of any money or service owed to the other party.
 Financial liabilities may be usually legally enforceable due to an agreement signed
between two entities. But they are not always necessarily legally enforceable.
 They can be based on equitable obligations like a duty based on ethical or moral
considerations or can also be binding on the entity as a result of a constructive
obligation which means an obligation that is implied by a set of circumstances in a
particular situation, as opposed to a contractually based obligation.
 Financial liabilities basically include debt payable and interest payable which are as a
result of use of others’ money in the past, accounts payable to other parties which are
as a result of past purchases, rent and lease payable to the space owners which are as a
result of the use of others’ property in the past and several taxes payable which are as
a result of the business carried out in the past.Almost all of the financial liabilities can
 be found listed on the balance sheet of the entity.

 Importance of liabilities & their impact on business



 Although liabilities are essentially future obligations, they are nonetheless a vital
aspect of a company’s operations because they are used to finance operations and pay
for large expansions.
 Liabilities also make the business transactions more efficient to carry out. For
instance, if a company needs to pay for every little purchased quantity every time the
material is delivered, it would require several repetitions of the payment process
within a short period of time.
 On the other hand, if the company gets billed for all its purchases from a particular
supplier over a month or a quarter, it would clear all the payments owed to the
supplier in a very limited number of transactions.
 However, they all have a date of maturity, stated or implied, on which they come due.
Once liabilities come due, they can be detrimental for the business.
 Defaulting or delaying the payment of a liability may add more liabilities to the
balance sheet in the form of fines, taxes and increased interest rate.
 Further, such acts can also damage the reputation of the company and affect the extent
to which it will be able to use that “others’ money” in the future.
 Types of financial liabilities

Liabilities are classified into two types based upon the time period within which they become
due and are liable to be paid to the creditors. Based on this criterion the two types of
liabilities are Short-term or Current Liabilities and Long term Liabilities.

 Short term or current liabilities are those that are payable within a period of 1 year
(next 12 months) from the time the economic benefit is received by the company.
 In other words the liabilities that belong to the current year are called short term
liabilities or current liabilities.
 For example, if a company has to pay yearly rent by virtue of occupying a land or an
office space etc. then that rent will be categorized under current or short term
liabilities.
 Similarly, the interest payable and that part of long term debt which is payable within
the current year will come under short term or current liabilities.

Long term liabilities

 Long term liabilities are those that are payable over a period of time longer than 1
year.
 For example, if a business takes out a mortgage payable over a 15 year period, it will
come under long term liabilities.
 Similarly, all the debt that is not required to be paid within the current year will also
be categorized as a long term liability.

Long term and Short term liabilities

For most companies, the long term liabilities comprise of mostly the long term debt which is
often payable over periods even longer than a decade. However, the other items that can be
classifies as long term liabilities include debentures, loans, deferred tax liabilities and
pension obligations.

On the other hand, there are so many items other than interest and the current portion of long
term debt that can be written under short term liabilities. Other short-term liabilities
include payroll expenses and accounts payable, which includes money owed to vendors,
monthly utilities and similar expenses.
In case a company has a short term liability which it intends to refinance, some confusion is
likely to arise in your mind regarding its classification. To clear this confusion, it is required
to identify whether there is any intent to refinance and also whether the process of
refinancing has begun. If yes, and if the refinanced short term liabilities (debt in general) are
going to become due over a period of time longer than 12 months due to refinancing, they can
very well be reclassified as long term liabilities.

Hence, there is only one criterion which forms the basis of this classification: the next one
year or 12 month period.

Analysis of Financial Liabilities

What is the need to analyse the liabilities of a company?

And who are the people most affected by a company’s liabilities?

liabilities after all result into a pay out of cash or any other asset in the future. So, by itself a
liability must always be looked upon as unfavourable. Still, when analysing financial
liabilities, they must not be viewed in isolation. It is important to realise the overall impact of
an increase or decrease in liabilities and the signals that these variations in liabilities send out
to all those who are concerned.

The people whom the financial liabilities impact are the investors and equity research
analysts who are involved in business of purchasing, selling and advising on the shares and
bonds of a company. It is they who have to make out how much value a company can create
for them in future by looking at the financial statements.

For the above reasons, experienced investors take a good look at liabilities while analyzing
the financial health of any company for the purpose of investing in them. As a way to quickly
size up businesses in this regard, traders have developed a number of ratios that help them in
separating the healthy borrowers from those who are drowning in debt.

Financial liabilities Ratios

All the liabilities are similar to debt which needs to be paid in future to the creditors. For this
reason, when doing the ratio analysis of the financial liabilities, we call them debt in general:
long term debt and short term debt. So wherever a ratio has a term by the name of debt, it
would mean liabilities.The following ratios are used to analyse the financial liabilities:
  This ratio is considered to be one of the more meaningful of the “debt” ratios – it
delivers the key insight into a company’s use of leverage.
 If this ratio has a low value, it would mean that the company has a low long term debt
and high amount of equity.
 And it is well known that a low level of debt and a healthy proportion of equity in a
company’s capital structure is an indication of financial fitness.
 Hence, a low value of capitalization is considered favourable by an investor.

#4 – Cash flow to total debt ratio:

This ratio gives an idea about a company’s ability to pay its total debt by comparing it with
the cash flow generated by its operations during a given period of time.

Cash flow to debt ratio = Operating cash flow/Total debt

 The total debt does not completely belong to the given period since it also includes
the long term debt.
 Still this ratio indicates whether the cash being generated from operations would
suffice to pay the debt in the long term.
 Unlike the above three ratios, the debt related number (Total debt) comes in the
denominator here.
 So, the more the operating cash flow is, the greater this ratio is. Thus, a greater value
of this ratio is to be considered more favorable.

#5 – Interest coverage ratio:

Interest coverage ratio gives an idea about the ability of a company to pay its debt by using its
operating income. It is the ratio of a company’s earnings before interest and taxes (EBIT) to
the company’s interest expenses for the same period.

Interest coverage ratio=EBIT/Interest expense

 A greater value of this ratio must be taken as favourable while a lower value must be
considered as unfavourable for investment.
 This ratio is quite different from the above four ratios by virtue of being a short term
liability related ratio.
 It takes into account only the interest expense which is essentially one of the short
term liabilities.
 Also, do have a look at Debt Service coverage Ratio (important for credit analysts)
#6 – Current Ratios and Quick Ratios
Important among other ratios used to analyse the short term liabilities are the current ratio
and the quick ratio. Both of them help an analyst in determining whether a company has the
ability to pay off its current liabilities.

The current ratio is the ratio of total current assets to the total current liabilities.

Current ratio=Total current assets/Total current liabilities

 The current ratio is a liquidity ratio that measures a company’s ability to pay short-
term and long-term obligations.

The quick ratio is the ratio of the total current assets less inventories to the current liabilities.

Quick ratio= (Total current assets-Inventories)/Total current liabilities

 The quick ratio measures a company’s ability to meet its short-term obligations with
its most liquid assets.

The above ratios are some of the most common ratios used to analyse a company’s liabilities.
However, there is no limit to the number and type of ratios to be used.

 You can take any suitable terms and take their ratio as per the requirement of your
analysis. The only aim of using the ratios is to get a quick idea about the components,
magnitude and quality of a company’s liabilities.
 Also, as is true with any kind of ratio analysis, the type of company and the industry
norms must be kept in mind before concluding whether it is high or low on debt when
using the above ratios as the basis. It is a comparative analysis after all!
 For instance, large and well-established companies can push the liability component
of their balance sheet structure to higher percentages without getting into trouble
while smaller firms may not.

#1 – Debt Ratio
The debt ratio gives a comparison of a company’s total debt (long term plus short term) with
its total assets.

Debt ratio Formula =Total debt/Total assets=Total liabilities/Total assets

 This ratio gives an idea of the company’s leverage i.e. the money borrowed from
and/or owed to others.
 Sometimes analysts use it to gauge whether the company can pay out all its liabilities
if it goes bankrupt and has to sell off all its assets.
  That’s the worst that can happen to a company. So if this ratio is greater than 1, it
means that the company has more debt than the cash it can have on selling its assets.
 Hence, the lower the value of this ratio, the stronger the position of the company is.
And thus, investing in such a company becomes as much less risky.
 However, generally the current portion of total liabilities i.e. the current liabilities
(including the operational liabilities, such as accounts payable and taxes payable) is
not as risky as they don’t need to be funded by selling off the assets.
 A company usually funds them through its current assets or cash.

So a clearer picture of the debt position can be seen by modifying this ratio the “long-term
debt to assets ratio”.

#2 – Debt to equity ratio:

This ratio also gives an idea about the leverage of a company. It compares a company’s total
liabilities to its total shareholders’ equity.

Debt to equity ratio = Total debt/Shareholder’s Equity

 This ratio gives an idea about how much its suppliers, lenders and creditors are
invested in the company compared to its shareholders.
 It also tells about the capital structure of the company. The lower this ratio is, the
lesser the leverage and the stronger the position of the company’s equity.
 Again, you can analyse the long term debt against the equity by removing the current
liabilities from the total liabilities. That’s the analyst’s choice as per what exactly he
is trying to analyse.

#3 – Capitalization ratio:
This ratio specifically compares the long term debt and the total capitalization (i.e. long term
debt liabilities plus shareholders’ equity) of a company.

Capitalization ratio = Long term debt/(Long term debt +Shareholder’s equity)

 This ratio is considered to be one of the more meaningful of the “debt” ratios – it
delivers the key insight into a company’s use of leverage.
 If this ratio has a low value, it would mean that the company has a low long term debt
and high amount of equity.
 And it is well known that a low level of debt and a healthy proportion of equity in a
company’s capital structure is an indication of financial fitness.
 Hence, a low value of capitalization is considered favourable by an investor.
#4 – Cash flow to total debt ratio:
This ratio gives an idea about a company’s ability to pay its total debt by comparing it with
the cash flow generated by its operations during a given period of time.

Cash flow to debt ratio = Operating cash flow/Total debt

 The total debt does not completely belong to the given period since it also includes
the long term debt.
 Still this ratio indicates whether the cash being generated from operations would
suffice to pay the debt in the long term.
 Unlike the above three ratios, the debt related number (Total debt) comes in the
denominator here.
 So, the more the operating cash flow is, the greater this ratio is. Thus, a greater value
of this ratio is to be considered more favorable.

#5 – Interest coverage ratio:

Interest coverage ratio gives an idea about the ability of a company to pay its debt by using its
operating income. It is the ratio of a company’s earnings before interest and taxes (EBIT) to
the company’s interest expenses for the same period.

Interest coverage ratio=EBIT/Interest expense

 A greater value of this ratio must be taken as favourable while a lower value must be
considered as unfavourable for investment.
 This ratio is quite different from the above four ratios by virtue of being a short term
liability related ratio.
 It takes into account only the interest expense which is essentially one of the short
term liabilities.
 Also, do have a look at Debt Service coverage Ratio (important for credit analysts)

#6 – Current Ratios and Quick Ratios

Important among other ratios used to analyse the short term liabilities are the current ratio
and the quick ratio. Both of them help an analyst in determining whether a company has the
ability to pay off its current liabilities.

The current ratio is the ratio of total current assets to the total current liabilities.

Current ratio=Total current assets/Total current liabilities

 The current ratio is a liquidity ratio that measures a company’s ability to pay short-
term and long-term obligations.
The quick ratio is the ratio of the total current assets less inventories to the current liabilities.

Quick ratio= (Total current assets-Inventories)/Total current liabilities

 The quick ratio measures a company’s ability to meet its short-term obligations with
its most liquid assets.

The above ratios are some of the most common ratios used to analyse a company’s liabilities.
However, there is no limit to the number and type of ratios to be used.

 You can take any suitable terms and take their ratio as per the requirement of your
analysis. The only aim of using the ratios is to get a quick idea about the components,
magnitude and quality of a company’s liabilities.
 Also, as is true with any kind of ratio analysis, the type of company and the industry
norms must be kept in mind before concluding whether it is high or low on debt when
using the above ratios as the basis. It is a comparative analysis after all!
 For instance, large and well-established companies can push the liability component
of their balance sheet structure to higher percentages without getting into trouble
while smaller firms may not.

Financial Liabilities Examples

High debt companies:These days, the whole oil exploration and production industry is
suffering from an unprecedented piling up of debt. Exxon, Shell, BP and Chevron have
combined debts of $ 184 billion amid two-year slump. The reason is that crude oil prices
have stayed lower than profitable levels for too long now. And these companies did not
expect this downturn to extend this long. So they took too much of debt in order to finance
their new projects and operations.

But now, since the new projects have not turned profitable, they are unable to generate
enough income or cash to pay back that debt. This means that their Income coverage ratios
and Cash flow to debt ratios have seriously declined making them unfavorable to invest.
Exxon Mobil Debt to Equity (Quarterly Chart)

As the investment becomes unfavorable, investors pull out their money from the stock. As a
result, the debt to equity ratio increases as can be seen in the case of Exxon Mobil in the
above chart.

Now, the oil companies are trying to generate cash by selling some of their assets every
quarter. So, their debt paying ability presently depends upon their Debt ratio. If they have got
enough assets, they can get enough cash by selling them off and pay the debt as it comes due.

Low debt companies

On the other hand, there are companies like Pan American Silver (a silver miner), which are
low on debt. Pan American had a debt of only $ 59 million compared to the cash, cash
equivalents and short term investments of $ 204 million at the end of the June quarter of
2016. This means that the ratio of debt to cash, cash equivalents and short term investments is
just 0.29. Cash, cash equivalents and short term investments are the most liquid assets of a
company. And the total debt is only 0.29 times of that. So, from a view point of “ability to
pay the debt”, Pan American is a very favorable investment as compared to those oil
companies at the moment.

Pan America Silver Debt to Equity (Quarterly)

Now, the above chart of Pan American also shows an increase in debt to equity ratio. But
look at the value of that ratio in both charts. It’s 0.261 for Exxon while it’s only 0.040 for Pan
American. This comparison clearly shows that investing in Pan American is much less risky
than investing in Exxon.
Conclusion

There is no single method for analyzing financial liabilities. However, finding out meaningful
ratios and comparing them with other companies is one well established and recommended
method for the purpose of deciding over investing in a company. There are certain
traditionally defined ratios for this purpose. But you can very well come up with your own
ratios depending upon the purpose of analysis.

Questions:

 What are Financial Liabilities?

 Importance of liabilities & their impact on business
 Types of financial liabilities
 Long term and Short term liabilities
 Analysis of Financial Liabilities
 Financial liabilities Ratios
o #1 – Debt ratio
o #2 – Debt to equity ratio
o #3 – Capitalization ratio
o #4 – Cash flow to total debt ratio
o #5 – Interest coverage ratio
o #6 – Current Ratio and Quick Ratio
 Examples – High Debt companies
 Example – Low Debt Companies
 Conclusion

EFFECTS OF RISING INTEREST RATES

Rising rates impact all segments of the economy. Businesses in particular suffer
greatly from a rise in the average interest rate. Higher rates have both direct and
indirect effects on companies, all of which trickle down into the balance sheet.
Whether you are an investor, supplier or business owner, it is therefore crucial to
grasp the relationship between balance sheet metrics and interest rates in the broader
economy.
Liabilities
The higher the interest rates, the more a borrower will owe. Consequently, rising rates will
result in greater liabilities on the balance sheet; the net loan obligation reflected on a
company's balance sheet includes the original sum borrowed as well as accrued and as yet
unpaid interest expense. While the principal may not go up as a result of higher rates, the
interest owed to the lender will, resulting in a higher total loan balance. Companies that have
locked in long-term loans prior to the increase in rates are immune to this effect, at least until
they have to borrow again.
Shareholder Equity
Higher rates mean higher interest charges, which result in lower profits. The lower a
company's profitability, the lower the shareholder equity. This makes conceptual sense
because the sum of liabilities and shareholder equity on a balance sheet equals the sum of
assets. Since higher rates result in an increase in liabilities and have no effect on assets,
shareholder equity must decline to retain the equality between the two sides. Not all
companies retain earnings on the balance sheet, instead electing to distribute them to
shareholders in the form of dividends. Such companies will not necessarily record lower
shareholder equity on their balance sheet, but will distribute less in dividends instead.
Effect on Sales
When there is a broad rise in rates in an economy, interest rates on both business and personal
loans will go up. Borrowing money via credit cards, mortgages or auto loans will become
more expensive. This curbs consumer spending on essentially all kinds of products and
services, resulting in lower sales for most companies. This, too, will lead to lower profits, and
consequently less shareholder equity on the balance sheet. While companies that have
absolutely no loans on their balance sheet at all can avoid higher interest charges, the hit on
sales and profitability as a result of higher rates is inevitable for most companies.
Paradoxial Effects
If the rise in rates is excessive, companies may actually see a decline in the total sum of loans
carried on their balance sheets. This is because loans may become outright unaffordable,
resulting in less borrowing and less investment. In such cases, the assets will also decline,
since companies obtain assets when they borrow. Even if the borrowed sum is kept as cash,
total cash, which is an asset, will rise on the balance sheet. Many companies borrow to invest
in assets such as machinery, buildings and raw materials, all of which are recorded as assets.
So in extreme cases, higher rates may result in lower liabilities as well as assets on the
balance sheet.

Interest rate risk

Interest rate risk is the risk to current or anticipated earnings or capital arising from
movements in interest rates. Interest rate risk has the potential to create adverse effects on the
financial results and capital of the bank arising from positions in the banking book. One of
the fundamental objectives in banking is to borrow funds at a lower rate and lend them at a
higher rate, thereby making profits. Interest rate risk arises due to changes in market interest
rates, which have an impact on bank profitability. An interest rate rise puts financial pressure
on the client, which may in turn result in default of loan payments. The major factors that
lead to increased interest rate risk are the volatility of interest rates and mismatches between
the interest reset dates on assets and liabilities.
Interest rate risk is a major component of market risk. The NII or net interest margin (NIM) is
dependent on the movements of interest rates. Variations in the NIM of banks occur when
there are mismatches in cash flows (fixed assets or liabilities) or repricing dates (floating
assets or liabilities). Interest rate risk refers to the potential impact on the NII, the NIM, or the
market value of equity (MVE), which is caused by unexpected changes in market interest
rates.

 Effects of Interest Rate Risk

1. As the discussion above suggests, changes in interest rates can have adverse effects both
on a bank's earnings and its economic value. This has given rise to two separate, but
complementary, perspectives for assessing a bank's interest rate risk exposure.

2. Earnings perspective: In the earnings perspective, the focus of analysis is the impact of
changes in interest rates on accrual or reported earnings. This is the traditional approach to
interest rate risk assessment taken by many banks. Variation in earnings is an important focal
point for interest rate risk analysis because reduced earnings or outright losses can threaten
the financial stability of an institution by undermining its capital adequacy and by reducing
market confidence.

3. In this regard, the component of earnings that has traditionally received the most attention
is net interest income (i.e. the difference between total interest income and total interest
expense). This focus reflects both the importance of net interest income in banks' overall
earnings and its direct and easily understood link to changes in interest rates. However, as
banks have expanded increasingly into activities that generate fee-based and other non-
interest income, a broader focus on overall net income - incorporating both interest and non-
interest income and expenses - has become more common. The non-interest income arising
from many activities, such as loan servicing and various asset securitisation programs, can be
highly sensitive to market interest rates. For example, some banks provide the servicing and
loan administration function for mortgage loan pools in return for a fee based on the volume
of assets it administers. When interest rates fall, the servicing bank may experience a decline
in its fee income as the underlying mortgages prepay. In addition, even traditional sources of
non-interest income such as transaction processing fees are becoming more interest rate
sensitive. This increased sensitivity has led both bank management and supervisors to take a
broader view of the potential effects of changes in market interest rates on bank earnings and
to factor these broader effects into their estimated earnings under different interest rate
environments.

4. Economic value perspective:  Variation in market interest rates can also affect the
economic value of a bank's assets, liabilities and OBS positions. Thus, the sensitivity of a
bank's economic value to fluctuations in interest rates is a particularly important
consideration of shareholders, management and supervisors alike. The economic value of an
instrument represents an assessment of the present value of its expected net cash flows,
discounted to reflect market rates. By extension, the economic value of a bank can be viewed
as the present value of bank's expected net cash flows, defined as the expected cash flows on
assets minus the expected cash flows on liabilities plus the expected net cash flows on OBS
positions. In this sense, the economic value perspective reflects one view of the sensitivity of
the net worth of the bank to fluctuations in interest rates.
5. Since the economic value perspective considers the potential impact of interest rate
changes on the present value of all future cash flows, it provides a more comprehensive view
of the potential long-term effects of changes in interest rates than is offered by the earnings
perspective. This comprehensive view is important since changes in near-term earnings - the
typical focus of the earnings perspective - may not provide an accurate indication of the
impact of interest rate movements on the bank's overall positions.

6. Embedded losses: The earnings and economic value perspectives discussed thus far focus
on how future changes in interest rates may affect a bank's financial performance. When
evaluating the level of interest rate risk it is willing and able to assume, a bank should also
consider the impact that past interest rates may have on future performance. In particular,
instruments that are not marked to market may already contain embedded gains or losses due
to past rate movements. These gains or losses may be reflected over time in the bank's
earnings. For example, a long term fixed rate loan entered into when interest rates were low
and refunded more recently with liabilities bearing a higher rate of interest will, over its
remaining life, represent a drain on the bank's resources

DEBT OF FIRM IN DISTRESS

What Is Financial Distress?

Financial distress is a condition in which a company or individual cannot generate revenue or
income because it is unable to meet or cannot pay its financial obligations. This is generally
due to high fixed costs, illiquid assets, or revenues sensitive to economic downturns.

Ignoring the signs of financial distress can be devastating for a company. There may come a
time when severe financial distress cannot be remedied because the company or individual's
obligations are too high and cannot be paid, and there is just not enough revenue to offset the
debt. If this happens, bankruptcy may be the only option.

Understanding Financial Distress

If a company or individual experiences a period of time when it cannot pay its bills and other
obligations by their due date, it is likely experiencing financial distress. Some of these
expenses may include (expensive) financing, opportunity costs of projects, and employees
who aren't productive. Employees of a distressed firm usually have lower morale and higher
stress caused by the increased chance of bankruptcy, which could force them out of their
jobs.

Companies under financial distress may find it difficult to secure financing. They may also
find their market value dropping significantly, customers cutting back orders, and suppliers
changing their terms of delivery.

Looking at a company's financial statement can help investors and others determine its
financial health. For example, negative cash flow under the cash flow statements is one
indicator of financial distress. This could be caused by a big difference between cash
payments and receivables, high interest payments, and a drop in working capital.

Individuals who experience financial distress may find themselves in a situation where their
debts are much more than their monthly income. This includes home or rent payments, car
payments, and credit card and utility bills. People who experience situations like these tend to
go through it for an extended period of time.

There are multiple warning signs to indicate a company is experiencing financial distress.
Poor profits may indicate a company is financially unhealthy. Struggling to break even
indicates a business cannot sustain itself from internal funds and needs to raise capital
externally. This raises the company’s business risk and lowers its creditworthiness with
lenders, suppliers, investors, and banks. Limiting access to funds typically results in a
company (or individual) failing.

Poor sales growth or decline indicates the market is not positively receiving a company’s
products or services based on its business model. When extreme marketing activities result in
no growth, the market may not be satisfied with the offerings, and the company may close
down. Likewise, if a company offers poor quality products or services, consumers start
buying from competitors, eventually forcing a business to close its doors.

When debtors take too much time paying their debts to the company, cash flow may be
severely stretched. The business or individual may be unable to pay its own liabilities. The
risk is especially enhanced when a company has one or two major customers.

What is distressed debt?

Distressed debt refers to the securities of a government or company which has either
defaulted, is under bankruptcy protection, or is under distress and moving towards the
aforementioned situations in the near future. It includes all credit instruments that are trading
at a significant discount and have a spread substantially wider than the industry average.
Distressed debt is a part of the leveraged and high-yield loan market, and is rated below
investment grade debt. The most common distressed debt securities are bank debt, bonds,
trade claims, and common and preferred shares.

How does distressed debt arise?

So circling back to our question: What is distressed debt? Distressed debt is not issued
deliberately by an entity – they are only issued when the entity is in a situation of financial
distress due to the market economy/industry wide trends, internal mismanagement, or both.
When a company is in financial distress, the original holders of the issued securities sell them
to new buyers at a significantly discounted price. These new buyers hope to hold the
securities while the company restructures and sell them after their value appreciates.

 
When are securities classified as distressed?
The securities of an entity are classified as distressed when the issuer cannot meet a large
number of its financial obligations. Unlike junk bonds which have a credit rating of BBB (or
lower), distressed securities have credit rating of CCC or lower. Furthermore, fixed income
securities having a yield to maturity which is 1000 basis points greater than the risk-free rate
of return are classified as distressed debt (Note: a related category, stressed debt, has a yield
to maturity which is 600-800 basis points greater than the risk-free rate of return).

Rate of return
Distressed debt is sold for a very small fraction of its par value and offers a rate of return
1000 basis points higher than the risk-free rate of return. This is so because distressed debt is
a high risk-high return debt security. Given the financially distressed position of the issuer,
the potential for default is high. However, financial distress is also a precursor to corporate
restructuring. In the event that the corporate restructuring is successful and the company is
saved from bankruptcy and/or liquidation, then the debt security is likely to be repaid in full.

 Why invest in distressed debt?

So what is distressed debt used for in terms of investments? Distressed debt firms become a
major creditor of the distressed issuer by purchasing a large number of the issuer’s securities.
They then have the leverage to prescribe the terms for the reorganization. If the
reorganization is successful, they get a positive return on investment. Should the company be
liquidated, distressed debt firms may recover the entire amount invested because they are
entitled to be repaid before equity holders.

Hedge funds, mutual funds, brokerage firms, specialized debt funds (like Collateralized Loan
Obligations), and private equity firms are the dominant players in this market. Thus, investors
with a high appetite for risk should invest in distressed securities. However, it should be
noted that distressed stocks are riskier than distressed senior debt instruments.

 Tips for investing in distressed debt

As an asset manager, or as someone hiring an asset manager, you should have/look out for
the following qualities while investing in distressed debt:

1. Complete understanding of bankruptcies, restructuring and reorganization.

2. Credit research platform consisting of experienced and well-informed analysts.
3. Knowledge regarding every segment of the capital structure of the issuing company.
This consists of understanding the issuer’s repayment priorities, interdependent
obligations, collateral offered and covenants.
4. Ability to assess and ascertain the reason behind the issuer’s distress and advise about
downside risks and upside potential of investments accordingly.
5. Liquidity and flexibility to exploit investment opportunities as an when they arise
Retirement of debt prior to maturity

Meaning :-

Corporations and governments issue bonds to borrow money. When you invest in bonds, you
lend money and receive income in the form of regular interest payments. At some point, the
bond issuer pays back the borrowed money to retire the debt. As a bond owner, you get your
money back. However, the terms under which bonds can be retired vary and can be a plus or
minus for an investor.

Definition of Bond Retirement

Technically, “retirement of bonds” is an accounting term that you’ll see used on financial
statements. It refers to a buyback of bonds previously sold. In other words, it means a bond
issuer has paid off the debt represented by the bonds. For example, on a company’s cash
statement, retirement of bonds may be used to explain a reduction in the firm’s long-term
debt.
Bond Maturity
Each bond has a maturity date – the date on which the debt must be repaid. Bonds have
maturities ranging from a few months to 30 years or more. The bond issuer pays investors the
par value that is stated on the bond plus any accrued interest to retire the debt. Bond prices
can vary considerably during a bond's life. Consequently, when you hold a bond to maturity,
it’s likely you’ll have a capital gain if you bought the bond at a discount from the par value. If
you purchased a bond at a premium over par, you’ll have a capital loss.
Callable Bonds
Some bonds are sold with a call provision as part of their terms and conditions. When a bond
is callable, it means the bond issuer has the option of paying off the debt and retiring the bond
before it matures. Typically, these bonds can be called on or after a specified call date.
Corporate and municipal bonds are the most likely to have a call feature. If prevailing interest
rates go down, the bond issuer can retire callable bonds and reissue them at a lower interest
rate. This works to the advantage of bond issuers, and investors may lose out on favorable
interest rates.
Convertible Bonds
Corporations sometimes sell bonds that can be converted into a specific number of common
stock shares. If an investor chooses to exercise the conversion option, the debt represented by
the bond is retired when the bond is exchanged for stock. This can be a good deal for the
bond owner, because she has the opportunity to benefit from growth in the value of the stock
and earn income from the bond. Convertible bonds can also benefit the issuing company,
because a conversion retires the debt without the firm having to pay out cash
Bonds Issued Between Interest Dates, Bond Retirements, And Fair Value

Bonds issued between interest dates are best understood in the context of a specific example.
Suppose Thompson Corporation proposed to issue $100,000 of 12% bonds, dated April 1,
20X1. However, despite the April 1 date, the actual issuance was slightly delayed, and the
bonds were not sold until June 1. Nevertheless, the covenant pertaining to the bonds specifies
that the first 6-month interest payment date will occur on September 30 in the amount of
$6,000 ($100,000 X 12% X 6/12). In effect, interest for April and May has already accrued at
the time the bonds are actually issued ($100,000 X 12% X 2/12 = $2,000). To be fair,
Thompson will collect $2,000 from the purchasers of the bonds at the time of issue, and then
return it within the $6,000 payment on September 30. This effectively causes the net
difference of $4,000 to represent interest expense for June, July, August, and September
($100,000 X 12% X 4/12). The resulting journal entries are:

  
MyExceLab

Year-End Interest Accruals

Notice that interest was paid in full through September 30. Therefore, the December 31 year-
end entry must reflect the accrual of interest for October through December:
 

 
When the next interest payment date arrives on March 31, the actual interest payment will
cover the previously accrued interest, and additional amounts pertaining to January, February,
and March:
 
 
If these bonds had been issued at other than par, end-of-period entries would also include
adjustments of interest expense for the amortization of premiums or discounts relating to
elapsed periods.
Bonds Retired Before Scheduled Maturity
Early retirements of debt may occur because a company has generated sufficient cash
reserves from operations, and the company wants to stop paying interest on outstanding debt.
Or, interest rates may have changed, and the company wants to take advantage of more
favorable borrowing opportunities by “refinancing.”
Whether the debt is being retired or refinanced in some other way, accounting rules dictate
that the extinguished obligation be removed from the books. The difference between the old
debt’s net carrying value and the amounts used for the payoff should be recognized as a gain
or loss.
For instance, assume that Cabano Corporation is retiring $200,000 face value of its 6% bonds
payable on June 30, 20X5. The last semiannual interest payment occurred on April 30. The
unamortized discount on the bonds at April 30, 20X5, was $6,000, and there was a 5-year
remaining life on the bonds as of that date. Further, Cabano is paying $210,000, plus accrued
interest to date ($2,000), to retire the bonds; this “early call” price was stipulated in the
original bond covenant. The first step to account for this bond retirement is to bring the
accounting for interest up to date:
 

 Then, the actual bond retirement can be recorded, with the difference between the up-to-date
carrying value and the funds utilized being recorded as a loss (debit) or gain (credit). Notice
that Cabano’s loss relates to the fact that it took more cash to pay off the debt than was the
debt’s carrying value of $194,200 ($200,000 minus $5,800).

 The Fair Value Option

Be aware that bonds can change in value. Remember that the value of a bond is a function of
the bond’s stated rate of interest in relation to the going market rate of interest. If market
interest rates rise, look for a market value decline (reflecting a lower present value based on
the higher discount rate) and vice versa. Companies are permitted, but not required, to
recognize changes in value of such liabilities. Entities that opt for this approach are to report
unrealized gains and losses in earnings at each reporting date, and the balance sheet will be
revised to reflect the fair value of the obligation.
Specific rules dictate the process and judgment for determining fair value. If a company’s
debt is traded in a public market, the valuation would be based on its observable price
(“Level 1”). If the debt does not have a clearly determinable market, pricing would be tied to
similar securities (“Level 2”). Management may develop their own pricing models in the rare
case where the value is not otherwise observable (“Level 3”).

GAIN Or loss calculation on debt instrument

A bond is a type of debt instrument that a company uses to borrow money. A bondholder
pays money to a company to receive a bond, and the company in turn pays the bondholder
periodic interest payments and repays the bondholder on the bond’s maturity date. Some
bonds allow you to repay or retire the bonds before the maturity date. If your company
retires its bonds before their maturity date, you must calculate a gain or loss on the retired
bonds and report the amount on your income statement.

A bond is a type of debt instrument that a company uses to borrow money. A bondholder
pays money to a company to receive a bond, and the company in turn pays the bondholder
periodic interest payments and repays the bondholder on the bond’s maturity date. Some
bonds allow you to repay or retire the bonds before the maturity date. If your company
retires its bonds before their maturity date, you must calculate a gain or loss on the retired
bonds and report the amount on your income statement.
Determine from your accounting records the balance of your bonds payable account, which
is the amount you would have had to pay on the bonds’ maturity date had you not retired
them. For example, assume your bonds payable account balance is $10,000.

Determine either the unamortized amount of bond premium or the unamortized amount of
bond discount from your accounting records. A bond premium or discount is the amount
bondholders either overpaid or underpaid, respectively, depending on market interest rates,
to initially buy the bonds. The unamortized amount is the amount that is still in your
accounting records. In the example, assume you have $1,500 in unamortized bond
premium.

BOND CONVENENTS

What Is a Bond Covenant?

A bond covenant is a legally binding term of agreement between a bond issuer and a
bondholder. Bond covenants are designed to protect the interests of both parties. Negative
or restrictive covenants forbid the issuer from undertaking certain activities; positive
or affirmative covenants require the issuer to meet specific requirements.

Bond Covenants Explained

Bond covenants are utilized to restrict the borrowing firm from making decisions which will
deteriorate its financial health from the time of borrowing.
A covenant is a pledge or undertaking by an issuer to do certain things or avoid others.

In the bond market, a covenant will usually be a “financial covenant” which specifies that, for
example, the issuer will maintain an interest coverage ratio over a certain level or a leverage
ratio (debt/equity) under a specific level. These ratios are meant to constrain the issuer to
financial prudence.

Covenants can also be “non-financial” in nature, such as providing financial information to

bondholders, protecting against the selling of assets, or changes of control, or making sure the
assets of the company have adequate insurance.

Both types of covenants are utilized to restrict the borrowing firm from making decisions
which will deteriorate its financial health from the time of borrowing. Covenants can also
reward investors or punish borrowers based on their financial health. Covenants can add
coupon step-ups based on credit metrics or credit ratings.

Issuers do not like to have covenants because they restrict their actions. This is why the
majority of recent bond issues do not have meaningful covenants. These structures have
become known as Cov-Lite deals. Issuers tend to provide more stringent covenants in a slow
bond market when they are having trouble raising money, and inversely will provide very
few covenants in a hot bond market where investors are willing to forego the safety of
covenants just to get access to the issue.

Issuers with outstanding “covenant” bond issues have “closed off” these issues and currently
issue debt under their unsecured debenture and mid-term note programs. This is one of the
reasons for the development of “asset-backed securities”.

All bond covenants are part of a bond's legal documentation and are part of corporate bonds
and government bonds. A bond's indenture is the portion that contains the covenants, both
positive and negative, and is enforceable throughout the entire life of the bond until maturity.
Possible bond covenants might include restrictions on the issuer's ability to take on additional
debt, requirements that the issuer provide audited financial statements to bondholders and
limitations on the issuer's ability to make new capital investments.

When an issuer violates a bond covenant, it is considered to be in technical default. A

common penalty for violating a bond covenant is the downgrading of a bond's rating, which
could make it less attractive to investors and increase the issuer's borrowing costs. For
example, Moody's, one of the major credit rating agencies in the United States, rates a bond's
covenant quality on a scale of 1 to 5, with five being the worst. This means that a bond with a
covenant rating of five is an indication that covenants are being violated consistently. In May
2016, Moody's reported that overall covenant quality in the market declined to 4.56 from 3.8
the previous month. The downgrade is attributed to a high amount of junk bonds being
issued, ones with strict covenants that are easier to default.

An Example of a Bond Covenant

On June 23, 2016, Hennepin County, Minnesota, issued a bond to help finance a part of the
ambulatory outpatient specialty center at the county's medical center. Fitch Ratings gave the
bond a AAA rating, because the bond is backed by the county's full faith, credit, and
unlimited taxing power. Additionally, the rating agency gave the county's outstanding
Hennepin County Regional Railroad Authority limited tax GO bonds (HCRRA) a AAA
rating for the same reasons, including the fact that the county can pay the debt using ad
valorem taxes on all taxable property.

The HCRRA bond debenture contained a covenant stipulating that Hennepin County can levy
taxes to fund the debt service at 105% annually. The debenture also stipulated that the
maximum tax rate provides strong coverage of the debt service of 21.5x MADS.

These asset-backed securities enable bond investors to obtain specific assets as security and
protective features in bond issues. Instead of investing in an unsecured mid-term note of an
auto-finance company, an investor could invest in “auto-loan” receivables through an asset-
backed trust originated and serviced by the same company.

While covenant lite deals or ‘Cov-Lite’ deals are cyclical, the key for investors is
understanding the protections that they are legally entitled to. Some issuers are willing to pay
a higher coupon to be able to remain flexible with their covenants. Issuers that are involved in
a lot of acquisitions financed with debts need to be able to access the debt markets on a
regular basis and having a restrictive financial covenant could impair their ability to make
deals. As an investor you have to be compensated for the additional risk that comes along
with having fewer restrictions on what the borrower is able to do.

Debt Covenant Definition – debt covenants are the restrictions imposed by the lenders
(investors, creditors etc.) on the borrowers (the company/debtor). Ideally, when the lenders
lend the money to the borrowers, they sign an agreement. And under this agreement, the
borrowers have to maintain certain restrictions so that the interest of the lenders is protected.
Debt covenants (Bond Covenants) can be called by many names. Two of the popular names
are banking covenants and financial covenants. Actually, they all mean the same thing

WHY ARE BOND CONVENANT NECESSARY

In other words, why bond covenants lenders would restrict the borrowers from doing
something? The bond covenant lenders don’t want to pressurize the borrowers with rules and
restrictions. However, if they don’t bind the borrowers with few terms & conditions, they
may not get their money back.It is also important to note that debt covenants also help the
borrowers (yes, even after being restricted). When the agreement between the borrowers and
the lenders is signed, the terms & conditions are discussed. And if the borrowers abide by the
terms, they may need to pay a lower interest rate (cost of the borrowing) to the lenders.

Positive and negative covnants

Positive debt covenants are things that the borrowers must do to ensure that they get the loan.
Below is a Positive bond Covenant example.
 Aim a specific range of certain financial ratio: positive debt covenants is important
for the lenders to know that they’re protected. To ensure that the lenders may ask the
borrowers to reach a specific range for certain financial ratios to avail the loan.
 Ensure the accounting practices are as per GAAP: This is a basic ask, but an
important one. The lenders must ensure that the borrowers are adhering to the
Generally Accepted Accounting Principles (GAAP).
 Present yearly audited financial statements: positive debt covenants lenders must
ensure whether the financial statements are accurate and represent the right picture of
the company’s financial affairs. That’s why a yearly audit will definitely help.
 Negative debt covenants are the things the borrowers can’t do. Below is a
negative bond covenant example.

 Don’t pay cash dividends over a certain extent: If a firm gives away the majority of
its earnings in cash dividends, how would it pay off the money they owe to the
lenders? That’s why the lenders impose a restriction on the borrowers that they can’t
pay cash dividends over a certain extent.
 Don’t take an additional loan:  negative debt covenants is a borrower shouldn’t take
more loans before they pay off the due of the lenders. It helps protect the interest of
the lenders.
 Don’t sell specific assets: Negative debt covenants lenders may also restrict the
borrowers from selling certain assets until the debt is being paid off in full. Doing so
will compel the borrowers to generate more earnings to pay off the debt. The negative
debt covenants will protect both the lenders and the borrowers in the long-run.