pillars of wall street - financial statement analysis - debt and equity

Question 1

debt and equity

Answer 1

the ways company can raise financing

debt is interest-bearing obligation; must be repaid with interest; those who issue a company debt have first claim over the company’s assets

equity is financing from shareholders and issuing equity causes dilution of ownership; equity holders get residual claim to company’s assets; equity holders will benefit from increase in value of the company; it is possible that they may also receive dividends

Question 2

components of net debt

Answer 2

net debt is debt net of cash

cash includes cash in the bank, marketable securities and short term investments (basically anything that can be converted to cash quickly)

debt includes short-term borrowings, long-term borrowings, notes payable, commercial paper, bank overdrafts, revolving credit facility, loans, corporate bonds

Question 3

short-term vs. long-term debt

Answer 3

short-term is debt repaid in one year or less

long-term is debt that will be repaid in more than one year

long-term debt has two sub-categories:
amortizing = principal of debt is paid over time
bullet = principal is paid all at the end of the loan term

Question 4

types of leases

Answer 4

operating leases = short-term leases

capital leases = long-term leases (like when delta leases a plane)

Question 5

features of debt

Answer 5

principal = amount borrowed; aka face or notional

interest = the cost of the debt

two forms of interest = cash interest (the type you’re familiar with and PIK

PIK = payment-in-kind interest = interest you won’t pay in cash; like a credit card, it accrues to the principal balance

maturity date = aka repayment date

payment priority = senior tranche debt is paid before junior tranche debt

secured debt = term loans (like bank debt) is generally secured against some asset; this is why interest rates on term loans like mortgages are less than interest rates on unsecured debt like bonds and notes

covenants = restrictions on borrower to do something (affirmative covenants) or not do something (negative covenants)

Question 6

amortizing debt

Answer 6

you pay a portion of the principal regularly over an extended period of time

more typical of bank debt like mortgages

Question 7

bullet debt

Answer 7

aka balloon payment

almost all of the principal of the loan is due at very end

more typical of notes and bonds

Question 8

secured debt

Answer 8

backed by some asset

typical feature of term loans like bank mortgages

Question 9

unsecured debt

Answer 9

not backed by any asset; the loan is based on the creditworthiness of the debtor

typical of bonds and notes

Question 10

leverage and coverage ratios

Answer 10

1. debt to earnings multiple
   = [total debt] / EBITDA
   most common debt ratio
   tells us how many dollars of EBITDA we have to have for every dollar of debt
   recall that EBITDA is a good proxy for free cash flow; therefore, this ratio tells us how much free cash flow we need for each unit of debt
   *want this ratio to be low, and if you’re modeling a company’s future performance, want to see it decreasing (because if you’re paying down your debt over time, the amount of total debt remaining relative to your EBITDA should decrease)
2. debt to total capital ratio
   = [total debt] / [total capital]
   tells us total amount of debt in our capital structure
   *want this ratio to be low, and if you’re modeling a company’s future performance, want to see it decreasing

3.
interest coverage ratio
= [EBITDA] / [interest expense]
tells us how many times we can repay our interest expense for every dollar of EBITDA that we have
the lower the ratio, the higher the risk of not meeting your debt payments
*want this ratio to be high, and if you’re modeling a company’s future performance, want to see it increasing (because if you’re paying down your debt over time, the amount of interest expense you will have should decrease)

Question 11

equity

Answer 11

residual interest in a company’s remaining assets after subtracting all liabilities

aka book value

components = contributed capital (common and preferred), treasury stock, retained earnings, non-controlling interest

Question 12

retained earnings

Answer 12

the cumulative non-distributed earnings of a company since its inception

basically, cumulative earnings of a company that were not paid out as dividends

these belong to the common stockholders

retained earnings are increased by net income

they are decreased by dividend distributions

Question 13

non-controlling interest

Answer 13

someone else’s ownership in some part of a company

Question 14

contributed capital types

Answer 14

common stock =
the vast majority of contributed capital is common stock
residual interests in a company’s assets after all other claims, including preferred stock, are taken out
no dividend entitlement; you only get dividends if management decides to pay them
have voting rights
there can be different classes of common stockholders

preferred stock =
has priority claim over common
hybrid security = has characteristics of both stock and bond
incl. people like warren buffett who have significant influence over a company
typically pays dividends; accordingly, its is quoted as % of par value; divided payments are typically cumulative
generally non-voting
sometimes can be convertible to common or redeemable for another type of security

Question 15

cumulative dividends

Answer 15

applies to preferred stock

if company misses a dividend payment on its preferred stock for some reason, it has to pay the dividend it owes its preferred stockholders in the next period prior to distributing any dividends to common stock holders