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4. To fund operating needs: Debt is issued to pay operating expenses because
operating cash flow is negative. Depending on certain factors, this motive
may be a red flag. Below, we look at how you can determine whether a
company is issuing new debt to fund operating needs.

Be Careful of Debt that Funds Operating Needs
Unless the company is in the early growth stage, new debt that funds investment is
preferable to debt that funds operating needs. To understand this thoroughly, recall
from the cash flow installment that changes in operating accounts (that is, current
assets and current liabilities) either provide or consume cash. Increases in current
assets--except for cash--are "uses of cash" and increases in current liabilities are
"sources of cash." Consider an abridged version of RealNetworks' balance sheet for
the year ending December 31, 2003:




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From December 2002 to December 2003, accounts receivable (a current asset)
increased dramatically and accounts payable (a current liability) decreased. Both
occurrences are uses of cash. In other words, RealNetworks consumed working
capital in 2003. At the same time, the company issued a $100 million convertible
bond. The company's consumption of operating cash and its issue of new debt to
fund that need is not a good sign. Using debt to fund operating cash may be okay in
the short run but, since this is an action undertaken as a result of negative operating
cash flow, it cannot be sustained forever.

Examine Convertible Debt
You should take a look at the conversion features attached to convertible bonds
(a.k.a. "convertibles"), which the company will detail in a footnote to its financial
statements. Companies issue convertibles in order to pay a lower interest rate;
investors purchase convertibles because they receive an option to participate in
upside stock gains.

Usually, convertibles are perfectly sensible instruments, but the conversion feature
(or attached warrants) introduces potential dilution for shareholders. If convertibles
are a large part of the debt, be sure to estimate the number of common shares that
could be issued on conversion. Be alert for convertibles that have the potential to
trigger the issuance of a massive number of common shares (as a percentage of the
common outstanding), and thereby could excessively dilute existing shareholders.

An extreme example of this is the so-called "death spiral PIPE," a dangerous flavor of
the 'private investment, public equity' (PIPE) instrument. Companies in distress issue
PIPES, which are usually convertible bonds with a generous number of warrants
attached (for more info, see "What Are Warrants?"). If company performance


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deteriorates, the warrants are exercised and the PIPE holders end up with so many
new shares that they effectively own the company. And existing shareholders get hit
with a double-whammy of bad performance and dilution. A PIPE has preferred claims
over common shareholders, and it's advisable not to invest in the common stock of a
company with PIPE holders unless you have carefully examined the company and the
PIPE.

Look at the Covenants
Covenants are provisions banks attach to long-term debt that trigger technical
default when violated by the borrowing company. Such a default will lower the credit
rating, increase the interest (cost of borrowing), and often send the stock lower.
Bond covenants include but are not limited to the following:

• Limits on further issuance of new debt.

• Limits, restrictions, or conditions on new capital investments or acquisitions.

• Limits on payment of dividends. For example, it is common for a bond
covenant to require that no dividends are paid.

• Maintenance of certain ratios. For example, the most common bond covenant
is probably a requirement that the company maintain a minimum 'fixed
charge coverage ratio'. This ratio is some measure of operating (or free) cash
flow divided by the recurring interest charges

Assess Interest Rate Exposure
Two things complicate the attempt to estimate a company's interest rate exposure.
One, companies are increasingly using hedge instruments, which are difficult to
analyze.

Second, many companies are operationally sensitive to interest rates. In other
words, their operating profits may be indirectly sensitive to interest rate changes.
Obvious sectors here include housing and banks. But consider an oil/energy company
that carries a lot of variable-rate debt. Financially, this kind of company is exposed
to higher interest rates. But at the same time, the company may tend to outperform
in higher-rate environments by benefiting from the inflation and economic strength
that tends to accompany higher rates. In this case, the variable-rate exposure is
effectively hedged by the operational exposure. Unless interest rate exposure is
deliberately sought, such natural hedges are beneficial because they reduce risk.

Despite these complications, it helps to know how to get a rough idea of a company's
interest rate exposure. Consider a footnote from the 2003 annual report of Mandalay
Resort Group, a casino operator in Las Vegas, Nevada:




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Fixed-rate debt is typically presented separately from variable-rate debt. In the prior
year (2002), less than 20% of the company's long-term debt was held in variable-
rate bonds. In the current year, Mandalay carried almost $1.5 billion of variable-rate
debt ($995 million of variable-rate long-term debt and $500 million of a "pay
floating" interest rate swap) out of $3.5 billion in total (leaving $2 billion in fixed-rate
debt).

Don't be confused by the interest rate swap: it simply means that the company has a
fixed-rate bond and "swaps" it for a variable-rate bond with a third party by means
of an agreement. The term 'pay floating' means the company ends up paying a
variable rate; a 'pay fixed interest rate' swap is one in which the company trades a
variable-rate bond for a fixed-rate bond.

Therefore, in 2003, the proportion of Mandalay's debt that was exposed to interest
rate hikes increased from 18% to more than 40%.

Operating Versus Capital Lease
It is important to be aware of operating lease agreements because economically they
are long-term liabilities. Whereas capital leases create liabilities on the balance
sheet, operating leases are a type of "off-balance sheet financing." Many companies
tweak their lease terms precisely to make these terms meet the definition of an
operating lease so that leases can be kept off the balance sheet (improving certain
ratios like long term debt-to-total capital).

Most analysts consider operating leases as debt, and therefore manually add
operating leases back onto the balance sheet. Pier 1 Imports is an operator of retail
furniture stores. Here is the long-term liability section of its balance sheet:




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Long-term debt is a very tiny 2% of total assets ($19 million out of $1 billion).
However, as described by a footnote, most of the company's stores utilize operating
leases rather than capital leases:




The present value of the combined lease commitments is almost $1 billion. If these
operating leases are recognized as obligations and therefore manually put back onto
the balance sheet, both an asset and a liability of $1 billion would be created, and
the effective long term debt-to-total capital ratio would go from 2% to about 50%
($1 billion in "capitalized" leases divided by $2 billion).

Summary
It has become more difficult to analyze long-term liabilities because innovative
financing instruments are blurring the line between debt and equity. Some
companies employ such complicated capital structures that investors must simply
add "lack of transparency" to the list of its risk factors. Here is a summary of what to
keep in mind:

• Debt is not bad. Some companies with no debt are actually running a sub-
optimal capital structure.



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• If a company raises a significant issue of new debt, the company should
specifically explain the purpose. Be skeptical of boilerplate explanations--if
the bond issuance is going to cover operating cash shortfalls, you have a red
flag.

• If debt is a large portion of the capital structure, take the time to look at
conversion features and bond covenants.

• Try to get a rough gauge of the company's exposure to interest rate changes.

• Consider treating operating leases as balance sheet liabilities.



Pension Plans

Following from the preceding section focusing on long-term liabilities, this section
focuses on a special long-term liability, the pension fund. For many companies, this
is a very large liability and, for the most part, it is not captured on the balance sheet.
We could say that pensions are a type of off-balance-sheet financing. Pension fund
accounting is complicated and the footnotes are often torturous in length, but the
good news is that you need to understand only a few basics in order to know the
most important questions to ask about a company with a large pension fund.

There are various sorts of pension plans, but here we review only a certain type: the
defined benefit pension plan. With a defined benefit plan, an employee knows the
terms of the benefit that he or she will receive upon retirement. The company is
responsible for investing in a fund in order to meet its obligations to the employee,
and so, the company bears the investment risk. On the other hand, in a defined
contribution plan (e.g. 401k), the company probably makes contributions--or
matching contributions--but does not promise the future benefit to the employee. As
such, the employee bears the investment risk.

Among defined benefit plans, the most popular type bears a promise to pay retirees
based on two factors: 1. the length of their service and 2. their salary history at the
time of retirement. This is called a "career average" or "final pay" pension plan. Such
a plan might pay retirees, say, 1.5% of their "final pay," their average pay during
the last five years of employment, for each year of service (up to a maximum
number of years). Under this plan, an employee with 20 years of service would
receive a retirement benefit equal to 30% (20 years x 1.5%) of their final average
pay. But formulas and provisions vary widely; for example, some will reduce or
"offset" the benefit by the amount of social security the retiree receives.

Funded Status = Plan Assets - Projected Benefit Obligation (PBO)
A pension plan has two primary elements:

• The future liabilities--or benefit obligations--created by employee service.

• The pension fund--or plan assets--that are used to pay for retiree benefits.




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At this primary level, a pension plan is simple: the company (called the "plan
sponsor" in this context) contributes to its pension fund; the pension fund is invested
into bonds, equities, and other asset classes in order to meet its long-term
obligations; and retirees are then eventually paid their benefits from the fund.

Three things make pension fund accounting complicated. First, the benefit obligation
is a series of payments that must be made to retirees far into the future. Actuaries
do their best to make estimates about the retiree population, salary increases, and
other factors in order to discount the future stream of estimated payments into a
single present value. This first complication is unavoidable.

Second, the application of accrual accounting means that actual cash flows are not
counted each year. Rather, the computation of the annual pension expense is based
on rules that attempt to capture changing assumptions about the future.

Third, the rules require companies to "smooth" the year-to-year fluctuations in
investment returns and actuarial assumptions so that pension fund accounts are not
dramatically over- (or under-) stated when their investments produce a single year
of above- (or below-) average performance. Although well-intentioned, smoothing
makes it even harder for us to see the true economic position of a pension fund at
any given point in time.

Let's take a closer look at the two basic elements of a pension fund:


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