<THE RULE MAKER PORTFOLIO>

The Many Faces of Debt

By Phil Weiss (TMF Grape)

TOWACO, NJ (August 4, 1999) -- A key part of Rule Maker investing is becoming comfortable with financial statements. Last month, we did an installment on finding financial info. Being able to find the numbers is the first step, but the next step is learning how to understand what you're looking at. Our Rule Maker Criteria page gives a high-level explanation of interpreting financials, but sometimes it's necessary to delve a little deeper to make sense of all the accounting jargon.

So, get ready. Tonight's report is a bit technical, but the rewards of being able to read and interpret financial statements make the initial struggle of learning well worth it. Plus, if you ever have any questions, answers are just a click away at our Rule Maker Strategy and Beginners message boards.

It often seems that not a week goes by that somebody on one of our Rule Maker message boards doesn't ask a question related to debt. Tonight I'm going to talk a little about the many different terms you'll find describing liabilities that can appear on a company's balance sheet. As we go through these different liability accounts, there's one other thing you should keep in mind: a balance sheet represents a snapshot of a company's financial position at a particular point in time. It may include some estimates of future expenses, but it's still just a snapshot. In that way, it's different than an income statement, which measures earnings over a period of time.

A Rule Maker investor should spend time analyzing balance sheets, and one of the most important things to look for is debt -- both the short-term and long-term varieties. This is because we like to look for companies that have at least 1.5 times more cash than total debt. In addition, it's necessary to identify short-term debt because it is excluded from the other current liabilities that are in the denominator of our Flow Ratio calculation.

The problem is that there are so many terms for debt. It's often difficult to know which items should be considered when we calculate the ratio of cash to debt and the Flow Ratio for our companies. In essence, anything that appears in the liability section of the balance sheet is a kind of "debt."

These debts can be broken down into two groups. The first is what I'll call "good debt." The principal feature of good debt is that it's "non-interest-bearing," which means that someone else is loaning our company money for free. Free is good. It's not often that you get something for nothing, so we like to find companies that take advantage of the offer as much as they can.

The second kind of debt is that for which the borrower is charged interest. While not all such debt is necessarily bad (a topic that I'll explore in a future column), the general premise is that non-interest-bearing debt is good and interest-bearing debt is bad.

Okay, let's stop for a quick half-time summary:

Debt without interest payments = GOOD. Examples include:

  • Accounts payable
  • Deferred tax
  • Income taxes
  • Accrued liabilities
  • Deferred/unearned revenue
  • "Other current liabilities"

Debt with interest payments = BAD. Examples include:

  • Short-term debt
  • Short-term borrowings
  • Current portion of long-term debt
  • Debt maturing within one year
  • Long-term debt
  • Notes/Loans payable
  • Bank line of credit
  • Capital lease obligation
  • Preferred stock
  • Convertible notes

That's a lot of terms, but not every company has all or even most of these. It's just meant to be a comprehensive list of the various types of liabilities that you may encounter when studying a balance sheet. What follows is an explanation of all these terms, starting first with the non-interest-bearing (i.e. good) debt:

Accounts Payable -- This generally represents money a company owes to its suppliers. The most common payback term for accounts payable is net 30, which means that the purchaser has 30 days to pay its supplier. During that time, no interest expense is incurred. But if payment is not made within this time period, then the supplier may charge interest expense on the unpaid balance.

Deferred Tax -- This is an accounting concept created by the fact that the IRS has some different accounting rules than Generally Accepted Accounting Principles (GAAP). A deferred tax liability generally arises when the amount of a current deduction under GAAP is less than the deduction for income tax purposes. As a result, a temporary difference is created that allows a company to save on the taxes it has to pay today. In the future, this item will reverse and the deferred tax liability will have to be paid.

Income Taxes -- This could refer to deferred taxes or it could relate to income taxes that the company has not been required to pay by the balance sheet date.

Accrued Liabilities (payroll, compensation, advertising, other) -- Accrual accounting attempts to recognize events and circumstances as they occur rather than when the actual cash is paid. Accrued expenses are currently deductible under GAAP. An example of what we're talking about here is this: Your company pays you every two weeks. The quarter ends on June 30th. You get paid through July 3rd. Since as of June 30th your company owed you for 11 days of pay, they have to accrue this unpaid expense by deducting it from current income and setting up a liability on the balance sheet. Once you're paid on the 3rd, the accrual is removed from the balance sheet.

Deferred/Unearned Revenues -- I love to see this type of liability. It means that the company has enough authority that it can force its customers to pay in advance for services that haven't yet been rendered. GAAP states that a company shouldn't recognize revenues until all services have been performed. Deferred/unearned revenues represent future income that the company hasn't yet recognized, but for which cash has already been received. Among the companies that commonly report deferred revenues on the balance sheet are Microsoft, Intel, and America Online.

"Other current liabilities" -- To really know what's in this category you'll have to check the footnotes to the financial statements. The "other" category includes all of the items that aren't large enough to be separately stated. It's possible that there could be some interest-bearing items here, but it's more likely that there won't be.

Okay, next up are the types of interest-bearing (i.e. bad) debt you might find on a balance sheet. Again, these are the items that cause companies to pay interest for borrowing money.

Short-term debt / borrowings -- When you look at a balance sheet, both the assets and liabilities are broken down into two sections -- those that are current and those that are not. In order to be classified as "current," an asset should be convertible into cash within one year. On the liability side, "current liabilities" represent those liabilities that are due and payable within one year. Short-term debt or short-term borrowings represent interest-bearing liabilities due in one year or less.

Current portion of long-term debt / Debt maturing within one year -- GAAP requires companies to separately report the portion of its interest-bearing debt that is due in a year or less. For example, let's say a company has an interest-bearing debt of $1,000. Of this amount, $100 is due within one year and $900 is due beyond one year. Under this scenario, $100 should be reported on the balance sheet under the current liabilities section with one of the above labels. The reason that the short-term obligation is separately reported is to give investors a clearer picture of the company's overall financial position.

Notes payable / Loans payable / Bank lines of credit -- Depending upon where you find these items on the balance sheet (i.e., whether they appear above or below the total current liabilities line), these amounts all represent different types of current or non-current interest-bearing debt. The description of the debt (i.e., note, loan, etc.) is given to provide some specifics on the type of debt obligation that the company has. For example, there is usually a document providing the specific borrowing terms when there is a note payable. This may or may not be the case with a loan payable. A bank line of credit usually is just an informal agreement that works in a way that's similar to overdraft protection on a checking account or a line of credit that you can have on your home. This means that you usually just have to write a check to borrow the money.

Capitalized lease obligations -- So far, the items on this list have been fairly straightforward. This one is a bit tougher. Sometimes companies prefer to lease property rather than purchase it directly. Under GAAP, there are two types of leases. The first is called an operating lease. Payments made under this type of lease are similar to rent. You lease property for a pre-determined period. At the end of the lease term either the property reverts to the lessor or the lease is renewed. Operating leases do not give rise to debt. A capital lease is more akin to purchasing the property outright. Under GAAP a lease qualifies as capital under any of the following four scenarios:

  1. If the lease payments represent 90% or more of the fair market value at the time the lease starts;
  2. If the property automatically transfers to the lessee at the end of the lease;
  3. If the lease contains an option to purchase the property at a bargain purchase price; or
  4. The lease term is equal to 75% or more of the estimated useful life of the property.

In other words a capital lease is similar to a purchase of the property. GAAP requires that a portion of the capital lease payments be treated as interest expense. The amortization of the monthly payments is similar to those for mortgage on your home. When you look at a balance sheet, the capitalized lease obligation represents the amount of interest that will be paid over the remaining life of the lease.

Preferred stock -- This one is a little tricky. Preferred stock is listed under equity, but it's more like debt. Sometimes if you read the footnotes of a company's financial statements, you'll find that the preferred stock has a mandatory redemption feature that requires a company to pay the holders a fixed amount on a predetermined date. Such stock should be treated as debt.

One of the companies in our portfolio, Microsoft (Nasdaq: MSFT), has some preferred stock on its balance sheet that we treat as debt in calculating its cash-to-debt and Flow ratios. According to the footnotes to Microsoft's financial statements, this preferred stock is convertible into common stock, and the principal is protected. Preferred stock actually pays dividends rather than interest to its holders, but these dividends are normally different than the kind paid on common stock. They are normally cumulative and paid in arrears (the case with Microsoft's preferred), which means that if a company didn't have the money to pay the dividends when due, they would have to be paid in the future when the company's cash position improved. (Of course this is not likely with Microsoft, considering its strong financial standing.) When the characteristics of the preferred stock require the payment of dividends, we treat it as debt.

Convertible notes -- Convertible notes are those that are convertible into common stock based on a pre-determined formula. GAAP generally classifies convertible debt as a liability on the balance sheet rather than equity. As such, any payments made on these notes are treated as interest, and the notes themselves are treated as debt.

That's about all the accounts that I could think of. Did I miss any? If so, or if you have any questions, please ask them on one of our message boards linked below.

Phil Weiss, Fool

[If you know of some friends who might like to learn more about reading financial statements, scroll up and click on the "E-mail this to a friend" link in the upper-right-hand corner.]

08/04/99 Close

Stock Change    Bid
AXP   -3 3/16   123.50
CHV   +  9/16    93.56
CSCO  -  5/8     60.50
DPH   +  1/16    18.13
EK    +  5/16    70.50
GM    -  1/4     62.81
GPS   -3 1/8     43.31
INTC  -  1/8     72.81
KO    -  11/16   60.13
MSFT  +  3/16    84.94
PFE   -  13/16   33.31
SGP   -1 3/8     49.00
TROW  -  15/16   33.00
XON   +1 1/16    79.88
YHOO  -4 3/8    121.00


                  Day     Month  Year    History
        R-MAKER  -1.67%  -2.08%   9.53%  37.93%
        S&P:     -1.27%  -1.76%   6.77%  32.10%
        NASDAQ:  -1.85%  -3.73%  15.84%  53.67%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
   6/23/98   68 Cisco Syst    29.21     60.50   107.16%
    2/3/98   54 Microsoft     45.13     84.94    88.19%
    5/1/98   82 Gap Inc.      23.05     43.31    87.88%
   2/13/98   52 Intel         46.93     72.81    55.16%
    2/3/98   66 Pfizer        27.43     33.31    21.43%
   5/26/98   18 AmExpress    104.07    123.50    18.67%
    6/3/99   11 *Delphi Au    17.19     18.13     5.44%
   8/21/98   44 Schering-P    47.99     49.00     2.10%
    2/6/98   56 T. Rowe Pr    33.67     33.00    -2.00%
   2/27/98   27 Coca-Cola     69.11     60.13   -13.00%
   2/17/99   16 Yahoo Inc.   126.31    121.00    -4.20%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon         64.34     79.88    24.15%
   3/12/98   15 Chevron       83.34     93.56    12.26%
   3/12/98   20 Eastman Ko    63.15     70.50    11.64%
   3/12/98   17 *General M    61.28     62.81     2.50%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   54 Microsoft   2437.28   4586.63  $2149.35
   6/23/98   68 Cisco Syst  1985.95   4114.00  $2128.05
    5/1/98   82 Gap Inc.    1890.33   3551.63  $1661.30
   2/13/98   52 Intel       2440.28   3786.25  $1345.97
    2/3/98   66 Pfizer      1810.58   2198.63   $388.05
   5/26/98   18 AmExpress   1873.20   2223.00   $349.80
   8/21/98   44 Schering-P   2111.7   2156.00    $44.30
    6/3/99   11 *Delphi Au   189.09    199.38    $10.29
   2/27/98   27 Coca-Cola   1865.89   1623.38  -$242.52
    2/6/98   56 T. Rowe Pr  1885.70   1848.00   -$37.70
   2/17/99   16 Yahoo Inc.  2020.95   1936.00   -$84.95

Foolish Four Stocks
    Rec'd    #  Security     In At     Value    Change
   3/12/98   15 Chevron     1250.14   1403.44   $153.30
   3/12/98   20 Eastman Ko  1262.95   1410.00   $147.05
   3/12/98   20 Exxon       1286.70   1597.50   $310.80
   3/12/98   17 *General M  1041.80   1067.81    $26.01

                              CASH    $255.59
                             TOTAL  $33957.22

Notes: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.

*Although DPH is not a Foolish Four stock, it was spun-off from GM on June 3, 1999

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