 Hello and welcome to this session. This is Professor Farhad and this session we would look at the debt ratio and the different types of debt. This topic is covered in financial accounting as well as the CPA exam. As always I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1600 plus accounting, auditing, finance and tax lectures. This is a list of all the courses that I cover, including many CPA questions. If you like my lectures, please like them, share them, put them in playlists, subscribe. If they help you, it means they might help other people, especially these days with the coronavirus out there. People are relying on online lectures and connect with me on Instagram. On my website farhadlectures.com you will find additional resources. So if you're looking to supplement your accounting education and or study for your CPA exam, I strongly check out my website. So let's take a look at the first topic for today, which is debt to equity ratio. Every time you hear the word debt, it means risk. What does that mean? Let's think from the accounting from the accounting equation perspective. We have assets equal to liabilities plus equity. Let's assume we have two different companies. We have company A and company B. Company A, they have 100,000 in assets of which liabilities is 20,000 and equity must be 80,000. And let's take a look at another company with $100,000 in assets. They have liabilities of 80,000 and equity of 20. Notice both companies, they have assets of 100,000. Now let's compute the debt to equity ratio for each of these companies. So let's take a look at this. So taken total debt, which is 20,000 for company A divided by 80. So what is 20 divided by 80? Let's take a look at the calculator here and do the computation. 20 divided by 80 will give us 0.25. So for company A, it's 0.25. And let's do the same thing for company B. Now we're going to take 80 divided by 20 and that's going to give us 4. So 0.25 for company A and 4 for company B. Now how do we interpret those? And hopefully by looking at these figures, you understand how do we interpret those? Let's assume both company A and company B went to the bank to borrow money and I was a loan officer at some point in my life. So those are the numbers you actually look at before you grant out a loan. So immediately you will notice that company B, company B right here relies on loans to finance their operation, rely for every dollar in equity the way we interpret this. For every dollar in equity, they're borrowing $4. That's pretty risky because they're relying more on debt versus company A, they're only for every dollar in equity, they're only borrowing 25 cent to finance their assets. Simply put, the higher this ratio, the riskier is the company. It means you are relying more on that. So this ratio helps investors determine the risk of investing in a company by dividing the total liabilities by total equity. So the more debt you have in relationship to your equity, the riskier you are. So let's take a look at an actual number for some companies. Here, for example, we have Nike versus Under Armour. The current ratio for the current debt to equity ratio for Nike is 0.87 versus Under Armour 0.98. Almost Under Armour for every dollar in lab, for every dollar in equity, almost for every dollar in equity, they have a dollar in liabilities. So simply put, we can say from this limited information that Under Armour is riskier, not that much different because Nike, they're relying for every dollar in liabilities, for every dollar in equity, they're having 90 cent in liabilities, not that much of a difference. But the point to remember here is that different ratios will affect the companies differently. For example, airline companies might have a high debt to equity ratio versus non-airline companies. So you cannot look at one ratio and make a general statement. You have to look at the whole picture and these ratios differ within each industry. The other topic we're going to be looking at today is a few topics that deals with bonds and notes, the different types of bonds and notes. For example, we could have secured bonds or notes. What does it mean secured bonds and notes? It means the bond or the note have a specific asset of the issuer that pledged as a mortgage or collateral. So if you cannot pay back your loan, the company can sell your building. So the building here is a collateral. So the bond is secured by a building versus unsecured bond or debt. Unsecured means it's also called the venture. That's another term for it in case you see it. The issuer is trusting you. So the issuer says, I'm going to give, I'm sorry, the lender trusts you. The lender says, I'm going to give you the money and I'm going to trust your credit standing. What does it mean credit standing? Each individual, they have their own individual credit, but also companies they have credit rating. So for example, company with a AAA rating, they might be able to get an unsecured credit because they have a good rating. Usually unsecured, they are riskier. They're only granted anyway to credit worthy company. It means the company can be really trusted or the company has a high credit. Another type of that is term, bond or term debt. This is when the note or the bond is mature all at once. You have to pay all the amount, the principal amount all at once. Some bonds or some debt are different. What you do is serial bond or debt, they mature at more than one date, often in series and thus usually repaid over a period of time. For example, if you have a $100,000 Syrian serial bond, it might mature at a rate of $10,000 each year from year six to year 15. So rather than paying the whole $100,000 all at once, you can pay it in pieces, $10,000 starting year six. So this way you don't have to come up with the whole money. Oftentimes the issuer, what they require, they require a sinking fund bond. It reduces the holder risk by requiring the issuer to set aside asset to pay after that. So when we say sinking fund bonds, it means put money away to pay that bond. And oftentimes the lender, they ask you to do so, why they want to protect themselves. So simply put the difference between term and serial, is it better to pay off the debt all at once or is it better to pay it off slowly? All at once is a term bond. You have to pay everything all at once. Serial, it means you have to pay it in payments. Obviously companies will prefer to pay their debt in payments because it put less pressure on the company. We have convertible bonds versus callable. Convertible means you can exchange it for a fixed number of shares by the issuing corporations. So simply put, you have a bond but you really don't like the bond anymore. You want to convert it into a stock. So what you do if the bond is convertible or if the note is convertible, the holder, the individual of the bond, have the potential to make a lot of profit if the stock price increases. So basically you take your bonds and you exchange them into stocks. This is what convertible. Callable, on the other hand, callable notes give the issuer, the company, the option to retire to buy back the bond at some specific dollar amount. So simply put, now here the company determines that they want to buy back your bond and you have no option. You have no option. We also have bearer bond, bearer bond and register bond. Bearer bonds are bonds to whoever holds them. It's the bearer. The bearer means if I hold that bond in my hand, they are unregistered. They're mine. So if you lose it and someone else finds that bond, they can have it. So the holder of the bond is presumed to be the rightful owner, which is risky. You don't want to have a bearer bond. Many bearer bonds are also called coupon bonds and we're going to say I'm going to show you a picture why they are called coupon bond. The term reflect interest coupon that are attached to the bond when the each bond, when each coupon mature and the holder present it to the bank or the broker for collection. So let's take a look at a coupon bond. So if you have a bond that's a coupon bond and notice those are old coupon bonds are all no longer, no longer issued, simply put every, every six months or every year when the interest payment is due, you would clip this coupon and you will take it to the bank or to the broker and you will ask for the payment. So if you can get your hand on this bearer bond and you wait for the maturity, you can get your money, you can get the interest payment. So this is a bearer bond. Notice already one payment has been cut out of this versus a registered bond. Registered bond is registered in the name and the address of the holder. So simply put, now you have your bond computerized. Even if you lose it, it doesn't matter because your name, your social security, your address is registered with the issuing company. So the issuer makes payment by sending a check or transfer the cash to your bank account and usually a registered bond is printed on the register but no one uses registered bond anymore. It's just a computerized entry. The last thing we're going to look at is advantages and disadvantages of bond financing. Bond financing is borrowing money. Basically, what are the advantages? First, bonds do not affect owner's control. So if you issue bonds, if you issue bonds to raise money, you don't have to issue stocks. This way, the control of the current shareholders is not affected. That's one. Two, interest on the bond is tax deductible. What does that mean? It means when you pay interest, interest is the cost of bond. When you pay interest and we saw that we have to pay interest every six months, you can have a tax savings because the interest reduces your taxable income, which in turn reduce your taxes. Also, bond can increase your return on equity. What does that mean? It means if you're borrowing money at 5% and using this money in projects that earns 8%, then your return on equity, you are better off as a company. Those are the advantages, but this also could be a disadvantage if you are only making rather than five. You can only make 3%, then this is a disadvantage. So what are the other disadvantages of financing with bond? The biggest disadvantage is it requires payment of interest and par value. So if you have a bond, you have to come up with that payment, whether you are making money or not making money. That periodic interest payment is very risky because it's a constant pressure on the company and you have to pay the bond back. You have to pay it at maturity. If you finance with stocks, you don't have to pay dividend and you don't have to pay the stocks back. Also another disadvantage is the bond can decrease return on equity if you only earn 3% on a bond that you are borrowing at 5%. And this is basically wrap up the session. As always, I would like to remind you to like the recording. If you like them, subscribe, visit my website for additional resources, PowerPoint slides, true, false, multiple choice, especially if you're studying for your CPA exam. Good luck, study hard and stay safe during those coronavirus out.