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Debt Financing When a company borrows money from he bank for longer than a year the obligation is a long term note payable These liabilities are typically repaid in equal installments part of which are repayment of principal and part of which are interest A major objective is determining how much of each loan is interest and how much is a payment amortization table To spread the loan payments between interest and principal reduction use an Example 1 Mortgage is a special type of note payable The liability is initially required for each installment payment usually monthly payments with each payment consisting of both interest and principal reductions Example 2 a contract that specifies the terms under which the owner of an asset Lease agrees to transfer the right to use the asset to another party Lessee the leases Lesser Two Types of Leases the owner of the property that is rented leased to another party the party that is granted the right to use property under the terms of 1 Operating Lease o Lessee assumes no risk of ownership o Each lease payment is classified as rent expense o At the end of loose term right to use the property reverts back to lesser 2 Capital Lease o Treated as if the lessee had purchased the asset o Lessee assumes rights and risk of ownership o Lessee records an asset on their balance sheet with related liabilities and depreciation Example 3 o Capital lease lessee records a leased asset and a leased liability on their balance sheet PV of lease payments The leased asset must be depreciated over the lease term The leased liability is amortized to separate the payment into interest and principal reduction o In last year the lease balance must be zero However there is always a rounding error Simply make the reduction to last liability balance Companies would prefer to categorize all leases as an operating lase o Reason companies are not required to record a liability on the balance sheet related to the lease Allows for better financial position Allows for better debt ratios Operating leases are referred to as off balance sheet financing Companies would prefer to categorize all leases as operating lease because of this concept of off balance sheet financing FASB issued SFAS No 13 which sets forth specific criteria that requires leases to be recorded as capital leases Financial Ratios relating to Debt 1 Debt to Equity Ratio measures the percentage of funds being provided by creditors versus stockholders o Total liabilities total equity ratio o Provides a measure of how protected creditors are in event of company not being able to pay its debts o All things equal the higher the Debt to equity ratio the higher the risk to creditors o The higher the ratio the higher creditors claims on assets so the higher the likelihood an individual creditor would not be paid in full if the company is unable to meet its obligations o Higher ratio there is a higher interest rate charged 2 Times Interest Earned Ratio measures the company s ability to meet its interest payments as they come due o Higher is better o Can be thought of as a margin of safety to creditors o The higher the more income the company has to pay interest and the less likely the company is to default on these payments


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