Chapter 14

EXTINCTION OF BONDED
INDEBTEDNESS
 1. Extinction by Conversion

~ Refers to the exchange of one

security with another security. That is
exchanging bonds for stocks at a certain
conversion ratio, which is provided in the
trust Indenture.
REASONS WHY BONDS ARE
MADE CONVERTIBLE
1. It adds to the possibility of the appreciation of
the value of the bonds, which enables the
corporation and sells them at a lower rate.

2. In times of poor stock market conditions the

corporation may be prompted to attach the
provision to a bond issue.
3. The conversion of bonds to stocks
allows a convenient and relatively easy
way of getting rid of the bonded
indebtedness, which has a fixed interest
rate.
DISADVANTEGES OF
CONVERTIBLE BONDS
1. The corporation must have
sufficient un-issued stocks at all
times to meet the demand for
conversion to bonds.
2. If substantial bonds are converted to
stocks, there is the possibility that
earnings per share will be reduced
since there will be more shares
outstanding without a correspondent
increase in earnings.
3. If the price in the stock market is
depressed it will affect the future sale of
stocks.

4. the control over the corporation might

be affected by the conversion of bonds
to stocks.
5. Since interest on bonds are considered an
expense and is deducted after computing
the income tax, the dividends on the other
hand are not considered expense of
operation and income tax is computed on
the profits before dividends are distributed
 Conversion Ratio:
It is the rate at which bond can be
converted into other securities of a
corporation.

Bonds are said to be in their conversion point when

there is no profit or loss in the conversion
6. It would be unfair to allow bondholders to
share in the retained earnings of the firm which
has been accumulated through the years and
which should only accrue to the stockholders in
record. If bonds were allowed to be converted
into stocks, the original stockholders before the
conversion would be receiving less after the
conversion
3. Extinction by refunding
Refunding: The exchange of one issue
by another bond issue.
Refunding is more of a
mutual agreement
between the bondholders
and the corporation.
 Refunding at maturity date

Arises when bonds issued reaches its

maturity date and the company is not in
a position to pay the face value of the
bonds either because the company is
short of funds or the funds can still be
invested by the company profitability.
Refunding before maturity

Most companies refund bonds before

maturity either to consolidate several
refundable issues into one new issue to
make the debt more manageable and
desirable as to interest rates, redemption
price and other features.
Refunding by short-term notes
When interest rates are low at the time
when the bond issue matures the company
may find a good reason for refunding the
bonds into short-term notes. This becomes
possible when short term-notes are popular
and command an excellent market, a
condition that usually exist when interest
rates are low.
3. Mandatory redemption
The corporation is obligated to redeem
the bonds at the stated time. here the
bonds are selected by lot and the holder is
notified by publication. The bond holders
will turn in their bonds at the stated
redemption price.
Redemption by solicitation

The corporation can merely offer the

redemption of a certain number of bonds.
Redemption price
The redemption price is fixed in the
indenture. Redemption price is almost
always higher than the face value of
the bonds.
 Two methods of providing cash for
redemption
1.The corporation voluntary sets up an amount to
redeem the bonds. These may be accumulated
through the years.
2.The corporation may be required to set up a
sinking fund where in a certain percentage of
the annual income of the corporation or a
percentage of the surplus is set aside for that
purpose.
Refunding through the banks

This is a method where a

corporation may enter into an
agreement with an investment
banker to put up cash for the
redemption of the old bonds.
Serial redemption

These are bonds issued in serials.

They are all issued all at the same
time but having various groups
maturing in succession at regular
intervals.
 Chapter 15
FINANCIAL STATEMENTS AND
ANALYSIS OF FINANCIAL
STATEMENTS
Two types of information given to the annual report:

~ Verbal section: often presented as a letter from

the chairman that describes the firms operating
results.

~ Presents the four key Financial statements (

income statement, balance sheet, statement of
retained earnings, statement of cash flows).
Financial statements should cover at least three
recent years of operation.
 FINANCIAL STATEMENTS
 Income Statement: Summarizes the results of the firms
operations during specified period.

 Balance Sheet: Provides a summary of the firm’s

financial position as of a given date.
• Current Asset – Convertible into cash within one
year or less
• Fixed Asset – Can be used for more than a year
in the normal operation of the business and are
not easily convertible into cash.
 • Current liabilities – Payable within a year or
less.
• Fixed or long-term liabilities – payable for more
than a year.

 Statement of Retained Earnings – Reconcile

the net income earned during a given
year, and any cash dividend paid, with the
change in retained earnings between the
start and end of the year.
 Statement of cash flows – Provides a summary of the
cash flows over the period concern.

Ratio Analysis – Involve the methods of calculating

and interpreting financial statements to assess the
firms performance and status.
 Interested parties:
• Present and prospective stockholders – Interested in
the firm’s current and future level of risk and
return.
• Creditors – Interested I the firm’s ability to pay short-
term and long-term obligations
promptly.
• Management – most concerned with all aspects
related to financial situations.
Ratio Comparisons
Ratios become more useful and informative if
compared with the ratios in the previous
years or the ratios of its competitors.

Cross Sectional Analysis – financial statements

of different firms at the same point in time
are compared.
Time Series Analysis – involves comparison of
financial statements of a single firm for two or
more consecutive years.
Group of Financial Ratios
1. Liquidity Ratios – used to measure the
firm’s ability to pay its short-term debts
as they fall due.
2. Activity Ratios – used to measure the
ease or speed of converting various
accounts into cash or sales.
3. Debt Ratios – used to measure the
degree of indebtedness of the firm
and its ability to service its debts.
4. Profitability Ratios – used to show the
combined effects of liquidity, asset
management, and debt management on
operating results.
Liability Ratios
Higher liquidity ratios suggest that the firm is more
able to pay its short-term debts as they fall due.

Current Ratio – calculated by dividing current

assets by current liabilities.

Current assets
Current Ratio =
Current Liability
Quick or Acid Test Ratio – calculated by dividing
quick asset ( cash + Receivables +Marketable
Securities) by current liabilities or by deducting
inventories from current assets then dividing the
remainder by current liabilities.
= Current Assets – Inventories
Current Liabilities

= Cash + Receivables +Marketable Securities

Current Liabilities
Cash Ratio – calculated by dividing the sum
of Cash + Marketable Securities by Current
Liabilities.
300 + 700 = 1000 = .67
1500 1500

Activity Ratios – measure how effective the

firm is in managing its assets, hence, it is also
called “Asset Management” ratios.
Inventory Turnover – measures the activity or
liquidity of a firm’s inventory. It shows the length of
time a firm can convert its inventory into cash.

Inventory Turnover = Cost of Goods Sold

Inventory

= 2000 = 2.5 X
800
Average Collection Period – also called Days Sales
Outstanding (DSO), Average Collection Period is
used to appraise accounts receivable and in
evaluating credit and collection policies.
Average Collection Period = Accounts Receivable
Sales Per Day Average

= Accounts Receivable
Annual Sales
360
 Average Payment Period
Average Payment Period = Accounts Payable
Average Purchases Per Day

= Accounts Payable
Annual Purchases
360
Total Asset Turnover – measures the firm’s
efficiency in using all its assets to generate
sales.

Total Asset Turnover = Sales

Total Sales

= 3,700 = .77
4,800
Fixed Asset Turnover – also measures the
firm’s efficiency in using its fixed or earning
assets to generate sales.

Fixed Asset Turnover = Sales

Net Fixed Assets

= 3,700 = 1.85
2,000
Debt Ratio – also called stability ratio;
measures the proportion of total assets by
creditor’s money.

Debt Ratio = Total Liabilities

Total Assets

= 2,700 = .56
4,800
Debt-to-Equity Ratio – indicates the
relationship between the long-term funds
provided by creditors and those provided by
the firm’s owners. Calculated by dividing
long-term debt by Stockholder’s equity.

Debt Equity Ratio = Long-term Debt

Stockholder’s Equity

= 1,200 = .57
2,100
Times Interest Earned Ratio (TIE) – measures
the firm’s ability to make contractual interest
payments.

Time Interest Earned = EBIT (Operating Profits)

Interest

= 1,150 = 7.67
150
Profitability Ratios
Net Profit Margin – measures the proportion of
sales that is available to the firm’s owners after
deducting all costs and expenses including
interest and taxes.

Net profit Margin = Net Profit Margin After Taxes

Net Sales
Gross Profit Margin – measures the
percentage of each peso sales remaining
after goods had been paid.

Gross Profit Margin = Gross Profits

Sales

= 1,700 = .46
3,700
Operating Profit Margin – measures the
percentage of each peso sales remaining
after all costs and expenses excluding
interest and taxes are deducted. It represents
the “pure” profits earned on each peso sales.

Operating Profit Margin = Operating Profits

Sales
Return on Assets – also called Return on
Investment measure’s management’s
effectiveness in generating profits with its available
assets.

Return on Assets = Net Profits After Taxes

Total Assets
Return on Equity – measure the shareholders’
earnings in relation to their investment in the
firm.

Return on Equity = Net Profit After Taxes

Stockholders’ Equity
Earnings Per Share (EPS) – represents the
earnings available per outstanding share of
common stock.

Earnings Per Share = Earnings Available For

Common Stockholders

No. of shares of common stock

outstanding