Lesson 6 of 8
Obligations not called debt
Past leases. Factoring, securitisation, take-or-pay and purchase commitments, where each is disclosed, and what each does to a leverage ratio that ignores it.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Leases came onto the balance sheet under ASC 842. Four other families of obligation largely did not.
- Receivables factoring and securitisation reduce reported debt and reported receivables at the same time, which improves two ratios at once.
- Each of the four is disclosed somewhere; none is in the debt note, and none appears in a leverage ratio computed from reported debt.
The financial health course teaches the leases that arrived on the balance sheet in 2019. This lesson is about what stayed off it, which is where the same question now lives.
Four families of obligation, and where each is disclosed
- 1Receivables factoringSold receivables. Cash now, less cash later. Transfers of financial assets note, under ASC 860
- 2SecuritisationAssets into a separate entity that issues its own debt. Consolidation and transfers notes
- 3Take-or-pay contractsPay whether you take delivery or not. Commitments and contingencies note
- 4Purchase commitmentsContracted future purchases. Commitments note, often with a maturity table of its own
Factoring, and the two ratios it moves
A company sells its receivables to a bank at a discount. Cash arrives now and the receivable leaves the balance sheet.
Two things improve at once. Days of sales outstanding falls, because the receivable is gone. And the cash could have been raised by borrowing instead, so reported debt is lower than it would otherwise be. A reader comparing this company with one that borrows against its receivables sees a better working capital cycle and less leverage, and neither difference is about the business.
Whether the receivable truly left is a question ASC 860 answers, and the disclosure of transfers of financial assets is where to look. The recourse terms matter: a sale with recourse leaves the credit risk behind.
Securitisation
The larger version. Assets are transferred to an entity that issues debt against them. Whether that entity is consolidated decides whether its debt appears, and the consolidation analysis is disclosed rather than obvious.
For an equity reader the practical question is narrower than the accounting one: if that entity needs to refinance and cannot, what does the parent do. The answer is usually in the commitments note, in the form of any support the parent has agreed to provide.
Take-or-pay and purchase commitments
A take-or-pay contract obliges payment whether or not delivery is taken. A purchase commitment obliges the purchase. Both are fixed future outflows agreed in advance, which is the economic property that makes debt debt, and neither is in the debt note.
They are disclosed in commitments and contingencies, often with a maturity table of their own. That table is the one to read beside the debt maturity schedule, because the two are additive and the company will face both.
What this means for a condition
A leverage condition written on reported debt is a condition on the part of the obligation that happens to be in the debt note. That is not wrong, and it is checkable and automatable, which is worth a great deal.
What it needs is a companion: a note, in the thesis itself, saying what was in the commitments disclosure when the condition was written and when it will next be read. The guardrails course calls this a condition that has to be checked by hand, and it is the second of the two examples in this track.
Check yourself
Why does receivables factoring improve two ratios at once?
- Because it increases revenue and reduces costs
- Because the receivable leaves the balance sheet, reducing days of sales outstanding, and the cash raised means less borrowing is reported
- Because it removes the credit risk
Show the answer
Answer: B.
A sale with recourse leaves the credit risk behind. The disclosure of transfers of financial assets is where the recourse terms are found.What makes a take-or-pay contract economically like debt?
- It carries an interest rate
- It is a fixed future outflow agreed in advance, whether or not delivery is taken
- It is secured on the assets
Show the answer
Answer: B.
That property is what makes debt debt. The contract is disclosed in commitments and contingencies rather than in the debt note.Why does an automated leverage figure count only reported debt?
- Because the other obligations are immaterial
- Because only reported debt is a balance sheet line; the rest is disclosed in notes that are not tagged as comparable data
- Because standards prohibit including them
Show the answer
Answer: B.
That is a limit on what any screen can do, which is why a condition on reported debt needs a companion note about the commitments disclosure.Sources
- ASC 860, Transfers and Servicing, for when a transferred receivable is derecognised and for the recourse disclosures.
- ASC 842, Leases, for the obligation that moved onto the balance sheet for fiscal years beginning after 15 December 2018.
- ASC 440, Commitments, for the disclosure of unconditional purchase obligations.
- ASC 810, Consolidation, for whether an entity holding securitised assets is consolidated.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- The three-line table is invented round arithmetic chosen so the 65 percent difference can be checked by hand. No company is described by it.
- The four families are the four this course met most often. The list is not exhaustive, and pension and deferred consideration obligations are treated elsewhere in the academy.
- Whether any particular transfer results in derecognition is an accounting conclusion the filer reaches and discloses. This lesson does not second-guess any filer's conclusion.