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Liabilities with equity attributes are enriching
I’m introducing a concept that I call “liabilities
with equity attributes.” These are certain liabilities that have many of
the characteristics of equity and that add value to investors without any of
the associated cost. They include customer cash advances, accounts payable
purchases, and deferred income taxes, and are usually reflected on the
balance sheet as liabilities, or in deferred revenue accounts. Economically,
if the company has unrestricted use of the cash, and the balances are steady
from year-to-year, then they constitute a form of temporary equity.
These liabilities with equity attributes add to the
profitability of a company, by reducing the amount of debt or equity
financing a company needs, and improving its leverage and profitability
ratios. This results in a positive impact on the stock price of the company,
with increased EPS, as well as a higher P/E ratio.
Listed below are some examples:
Customer contributed equity – These are
normally customer cash advances for future services (Unearned Revenue).
Moody’s Corporation is a good example of a company
with customer contributed equity. As of December 31, 2006 their liabilities
reflect $360 million of current deferred revenue advances, plus another $102
million of non-current deferred revenue advances. This represents money that
was collected or accrued as a receivable, (and therefore could be borrowed
against), for future rating agency fees and monitoring services. Moody’s
creative billing feature acts as equity, and is one of the reasons a company
with a relatively insignificant book value, of $167 million, commanded a
market capitalization of approximately $18 billion in March, 2007.
Supplier contributed equity – These are
supplier accounts payable. Many suppliers offer extended credit terms to
their customers without any formal lending security agreements. This can
enable the purchasing company to convert the merchandise into cash, which
can be used in their operations until the credit terms become payable. In
effect, these suppliers are providing free short-term financing. If one’s
business is non-cyclical and consistent in nature, then this supplier
financing essentially has many of the same characteristics as equity.
Government contributed equity – The government
offers various forms of temporary tax relief to companies, in order to
stimulate the economy. The best known of these techniques is the use of
accelerated tax depreciation. This and other tax incentives give companies
larger tax deductions, or reduced taxable income, deferring their tax
payments. These benefits are hopefully reinvested in additional capital
purchases that will aid in growing the company. This generates jobs, more
profits, and eventually more taxes for the government. These initial tax
savings are reported on the balance sheet as deferred taxes. Individually,
these tax benefits reverse as the transaction unfolds, but in a consistently
growing business, the aggregate amount of the cash tax savings actually
grows and is always outstanding. This gives the organization a free source
of capital that can be used to grow the business, similar to how equity
dollars are invested.
Properly analyzing the book value section of the
balance sheet can aid in making profitable investment decisions.
The
unrestricted use of interest free funds can give a nice boost to a company’s
stock price.
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