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Moody’s Adjustments andFinancial RatiosAndrew HolmesMay 2014

Moody’s Analytics, Inc. and/or its licensors and affiliates.Moody’s adjustments and financial ratiosMeet your Instructor Andrew Holmes» Director, Leveraged Finance, Credit Suisse FirstBoston, New York and London» Equity capital markets and Leveraged Finance, JPMorgan, New York» MBA from University of Chicago» 5 years in asset managementMoody’s Adjustments and Financial Ratios2

Moody’s Analytics, Inc. and/or its licensors and affiliates.Moody’s Corporation» Credit Ratings» Credit Research & Risk Measurement– Corporate» Economic & Consumer Credit Analytics– Financial Institutions» Enterprise Risk Solutions– Structured» Structured Analytics & Valuations– Municipal/Public» Professional Services» Credit Research» Training & CertificationMoody’s Adjustments and Financial Ratios3

Moody’s Analytics, Inc. and/or its licensors and affiliates.Session OutlineMoody’s adjustments and financial ratios1Financial Statement Adjustments2Operating Lease Adjustment3Defined Benefit Plan Adjustment4Other Possible Adjustments5Analyzing and Rating Hybrid Instruments6Key Financial RatiosMoody’s Adjustments and Financial Ratios4

Moody’s Analytics, Inc. and/or its licensors and affiliates.Case ExerciseFinancial statement adjustmentsCalculate total debt, EBITDA and totaldebt/EBITDAMoody’s Adjustments and Financial Ratios5

Moody’s Analytics, Inc. and/or its licensors and affiliates.Why the need for adjustments?Debt adjustments for 9 major retailersMoody’s Adjustments and Financial Ratios6

Moody’s Analytics, Inc. and/or its licensors and affiliates.Financial Statement Data AdjustmentsMoody’s Adjustments and Financial Ratios7

Moody’s Analytics, Inc. and/or its licensors and affiliates.Moody’s Financial Statement AdjustmentsUS GAAPIFRSJGAAPDefined Benefit PensionsXXXOperating LeasesXXXFinance LeasesCapitalized InterestXXXCapitalized Development CostXInterest Expense: discount of LT liabilitiesXXHybrid SecuritiesXXXSecuritizationsXXXInventory on LIFO cost basisXFFO and working capital consistencyXUnusual and non-recurring itemsXXXOther analytical non-standard adjustmentsXXXMoody’s Adjustments and Financial Ratios8

Moody’s Analytics, Inc. and/or its licensors and affiliates.Why the Need for Adjustments?» Better capture the underlying economics» Improve comparability» Segregate unusual or non-recurring items» Use estimates or assumptions that are more prudentMoody’s Adjustments and Financial Ratios9

Moody’s Analytics, Inc. and/or its licensors and affiliates.Operating Lease AdjustmentThe Reporting ProblemMoody’s Analytical ResponseIn Moody’s view, incurring operating leaseobligations reduces a company’s borrowingcapacity.» Balance sheet: To recognize the off-balancesheet operating lease liability as debt and anincrease in fixed assets.For operating leases, companies are contractuallyobligated for lease payments and a failure tomake a lease payment often triggers events ofdefault, as if the obligation were debt.» Income statement: To reclassify the rentexpense into to interest expense anddepreciation expense.Financial statement presentation of operatingleases and capital leases is very different:» Accounting standards distinguish betweenoperating and capital leases using arbitrarytests» Cash flow statement: To reclassify theprincipal portion of the lease payment fromoperating cash flow (CFO) to a financing cashoutflow (CFF). We also simulate capitalexpenditure for newly acquired leased assetsby increasing the capital expenditures line ininvesting cash flows (CFI).Moody’s Adjustments and Financial Ratios11

Moody’s Analytics, Inc. and/or its licensors and affiliates.Operating Lease AdjustmentBalance Sheet: Add both debt and fixed assets (usually gross plant, propertyand equipment). Compute debt by multiplying current rent expense by a factor of5x, 6x, 8x, or 10x, or, use the present value (PV) of the minimum leasecommitments (incremental borrowing rate as the discount rate) if higher.Income Statement: Reclassify one-third of the rent expense to interest expenseand remaining two-thirds to “Depreciation - Capitalized Operating Leases” (acomponent of operating profit), and adjust operating expenses (or cost of goodssold and selling, general & administrative expenses) proportionally.Cash Flow: Reclassify the principal portion of lease payments from operatingcash flow (CFO) to a financing cash outflow (CFF). Simulate capital expenditurefor newly acquired leased assets by increasing the capital expenditures line ininvesting cash flows (CFI) with a concomitant borrowing in CFF to fund thecapital expenditures.Moody’s Adjustments and Financial Ratios12

Moody’s Analytics, Inc. and/or its licensors and affiliates.Lease adjustments – effect onDebt/EBITDAMoody’s Adjustments and Financial Ratios13

Moody’s Analytics, Inc. and/or its licensors and affiliates.Case ExerciseOperating LeasesOperating Lease AdjustmentExamine how adjusting for off-balance sheetleases affects elements of profitability, interestcoverage, and leverageMoody’s Adjustments and Financial Ratios14

Moody’s Analytics, Inc. and/or its licensors and affiliates.Defined Benefit Plan Adjustment (US)The Reporting ProblemCurrent accounting standards fail to recognize onthe sponsor's balance sheet the sponsor'seconomic obligation to its pension trust andemployees because of extensive artificialsmoothing mechanisms.Artificial smoothing also distorts the measurementof pension expense.On the cash flow statement, standards requirecompanies to classify cash contributions to thepension trust as an operating cash outflow,including the portion that is reducing plan underfunding, which arguably represents the reductionof debt. As a result, cash from operations (CFO)is diminished for a contribution to the trust that ismore akin to a financing activity.Moody’s Analytical Response» Because of the contractual nature of pensionobligations, we view the pension liability as"debt - like".» Thus, we classify it as debt on the balancesheet and include it in the computation ofratios that use debt.» On the income statement, our goal is to reportpension expense absent the effects of artificialsmoothing, such as the amortization of priorservice cost and actuarial gains and losses.» On the cash flow statement, we view cashcontributions in excess of service cost as therepayment of (pension) debt.Moody’s Adjustments and Financial Ratios16

Moody’s Analytics, Inc. and/or its licensors and affiliates.Differences between Pensions and OPEBsIssueStatutory funding requirementDefined Benefit PensionsOPEBYesNoPriority of claim in bankruptcy:· 11Chapter· Pari Passu with SeniorUnsecured for both· 7Chapter· Other Unsecured claims *Pre-Funding is deductible for taxpurposesYesAbility to make modifications to orcancel plans to control costsVery LimitedInsured by the PBGC· Subject to negotiation withEmployer (can be modified)*YesNoLimited only for some plansNo* For both Chapter 11 and 7 bankruptcy filings, the postretirement benefit costs incurred during the bankruptcy process aretreated as administrative expenses (highest priority for an unsecured claim). Additionally, in Chapter 11, not only can thebenefits be modified, but also terminated, both subject to court approval.Moody’s Adjustments and Financial Ratios17

Moody’s Analytics, Inc. and/or its licensors and affiliates.BT’s long-term fundingTime to call in thereceivers?Moody’s Adjustments and Financial Ratios18

Moody’s Analytics, Inc. and/or its licensors and affiliates.Are the markets nuts?Moody’s Adjustments and Financial Ratios19

Moody’s Analytics, Inc. and/or its licensors and affiliates.What a year and a change in assumptionscan do.Happy days!Moody’s Adjustments and Financial Ratios20

Moody’s Analytics, Inc. and/or its licensors and affiliates.Fast forward – here we go again.OUCH!!!Moody’s Adjustments and Financial Ratios21

Moody’s Analytics, Inc. and/or its licensors and affiliates.Do the markets adjust for pensions?BT’s (adjusted!) fiscal 2010 (to March) was 5.6bnCompanyDeutsche TelekomFrance TelecomTelefonicaSector AverageEV/ 2009A EBITDA*5.4x4.9x5.7x6.2x* As of July 2010» Is the market over or undervaluing BT’s equity?» Does the following disclosure help (figures as of March 2010)?– Cash and short term investments of 1.86bn– Short term debt of 3.27bnMoody’s Adjustments and Financial Ratios22

Moody’s Analytics, Inc. and/or its licensors and affiliates.Capitalized InterestBalance Sheet: We adjust the balance sheet to reduce PP&E by theamount of any interest capitalized during the period, adjust deferredtaxes, and reduce retained earnings by the after-tax cost of the additionalinterest expense recognized on the income statement.Income Statement: We adjust the income statement to increase interestexpense by the amount of any capitalized interest during the currentperiod, and reduce applicable tax expense.Cash Flow: We adjust the cash flow statement to reclassify anycapitalized interest from capital expenditures, an investing cash outflow(CFI), to interest expense, an operating cash outflow (CFO).Moody’s Adjustments and Financial Ratios24

Moody’s Analytics, Inc. and/or its licensors and affiliates.Case ExerciseCapitalized interestHow much interest expense did Chesapeakecapitalize in 2012 and what was the effect onits cash flow?Moody’s Adjustments and Financial Ratios25

Moody’s Analytics, Inc. and/or its licensors and affiliates.Capitalized Development Costs (IFRS)*Balance Sheet: We adjust the balance sheet to reduce intangible assetsby the cumulative amount of development costs capitalized, adjustdeferred taxes accordingly, and reduce retained earnings by thecumulative amount of development costs capitalized, net of tax.Income Statement: We adjust the income statement to increaseoperating expenses by the amount of capitalized development costs forthe period, remove the amortization charge related to the capitalizeddevelopment costs (including any impairment charge), and adjustapplicable tax expense.Cash Flow: We adjust the cash flow statement to reclassify capitalizeddevelopment costs from an investing cash outflow (CFI) to an operatingcash outflow (CFO).* All R&D for intangibles expensed per US GAAP with minor exceptionsMoody’s Adjustments and Financial Ratios26

Moody’s Analytics, Inc. and/or its licensors and affiliates.Be careful – GAAP allows some Costs tobe CapitalizedMoody’s Adjustments and Financial Ratios27

Moody’s Analytics, Inc. and/or its licensors and affiliates.Unusual and Non-Recurring ItemsBalance Sheet: We adjust the balance sheets in those instances when itis material to our analysis.Income Statement: We adjust the income statement to reclassify theeffects of unusual or non-recurring revenues, gains or costs, net of therelated tax effect, to a special income statement caption that is below netprofit after tax. Our computation of key ratios excludes amounts in thespecial income statement caption.Cash Flow Statement: We adjust the cash flow statement to reclassifythe effects of unusual or non-recurring operating cash inflows andoutflows to a special caption in the operating section of the cash flowstatement. Our computation of key ratios excludes amounts in thespecial cash flow statement caption.Moody’s Adjustments and Financial Ratios28

Moody’s Analytics, Inc. and/or its licensors and affiliates.Chesapeake's other adjustmentsp145P102p126p125p112pp102 and 96Moody’s Adjustments and Financial Ratios29

Moody’s Analytics, Inc. and/or its licensors and affiliates.Chesapeake's preferred stock adjustment» Chesapeake's 2012 balance sheet shows the following in preferredstock:» In addition there is 1,911 of contingent convertible senior notes:» Moody’s considers the preferred stock to be debt and allocates half ofthe convertible stock to debt and half to equityMoody’s Adjustments and Financial Ratios31

Moody’s Analytics, Inc. and/or its licensors and affiliates.Moody’s Hybrid Tool KitHybrid instruments analyzed by Moody’s Hybrid Capital GroupClassification of hybrid securities based on following:» Does the hybrid absorb losses for a “going” concern?» Does the hybrid absorb losses for a “gone” concern?» Is the loss absorbing capital there when needed?Loss Absorption – key points» Coupon payments – cumulative or non-cumulative?» Existence of coupon skip triggers?Assign a basket from A to E on the continuum» A is most debt-like while E is most equity-likeMoody’s Adjustments and Financial Ratios32

Moody’s Analytics, Inc. and/or its licensors and affiliates.Hybrid Equity CreditLevel of Equity Credit0%25%50%75%100%ABCDEMoody’s Adjustments and Financial Ratios33

Moody’s Analytics, Inc. and/or its licensors and affiliates.Generic Hybrid ExamplesMoody’s Adjustments and Financial Ratios34

Moody’s Analytics, Inc. and/or its licensors and affiliates.Hybrid Security AnalysisThe Reporting Problem» Although accounted for as debt, equity orminority interest, hybrid securities havecharacteristics of both debt and equityinstruments.» For some instruments, accounting standardsfocus on legal form, even though theeconomics of these instruments suggest adifferent classification.» For example, standards classify certainpreferred securities as 100% equity eventhough these instruments have importantattributes of debt.Moody’s Adjustment» Balance Sheet: Reclassify hybrid securities toeither debt or equity in accordance with thehybrid basket treatment assigned.» Income statement: Adjust interest expense inaccordance with the hybrid basket treatmentassigned, e.g. reclassify preferred dividends tointerest expense in the case of hybridsecurities considered to be debt-like.» Cash flow statement: Based on the hybridbasket treatment, reclassify preferreddividends (a financing cash outflow) to interestexpense (an operating cash outflow) for thecalculated debt portion (or visa versa in thecase of equity).Moody’s Adjustments and Financial Ratios35

Moody’s Analytics, Inc. and/or its licensors and affiliates.General GuidelinesDetermine Issuer Type and Base Rating» For Investment grade use senior unsecured rating» For Sub-investment grade use corporate family ratingFor Senior Unsecured Rating of Baa3 or above» Subordinated debt is 1 notch lower» Preferred stock is 2 notches lowerFor Corporate Family of Ba1 or below» Subordinated debt is 2 notches lower» Preferred stock is 3 notches lowerMoody’s Adjustments and Financial Ratios36

Moody’s Analytics, Inc. and/or its licensors and affiliates.Genting’s hybridMoody’s Adjustments and Financial Ratios37

Moody’s Analytics, Inc. and/or its licensors and affiliates.Genting’s 2012 equity disclosureMoody’s Adjustments and Financial Ratios38

Moody’s Analytics, Inc. and/or its licensors and affiliates.Moody’s viewMoody’s Adjustments and Financial Ratios39

Moody’s Analytics, Inc. and/or its licensors and affiliates.Moody’s Key Financial Ratio MediansGlobal Non-Financial Corporations, 2012Moody’s Adjustments and Financial Ratios41

Moody’s Analytics, Inc. and/or its licensors and affiliates.Which ratios would youuse to analyze an energycompany?Moody’s Adjustments and Financial Ratios42

Moody’s Analytics, Inc. and/or its licensors and affiliates.Key credit ratios in the Integrated sectorShell’s metrics (Q4 2011)Moody’s Adjustments and Financial Ratios43

Moody’s Analytics, Inc. and/or its licensors and affiliates.Key credit ratios in the independent E&PsectorRange Resource’s metrics (Q4 2011)Moody’s Adjustments and Financial Ratios44

Moody’s Analytics, Inc. and/or its licensors and affiliates. versus, for example, refineriesMoody’s Adjustments and Financial Ratios45

Moody’s Analytics, Inc. and/or its licensors and affiliates. or unregulated utilities and powercompaniesMoody’s Adjustments and Financial Ratios46

Moody’s Analytics, Inc. and/or its licensors and affiliates.Q&AMoody’s Adjustments and Financial Ratios47

Moody’s Analytics, Inc. and/or its licensors and affiliates.moodysanalytics.comThank You!For more information, please contact usThis SeminarTailored Training SolutionsAndrew HolmesShawn dys.comMoody’s Adjustments and Financial Ratios48

Moody’s Analytics, Inc. and/or its licensors and affiliates. 2014 Moody’s Analytics, Inc. and/or its licensors and affiliates (collectively, “MOODY’S”). All rights reserved. ALL INFORMATION CONTAINED HEREIN IS PROTECTED BYCOPYRIGHT LAW AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED,DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER ORBY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR WRITTEN CONSENT. All information contained herein is obtained by MOODY’S from sourcesbelieved by it to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors, however, all information contained herein is provided “ASIS” without warranty of any kind. Under no circumstances shall MOODY’S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resultingfrom, or relating to, any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY’S or any of its directors, officers, employees oragents in connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct, indirect,special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY’S is advised in advance of the possibility of suchdamages, resulting from the use of or inability to use, any such information. The ratings, financial reporting analysis, projections, and other observations, if any, constituting part ofthe information contained herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities.NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OFANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER WHATSOEVER. Each rating or other opinion mustbe weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user must accordingly make its ownstudy and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it may consider purchasing, holding, or selling.Moody’s Adjustments and Financial Ratios49

sheet operating lease liability as debt and an increase in fixed assets. » Income statement: To reclassify the rent expense into to interest expense and depreciation expense. » Cash flow statement: To reclassify the principal portion of the lease payment from operating cash flow (CFO) to a financing cash outflow (CFF). We also simulate capital