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• If a company raises a significant issue of new debt, the company should specifically explain the purpose. Be skeptical of boilerplate explanations--if the bond issuance is going to cover operating cash shortfalls, you have a red flag.
• If debt is a large portion of the capital structure, take the time to look at conversion features and bond covenants.
• Try to get a rough gauge of the company's exposure to interest rate changes.
• Consider treating operating leases as balance sheet liabilities.
Pension Plans
Following from the preceding section focusing on long-term liabilities, this section focuses on a special long-term liability, the pension fund. For many companies, this is a very large liability and, for the most part, it is not captured on the balance sheet. We could say that pensions are a type of off-balance-sheet financing. Pension fund accounting is complicated and the footnotes are often torturous in length, but the good news is that you need to understand only a few basics in order to know the most important questions to ask about a company with a large pension fund.
There are various sorts of pension plans, but here we review only a certain type: the defined benefit pension plan. With a defined benefit plan, an employee knows the terms of the benefit that he or she will receive upon retirement. The company is responsible for investing in a fund in order to meet its obligations to the employee, and so, the company bears the investment risk. On the other hand, in a defined contribution plan (e.g. 401k), the company probably makes contributions--or matching contributions--but does not promise the future benefit to the employee. As such, the employee bears the investment risk.
Among defined benefit plans, the most popular type bears a promise to pay retirees based on two factors: 1. the length of their service and 2. their salary history at the time of retirement. This is called a "career average" or "final pay" pension plan. Such a plan might pay retirees, say, 1.5% of their "final pay," their average pay during the last five years of employment, for each year of service (up to a maximum number of years). Under this plan, an employee with 20 years of service would receive a retirement benefit equal to 30% (20 years x 1.5%) of their final average pay. But formulas and provisions vary widely; for example, some will reduce or "offset" the benefit by the amount of social security the retiree receives.
Funded Status = Plan Assets - Projected Benefit Obligation (PBO)
A pension plan has two primary elements:
• The future liabilities--or benefit obligations--created by employee service.
• The pension fund--or plan assets--that are used to pay for retiree benefits.
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