Underwriter model exists where a company contracts another financial institution to offer its securities for sale to interested investors the risk associated with this is the company issuing its securities will have to pay the financial institution some commission which might end up reducing the expected amount by the issuing company and is more riskier if the two parties don’t agree on a eat stock status which might see the issuing company get back it unsold securities. The investment model is where by the issuing company decides to sell its securities directly to the investors the risk with this is that if the stocks are not bought the company will incur losses equivalent to the floatation costs and thus this become the souce of the financial risk.
The highly leveraged a company is the more quickly it should respond to market conditions that turn against it but it should do so by not borrowing or financing its activities with debt finances since this would worsen its activities as it would continue rising its leverage ratio. The company should adopt a strategy that will greatly minimize dependence on non owner supplied finances to keep the company going. To understand the relationship between leverage and risk leverage is the extent to which of firm or a company depends on borrowed fund to keep it running the higher the leverage of a company the higher the financial risk of such company and for such the going concern of the company is in jeopardy and thus leverage and risk are positively related.
The accounting for ordinary repurchase agreement transactions and repos 105 have slight similarities and differences to start with they are similar in this form, both will yield coupons which are recorded as income on the books of the borrowing entity .both of them have a haircut value to hedge the lender against the risk of defaulting by the borrower.
The difference between the two is that the ordinary repurchase agreement is assume to be a collateral and thus the borrower will record the loan obtained as liability and not as revenue out of sale of equity while in repo 105 the transfer of the securities will be assumed to be a sale of the repos devoid of the coupons thereof and thus the amount transacted with the repos is shown as revenue other than a liability loan with a loss equivalent to the excess hair cut attached to the transferred securities.
The effect of the repos 105 repurchase agreement and the subsequent use of the proceeds thereof have significant impact on the financial statements of the borrowing entity
On the cash flow statement the amount paid to repurchase the repos 205 will be shown as a cash outflow the company accompanied by the interest tied the principal of the loan acquired. If the proceeds are used to pay other due debts to the creditors the amount paid to the creditors will be shown as a reduction in cash reserves thus a cash outflow entry.
The repurchase also impacts significantly on the financial position of the company a repurchase will lead to an increase in the amount of the securities owned by the company and for such there will appear an increase in the capital section of the balance sheet equivalent to the repurchased repos105.if such proceeds are used to pay creditors then the amount of the debts settled will reduces the section of the current liability with the amount paid or any other liability that is settled with amount obtained from the earlier transfer of the repos 105.
Amount of repo 105 usage (billion)
Reported net leverage
2007 4th quarter
2008 1st quarter
2008 2nd quarter
Analyzing the ratios of the company’s asset turnover it will require first to understand that asset turnover is the levels of sales generated by fixed asset of the company and thus the higher it is the more efficient is the company’s assets in generating revenue from the list of the companies then and specifically financial institutions then AIG performs better than any other financial institutions with bear sterns performing worse while Lehman experiences fluctuations in the entire period with a high of 0.095 in 2006 and a low of 0.055 in 2003.
A view on the assets to equity ratio which is a measure of leverage and thus the higher it is the high the company is leveraged and thus the higher the financial risk from the ratios of financial institutions bear and sterns is highly leveraged followed by Lehman and their trend has increased throughout the period while AIG is the least leveraged with its ratios averaging below 10%.
The returns on assets ratio shows how profitable the assets of a company are in generating revenue, the higher it is the better, steady ratio shows the company has no debt financing. Therefore AIG has the most profitable assets followed by Goldman, Lehman with bear sterns trailing but in bear sterns shoes steady ratios between year 2003 to 2005 and thus it can be assumed it didn’t have debt financing in these entire duration.
Returns on Equity measures the efficiency with which a firm utilises other suppliers fund to generate returns to shareholders. In this category of ratios bear sterns leads followed by Goldman Lehman and AIG trails and thus bear sterns is efficient in utilising other suppliers funds.
In general the performance of other companies in non financial activities performed better than those in the financial investments and this can be due to the fact that they are in a category with least competition and their consumable commodities are in constant daily demand and thus least surges in their performance. Such companies are less leveraged and thus little financial risk while their assets are the most efficient in revenue generation as depicted from their performance ratios.
John, B.and Oriol, A. (1989). Interpreting Accounts. London: International Thompson Business Press.