Lesson 12: How bonds work

Bonds as Debt

Whether we admit it or not, stocks, currencies and bonds are somehow interlinked. Of course when mentioning stocks, it is in reference to businesses. I have mentioned a number of times in previous lessons, when you are buying stocks, technically, you are buying businesses. We have briefly looked into how to assess a company’s financial statements.

Although not really necessary, having the ability to properly anticipate debt cycles in the market can give you a significant advantage over other market participants as it enables you to anticipate some developments you would have otherwise been unable to. It is not an easy task and has a lot that has to be considered which we will not cover in this particular lesson. Soros managed to anticipate some of the debt cycle patterns  and did offer extensive explanation on his approach of which could have partly contributed to his notable success in the financial markets as it enabled him to invest in businesses that would largely benefit from particular stages of debt cycles.

Whatever happens in the debt market almost always has to have an effect on both currencies and stocks. The link is especially more significant in relation to bonds and stocks. You only need to look into a few of the previous debt market bursts in different countries to see the significant effect they have had on the stock market movements (which is usually a good barometer on how business are generally doing especially in markets with a large diverse number of listed companies).

The debt crises in the process tend to create a lot of opportunities in the stock market as usually when a country is recovering from a debt market crash, stocks are usually very cheap due to the psychological impact the debt cycles have on investors. Businesses source for funding to grow their business from the debt market. They borrow in order to grow earnings in a way they would have otherwise been unable to. As an example, when debt markets crash, interest rates go up sharply because risks rise, when interest rates rise, it becomes difficult for businesses to finance their activities and investors may shy away from financing companies in the country and thereby worsening the situation and may lead to company collapses and bailouts especially in those companies that were reckless about debt.

The issue of  debt markets is a bit wide and to explain and I would have to spread out the lessons. I will begin by explaining on how to invest in the bond.


To define it simply, a bond is just a loan. Companies &  governments issue bonds to raise money from investors willing to lend them money for a certain amount of time (Also called maturity period).

Bonds are very popular as very low risk investments. Investors constantly use them to diversify their portfolios, so that they wouldn’t suffer significant loss in case there is significant market shock affecting investments in other financial instruments. By market shock, I mean events that may hurt performance of your stock purchases. Besides, its a better way to save up for retirement instead of stashing your money under the pillow(where you money loses against inflation), in the bank(paying little or no interest) or funds offering very little return over the long-term.

When you are buying a bond, you become a creditor for the company or government. You would be extending a loan that has compensations in form of periodic payments in form coupon interest. At the end of the agreed time period of the bond, you get back the amount of money you gave the government or company.

To illustrate, let us assume you are the Chief Finance Officer of a company called Home Kenya. You realize the business needs some 5 billion shillings to expand reach or finance a few projects you have identified have significant potential to create a future stream of income or boost your business financial position. You then talk to an adviser on the best way to raise funding.  The adviser may offer a range of options on how you can raise funding which include equity dilution, loan from bank or bond issue. You then maybe decide that you don’t want to dilute your company’s earnings per share since the owners of the business might not be happy about it. You also figure out that raising funding from banks may be a little bit expensive and some banks may be unwilling to extend to you the amount of money you require in a way where the business would remain profitable. Remember, high interests on loans you take will be eating up a huge portion of your earnings. (Some jurisdictions like Kenya require you to consult a professional by law).

You then decide to approach an investment bank to handle the issue(Also a mandatory requirement in some jurisdictions). The bank will then evaluate the ability of your company company to pay back the loan (bond inclusive of interest payments) before deciding on the rate at which the loan you will take, in form of a bond, will accumulate interest. If the bank determines it is healthy, they then facilitate the entire process by first restructuring the loan into a bond. They then decide on the lending rate to use which can be say for this situation 5% per year.


The bank can decide to split the loan into minimum amounts each investor can invest. In this case they split it into 500,000 bonds with each bond at a par value of 100,000. Par value is the minimum amount that lenders will lend to you and that you will have to pay back at the end of the agreed period of time.

The loan has to have a repayment period which in this case we can assume is 30 years. At the end of the 30 years, all those who bought the bonds and are holding the bonds issued by the company will get back  the per value of the bond which is equivalent to the money they invested when the bond was being issued.

To summarize, your bonds would look something like this

Bond per value : sh100,000

Term : 30 years

Coupon rate: 5%.

You will find that, instead of investors paying 100,000 for every bond, they may pay, 105,000 for the bond. The 5,000 extra is what the bank makes from facilitating the bond sale. Investors who buy the bond will make 5% every year. It is usually structured in a way where investors will receive money semi-annually. In this case it means after every 6 months, investors will receive a cheque of 2500 shillings for every bond they bought. At the end of the 30 years, they will get their 100,000 shillings back on every bond they bought.

Once investors buy the bonds, the relationship is now between the company and investors directly.

Some bonds have evolved and there are even smaller versions now called mini-bonds in some countries that are issued by very small businesses but are generally unsupervised and are considered high risk. They would however be deemed by the Act in Kenya as illegal as they do not meet the requirements stipulated in the act.

Lesson 10: Why the cashflow is important in analysis of a business

Examining the cashflow statement

As a recap, we have looked into the various approaches used in analyzing a business; we also looked into how to make some quick brief analysis on the income statement(P&L) and balance sheet.

In this lesson, I will briefly introduce on the cashflow and its importance before proceeding into detailed review of the statement.

Cashflow valuation

As we had noted in previous lessons, when you are buying shares, technically, you are buying a business. A business is supposed to earn profits for owners which can then be distributed to owners after they consent as dividends or can be retained for reinvestment.

Businesses/shares have traditionally been valued by investors as a multiple of earnings. Fundamental investors simply calculate how much the business would make during the time they invest then adjust for interest rates and inflation etc. (simply because money right now will not be worth as much in the future). The usual relationship is that when the rate of interest is high, the multiple paid for a business becomes low. Yet earnings are only part of pretax cashflow which is often a minor part. Cashflow is the primary criterion in determining the value of a business that is a candidate for acquisition/investment and there should be given as much emphasis as other items of the financial statements.

Just to lay a little bit more emphasis, when valuing a business, cash will always be king. The usual procedure is that we look at the value of the cash that can be taken out of a business during its remaining life time or over the period we want to invest, and then adjust. The value we get is called the intrinsic value. The calculation of intrinsic value, though, is not simple as I may have implied. This is because intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. So the market is always adjusting towards a moving target rather than a fixed valuation. That may be part of the reason why stock prices in the market are constantly moving. We will get into more details on cashflow valuation in a different lesson.

Why cashflow matters

The rules of accounting are not meant to create an income statement that tracks cash flow; rather, they’re meant to track earnings as defined for tax or financial-statement purposes. That means they may show income that the business has not yet received as cash or show expenses the business has not yet incurred, meaning that the underlying cashflow becomes blurred and may not show the real liquidity position of a business.

This is not to mean that an investor should only consider cash flow statements. Ideally, cash flow statements should be used together with information from the Profit and Loss, Balance Sheet and footnotes to assess the cash-generating ability of the firm. Some of the reasons why the cashflow statement should be used alongside the income statement and balance sheet are

  • Inventories in the balance sheet are recorded as assets rather than expenses implicitly assuming that they will be sold in the normal course of business. If a business is ‘dying’, this might not be the case.
  • The recording of revenue from credit sales in the income statement and the valuation of receivables assume that the firm will continue to operate normally. Failing firms may find that customers are unwilling to pay.
  • When doubts start arising that a business may not continue running for long, revenue recognition and asset valuation can no longer be taken for granted. The cashflow statement acts as a check on the various assumptions made in the other statements some of which include the above stated.

Besides, if a business looks good on the profit and loss statement but has to plough back all its earnings into the business in order to generate that kind of income, then it won’t be worth near as much as a business that’s generating excess cash. This is because when calculating earnings, a company does not have to restrict to just the cash it receives but can include cash that it anticipates it will receive.

Case example of potetial impact of bad cashflows using Samuel’s business

In our previous illustration on Samuel’s business, let us assume that he somehow managed to grow his business into a huge sausage selling empire.

The first thing that may happen when his business isn’t generating cash is that supplies start getting squeezed. This is because they are not getting paid because little or no cash is coming into the business. Remember suppliers run businesses also and they too have financial obligations either to the owners or creditors. If the business has been maintaining good relations with the supplier, they might not start making much noise

When suppliers to Samuel’s business realize that the business is really hurting them by not paying them, they start now making noise and may change a few things. They may start requiring that they be getting prepayments for the products they sell to the business. They may also start limiting the amount of products they sell to the business to cut risks of losing.

By then, the business may start getting into trouble because if there isn’t any cash, the next step the business will take in order to survive is to try and get a line of credit from a bank or other lenders. They may do this by increasing an existing one or try to borrow some additional money. When the lender reads the financial statements of the business, they will see that the business owes a lot of money to suppliers. So they will quickly figure out that the money you get will simply be used to pay money you owe to suppliers and signal that your business isn’t really doing well. But the more you need the money, the less the banks want to loan the business and if they do, they might place a higher risk on the business and then they will have to ask for more interest. More interest drains cash from the business and therefore the business reports lower net earnings. If the business is not growing fast enough, it becomes problematic because then the ability to pay down the loan it took reduces.

We will look into how we can quickly review the cash position of a business using the cashflow statement in the next lesson.

Lesson 9: Gauging Whether Company is Being Managed by Vigilant leaders

Stock must be managed by vigilant leaders

Buffettology proposes that for those of us who don’t have the luxury of visiting the management to gauge how well they would manage the company, an alternative would be to evaluate this factor by looking at how well they manage debt. But I would tend to think that, in any case, visiting the management might sometimes create an unnecessary bias when you are making your investment decision.

Warren Buffett and George Soros both do not actually object to the use of debt for a good purpose like in a situation where a company uses debt to finance the purchase of another strategically good company or invest in assets that would reasonably yield a lot more profits. He however objects if the added debt is used in a way that will produce mediocre results.


The act of lending does stimulates businesses earnings since it enables the business invest in more productive assets that they would have otherwise not been able to invest in. The exception arises where the assets that the business is investing in are not physical but financial ones. In this case, the effect might not necessarily be positive. Debt servicing can really have a depressing effect on a business because the resources that would otherwise been devoted towards future stream of income are drained from the business through interest payments. As the total amount of debt outstanding increases the portion that has to be utilized for debt service increases. It is only net new lending that stimulates a business and total new lending has to keep increasing in order to keep net lending stable until the business encounters limit of size problems and it is something you would not want to get caught up in, hence the need to properly evaluate the debts of a company.

There are various methods designed by analysts to check for the health of the business in terms of debt, but I will highlight two that I think you would help you comfortably get a quick idea on how the business is. The two are Debt to Equity ratio and current ratio.

  • Debt to Equity Ratio

 As a recap; in the first few lessons, we learnt that Equity is just how much you as the owner would get after selling assets and paying off money owed to lenders in case the business was closed.

The ratio allows us to determine how much debt we get for every shilling we invest in buying a single share.

Ideally when calculating this ratio, we are supposed to get total amount of liabilities, which in the case is what the business owes lenders, over the equity. It is however preferred especially when analyzing a large company to do a ratio of the long-term loans(which are earning interest) against equity.

What is the ideal ratio? In judging whether the debt to equity ratio is too high, it is important to as well put the industry into consideration. For example, manufacturing companies tend to be more capital intensive and therefore you will often find that their debt to equity ratio may be a little high. Also try and look into what the debt is being used for. There are investments that specifically take up debt to just finance projects like in real estate that potentially earn much higher income than the interest paid to lenders. Warren Buffett tends to favor ratios of somewhere around 0.5, because there, the risk is much lower, his preference may however vary with the industry as we had indicated earlier.

You can pick both the equity and debt ratios from the balance sheet.

If the ratio is too high, try and find out what the debt is being used for, if you do not know whether the debt is being used for the right purpose, I think you would be better off steering away from the company and looking for an alternative investment. If you have access to good detailed financial information to gauge all that, then you can take the risk.

  • Current Ratio


This is simply used in determining a company’s ability to pay debts that they are supposed to pay in a year or less. It is calculated as a ratio of the current assets against the current liabilities. The two can both be obtained from the balance sheet or consolidated statement of financial position.

Current assets are the cash or other assets that the company is likely to convert into cash within a 1 year period. Current liabilities are the debts that the company will pay within that same year. In doing the comparison, we are able to get a rough idea on whether the company will have to borrow more within the next 12 months to pay off the debts or if it will comfortably pay its short term debts. A ratio of 1.0 means that the business has just enough current assets to cover debts they are supposed to pay within one year. Below 1.0 is bad for the business because it means they will have to borrow more in the next financial year, conversely, above 1.0 is good for the business as it means the business can comfortably cover its current assets.

A ratio of less than one may also signal the probability of more problems arising like issues with suppliers who may not have been paid.

According to the writer of Buffettology, Warren Buffett prefers investing in companies with a current ratio above 1.5; but again, this varies with the industry.

Twitter: @moneyacademyKE

(This post will later be revised to add real company illustration)

Introduction (Understanding the Stock Market)

Lesson2:Why do stocks remain overvalued for extended periods of time

Lesson 3: Illustrating How Listed Companies Operate Using Small Business model

Lesson 4: Flow of money through a business

Lesson 5: Valuing a business in terms of earnings it makes

Lesson 6: Balance Sheet & Margin of safety in a business

Lesson 7: Explanation on shares in a business

Lesson 8: Quick Basic Stock valuation Techniques

Lesson 9: Gauging Whether Company is Being Managed by Vigilant leaders

Lesson 4: Flow of money through a business

In the previous lesson, we introduced how a business runs and detailed an illustration of how a business runs. In this lesson, we will look into how money flows through a business using Samuel’s business model.

Flow of money through a business to the owner/Income

As a recap, Samuel owns a Sausage business in the city. He has employed an employee who sends him a cheque at the end of every year. We have assumed Samuel’s business is fairly stable.

Now to illustrate the flow of money:

  • Assume customers buys sausages worth 1000 shillings from the business. Now The 1000 shillings is indicated as sales in some financial statements and other words with identical meaning can be used depending on the company but they all mean the same thing.
  • The business also incurs costs. We can assume that, Samuel pays employees 200 shillings and buys sausages worth 400 shillings and pays local authorities locally known as ‘Kanjos’ 100 shillings. That means that, Samuel’s business spends 700 shillings to make the 1000 shillings from the sausages that it sells.

At this point, the business makes a profit before deducting taxes of (1000-700) shillings which is 300 shillings. Assuming that the business pays taxes to the government worth 100 shillings, Samuel is entitled to receiving 200 shillings from the business at the end of the year. I have assumed that he hasn’t taken a loan. If he had taken a loan, the interest he pays on the loan would have been deducted before the taxes are calculated.

The 200 shillings that Samuel receives is called net EARNINGS or net income. It is important to remember this term since you will often hear it mentioned in reports provided by the company or by analysts. Earnings are important since they represent what the owner should get. That is the money that went through the process and comes to you.

Since we now know that Samuel is getting money amounting to 200 shillings at the end of every year from his business, as an owner he now has to make a choice on what to do with the money.

Samuel can choose to:

  • Take all money and go spend it on say school fees, rent, entertainment or charity whatever he likes
  • Grow the business by reinvest all the money to grow business more by maybe buying another stand or even buying out other competitors who might pose a threat to his business. Its all up to him. Of course he can seek advice from his employee who will probably propose a range of ideas.
  • Split the money into two, take one portion of it and reinvest the other portion

In both situations where Samuel chooses to reinvest his earnings back into the business, the business will be worth more at that point and may increase his how much he makes at the end of every year depending on whether his investment works.

Comparing Samuel’s business to a bigger listed company.

As is illustrated above, Kenya Power, the national electricity distributor on the left operates in a model very similar to Samuel’s business in the right. The owners are represented by the board of director. The CEO and other employees involved in the day to day running of the business are just employees of the company.

That basically roughly highlights how a business runs. Next we shall look into how to value a business in terms of earnings which is one of the most commonly used approaches by market participants.

Introduction (Understanding the Stock Market)

Lesson2:Why do stocks remain overvalued for extended periods of time

Lesson 3: Illustrating How Listed Companies Operate Using Small Business model

Lesson 4: Flow of money through a business

Lesson 5: Valuing a business in terms of earnings it makes

Lesson 6: Balance Sheet & Margin of safety in a business

Lesson 7: Explanation on shares in a business

Lesson 8: Quick Basic Stock valuation Techniques

Lesson 9: Gauging Whether Company is Being Managed by Vigilant leaders


As a continuation from lesson 6, let us assume that Samuel is unable to get one investor to buy the entire business or only wants to sell a small portion of it to investors. If he thinks the business is worth 100,000 shillings, he can split the business 10,000 times into small units called shares. Each share would be now worth $10.

Shares outstanding

The 10,000 shares are referred to as shares outstanding. It simply refers to how many times the business has been split intoIt is very important to remember this since you will often see it being mentioned and it is the figure that you use in getting the value of the business you are buying per share.

Difference between whole business and the one share that you buy:

When buying that one share, worth 10 shillings, think about it like you are buying a very small business identical to the bigger business. The only difference is that you are only using less capital.

The book value is the amount of equity in the balance sheet divided by the number of shares outstanding.

Using Samuel’s business illustration if he split his business 10,000 times so that he can sell to many investors, we would have something like this; (remember he had an equity of 7,000 and was getting net profits of 20,000 shillings every year)

Amount of shares in the business:                                10,000 shares

The market value (Value Samuel assigned to it):      sh10 for every share (100,000/10,000)

Earnings distributed to each share:                           20,000/10,000 = sh2

Book value:                                                         7,000/10,000 = sh 0.7

As an emphasis, always value that one single share you buy like you would value the entire business.

In the next lesson, we are going to look at valuing a business in relation to the market price now in terms of per one share.