Some companies have payment in kind or pick notes in their capital structure.
These are borrowings where the interest is accrued and added to the loan balance each year.
Rather than being paid out in cash at regular intervals, the full loan balance and all the accrued interest is then paid only at maturity of the instrument.
When we model with pick instruments, it's really important that we have a good understanding of the linkages between the income statement, the balance sheet, and the cashflow statement.
And the easiest way to do this is through base analysis as shown here.
The base calculation links the beginning and ending balance on the pick note in the balance sheet.
We do this by adding the interest, which is accrued on the note each year.
The base analysis does not require any amount to be subtracted except when the instrument matures and the note is repaid in full.
When we're building our base calculation for the pick note, we calculate the accrued interest using the contractual interest rate applied to the opening balance.
On the note. This prevents us creating a circularity in the interest calculation.
So how does this impact on our model? Well, the accrued interest that we've calculated is included as a finance expense in the income statement.
Since the interest calculation uses the opening balance on the loan, we don't need to worry about creating a circular reference in the model.
The ending balance on the pick note is then included in the balance sheet within long-term debt alongside any other borrowings.
We then need to make an adjustment in the cash flow statement.
This is because the calculation of operating cash flows starts with net income.
That includes the pick interest, but which is a non-cash expense.
So we need to add back the pick interest when we're calculating operating cash flows.
One final item to note when we are modeling with pick instruments is that the financing cash flows for debt issuance and repayment should include only debt actually issued or repaid in the year, not changes in long-term debt in the balance sheet.
This is because changes in long-term debt in the balance sheet will include interest, which has accrued on the pick note.
And we know this is not a cash flow, so when we're calculating the financing cash flows, we take the debt issuance or repayment from our debt schedules rather than directly from the balance sheet.
