Bonds, Equity, and Other Debt

The issuance of bonds will be reported on the statement of cash flows, the income statement, and the balance sheet. The issuance will be reported on financial statements depending on the offering value compared with the face value. If Megacompany Inc. issues 10,000 bonds for $1,000 each at par, or at face value, then it raises $10 million in capital.

This amount will be shown on the statement of cash flows as an increase of $10 million. The interest that it pays out will be recorded on the income statement as an expense at the time that it is accrued. The cash received from the bonds will increase the cash asset on the balance sheet. Because the principal of the bonds will need to be repaid, the balance sheet will also show a long-term liability called bonds payable. Long-term liability is a debt amount that will need to be paid back in over a year. If the bond is a Eurobond, or a debt security denominated in a currency that is not the home currency of the issuer, then currency exchange rates will also be reported.

If the interest rate of the bond is greater than what is required by investors, the bond will sell at a premium. This difference will affect the company's financial statements. The premium difference will be an amortized amount that will offset the interest expense. An amortized amount is an amount that accounts for the gradual decrease in the value of the bond. For example, if Megacompany Inc. issues $2 million in bonds with a $100,000 premium over 10 years, it will report $2.1 million in cash, have a $2 million liability, and have $100,000 in bonds payable. The premium will be reduced every year by $10,000 so that at maturity the bond premium payment is zero.

Conversely, a discount bond is a debt security that sells under the face value, or a bond currently trading for less than its par value in the secondary market. Discount bonds are similar to zero-coupon bonds, which are also sold at a discount, but the difference is that zero-coupon bonds do not pay interest. As an example, consider a bond with a par value of $1,000 set to mature in three years. The bond has a coupon rate of 3.5 percent and market interest rates are higher at five percent. Since interest payments are made on a semi-annual basis, the total number of coupon payments is six, or three years multiplied by two. The interest rate per period is 2.5 percent, or 5 percent divided by two.

The impact of a business decision is often determined through the analysis of financial statements. The health of a company is a function of the company's ability to meet debt obligations and generate cash flow either from investing, financing or operating activity. This ability to pay debt is often linked to the company's ability to generate cash and to sustain their cash flow from sales and capital generation. Financial statement analysis primarily involves a system of ratios that indicate the financial strength and weakness of a company in the current financial environment. A widely used ratio that measures financial leverage is the debt to equity ratio. The debt to equity ratio is a ratio used to measure how a company has financed its business through debt, shareholders’ equity, or a combination of both. More specifically, it is a measure of the degree to which a company is financing its operations through debt versus wholly owned funds and is calculated by dividing the debt of a company by the total equity held by the company's shareholders. As an example, if on Megacompany Inc.'s balance sheet the total liability is $775,943 and the total equity is $5,014,073: This means that for every $0.15 of debt, Megacompany Inc. has $1 in equity to cover their debt. This is very low, and Megacompany Inc. can take on more debt in its capital structure. Whether or not a debt ratio is good depends on the context within which it is being analyzed. From a pure risk perspective, lower ratios (0.4 or lower) are considered better debt ratios. For most companies the maximum acceptable debt to equity ratio is 1.5-2 and less. For large public companies, the debt to equity ratio may be much more than 2, but for most small and medium companies it is not acceptable.

When a company issues a bond, its total liability will increase, and this will change the debt to equity ratio. The increase in liability comes from the need to pay back the debt of the bond plus any interest. This liability is reported on the balance sheet as bonds payable. For bonds issued at par value there will be an increase in the value of financial assets. Financial assets are tangible assets, such as cash, stocks, and bonds that would essentially be equal to the increase in total liabilities, but the shareholders' liability would not change as a result. An increase in total liabilities over the unchanged shareholders' equity would increase the debt to equity ratio. The debt to equity ratio is a measure of financial leverage and is associated with risk. A high debt to equity ratio is often associated with a high risk to debtors because it shows that the company has been aggressive in financing its capital. For example, if Megacompany Inc. has a debt to equity ratio of 2 and a capital structure with no retained earnings, it means that for every dollar earned by the company, debt holders and the shareholders' equity will increase or the company will have the ability to leverage their debt to protect against economic downturn or to finance growth opportunities thus giving the company greater financial leverage to drive sustainability and growth assuming that the company is able to sustain and meet their debt obligations. Like all of the financial ratios, interpretations about the debt to equity ratio cannot stand alone. A proper analysis of the debt to equity ratio would be dependent on the capital structure and the use of the leveraged funds.