Bonds

Bonds, Equity, and Other Debt

Effects of Bond Offerings on a Company's Equity and Liabilities

Bonds are used to raise capital for a company, and they have a long-term impact on the business.
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.
10,000×$1,000=$10Million10{,}000\times\$1{,}000=\$10\;{\text{Million}}

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.

Comparing Stocks to Bonds

Stocks, unlike bonds, are not loans, and they offer a share of ownership in the company.

There are various investment categories. Equity and debt market securities are issued by an organization to generate capital. Stocks and bonds fall under this category and are the most commonly traded investment types. Other investment types include money market securities, which are created based on forms of currency or payment exchanges; derivatives, which are contracts on underlying assets; and indirect investments, which are investments in specially grouped forms of other investments.

Issuing stocks is a tool companies can use to raise capital. Unlike bonds, stocks are not loans. Stocks offer a share of ownership in the company. From the company's point of view, stocks are attractive because there is no agreement to pay back the purchase amount. For the investor, share price or stock price increases create wealth for investors due to an increase in value in the stock as the company continues to grow and succeed. It is not required, but some stock also pays dividends, which are a share of the company's profits. Because stocks come with ownership, the amount of stock issued is an important factor in the issuance decision.

Issuing more stock shares results in the dilution of ownership power, meaning that as more shares are sold to and purchased by the public from the company issuing those shares, that company will lose ownership due to individual investors owning more shares than the company owns. For example, if Megacompany Inc. has 10,000 shares of stock outstanding, each stock represents 1/10,000 ownership. If the company issues another 10,000 shares, now each share only gives 1/20,000 ownership, cutting ownership rights in half. This lowers the financial indicator of earnings per share (EPS), which compares the company's earnings with the number of shares issued. Because bonds do not offer ownership rights, the company can issue as many bonds as it wishes and as often as it wants, assuming that it has the resources to pay back all principal and interest (or coupons) to borrowers who purchased the bonds. EPS is an indicator of a company's financial health, and a high EPS is better than a low one. Unlike stocks, bonds do not affect the EPS.

Types of Investment Instruments

Both government and corporate bonds and corporate stocks are capital market securities because they are ways to raise capital.
When reviewing debt, or bonds, there are some bonds that are issued without ownership. This type of bond is called a bearer bond. A bearer bond is a bond or debt security issued by a business entity such as a corporation, or a government. As a bearer instrument, it differs from the more common types of investment securities in that it is unregistered. This means that there are no records kept of the owner, or the transactions involving ownership.

Investors buy bonds because they provide a predictable income stream as they typically pay interest twice a year. If the bonds are held to maturity, bondholders get back the entire principal meaning that bonds are a way to preserve capital while investing. However, bonds are also subject to various other risks such as call and prepayment risk, credit risk, reinvestment risk, liquidity risk, event risk, exchange rate risk, volatility risk, inflation risk, sovereign risk, and yield curve risk.

To get the benefits of stocks and to reduce the probability of potential financial loss, a company may issue a convertible bond. A convertible bond is a debt security that can be changed into a number of shares of the bond issuer's stock. When a company takes out a loan, investors may assume that it is going to be used to improve the company, which could increase stock value. A convertible bond allows a bondholder the option of converting the bond's value into stock shares at a specific price in order to capitalize on any such increase.

Debt to Equity Ratio

The debt to equity ratio is a measure of a company's financial health.
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.
Debt to Equity Ratio=Total LiabilitiesShareholders’ Equity{\text{Debt to Equity Ratio}}=\frac{\text{Total Liabilities}}{\text{Shareholders' Equity}}
As an example, if on Megacompany Inc.'s balance sheet the total liability is $775,943 and the total equity is $5,014,073:
Debt to Equity Ratio=$775,943$5,014,073=0.15{\text{Debt to Equity Ratio}=\frac{\$775{,}943}{\$5{,}014{,}073}=0.15}
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.