Concept

Bond Markets: The relationship between assets, equity and debt

We begin here by elaborating on the accounting equation: assets equal equity plus debt. One view of this equation is that all of the entity’s assets, or the entity itself (since it may be viewed as consisting of these assets) need to be purchased in one of two ways. Purchases can be conducted with either money contributed by the owners, or money that the owners have borrowed.

The owners’ contributions — the equity — does not just consist of the initial investment of capital the owners began with, but also includes profits that have been reinvested in the entity. This reinvestment of capital includes any money the entity produces or that belongs to the owners (if the obligations associated with the borrowings are accounted for) since it represents additional equity that they are effectively contributing.

Another view is that the equity of the business — the part that belongs to the owners — is simply the assets of the business minus any liabilities. These assets include, amongst other things, all the accumulated profits in the business’s bank account. Typically, the most significant liability is the long-term debt of the business. According to this view, we have taken the debt to the other side of the equation: we have assets minus debt equals equity. Since the entity’s assets are ultimately funded by a combination of debt and equity, the debt holders and the equity holders are often described as the primary stakeholders of the entity.

The debt holders are the lenders to the business, which could be a bank that has extended a loan or a collection of bond investors. The equity holders are the owners of the business, whether the sole founder of a small business or the millions of shareholders of a large corporation.

These primary stakeholders have a vested interest in the business (due to either a loan or an equity contribution), which they put forward in the hope of future rewards. These rewards may be either the repayment of the loan with compensating interest, or increased value derived from their equity, which follows from an increased share price or dividends received from the shares.

From the perspective of the entity itself, the equity holders and debt holders both represent liabilities or obligations: the entity must meet its debt obligations, and, because it is owned by its equity holders, it owes its eventual profits (or losses) to its owners. It is important to note that there is a crucial difference between these two obligations: the amount due to lenders is fixed, while the amount due to equity holders is flexible and depends on how much profit is made.

This flexibility makes the equity a less risky obligation from the perspective of the entity. This is because the equity holders are entitled to precisely what is available for them, even if that amount is negative. Therefore, if the entity makes a loss, this loss is just transferred over the equity holders. The fixed nature of the debt obligation makes it risky — the debt holders are entitled to a certain amount, whether or not the entity has this money available. If the entity does not have the required money, they will default on their debt obligations, with dire consequences. This can potentially include the declaration of bankruptcy and the entity being wound up (the operations being terminated, and the individual assets sold so that the lenders recover some of their stake).

To illustrate this, suppose it takes 100 dollars to start a business. In scenario A, an individual contributes this 100, and becomes the sole stakeholder in the new business. In scenario B, the individual borrows 50 and contributes the remaining 50 needed. A year later, suppose the business in both scenarios has been equally profitable and is now worth 130 (net profits of 30 have been earned and thus added to the initial value).

In scenario A, this new, increased value belongs to the owners, who has made a good return on his investment (of 30%, the increase to the initial contribution). In scenario B, the new value of 130 does not only belong to the owner — the lender is entitled to the loan of 50, and an interest payment of 5. So, the owner’s contribution grows from 50 to 75, since 75 = 130-55 (which is a 50% increase/return). If the business makes no profit, there is no return in scenario A, but in scenario B, the owner in fact makes a loss — the owner’s stake has shrunk from 50 to 45, since 5=100-55, noting that the lender is still entitled to their repayment with interest. The following table shows these outcomes as well as others, which you should verify by calculating the returns and comparing the two scenarios.



Note how the introduction of debt in scenario B increases the range of possible returns. One way to think about this is that, in the presence of debt, the equity holders don’t have to share profits with the lenders — the profits, generated in part with the borrowed money, belong only to the equity holders. Conversely, they cannot share any losses with the lenders — all of the losses are theirs to bear. In general, debt increases the variation possible in returns on equity. A high debt-to-equity ratio is risky in this sense.

Note that the ratio between debt and equity is referred to as the capital structure of an entity. Also note that the distinction between debt and equity is not necessarily so clear in practice. Preference shares, for example, are a type of equity with certain debt-like characteristics.