What's Up

       In order for meaningful comparisons to made by a potential investor, lender, or borrower, all balance sheets follow a standard format: The entity's assets are ranked according to liquidity (how easily they can be converted to cash) and liabilities are ranked according to how soon they become due and owing. "Current" accounts are those which will (theoretically, at least) change within a year -- the assets liquidated and the liabilities paid. Whether you are applying for a loan or loaning money to someone else, the creditor in the given transaction is always concerned about the debtor's ability to satisfy the loan, and the keys to that answer lie in the debtor's balance sheet. For starters, would you loan money to someone who already carried a lot of debt? Probably not, especially if the person didn't own outright much of anything of value. In this example you would be rejecting the loan because of a too high debt-to-asset ratio, a measure of the debtor's solvency.

       By analyzing the significance of the numbers in relation to one another, the reality becomes clearer that the (stated) valuation of debt for accounting and balance-sheet purposes does not necessarily correlate to its market value when viewed from the standpoint of a creditor. Among other factors which can impact upon the market value of the obligation are: the term (length of time) to maturity, whether and how long before the debtor may refinance, changes in market interest rates, taxation factors, any guarantees toward payment or earmarked funds, etc.. All of those factors which relate to the "safety" of the obligation to pay and the creditworthiness of the issuer are much the same for a business as for an individual. We have so-called credit ratings, and corporate debt carries bond ratings that mean much the same thing: what is the relative risk a creditor assumes by loaning money to this particular debtor? The greater the risk to the creditor, the higher the interest rate required of the debtor. How do you think Junk Bonds got their name?

       Rates-of-return on investments of similar quality and maturity tend to seek equilibrium in the marketplace. Moreover, bond prices and interest rates are inversely related -- when one goes up, the other goes down. So, when you hear that bond prices are lower -- i.e., investors are paying less for this particular type of debt instrument -- that means market interest rates (effective yields) have climbed. Follow this example: A $1000 bond pays 10% interest ($100) annually, but market rates jump to 12% for a bond of the same quality and maturity. Would you still be willing pay $1000 (at par) for the 10% bond? No, you'd pay about $830 (at a discount) so that the $100 in annual interest provides a current yield of 12% ($100 ö $830 = .12). When market interest rates drop, older bonds may trade at a premium, i.e., a price greater than par (face- or stated- value).

       And what if you decide instead to become an equity investor in a business venture? What exactly is taking place in a transaction that results in you becoming a part owner of the enterprise? Essentially you are purchasing the right to share in the profits -- and perhaps even the losses, depending upon whether your participation is accorded limited liability. When a venture succeeds, sometimes some of the profits are dis- tributed out directly to the onwers, but often the majority of the profits are reinvested in the venture such that (1) the assets increase and (2) the difference between the assets and liabilities -- i.e., its net worth, or equity -- also grows. Essentially, your equity share in the venture has more value. When the entity is a corporation, its ownership is represented by certificates of stock; changes in the net worth of a corporation inure to value of its common stock.