A balance sheet is a financial document that corporations share with investors to help them value the company. The balance sheet lists the corporation's assets, liabilities and shareholders' equity. A bond is a type of "liability," and one type of bond is a convertible bond, which the bondholder can convert to stock at any time. However, a stock is considered "shareholders' equity," so this bond conversion can affect the balance sheet.
Why Convertible Bonds?
Corporations like to issue convertible bonds to raise money because they charge less interest than normal bonds. Investors like to buy convertible bonds because they have the option of taking advantage of a rising stock price if that were to occur.
On the most basic level, when a bond is converted to a stock the liabilities on the balance decrease and the shareholders' equity increases. However, there are a host of ratios important to investors that will change as well, for example, Earnings Per Share (EPS). EPS is the ratio most frequently used by investors to compare stocks within the same industry. By issuing more stock through the conversion of bonds, EPS decreases, making the corporation less attractive to investors.
Valuing a Company That Has Issued Convertible Bonds
The problem arises when an investor tries to value a company that has issued convertible bonds that have not yet been converted. Investors should be aware that this debt may in the future be converted to equity. For this reason, accountants tell investors not only about the number of shares outstanding, but also the "diluted shares outstanding" to represent the amount of outstanding stock that may occur if all the outstanding convertible bonds are converted to stock. Diluted shares also represent the number of shares outstanding if all stock options are exercised.
Debt vs. Equity
Issuing bonds and issuing stock are two important ways companies raise money. Companies must choose between the two in such a way that they don't penalize their existing shareholders by needlessly diluting their stock, or induce bankruptcy by missing payments on bonds. Convertible bonds exist as a sort of compromise between these options.
Ratios such as "Debt to Equity" or "Return on Equity" are also affected by these decisions, and sometimes important financial decisions are made to improve ratios that are in vogue with institutional investors at the time, or to make the ratios compare favorably to those of competitors.