Debt Conversion to Equity

A debt conversion to equity, or swap agreement, helps to renegotiate debt terms.

A debt conversion to equity is also referred to as a debt-equity swap, or hybrid, transaction. A debt-equity swap allows a borrower to convert loan amounts into shares of equity. In other words, a lender, such as a bank or an insurance company, becomes a shareholder after a debt to equity conversion process.

Debt Defined

Debt represents amounts that a corporation owes, and that it must reimburse. Debt is also known as liability. Debt may be short-term or long-term. A short-term liability represents a loan or any other financial commitment that must be reimbursed or paid within 12 months. Examples of short-term debt are accounts payable and salaries due. A long-term liability indicates amounts that a firm must reimburse in more than a year, and it could be bonds payable.

Equity Defined

Equity represents investments that shareholders, or corporate owners, make in a firm. A shareholder typically holds voting rights, and he may participate at the annual shareholders' meeting. He also receives periodic dividend payments, and makes profits when stock prices rise on financial markets. In the standard accounting equation, equity also equals total assets minus total liabilities. In other words, a corporation's net worth, or equity, represents what the firm owns minus what it owes.

Debt-Equity Swap

A debt-equity swap, or a debt conversion to equity, is a transaction in which a lender agrees to convert a loan into shares of equity. There is no cash exchange in a debt-equity swap transaction. To illustrate, a retail store is unable to reimburse a $10 million loan because of temporary financial difficulties. The store's lender wants to swap the debt with equity shares. The store's manager agrees to give 25 percent of ownership stake—currently valued at $12.5 million—in the store's equity.

Accounting and Financial Reporting

The retail store's accounting manager must make journal entries in corporate ledgers on the transaction date. He debits long-term loan payable for $10 million (to bring the account back to zero), and he credits the common equity account for $12.5 million (to record the new equity issuance). The accountant also debits the interest expense account for $2.5 million to record the additional loss incurred in the debt-equity conversion process.

Significance

A debt to equity conversion mechanism often may be significant to a company because it helps top leadership reduce corporate debt levels. Reduced levels of liability may be appealing to a firm's business partners, such as customers, suppliers, lenders and investors, because they improve the company's economic picture. A firm with higher leverage (debt levels) may be unable to raise cash on securities exchanges or engage in private loan transactions with institutional investors such as hedge funds, banks and insurance companies.

References

• Investopedia: What Is Debt/Equity Swap?
• Globe Law and Business: Debt-for-Equity Swaps