Book Value vs. Market Value
Since financial statements are historical records, they represent what a company was at a point in the past. However, the value of a company’s assets and liabilities are constantly changing in reaction to market changes, currency values, and management’s decisions. Whereas asset discrepancies between book and market value can fluctuate dramatically, liability differences are usually smaller and less of a concern for the investor.
The most important factor in valuing a liability is the time until the liability ends. This maturity date is the aspect of liabilities most responsible for differences in book and market value. The maturity of a liability refers to the time when the entire liability must be paid including the principal and any interest due. Unlike assets, a liability represents a contract between a borrower and a lender with strict rules for how the liability will be repaid and even contains instructions and penalties for failure to meet scheduled payments. When a company does not have enough liquid assets to cover short-term or current debt, the company will likely face bankruptcy.
When a liability comes due, it reaches its maturity date and its book value and market value are equal. This is due to the Time Value of Money principle which states that money in the future must be discounted to arrive at a present value. The discount rate, or interest rate, is a measure of the risk associated with a creditor loaning the money. Liabilities with long maturity dates are valued with current economic conditions, current market conditions, and expected future profitability of the corporation.
Suppose a corporation borrows $1,000,000 with a maturity date of 10 months. The interest due on the loan is relatively insignificant when compared to the amount of the loan. For example, at 10% interest, the total interest paid on the loan will be only $86,528.80, only 8.65% of the total loan. Suppose now that the company borrows $1,000,000 at 8% interest with a maturity date of 10 years. If the market value of that loan is 10%, the market value of the loan is less than the book value and the company can enjoy the lower 8% rate for the remainder of the loan.
When valuing the liabilities of a corporation, investors must have a firm understanding of current market rates in comparison to the rates at which the firm borrowed money. When the book value of a liability is more than the market value, corporations will seek to refinance the liabilities to reduce the interest paid on the loan. Otherwise, they will keep the interest rates on the loan and enjoy the lower-than-market rates until the liabilities mature.
This post is part of the series: Market Value versus Book Value of Liabilities
- How Time Until Maturity Affects Book and Market Values
- How Financial Distress Affects the Book Value and Market Value of Liabilities