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AFAIK, borrowing money does not change Equity, because it increases Assets (more money in the bank) and Liabilities (more debt) by the same amount so Equity stays the same.


Sorry, yes, I should have been more clear!

1. Profit/loss measures changes in equity resulting from operating activity, as opposed to financing activities (which just rearrange how the company is financed).

2. Examples of financing activities are taking out (or paying back) loans, issuing (or buying back) shares, and issuing dividends.

3. Some (not all, as you point out!) of those financing activities will increase or decrease equity. So, when thinking about profit as the rate of change of book value, you should be careful add back any changes that are the result of financing activities. (specifically: ignore changes in equity due to money going to, or coming from, shareholders)


Where are you borrowing this money without any interest? "Money you borrow" and "cost to borrow that money" are rarely the same value.


Normal interest that will be charged if the debt is not paid off is initially neither an asset or liability, it is an expense as it is charged.


If you take a $1MM loan from a bank:

- Your bank account (an asset) goes up by $1MM

- Your loan account (a liability) goes up by $1MM

So equity is unchanged at that point.

But every month after that, you'll be charged interest:

- Loan account (liability) increases (CR)

- P+L account (equity) decreases (DR)


Presumably you'd have to pay back more than you get in the loan, right? Wouldn't your liability increase by more than a million dollars?


Not until the interest accrues. You could (no idea why you would) borrow $1MM and immediately pay it back before owing any interest. You would need to reflect this on your books but nothing material has changed.


> You could (no idea why you would) borrow $1MM and immediately pay it back before owing any interest.

Can you in fact do that? It's possible with a residential mortgage in the US, because there are laws prohibiting prepayment penalties. And I think even those don't apply to refinanced mortgages?


Yes, just because it’s hard to find a lender that will except those terms doesn’t mean it’s not possible.


Interest is not reflected in the balance sheet, but in the income and cashflow statements.


This is true in a perfect market, based on Modigliani-Miller theory of capital structure.

In reality, increasing debt to a certain point also increases risk, which in turn increases return on equity.


A change in return on equity isn't the same as a change in equity.

When a company takes a loan, even if that loan is so large as to make insolvency almost inevitable, there is no impact on equity (book value).


* should increase return on equity. :-)




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