Before we move on to explain how to calculate total debt from the balance sheet, it would be important to patiently understand the various definitions of debt. If you are clear on these terms, you can move on to the next section of this post.
Various Definitions of Debt
Table of Contents
- 1 Various Definitions of Debt
- 2 How to Calculate Total Debt?
- 3 Why Calculating Debt is Important?
When we say ‘debt’, the literary meaning is ‘owing to someone’. But, in accounting and finance, this definition will be too vague. The literary meaning of the term would include accounts payable also a part of the debt. In normal parlance, we associate debt with paying ‘interest’. Considering this fact, in accounting, a short term loan would be a part of the debt (short term) but accounts payable will be a part of current liabilities.
The terms relating to debt that we will understand here are as follows:
- total debt,
- long term debt,
- current liabilities & short term debt,
Total Debt, in a balance sheet, is the sum of money borrowed and is due to be paid. Calculating debt from a simple balance sheet is a cakewalk. All you need to do is to add the values of long-term liabilities (loans) and current liabilities.
Long Term Debt
Long-term liabilities or debt are the liabilities whose due dates for repayment is spread over more than one financial year.
Current Liabilities & Short Term Debts
Current liabilities are the liabilities that are due within less than one financial year. The important thing to note here is that short term debt is a subset of current liabilities. In other words, short term debts are one of the many components of current liabilities.
How to Calculate Total Debt?
The simplest formula for calculating total debt can be quoted as follows:
Total Debt Formula
[alert-announce]Total Debt = Long Term Liabilities (or Long Term Debt) + Current Liabilities[/alert-announce]
We can complicate it further by splitting up each component i.e. long term liabilities and current liabilities into their sub-components. For example, a detailed total debt formula could be written as follows:
[alert-announce]Total Debt = [Debenture + Long Term Loans from Banks and Financial Institutions + Mortgaged Loans ……] + [Short Term Debts + Accounts Payable + Outstanding Expenses …… ][/alert-announce]
We can see that there are following components of the formula which needs appropriate definition.
How to Calculate Long Term Debt?
For calculating total debt, long term debt is an important component. So, for further calculating the long term debt or liabilities, we need to pick the following items from the liability side of the balance side
- long term loans from banks and financial institutions,
- mortgaged loans, etc.
They are comparatively easy to identify from the books of accounts. This list can be extend to too many number of items here. You should be understanding the definition/concept of long term liabilities and try to apply to all the items which are part of a trial balance or balance sheet. The one which falls under the definition will become part of this list.
[divider]Please note that in accounting, for reporting purposes, the part of long term liability which is due within the coming 1 year is separately presented in Current Liabilities. They are the current part of long term liabilities.[divider]
How to Calculate Current Liabilities (including Short Term Debts)?
We need to calculate current liability that is the other component for calculating the total debt. For calculating current liabilities, we need to include the following items from the balance sheet.
- short term debt
- accounts payable (creditors) balances,
- outstanding expenses,
- provision for taxation,
- proposed dividend,
- unclaimed dividend,
- employee’s accrued salaries and wages payable,
- taxes payable,
- unearned revenues,
- advances received from customers,
- interest payable, etc.
How to Calculate Short Term Debts?
Short term debt is also not a single item but a category in itself. So, for calculating short term debt, you need to include
By their nature, they are due within less than a year and normally associate with making interest payments.
This list can be too long and still may not be comprehensive. The best way is to understand the concept/definition of current liabilities and try to apply to all the items which are part of a trial balance or balance sheet.
Why Calculating Debt is Important?
Debt is a very sensitive area on a balance sheet. It is very rare to find a business without debt. If I wish to define debt differently, I can say debt is an arrangement whereby entrepreneurs carry on business without having money. Long term and short term debt are provided by financial institutions and banks whereas short-term interest-free financing is available through creditors/accounts payable of any business. Both these parties assess the credibility, capacity, and willingness to pay and also assess the genuine requirement of the business for loans or any type of credit.
There are various ratios involving total debt or its components such as current ratio, quick ratio, debt ratio, debt-equity ratio, capital gearing ratio, debt service coverage ratio (DSCR). Various entities use these ratios for different purposes. Understanding debt in its absolute terms is inappropriate. Debt has a different meaning for a different purpose.
For example, the debt service coverage ratio is worked out by the banks to assess the future cash flow and its ability to pay the installment. Here, the definition of debt is limited to the debt given by the institution. In the current ratio, only the current liabilities are utilized to assess the short-term liquidity position of a business.