Long Term Debt or LTD is a loan that is held beyond 12 months or more. In the Balance Sheet, companies classify long term debt as a non-current liability. Such type of loans can have a maturity date of anywhere between 12 months to 30+ years.
Usually, the capital intensive industries who want to maintain a balance between their equity and debt go for a long term debt for raising money. Assessing the long term debt helps in understanding the financial health of a company.
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Different Types of Long Term Debt
These instruments are publically tradable securities and carry a maturity of over twelve months. Bonds come with fixed maturity time such as a 10-year bond, 20-year bond, 30-year bond and more. There are so many categories of bonds such as puttable, callable, convertible, non-convertible, high yield bonds and investment grade bonds.
Any loan that comes from a bank or any other financial institutions comes under bank debt. Unlike bonds, these loans are not tradable or transferable.
To draw such loans, the company needs to put something as collateral such as real estate, buildings or land.
It is a type of debt that is not backed by any specific assets. Therefore, it comes below other types of debt in terms of priority of repayment.
As we said before LTD comes in the balance sheet and is a non-current liability. A company can club all its long term debts into a one line-item, and then list different types of debt under it. Or, the company can list each LTD as separate items. Both the treatments are correct, and a company may go for either of the two depending on its accounting policies.
Interest that a company pays on loan is an expense, and thus, comes in the profit and loss account.
In the books of the companies, there is an item called “current portion of long-term debt.” While raising the money through debt, a company has to pay some portion of the debt every year until the principal amount is paid in full.
The entire debt might be long term in nature, but the portion that the company pays in the current year does not fall under the long-term debt. This amount comes under the current liabilities as “current portion of the long-term debt.”
Benefits of Long Term Debt
- Every company needs funds to run its day-to-day business, buy fixed assets and for other business activities. Long term debts give the organization immediate access to funds without worrying for paying it in the short term. The borrower only has to make the payment of the current portion.
- In case, a company wants only a portion of total debt currently, they have the option to structure the debt that way. This way the company receives the debt as and when they need.
- Interest that the borrower pays on the debt is taken as expense in the income statement. Therefore, it helps to bring down the taxable income. Such an arrangement helps the company to pay less tax.
- Reducing taxable income is never a primary aim of the company while taking the long term debt. A company can also do so by increasing any other expense. The real reason behind companies preferring such debt is to take advantage of financial leveraging.
Financial Leverage and LTD
Financial Leverage helps a company in increasing its earnings because such LTD carries a fixed cost. Also, the interest payment is usually lower than the earnings that a company expects from the asset. Thus, companies prefer to have some portion of their total capital in the form of debt.
Use of financial leverage to buy assets or fund growth amplifies the earnings potential of a company. For instance, if a company buys an asset using LTD, and it generates more return than the interest on the LTD. In such a case, the value of asset and company would increase.
Let’s understand this with the help of an example. Suppose Company A buys land for $50000 using its own capital. Company B buys the same land using $30000 (@10%) LTD and $20000 own cash.
After one year, Company A sells the land at $60000, i.e., at a profit of $10000 or 20% on an investment of $50000.
Company B also sells it for $60000. Its total profit will be $7000 ($10000 – $3000 interest). Return on investment, in this case, is 35% ($7000/$20000 own cash).
This proves that the use of financial leverage boosts the earnings.
Disadvantages of LTD
- Too much of anything is bad and the same goes for the LTD. A company should not be overly dependent on the debts because one has to pay it eventually. Not just the principal amount, but the company has to pay the periodic interest as well.
- Equity is a safer option for the reason that it is not mandatory for a company to pay dividends. However, if a company is issuing debt then interest payment is mandatory.
LTD – What it means for Investors?
While investing in a company, an investor should always keep a check on the debt to equity ratio of the company. Further, investors should keep track of the changing debt structure of a company.
Every time, a company issues new debt, investors should know the exact purpose. For instance, investors should examine if the new debt is for paying another, buy new assets, buy back shares or just to find the operating expenses. Taking a loan for funding growth or buy back shares is in the interest of the investors.
On the other hand, going for a loan just to fund operating expenses or pay another loan should ring warning bells for the investors. It could mean that the company is having issues with the cash flows.
Moreover, investors must be aware of the industry standards when it comes to capital structure. For instance, manufacturing companies raise more capital in the form of debt to buy plant and equipment. Similarly, asset-heavy industries, such as steel and the telecommunication have relatively more debt on their balance sheet.
A company must always aim for the optimal debt structure. An organization should know their capacity, the growth target of the business every year and consider other aspects before bulking up the debt. Also, the company should be extra careful and ensure that the principal and interest amount do not impact the cash flow considerably.Last updated on : May 15th, 2019