What Is Long-Term Debt?
Long-term debt is debt that matures in more than one year. Long-term debt can be viewed from two perspectives: financial statement reporting by issuer and financial investing. In financial statement reporting, companies must record long-term debt issuance and all of their associated payment obligations on their financial statements. On the flip side, investing in long-term debt includes putting money into debt investments with maturities of more than one year.
Understanding Long-Term Debt
Long-term debt is debt that matures in more than one year. Entities choose to issue long-term debt with various considerations, primarily focusing on the timeframe for repayment and interest to be paid. Investors invest in long-term debt for the benefits of interest payments and consider the time to maturity as liquidity risk. Overall, the lifetime obligations and valuations of long-term debt will be heavily dependent on market rate changes and whether or not a long-term debt issuance has fixed or floating rate interest terms.
Why Companies Use Long-Term Debt Instruments
A company takes on debt to obtain immediate capital. For example, startup ventures require substantial funds to get off the ground and pay for basic expenses such as research, insurance, licenses, equipment, supplies, and advertising. Mature businesses also use debt to fund their regular operations as well as new capital-intensive projects. Overall, all businesses need to have capital on hand and debt is one source for obtaining immediate funds to finance business operations.
Long-term debt issuance has a few advantages over short-term debt. Interest from all types of debt obligations, short and long, are considered a business expense that can be deducted before paying taxes. Longer-term debt usually requires a slightly higher interest rate than shorter-term debt. However, a company has a longer amount of time to repay the principal with interest.
Financial Accounting for Long-Term Debt
A company has a variety of debt instruments it can utilize to raise capital. Credit lines, bank loans, and bonds with obligations and maturities greater than one year are some of the most common forms of long-term debt instruments used by a company. All debt instruments provide a company with some capital that serves as a current asset. The repayment of debt is considered a liability on the balance sheet.
Companies use amortization schedules and other expense tracking mechanisms to account for each of the debt instrument obligations they must repay over time with interest. If a company issues debt with a maturity of one year or less, this debt is considered short-term debt and a short-term liability which is fully accounted for in the short-term liabilities section of the balance sheet.
When a company issues debt with a maturity of more than one year, the accounting becomes more complex. At issuance, a company debits assets and credits long-term debt. As a company pays back its long-term debt, some of its obligations will be due within one year and some will be due in more than a year. Close tracking of these debt payments is required to ensure that short-term debt liabilities and long-term debt liabilities on a single long-term debt instrument are separated and accounted for properly. To account for these debts, companies simply notate the payment obligations within one year for a long-term debt instrument as short term liabilities and the remaining payments as long-term liabilities.
In general, on the balance sheet, any cash inflows related to a long-term debt instrument will be reported as a debit to cash assets and a credit to the debt instrument. When a company receives the full principal for a long-term debt instrument, it is reported as a debit to cash and a credit to a long-term debt instrument. As a company pays back the debt, its short-term obligations will be rotated each year with a debit to liabilities and a credit to assets. After a company has repaid all of its long-term debt instrument obligations, the balance sheet will reflect a cancelling of the principal, and liability expenses for the total amount of interest required.
Business Debt Efficiency
Interest payments on debt capital carry over to the income statement in the interest and tax section. Interest is a third expense component that affects a company’s bottom line net income. It is reported on the income statement after accounting for direct costs and indirect costs. Debt expenses differ from depreciation expenses which are usually scheduled with consideration for the matching principle. The third section of the income statement including interest and tax deductions can be an important view for analyzing the debt capital efficiency of a business. Interest on debt is a business expense that lowers a company’s net, taxable income but it also reduces the income achieved on the bottom line and can reduce a company’s ability to pay its liabilities overall. Debt capital expense efficiency on the income statement is often analyzed by comparing gross profit margin, operating profit margin, and net profit margin.
In addition to income statement expense analysis, debt expense efficiency is also analyzed by observing several solvency ratios. These ratios can include the debt ratio, debt to assets, equity debt, and more. Companies typically strive to maintain average solvency ratio levels equal to or below industry standards. High solvency ratios can mean a company is funding too much of its business with debt and therefore is at risk of cash flow or insolvency problems.
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