This article will explain long-term debt. The overview provides an introduction to the most common types of long-term debt and long-term debt lenders. This article will also describe how investors and creditors can determine a company's long-term debt by using mathematical formulas and by examining a company's balance sheet. In addition, the reasons why creditors and investors pay close attention to a company's long-term debt obligations are explained, as are the reasons why companies choose to use long-term debt to pay for their business growth objectives. Also, explanations of corporate financial analyses in which long-term debt is an important issue, such as identifying profitable borrowing, reading balance sheets and comparing the financial positions of various companies based on their assets and debt obligations are included to help illustrate how long-term debt factors into common corporate finance considerations.
Keywords Bonds; Debentures; Debt; Equity; Loan; Inflation; Interest Rate; Investment; Term
Finance: Long-Term Debt
There are many ways that companies finance, or pay for, their costs of doing business. Successful businesses earn profits that are re-invested back into the company to pay for research and development or other expansion efforts to further grow the business. However, there are many instances in which a company's earnings are not sufficient to cover its costs and growth objectives. For instance, young companies or companies that are struggling to stay afloat financially may not generate enough profit to cover all of their internal costs as well as the costs of growing and expanding. Even strong, stable companies may need to make significant purchases — such as equipment, building space or even the acquisition of another company — to continue to grow and remain competitive, and these costs may exceed the amount of liquid assets a company has on hand. And even after years of successful growth, a company may face lean years where the market plateaus, consumers' interests change or a competitive product or service begins to siphon off its customers or clients.
In situations such as these, companies must look beyond their earnings to consider options that will create an inflow of capital to help it grow or survive during times of economic hardship. A common form of financing that companies use to generate the resources it needs for significant projects is long-term debt. Long-term debt consists of money that a company will use for a longer period of time, generally one year or more, and that the company will repay over time. Long-term debt may consist of loans that a company borrows or it may consist of debt securities that a company issues. These two forms of debt are known as debt financing or equity financing. Debt financing consists of short-term debt and long-term debt. These two forms of debt serve two very different functions. Short-term debt is debt that a company will pay off within 12 months and is usually acquired to pay for temporary increased expenses, such as purchasing additional inventory for sale during the holiday season. On the other hand, long-term debt consists of loans and financial obligations that will last for over one year. For example, long-term debt may consist of the mortgage a company holds on its corporate buildings and property or various business loans that it has assumed. In addition, a company's debt obligations, such as bonds and notes that will not mature before one year, are other forms of long-term debt. Securities such as T-bills and commercial paper are generally not considered long-term debt because their maturity dates are typically shorter than one year.
If a company decides not to use debt financing to pay for its business objectives, it may decide to pursue equity financing. Equity financing occurs when a company offers shares of the company for sale. The benefit of this form of financing is that the most common types of shares, such as common stocks and preferred stocks, do not require dividend distributions to shareholders. Thus, the company experiences an influx of capital when shareholders purchase stock in the company and the company is not required to pay an annual dividend. Shareholders profit from their investment only if the company makes enough money to authorize a dividend distribution or through the capital appreciation of the shares. On the other hand, shareholders are purchasing ownership in a company when they buy shares, and thus a company that makes a public offering of its shares exchanges its autonomy for equity in that shareholders may receive the right to vote on important corporate matters and thus will have a say in how the company is run.
There are many advantages of long-term debt that companies can exploit if they select the best form of financing for their needs while keeping their overall levels of debt manageable. For instance, long-term debt can provide much needed working capital that can be used to pay for ventures that will create profit and increase its earnings. In addition, if debt can be borrowed at a lower interest rate than the earnings a company will generate from plants, equipment or other resources purchased with the borrowed funds, borrowing can actually be profitable for a company. Thus, while debt is frequently discussed with negative connotations, some types of long-term debt can actually be good for companies. The following sections provide a more in-depth explanation of the basic financial concepts involving long-term debt.
Basic Financial Concepts
Long-Term Debt Defined
"Term" refers to the time period for which money is borrowed and the period over which the loan will be repaid. Thus, long-term debt consists of money that a company will borrow to use for a long period of time, generally longer than one year, and that the company will repay over time, also longer than 12 months. Long-term debt primarily consists of longer term loans that are taken to pay for assets that companies will use for a period of many years, such as land, buildings, machinery, equipment or technology. Thus, long-term debt arises when the planned repayment of the loan and the predicted valuable life of the assets purchased exceed one year. Most long-term loans have a repayment period of five to seven years, although they may even be extended to 30 years.
There are a number of reasons why companies decide to incur long-term debt. Some companies may prefer to borrow money to purchase a significant acquisition that will generate additional profits while the company repays the loan in lower monthly installments over a period of time. The other form of debt financing that a company may consider is to issue fixed-income debt securities, such as bonds, notes or commercial paper. Debt securities issued by the company are purchased by investors, and their maturity dates-or the date in which the company must repay the principal of the security-may be longer than the length of a typical term loan. Thus, issuing debt securities allows a company to raise more money and borrow the money for longer periods of time than loans typically allow. However, in addition to honoring the debt securities and any interest they accrue, companies must also pay the underwriting fees involved in issuing securities. Long-term loans, on the other hand, generally consist of funds that are borrowed from a private entity such as a commercial bank. The loans a company borrows from a bank may be used to just about any purpose, but they generally have shorter terms than debt securities and thus require repayment sooner than the maturity dates of their outstanding debt securities. However, while companies must pay interest on the loans, there are no underwriting fees associated with long-term loans. Thus, companies must weigh all of their financing options to choose the form of financing that best suits their growth objectives and financial position.
Types of Long-Term Debt
There are many different types of long-term debt that businesses may incur in order to finance their growth and operations. The most common types of long-term debt are term loans, bonds and debentures. Bonds are generally classified as either secured or unsecured forms of debt securities. Secured bonds are backed by a company's assets. For instance, mortgage bonds are a form of secured bonds that are back by real estate. Unsecured bonds, called debentures, are not backed by a specific asset but are issued based on the full faith and credit of the issuing company. In addition, the various types of long-term debt may be assigned a priority status, which refers to the rank of the lender in terms of gaining access to a company's assets in the event of insolvency. For instance, a company may have some forms of long-term debt that are considered senior, which means they have a higher priority than lower-ranked subordinated debt.
Although companies do use bonds and debentures as a long-term debt financing option, term loans are the form of long-term debt most frequently used by businesses to finance their expansion efforts. A term loan is a loan from a bank to a company that has an established maturity date—usually five to seven years after the start of the loan—in which the company will repay the loan in monthly installments accounting for both principal and interest. When the principal of a loan is repaid in equal payments over the life of the loan, this process is called loan amortization. When monthly payments of principal and interest are made, the companies are considered to be "servicing" their debt. Most companies choose to repay a loan in equal installments over a period of time so that the principal plus the interest is repaid in full upon the final payment. However, sometimes a company will borrow a loan that is structured so that an amount of principal is still due at the end of the loan period. That ending balance is called a balloon payment. This type of long-term loan is used to allow a company to make lower monthly payments over the life of the loan.
Bonds have many characteristics similar to those of a term loan, but they are debt obligations, or IOUs, that are issued by private and public companies and purchased by investors rather than funds that companies borrow from and repay to lenders such as commercial banks. Bonds are usually sold in units of $1,000 and firms use the money they raise from selling bonds for a multitude of purposes, such as building new facilities or purchasing new equipment. When a company issues bonds, it promises to repay the bondholder all of principal, or the amount of the debt obligation purchased by the investor, in the future on a specified maturity date. A bond may have maturity date that is set a few years in the future, or even further, such as 10 years down the road. Until the bond matures, the issuing company pays the bondholder a stated rate of interest, called a coupon, at specified intervals, which are typically every six months. Unlike other types of securities that companies can issue, such as stocks, bonds do not give holders an ownership interest in the issuing corporation.
Debentures are a bond whereby a company uses its full faith and credit as collateral rather than a specific, tangible asset. Creditors who purchase debentures must rely on the credit rating and creditworthiness of the issuing company in determining the risk of this form of long-term debt. Because the risks involved with purchasing debentures is higher than other forms of debt securities, debentures often pay higher rates of return. Owners of debentures are called unsecured creditors of a company.
Convertible bonds are a type of debenture that provide the bondholder with the right to convert the bonds into shares of common stock at a later specified date. These bonds are an attractive financing option for companies because they allow the company to issue debt securities at a more affordable interest rate than other types debentures because they are less risky. They are also attractive to investors because convertible bonds allow bondholders to receive interest payments during the life of the bond while retaining the ability to convert the bonds to shares of common stock if the price of shares of the company's common stock increase above a threshold level, called a strike price. Thus, convertible bonds are a form of debt security that are appealing to both companies and investors.
Junk bonds are another form of debenture that companies issue if they do not have a strong enough credit rating to issue investment grade bonds. Bonds are classified as either investment grade or junk bonds. Investment grade bonds are issued by companies with higher credit ratings and thus are considered low or medium-risk investments. Since the risk of these bonds is lower, so are their returns. Because companies with lower credit ratings are considered a riskier investment, the junk bonds these companies issue pay higher returns. Thus, some investors are willing to purchase junk bonds from companies that the investors believe are relatively stable in order to take advantage of the higher returns that these debt securities offer.
Common Long-Term Debt Lenders
The most common financial institutions that make long-term loans are commercial banks, credit unions or other financial companies. Within these financial institutions are lenders that specialize in certain types of long-term debt, including mortgage lenders, term loan lenders and equipment leasing lenders. Lenders are willing to let companies borrow long-term debt because the companies eventually pay the lenders back all of the money they borrowed plus interest. Thus, long-term debt is considered an asset to the lender and a liability to the borrowing company. Since there is some risk that the company will not be able to repay the loan or will even go bankrupt, lenders do face the possibility that they will not make money on every loan. However, lenders factor these costs, along with the creditworthiness of a company, into the interest rate that is set for the long-term loan. These lenders of long-term debt are described in more detail in the following sections.
Mortgage lenders are generally large companies that can afford to lend funds to companies for the purchase of land and commercial properties. Mortgage lenders include banks, credit unions, financial companies and other institutional lenders. Mortgage lenders take proactive steps to try minimizing the risk of a company defaulting on a loan or the property losing value. Thus, mortgage lenders investigate the financial soundness, or creditworthiness, of the borrowing company before making a loan. To make this assessment, lenders examine company documents such as current financial statements, balance sheets and financial projections that show how the building will allow the company to expand its operations to generate profits. In addition, the lender will require that the company requesting a loan provide a significant amount of paperwork to demonstrate the value of the building the company wishes to purchase, such as its location, condition and proposed use.
Long-Term Loan Lenders
Commercial banks and credit unions are the most common lenders of long-term loans. Like mortgage lenders, the financial institutions that make long-term loans also investigate the creditworthiness of any company that seeks to borrow a long-term loan. To make this determination, lenders of long-term loans evaluate the company's business plan, products and services, management team and financial statements. In addition, these creditors consider the collateral that a company has available to support the loan and the purpose for which the loan is intended. Most creditors also require that companies provide financial projections that give a detailed history of their production methods and operations and their position in the marketplace.
Equipment financiers, which include commercial banks, credit unions and equipment vendors themselves, lend companies money to purchase equipment that will enhance the company's production abilities to generate increased corporate earnings. Equipment financiers require evidence of a company's financial stability and growth projections that is similar to the documentation required by long-term creditors. One difference is that companies must generally submit business plans that include two sets of financial projections-one projection based on the company's use of its current equipment and a second set based on the company's use of the newly purchased equipment. In addition to these financial projections, equipment financiers often require that...
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