What is long-term debt? – Example, Types, Benefit, and Disadvantages

Long Term Debt

A company acquires debt in order to obtain immediate capital. For instance, startup ventures need significant funds to pay for necessary expenses such as research, insurance, licenses, supplies, equipment, and advertising.

Developed businesses also need debt to fund their regular operations as well as new capital-intensive projects. In short, all businesses need to have capital on hand, and debt is one of the sources for obtaining quick funds to finance business operations.

Issuance of long-term debt has a few vantages over short-term debt. Interests from all types of debt obligations, short and long, are viewed as the expense of the business that can be deducted before payment of taxes.

Longer-term debt usually necessitates a bit higher interest rate than shorter-term debt. However, a company has enough time to repay the principal amount with interest.

Definition

In accounting and finance, long-term debt pertains to a company’s loans and other liabilities that will not become due within the period of one year of the statement of financial position date. (The amount that due within one year of the statement of financial position date is termed as current liability).

Accounting becomes more complex when a company issues debt with a maturity of more than one year. At the date of receiving the debt amount, a company debits its assets and credits its long-term debt and at the date of payment when a company pays back its long-term debt, it debits the liability with the amount of debt paid and credits its bank.

A company needs to keep close tracking of these debt payments to ensure that short-term debt liabilities and long-term debt liabilities on a single long-term debt instrument are separated out and properly accounted for.

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Example of Long-term Debt

How long-term debt is shown on the statement of financial position? Let’s understand this concept with the help of an example by assuming that a company has a mortgage loan with a principal balance of $300,000 with 130 monthly payments left over.

The loan payments due in the next 12 months include $22,000 of principal payments. The $300,000 of debt should be reported on the company’s statement of financial position as follows:

$278,000 as a non-current or long-term liability such as non-current part of the mortgage loan.

$22,000 as a current liability such as current part of the mortgage loan.

Types of Long-term Debt

The following are some types of long-term debt.

Term Loans

Usually, a term loan has a fixed term of five or more years for paying back the principal amount of the loan and interest payments on a monthly basis until the principal amount is fully paid back at the expiry of the loan term. This procedure of paying back the loan principal over the term of the loan is known as “loan amortization.”

Treasury and Government Bonds

Bonds are debt instruments with fixed interest payments and with fixed terms of repayment made during the life of the bond. The interest on the bond is paid regularly from time to time according to the terms as set upon the issuance of the bond. However, the capital amount is fully repaid at the expiry of the loan term. Bonds are traded in the financial markets and are used to raise funds by governments at the local, federal, and state level.

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Federal government bonds are the ones with maturity dates of 30 years from the time of issuance are Treasury Bonds. Publicly issued bonds are considered as low-risk investments, based on the ability of governments to repay them.

Convertible Bonds

If a company is a relatively new startup and does not have a high credit rating, they have this option of issuing bonds with interest rates that are much higher than current rates offered by banks which means that issuing bonds to raise finance for expansion would be costly.

To handle this situation, businesses usually issue convertible bonds to raise the money that is required. Convertible bonds offer competitive and attractive rates of interest even though the company does not have a high credit rating, but investors are swayed to acquire these bonds because they provide the opportunity for the bond to be exchanged with common stock in the company later.

The lender shares in the success of the company if the company does well and its share price increases but in the vice-versa case, the company is obliged to pay interest payments on the bonds and also repay the capital amount on the expiry of the bond term.

Benefits of Long-Term Debts

Following are discussed a few benefits of taking long-term debts.

  • Interest payments made by the borrower on the loan amount is tax allowable expense which helps in bringing down the taxable income and paying less tax.
  • Almost every organization needs funds to run its day-to-day business like buying fixed assets and for other business activities. Long-term debts give the organization quick access to funds without concern for paying them in the short term. The recipient of the loan only has to make the payment of the current portion.
  • Cutting down taxable income is never the intention of the company while taking the long-term debt because this can be done by increasing any other expense. The main reason for doing this is to take advantage of financial leveraging.
  • In case, an organization wants only a portion of total debt, for the time being, they may have it that way. By this method, the company receives the debt as and when they want.
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Disadvantages of Long-term Debts

Following are few drawbacks of taking long-term loans.

  • In this type of longer-term loan, it is usually mandatory to have guarantees that cover the possible events which may occur during the debt period. This is one of the major limitations of long-term loans. Also, it is to be noted that to the long duration of long-term debt repayment, the total cost of repayment of the debt amount increases greatly.
  • Businesses avoid long-term loans in order not to mortgage their future in terms of investment and growth possibilities. They prefer short-term financing formulas, such as the advance of invoices or the discount of promissory notes. A financial institution advances the money of the pending collections and, in this way, liquidity is received quickly, although the costs are fairly higher.
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