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.
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 is 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 track 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.
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 a non-current part of the mortgage loan.
$22,000 as a current liability such as the current part of the mortgage loan.
Types of Long-term Debt
The following are some types of long-term debt.
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.
Federal government bonds 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.
If a company is a relatively new startup and does not have a high credit rating, they have the 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
Long-term debts come with several advantages that individuals should consider when evaluating their financial options.
One significant advantage is the lower interest rates typically associated with long-term debts than short-term ones.
Lenders are generally more willing to offer lower interest rates on debts that will be repaid over a longer period.
This can result in substantial savings in interest payments over the life of the loan.
Another advantage of long-term debts is the fixed payments they offer. With long-term debts, you often have fixed monthly payments, meaning the amount you pay each month remains the same.
This predictability can make it easier to budget and plan for your financial future.
Sometimes, you may be eligible for tax deductions on the interest you pay on long-term debts.
This can provide additional savings on your tax bill, reducing your overall financial burden.
Regularly making payments on long-term debts can positively impact your credit score.
By demonstrating responsible financial behavior, you can improve your creditworthiness, making it easier to obtain loans and credit in the future.
Long-term debts can also provide you with access to capital that you may not be able to obtain otherwise.
This capital can be utilized for significant purchases such as buying a home or starting a business, enabling you to achieve your long-term goals.
Furthermore, long-term debts present investment opportunities. By taking advantage of the lower interest rates and utilizing the borrowed funds wisely, you can invest in assets that appreciate over time.
This can contribute to the growth of your wealth and provide financial security in the long run.
Diversification of your portfolio is another advantage of long-term debts. They are considered relatively safe investments, allowing you to diversify your portfolio and reduce overall risk.
By opting for long-term debt, you can lock in a fixed interest rate for the duration of the loan.
This eliminates the worry of increasing interest rates in the future, providing stability and peace of mind.
Certain types of long-term debts, such as mortgages, can help you build equity in an asset.
Over time, your regular payments contribute to the ownership of the asset, increasing your net worth and providing a valuable asset for the future.
Considering these advantages, long-term debts can be a valuable financial tool for individuals seeking stability, capital access, and wealth growth opportunities.
However, it is crucial to carefully assess your financial situation and long-term goals before committing to any debt obligation.
Disadvantages of Long-term Debts
There are several disadvantages associated with long-term debts that individuals should consider before taking on such financial obligations.
One significant drawback is the higher interest rates typically associated with long-term debts than short-term ones.
This means that over the life of the loan, you will end up paying more in interest, which can significantly impact your overall financial situation.
Another disadvantage of long-term debts is the increased number of monthly payments.
While these payments may be lower than short-term debts, the extended repayment period means that you will be making payments for longer.
This can restrict your financial flexibility and limit the money available for saving or investing.
Long-term debts also carry an increased risk of default. You may default on the loan if you cannot meet the monthly payments.
This can have severe consequences, including damage to your credit score, making obtaining future loans or credit more challenging.
Tax implications can also be a disadvantage of long-term debts. Unlike short-term debts, the interest you pay on long-term debts may not be tax-deductible.
This means you cannot reduce your taxable income by the interest paid, potentially resulting in higher tax liability.
In addition, some long-term debts may have early repayment penalties. If you decide to pay off the loan early, you could be subject to fees or penalties, reducing the potential benefits of early repayment.
Long-term debts also come with an increased risk of inflation. If inflation rates rise, the value of your debt remains the same, but the purchasing power of your income may decrease.
As a result, you will have to allocate more of your income in real terms to repay the debt.
Taking on long-term debt also means sacrificing some control over your finances.
With monthly payments extending over a prolonged period, you may lose control over your financial situation.
Lastly, long-term debt can create emotional stress. The responsibility of making monthly payments and fearing potential consequences, such as defaulting on the loan, can lead to anxiety and emotional strain.
Considering these disadvantages, it is crucial to carefully assess your financial situation and long-term goals before committing to long-term debts.
Is Long-term Debt Better than Equity?
Whether long-term debt is better than equity depends on various factors, including your circumstances and risk tolerance.
Let’s compare long-term debt and equity based on several key factors:
- Interest payments: When you have long-term debt, you must make interest payments, which can be a significant expense over time. On the other hand, equity does not involve interest payments, but you may be obligated to pay dividends to shareholders.
- Maturity date: Long-term debt has a maturity date, meaning you have a set timeline to repay the borrowed amount. Equity, however, does not have a maturity date, and you are not required to repay the initial investment.
- Liquidity: Debt tends to be more liquid than equity, which can be easily converted into cash if needed. Conversely, equity is typically less liquid; converting it into cash may take more work.
- Risk: Long-term debt is generally considered a less risky investment because you have a guarantee of getting your money back (plus interest) as long as you repay the debt. Equity, however, is riskier as there is no guarantee of recovering your investment if the company faces financial difficulties or goes bankrupt.
- Tax treatment: The interest payments made on long-term debt may be tax-deductible, potentially providing savings on your tax liability. Conversely, the dividends received from equity investments may be subject to taxation as ordinary income, potentially increasing your tax liability.
Ultimately, deciding between long-term debt and equity depends on your financial goals, risk tolerance, and investment preferences.
Long-term debt may be a suitable option if you seek a more stable investment with predictable fixed payments.
On the other hand, if you are willing to assume more risk in exchange for the potential for higher returns, equity investments may be more appealing.
It is essential to note that this response is not financial advice, and it is advisable to consult with a qualified financial advisor who can assess your situation and provide personalized recommendations before making any investment decisions.