Definition:
Long-term debts are non-current liabilities with obligations beyond one year. Long-term debt can be viewed from two perspectives: financial statement reporting by issuer and financial investing.
The balance sheet must record long-term debts and the related payment obligations in the non-current section of the balance sheet.
On the other hand, investing in long-term debt means putting in debt instruments having maturities of more than one year.
Companies choose long-term debt with various considerations. They focus on the timeframe for repayment, including the interest component.
Investors invest in long-term debt for the advantages of regular interest payments and consider the time to maturity as a liquidity risk.
The risk of long-term debt depends largely on market rate changes and whether or not it has fixed or floating rate interest terms.
Investing in Long-Term Debt
Companies must consider various factors when issuing and investing in long-term debt. For investors, long-term debt means debt maturing beyond one year.
There are various long-term debts that the company can choose from for investing. Generally, these debts include central bank-backed treasuries and corporate and municipal bonds.
Why Do Companies Use Long-Term Debt Instruments?
All businesses need capital, and debt is one source for obtaining immediate funds to finance business operations.
Any company takes on long-term debt to obtain immediate capital. Housing finance companies and startup ventures are leveraged on financial aspects and must take on debts regularly to meet basic business expenses.
Long-term debt has advantages over short-term debts. Interest from long-term debts is taken as business expenses and deductible. Long-term debt has a higher than one-year obligation.
7 Types of Long-term Debts You Should Know
The various types of long-term debts are discussed below:
1. Treasuries
The central banks and governments issue both short-term and long-term debt securities.
The long-term treasury maturities have two, five, and ten years. Some government issues as far as 15 to 20-year maturity treasuries.
2. Municipal Bonds
These are debt instruments issued by the government to fund infrastructure projects launched by the government.
Municipal bonds are typically considered the lowest risk bond, with a risk slightly higher than the treasuries.
The government issues short-term and long-term municipal bonds for public investment.
3. Corporate Bonds
Corporate bonds have higher default risks than Treasuries and municipals. These bonds receive ratings from rating agencies, and since companies back these, they carry a higher risk than municipal bonds and treasuries.
Rating agencies depend on solvency ratios when analyzing and providing entity ratings. These bonds are common types of long-term debts.
Corporations may issue debts with various maturities. All corporate bonds with maturities greater than one year are considered long-term debt investments.
4. Mortgages
The company here puts collateral such as real estate, buildings, or lands to get a loan equivalent to up to 80% value of the collateral.
These are generally long-term debts meaning obligations are spread for more than one year.
5. Debentures
Debentures refer to unsecured bonds of the corporation. Any specific company does not secure debentures. The debenture holder becomes the creditor general in case of liquidation of the company.
Hence, investors try to look earning power of the company as an essential prerequisite for investment or raising debt. Although unsecured, debenture holders get priority over equity shareholders.
This means debenture holders will be paid before any amount is paid to equity or preference shareholders.
6. Income Bonds
The company must only pay interest on an income bond when the claim is earned. The exciting feature may be cumulative, meaning it accumulates if not paid.
If the company does not generate enough profits, it will have to provide for interest to the extent the earnings of the company permit.
7. Equity-Linked Debt Some debt issues
These are linked to common or preferred stock and allow the holder to exchange the security for the company’s common stock at the holder’s option.
Interest costs of the convertible debt issue are less than similar debt issues without conversion options and investors willing to accept conversion.
Likewise, another type of equity-linked debt is the issuance of warrants with debt securities.
9 Benefits of Long-term Debt You Should Know
- Lower Interest Rates: Long-term debt typically comes with lower interest rates than short-term debt, meaning businesses can save money on loan repayments.
- Fixed Payments: When you take out a long-term loan, payments are fixed which makes budgeting easier and helps businesses plan for the future.
- More Flexibility: Long-term loans also come with more flexible repayment arrangements, allowing businesses to adjust their repayment schedule if needed.
- Easier Qualification: With some types of long-term debt, such as corporate bonds and government loans, qualification is often easier given that lenders have longer to assess the borrower’s risk.
- Tax Benefits: Businesses may claim certain tax deductions for borrowing costs when taking out a long-term loan or another form of long-term debt financing.
- Improved Cash Flow Management: Companies can use long-term debt to supplement regular cash flow and make it easier to manage operational expenses without having to liquidate assets or dip heavily into cash reserves or operating capital funds.
- Asset Funding: Longer terms offer companies more opportunity to pay off assets from borrowed funds, which improves cash flow in the short term but allows for larger purchases that wouldn’t be possible in one lump sum payment upfront.
- Increased Creditworthiness: Taking on long-term debt can improve a company’s creditworthiness over time, making them more attractive to potential investors and creditors in the future due to its reliable record of timely payments and responsibility with money management practices.
- Increased Currency Options: Borrowers may have access to different currency options when going through a longer-term loan process because it gives them additional time to make international payments without relying solely on domestic funds or resources.
9 Limitations of Long-term Debt You Should Know
- Risk of Default: Taking on long-term debt increases the risk of default as there is more opportunity for economic downturns or unforeseen events that may make repayment impossible.
- Increased Interest Costs: Although long-term debt typically comes with lower interest rates than short-term debt, businesses can still face higher costs due to the extended repayment period, which may increase their overall financial burden.
- Longer Commitment Time: Companies must be committed to repaying their loans for longer and have less flexibility to stop or restructure repayment if necessary.
- Unforeseen Expenditures: While long-term financing can be beneficial in terms of cash flow management, it doesn’t always account for unexpected expenses or significant changes in the industry that could affect a company’s ability to repay its loan on time.
- Negative Credit Ratings: There is a risk that companies taking out large amounts of long-term debt could suffer from unfavorable credit ratings if they fail to make regular payments and eventually default on their loan obligations.
- Dilution of Equity and Profits: When issuing securities such as corporate bonds, businesses need to consider how much equity they are sacrificing to raise finances and whether the returns will be sufficient to cover their borrowing costs over the long term.
- Increased Leverage: High leverage ratios associated with long-term debt can lead to increased volatility and pose more significant risks than short-term financing options due to extended exposure to changing market conditions.
- Immediate Cash Requirements: Longer terms might not always meet immediate cash requirements when cash is needed for expansion projects or other business operations quickly, which could lead companies into difficult positions where they need additional funds faster than what their existing loan arrangement offers them.
- Rigid Terms: Lastly, lenders tend to impose strict terms concerning maturities, payment schedules, and collateral requirements when offering long-term loans; this makes it difficult for borrowers who may require flexible repayment plans.
Top 10 Reasons Why You Should Not Obtain the Long Term Debt
- Risk of Default: One of the most significant risks associated with long-term debt is the possibility of defaulting on the loan. The risk increases if you take out a large loan with high-interest rates and unfavorable terms.
- Higher Interest Rates: Long-term debt often comes with higher interest rates than short-term debt, which can add up over time and increase your overall cost of borrowing, making repayment more difficult.
- Lower Credit Score: Taking on too much long-term debt can negatively impact your credit score, making it harder for you to obtain other forms of financing in the future.
- Unpredictable Future Costs: Unexpected costs like medical bills or home repairs can make it challenging to pay back long-term debt if you don’t have the resources to do so.
- Inflexible Repayment Terms: Many lenders offer inflexible repayment terms requiring borrowers to adhere to strict schedules and may not provide any leeway to make payments on time.
- Increased Financial Obligations: Long-term debt will increase your financial obligations, leaving less money available for other essential items such as food, housing, and transportation costs.
- Depletes Savings & Assets: Repaying long-term debts can deplete savings and assets that could be used in case of an emergency or other unexpected expenses, leaving you without a financial cushion should something happen.
- Reduced Financial Flexibility: Long-term debt limits your financial flexibility by tying up most of your monthly income in loan repayments rather than allowing you discretionary spending power or saving money towards retirement or other significant investments such as buying a home or business asset purchases.
- More Difficult To Refinance: Refinancing certain types of loans can be more difficult after taking out a long-term loan due to higher interest rates and greater risk associated with lending for extended periods.
- Debt Servitude Syndrome: Perhaps one of the most concerning aspects associated with obtaining long-term debt is known as “debt servitude syndrome,” where individuals become trapped in cycles of dependence due to increasingly large loans against their property or assets that are nearly impossible to pay back without putting their physical well being at risk by working multiple jobs at once or sacrificing essential life necessities like healthcare coverage or additional education opportunities needed for career advancement possibilities in their future.
