Long-Term Debt and Balance Sheet Debt-To-Equity Ratio
What Is Long-Term Debt on a Balance Sheet?
The amount of long-term debt on a company's balance sheet refers to money a company owes that it doesn't expect to repay within the next 12 months. Debts expected to be repaid within the next 12 months are classified as current liabilities.
What Kind of Debts Make Up Long-Term Debt?
Long-term debt can consist of obligations such as mortgages on corporate buildings or land, business loans underwritten by commercial banks, and corporate bonds issued with the assistance of investment banks to fixed income investors who rely on the interest income. Company executives, in conjunction with the board of directors, often use long-term debt for reasons including, but not limited to:
- Opportunity: Funding growth and acquisitions without diluting the stockholders
- Capital: Taking advantage of low-interest rate environments when it is possible to raise a lot of money very cheaply, perhaps below the long-term rate of inflation once income tax deductions have been taken into account, then stockpiling it for future use
- Stock buybacks: Repurchasing shares so that the remaining shares represent more ownership in the business.
What's a Good Balance?
When a company is paying off its liabilities, and current asset levels are increasing, especially for several years in a row, the balance sheet is said to be "improving." However, if a company's liabilities are increasing and current assets are decreasing, it is said to be "deteriorating."
Still, it can be a wise strategy to leverage the balance sheet to buy a competitor, then repay that debt over time using the cash generating engine created by combining both companies under one roof.
How can you tell if a company has too much long-term debt? There are several tools that need to be used, but one of them is known as the debt-to-equity ratio.
Debt-To-Equity Ratio and Why It Matters
The debt-to-equity ratio tells you how much debt a company has relative to its net worth. It does this by taking a company's total liabilities and dividing it by shareholder equity.
The result you get after dividing debt by equity is the percentage of the company that is indebted (or "leveraged"). The customary level of debt-to-equity has changed over time and depends on both economic factors and society's general feeling towards credit.
All else being equal, any company that has a debt-to-equity ratio of more than 40% to 50% should be looked at more carefully to make sure there are no major risks lurking in the books, especially if those risks could portend a liquidity crisis. If you find the company's working capital, and current ratio/quick ratios drastically low, this is is a sign of serious financial weakness.
Factor In the Economic Cycle
It is critical to adjust the present profitability numbers for the economic cycle. A lot of money has been lost by people using peak earnings during boom times as a gauge of a company's ability to repay its obligations. Don't fall into that trap.
When analyzing a balance sheet, assume the economy can turn downward. Do you think the liabilities and cash flow needs could be covered without the competitive position of the firm being harmed due to a curtailment of capital expenditures for things like property, plant, and equipment? If the answer is "no," proceed with extreme caution.
Long-Term Debt Can Be Profitable
If a business can earn a higher rate of return on capital than the interest expense it incurs borrowing that capital, it is profitable for the business to borrow money. That doesn't always mean it is wise, especially if there is the risk of an asset/liability mismatch, but it does mean it can increase earnings by driving up return on equity.
The trick is for management to know how much debt exceeds the level of prudent stewardship.
Investment Grade Bonds and Long-Term Debt
One way the free markets keep corporations in check is by investors reacting to bond investment ratings. Investors demand much lower interest rates as compensation for investing in so-called investment grade bonds.
The highest investment grade bonds, those crowned with the coveted Triple-A rating, pay the lowest rate of interest. It means interest expense is lower and profits are higher. On the other end of the spectrum, junk bonds pay the highest interest costs due to the increased probability of default. It means profits are lower than they otherwise would have been due to the higher interest expense.
Another risk to investors as it pertains to long-term debt is when a company takes out loans or issues bonds during low-interest rate environments. While this can be an intelligent strategy, if interest rates suddenly rise, it could result in lower future profitability when those bonds need to be refinanced.
If that presents a problem and management has not adequately prepared for it long in advance, absent extraordinary circumstances, it probably means the firm has been mismanaged.