Long-Term Debt and the Debt-to-Equity Ratio on the Balance Sheet
Investing Lesson 3 - Analyzing a Balance Sheet
Long-term debt on the balance sheet is important because it represents money that must be repaid by the company. It's also used to understand the company's capital structure including its 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 twelve months.
Remember that debts expected to be repaid within the next twelve months are classified as current liabilities. (Simply stated, debts owed within the next 12 month are current liabilities, and debts owed after the next 12 months are long-term debts.)
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 several reasons including, but not limited to:
- Funding growth and acquisitions without diluting the stockholders;
- 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, stockpiling it for future use; and
- Repurchasing shares through stock buy back programs so that the remaining shares represent more ownership in the business.
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".
Companies with too much long-term debt, who find themselves in a liquidity crisis for one reason or another, risk having too little working capital or missing a bond coupon payment and being hauled into bankruptcy court. On the other hand, it can be an incredibly wise strategy to lever up the balance sheet to buy a competitor lock, stock, and barrel, then repay that debt over time using the now-combined cash generating engine that has been assembled 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.
The Debt-To-Equity Ratio and Why It Matters to Your Balance Sheet Analysis
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. (We haven't covered shareholder equity, yet, but we will later in this lesson. For now, you only need to know that the number can be found at the bottom of the balance sheet. For practice, I'll have you calculate the debt-to-equity ratio of some companies in segment two when we look at various balance sheets.)
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 equal, any company that has a debt-to-equity ratio of over 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. It is of the utmost importance that you 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 go to hell in a hand basket and then ask yourself whether you think the liabilities and cash flow needs could still 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.
The Use of Long-Term Debt Can Be Profitable for Many Firms
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 that it can increase earnings by driving up return on equity. For the more mathematically minded among you, this is achieved by increasing the equity multiplier in the DuPont model return on equity formula.
The trick is for management to know how much debt exceeds the level of prudent stewardship. Leverage can be tricky as it juices returns on the upside but can wipe out the owners much faster if things go south in an economic recession or depression. That is never a situation in which you want to find yourself when it's your family's money on the line. To learn more about this topic, read An Introduction to Capital Structure.
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 much-coveted Triple-A rating, pay the lowest rate of interest. This 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. This 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.