Long-Term Debt

This article will explain long-term debt. The overview provides an introduction to the most common types of long-term debt and long-term debt lenders. This article will also describe how investors and creditors can determine a company's long-term debt by using mathematical formulas and by examining a company's balance sheet. In addition, the reasons why creditors and investors pay close attention to a company's long-term debt obligations are explained, as are the reasons why companies choose to use long-term debt to pay for their business growth objectives. Also, explanations of corporate financial analyses in which long-term debt is an important issue, such as identifying profitable borrowing, reading balance sheets and comparing the financial positions of various companies based on their assets and debt obligations are included to help illustrate how long-term debt factors into common corporate finance considerations.

Keywords Bonds; Debentures; Debt; Equity; Loan; Inflation; Interest Rate; Investment; Term

Finance > Long-Term Debt

Overview

There are many ways that companies finance, or pay for, their costs of doing business. Successful businesses earn profits that are re-invested back into the company to pay for research and development or other expansion efforts to further grow the business. However, there are many instances in which a company's earnings are not sufficient to cover its costs and growth objectives. For instance, young companies or companies that are struggling to stay afloat financially may not generate enough profit to cover all of their internal costs as well as the costs of growing and expanding. Even strong, stable companies may need to make significant purchases — such as equipment, building space or even the acquisition of another company — to continue to grow and remain competitive, and these costs may exceed the amount of liquid assets a company has on hand. And even after years of successful growth, a company may face lean years where the market plateaus, consumers' interests change or a competitive product or service begins to siphon off its customers or clients.

In situations such as these, companies must look beyond their earnings to consider options that will create an inflow of capital to help it grow or survive during times of economic hardship. A common form of financing that companies use to generate the resources it needs for significant projects is long-term debt. Long-term debt consists of money that a company will use for a longer period of time, generally one year or more, and that the company will repay over time. Long-term debt may consist of loans that a company borrows or it may consist of debt securities that a company issues. These two forms of debt are known as debt financing or equity financing. Debt financing consists of short-term debt and long-term debt. These two forms of debt serve two very different functions. Short-term debt is debt that a company will pay off within 12 months and is usually acquired to pay for temporary increased expenses, such as purchasing additional inventory for sale during the holiday season. On the other hand, long-term debt consists of loans and financial obligations that will last for over one year. For example, long-term debt may consist of the mortgage a company holds on its corporate buildings and property or various business loans that it has assumed. In addition, a company's debt obligations, such as bonds and notes that will not mature before one year, are other forms of long-term debt. Securities such as T-bills and commercial paper are generally not considered long-term debt because their maturity dates are typically shorter than one year.

If a company decides not to use debt financing to pay for its business objectives, it may decide to pursue equity financing. Equity financing occurs when a company offers shares of the company for sale. The benefit of this form of financing is that the most common types of shares, such as common stocks and preferred stocks, do not require dividend distributions to shareholders. Thus, the company experiences an influx of capital when shareholders purchase stock in the company and the company is not required to pay an annual dividend. Shareholders profit from their investment only if the company makes enough money to authorize a dividend distribution or through the capital appreciation of the shares. On the other hand, shareholders are purchasing ownership in a company when they buy shares, and thus a company that makes a public offering of its shares exchanges its autonomy for equity in that shareholders may receive the right to vote on important corporate matters and thus will have a say in how the company is run.

There are many advantages of long-term debt that companies can exploit if they select the best form of financing for their needs while keeping their overall levels of debt manageable. For instance, long-term debt can provide much needed working capital that can be used to pay for ventures that will create profit and increase its earnings. In addition, if debt can be borrowed at a lower interest rate than the earnings a company will generate from plants, equipment or other resources purchased with the borrowed funds, borrowing can actually be profitable for a company. Thus, while debt is frequently discussed with negative connotations, some types of long-term debt can actually be good for companies. The following sections provide a more in-depth explanation of the basic financial concepts involving long-term debt.

Basic Financial Concepts

Long-Term Debt Defined

"Term" refers to the time period for which money is borrowed and the period over which the loan will be repaid. Thus, long-term debt consists of money that a company will borrow to use for a long period of time, generally longer than one year, and that the company will repay over time, also longer than 12 months. Long-term debt primarily consists of longer term loans that are taken to pay for assets that companies will use for a period of many years, such as land, buildings, machinery, equipment or technology. Thus, long-term debt arises when the planned repayment of the loan and the predicted valuable life of the assets purchased exceed one year. Most long-term loans have a repayment period of five to seven years, although they may even be extended to 30 years.

There are a number of reasons why companies decide to incur long-term debt. Some companies may prefer to borrow money to purchase a significant acquisition that will generate additional profits while the company repays the loan in lower monthly installments over a period of time. The other form of debt financing that a company may consider is to issue fixed-income debt securities, such as bonds, notes or commercial paper. Debt securities issued by the company are purchased by investors, and their maturity dates-or the date in which the company must repay the principal of the security-may be longer than the length of a typical term loan. Thus, issuing debt securities allows a company to raise more money and borrow the money for longer periods of time than loans typically allow. However, in addition to honoring the debt securities and any interest they accrue, companies must also pay the underwriting fees involved in issuing securities. Long-term loans, on the other hand, generally consist of funds that are borrowed from a private entity such as a commercial bank. The loans a company borrows from a bank may be used to just about any purpose, but they generally have shorter terms than debt securities and thus require repayment sooner than the maturity dates of their outstanding debt securities. However, while companies must pay interest on the loans, there are no underwriting fees associated with long-term loans. Thus, companies must weigh all of their financing options to choose the form of financing that best suits their growth objectives and financial position.

Types of Long-Term Debt

There are many different types of long-term debt that businesses may incur in order to finance their growth and operations. The most common types of long-term debt are term loans, bonds and debentures. Bonds are generally classified as either secured or unsecured forms of debt securities. Secured bonds are backed by a company's assets. For instance, mortgage bonds are a form of secured bonds that are back by real estate. Unsecured bonds, called debentures, are not backed by a specific asset but are issued based on the full faith and credit of the issuing company. In addition, the various types of long-term debt may be assigned a priority status, which refers to the rank of the lender in terms of gaining access to a company's assets in the event of insolvency. For instance, a company may have some forms of long-term debt that are considered senior, which means they have a higher priority than lower-ranked subordinated debt.

Term Loans

Although companies do use bonds and debentures as a long-term debt financing option, term loans are the form of long-term debt most frequently used by businesses to finance their expansion efforts. A term loan is a loan from a bank to a company that has an established maturity date—usually five to seven years after the start of the loan—in which the company will repay the loan in monthly installments accounting for both principal and interest. When the principal of a loan is repaid in equal payments over the life of the loan, this process is called loan amortization. When monthly payments of principal and interest are made, the companies are considered to be "servicing" their debt. Most companies choose to repay a loan in equal installments over a period of time so that the principal plus the interest is repaid in full upon the final payment. However, sometimes a company will borrow a loan that is structured so that an amount of principal is still due at the end of the loan period. That ending balance is called a balloon payment. This type of long-term loan is used to allow a company to make lower monthly payments over the life of the loan.

Bonds

Bonds have many characteristics similar to those of a term loan, but they are debt obligations, or IOUs, that are issued by private and public companies and purchased by investors rather than funds that companies borrow from and repay to lenders such as commercial banks. Bonds are usually sold in units of $1,000 and firms use the money they raise from selling bonds for a multitude of purposes, such as building new facilities or purchasing new equipment. When a company issues bonds, it promises to repay the bondholder all of principal, or the amount of the debt obligation purchased by the investor, in the future on a specified maturity date. A bond may have maturity date that is set a few years in the future, or even further, such as 10 years down the road. Until the bond matures, the issuing company pays the bondholder a stated rate of interest, called a coupon, at specified intervals, which are typically every six months. Unlike other types of securities that companies can issue, such as stocks, bonds do not give holders an ownership interest in the issuing corporation.

Debentures

Debentures are a bond whereby a company uses its full faith and credit as collateral rather than a specific, tangible asset. Creditors who purchase debentures must rely on the credit rating and creditworthiness of the issuing company in determining the risk of this form of long-term debt. Because the risks involved with purchasing debentures is higher than other forms of debt securities, debentures often pay higher rates of return. Owners of debentures are called unsecured creditors of a company.

Convertible bonds are a type of debenture that provide the bondholder with the right to convert the bonds into shares of common stock at a later specified date. These bonds are an attractive financing option for companies because they allow the company to issue debt securities at a more affordable interest rate than other types debentures because they are less risky. They are also attractive to investors because convertible bonds allow bondholders to receive interest payments during the life of the bond while retaining the ability to convert the bonds to shares of common stock if the price of shares of the company's common stock increase above a threshold level, called a strike price. Thus, convertible bonds are a form of debt security that are appealing to both companies and investors.

Junk bonds are another form of debenture that companies issue if they do not have a strong enough credit rating to issue investment grade bonds. Bonds are classified as either investment grade or junk bonds. Investment grade bonds are issued by companies with higher credit ratings and thus are considered low or medium-risk investments. Since the risk of these bonds is lower, so are their returns. Because companies with lower credit ratings are considered a riskier investment, the junk bonds these companies issue pay higher returns. Thus, some investors are willing to purchase junk bonds from companies that the investors believe are relatively stable in order to take advantage of the higher returns that these debt securities offer.

Common Long-Term Debt Lenders

The most common financial institutions that make long-term loans are commercial banks, credit unions or other financial companies. Within these financial institutions are lenders that specialize in certain types of long-term debt, including mortgage lenders, term loan lenders and equipment leasing lenders. Lenders are willing to let companies borrow long-term debt because the companies eventually pay the lenders back all of the money they borrowed plus interest. Thus, long-term debt is considered an asset to the lender and a liability to the borrowing company. Since there is some risk that the company will not be able to repay the loan or will even go bankrupt, lenders do face the possibility that they will not make money on every loan. However, lenders factor these costs, along with the creditworthiness of a company, into the interest rate that is set for the long-term loan. These lenders of long-term debt are described in more detail in the following sections.

Mortgage Lenders

Mortgage lenders are generally large companies that can afford to lend funds to companies for the purchase of land and commercial properties. Mortgage lenders include banks, credit unions, financial companies and other institutional lenders. Mortgage lenders take proactive steps to try minimizing the risk of a company defaulting on a loan or the property losing value. Thus, mortgage lenders investigate the financial soundness, or creditworthiness, of the borrowing company before making a loan. To make this assessment, lenders examine company documents such as current financial statements, balance sheets and financial projections that show how the building will allow the company to expand its operations to generate profits. In addition, the lender will require that the company requesting a loan provide a significant amount of paperwork to demonstrate the value of the building the company wishes to purchase, such as its location, condition and proposed use.

Long-Term Loan Lenders

Commercial banks and credit unions are the most common lenders of long-term loans. Like mortgage lenders, the financial institutions that make long-term loans also investigate the creditworthiness of any company that seeks to borrow a long-term loan. To make this determination, lenders of long-term loans evaluate the company's business plan, products and services, management team and financial statements. In addition, these creditors consider the collateral that a company has available to support the loan and the purpose for which the loan is intended. Most creditors also require that companies provide financial projections that give a detailed history of their production methods and operations and their position in the marketplace.

Equipment Financiers

Equipment financiers, which include commercial banks, credit unions and equipment vendors themselves, lend companies money to purchase equipment that will enhance the company's production abilities to generate increased corporate earnings. Equipment financiers require evidence of a company's financial stability and growth projections that is similar to the documentation required by long-term creditors. One difference is that companies must generally submit business plans that include two sets of financial projections-one projection based on the company's use of its current equipment and a second set based on the company's use of the newly purchased equipment. In addition to these financial projections, equipment financiers often require that companies generate an estimation of the useful economic life of any equipment it is considering purchasing and the probable resale value of the equipment over the course of its useful life.

Long-Term Debt Financing

Calculating Long-Term Debt

Creditors and investors need to be able to quickly calculate a company's long-term debt so that they can make decisions about whether to invest in the company or extend credit to the company based on the company's financial stability. Too much long-term debt can signal that the company has experienced low earnings or sluggish growth. Too little long-term debt may indicate that the company's management does not have a solid financial plan to grow the company over time. Thus, long-term debt can be an important factor in evaluating the financial position of a company at any given point in time.

The way creditors and investors calculate long-term debt is by using a formula known as the debt-to-equity ratio. The debt-to-equity ratio measures the percentage of the company that is indebted, or "leveraged." This calculation compares the company's total liabilities (including short term and long-term obligations) with the proportion of the company that is equity owned by shareholders and owners. The debt-to-equity ratio divides the company's total debt by the amount of shareholders' equity. Shareholders' equity equals the amount of common stock owned by shareholders plus firm profits or losses. The resulting figure is also an indication of the amount of money that a company could safely borrow over long periods of time.

The formula used to calculate a company's debt-to-equity ratio is as follows.

Debt-to-Equity Ratio = Total Liabilities/Shareholders Equity

For instance, to determine the debt-to-equity ratio of Corporation A, assume that its total liabilities are $5,000 and its shareholder equity is $18,000. The calculation would be as follows:

Corporation A debt-to-equity ratio = $5,000/$18,000 = 0.27 or 27%

In evaluating a company's debt-to-equity ratio, the higher the percentage of the debt-to-equity ratio, the higher the company's debt obligations. While the levels of debt-to-equity that are generally regarded as acceptable by investors and creditors may fluctuate according to economic factors in the markets, generally debt-to-equity ratios of less than 40% are considered acceptable, while ratios of 40 to 50% may indicate that a company will encounter problems with liquidity where it is unable to meet its operational costs and debt obligations for a period of time. Also, many creditors and investors assume that a debt-to-equity ratio greater than one means a company has been primarily financing its assets through debt. On the other hand, a ratio of less than one means that a company has used equity for most of its financing. In general, the debt-to-equity ratio includes both short-term and long-term debt in figuring a company's "total liabilities." However, some creditors and investors use only interest-bearing long-term debt instead of total liabilities in calculating a company's debt-to-equity ratio to get a more precise measure of a company's financial stability.

How Companies Acquire Long-Term Debt

Companies acquire long-term debt when debt lenders, generally called creditors, provide loans to the company for use in major acquisitions, product development, geographic expansion or other growth objectives. Thus, companies borrow money to pay for their business expansion efforts and creditors lend money to earn interest as the companies pay back the borrowed money over time plus any accrued interest.

While the explanation of how companies acquired debt is relatively simple, the process that companies and creditors undergo before a loan is actually extended can be relatively complex, especially if the loan is for a significant amount of money. This is because creditors assume some risk in lending funds to a company in that there is no guarantee that the additional funds will enable a company to generate sufficient earnings to repay the loan. Even if a company does grow initially after it borrows debt from a creditor, the company could experience a loss of sales or production capabilities that cripple its financial stability. Thus, creditors carefully examine the financial status of any company that applies for a loan before lending funds in an attempt to reduce the risk that the company will default on the loan.

To borrow long-term debt from a creditor, a company must first determine how much money it needs to borrow, how much money it can afford to borrow, the length of time it intends to borrow the money and any collateral or assets it could use to back a loan. Then, companies typically draft a written business plan that details its cash flow, financial projections and earnings expectations. Creditors examine these calculations to try to determine a company's ability to repay the loan over the term of the repayment schedule.

Once a company has created a solid business plan and identified how much money it will need to finance its growth objectives, the company generally approaches a number of creditors in an attempt to secure financing at the most affordable interest rate. The interest rate that is assigned to a term loan is generally a function of the creditworthiness of the borrower, the economic conditions in the market and the purpose for which the funds are being borrowed. The interest rate is important because it determines the amount of money that the company will have to repay in addition to the principal. Companies prefer lower interest rates while creditors make more money from higher interest rates. The creditor will generally set the interest rate at a percentage that is competitive and yet takes into consideration the financial stability of the company. Once the interest rate is set and the loan is taken out, the rate usually remains constant for the life of the loan. Companies may repay a loan before its term to get out of debt sooner, but creditors may charge a penalty for early repayment of a term loan because the creditor was still expecting to receive interest payments on the outstanding balance of the loan.

Once a creditor has investigated the stability of a company and is ready to extend a loan, the creditor may also attempt to limit its risk by securing the loan through acquring ownership interest in the asset that a company intends to purchase with the borrowed funds. With this ownership interest, creditors minimize their risk of total loss in the event of a company's bankruptcy and liquidation and the company is also able to pay a lower interest rate on loans secured by assets. Finally, creditors also generally require that companies maintain sufficient levels of insurance to protect the assets that they purchase with borrowed funds. In sum, to acquire long-term debt, companies approach creditors with a business plan that details their financial fitness. A company desires long-term debt because it provides the funds needed to attain assets and resources that will allow the company to grow and expand. Creditors investigate the financial stability of companies, and then determine whether to extend financing and, if so, they will set the interest rate. To protect their risk exposure, creditors normally require that a long-term loan be secured by the new assets the funds are being used to purchase as well as by an insurance policy. Companies use the borrowed funds to purchase the resources necessary to grow in size and profitability.

Implications of Long-Term Debt

Long-term debt plays an important role in the overall financial stability of a company. Companies are willing to assume some long-term debt in order to pay for important acquisitions, such as buildings or equipment, that will in turn enable it to expand and become more profitable. On the other hand, if a company acquires too much long-term debt, the payments that it must make to service the debt principal and any interest that accrues can erode a company's cash reserves, and may even destabilize a company's financial position to the point of bankruptcy. Thus, determining a company's long-term debt helps creditors and investors assess whether a company is financially sound so that it can pay its bills while still earning profits, or whether its debts and other liabilities threaten to erode its stability and profitability.

Creditors and investors examine a company's balance sheet in order to calculate its debt-to-equity ratio. In addition to looking at a company's total assets, liabilities and shareholders' equity, investors and creditors also distinguish between a company's short or current long-term debt and its overall long-term debt obligations. Liabilities that are considered short or current long-term debt include those portions of the company's total long-term debt that it must pay in the next 12 months. The reason why investors and creditors examine the current portion of long-term debt on a balance sheet is to get an indication of how much money the company will spend in the current year toward servicing its long-term debt. Once this figure is determined, it can then be compared to the company's cash reserves as listed on its balance sheet in order to determine whether the company has enough cash and liquid assets to pay the current obligations on its long-term debt. A company whose current long-term debt is equal to or greater than its cash reserves has a higher risk of default, and creditors will carefully consider this in deciding whether to extend loans to the company and in determining the interest rates of the loans.

While there is no simple way for investors or creditors to quickly assess a company's overall debt obligations, looking at a balance sheet to calculate its debt-to-equity ratio can provide a reliable indication of a company's financial fitness. An even more valuable resource is to calculate a company's debt-to-equity ratios over time. In other words, if a creditor or investor is able to look at a company's balance sheets over the last five to ten years and calculate the company's debt-to-equity ratio for each year, these ratios will reveal whether the company's overall debt is increasing, decreasing or remaining steady. In general, a financially stable and healthy company should be paying down its debts every year, and so its debt-to-equity ratios should be tracking downward over time.

In addition, investors or creditors may pay particularly close attention to the strength of a company's balance sheet when the economy begins to tip into a recession or downward cycle. This is because a company's debt-to-equity ratio may provide some indication as to whether the company has a strong enough financial position to weather an economic downturn. The debt-to-equity ratio is important during the start of a recession because companies with higher levels of debt are at a higher risk of struggling — or becoming unable — to pay the interest obligations on their outstanding debt should the company experience a flat or declining level of income. Companies unable to pay their debts face bankruptcy and liquidation. Companies that struggle to pay their debts become increasingly less credit-worthy, and thus are less able to acquire any further financing that may be necessary to stay afloat.

Applications

Long-Term Debt in Corporate Finance Analyses

Long-term debt plays an important role in several corporate finance analyses. For instance, considerations about long-term debt commonly arise when companies are considering whether borrowing money-including long-term debt-can actually be profitable for it. Also, creditors and investors can read a company's balance sheet to determine the financial stability and debt structure of a company in making their lending and investment decisions. Finally, long-term debt is a consideration for anyone who wants to compare the financial strength of a number of companies. The following sections explain these factors in more detail.

When Borrowing Is Profitable

Although it seems counterintuitive, there are instances where it is profitable for a company to incur long-term debt. For instance, if a company can earn a higher rate of return by borrowing money and re-investing it back into the company to earn higher dividends than the interest rate at which the money was borrowed, it is actually profitable for the company to borrow the money. This would be the case if, for example, a company borrowed a long-term loan at an 8% annual interest rate but used to money to purchase equipment that would speed up production times so that the company earns an annual return of 12%. In this instance, the company nets a 4% profit by borrowing the money (12% return — 8% cost of borrowing money = 4% net profit).

However, just because assuming more long-term debt would be profitable for a company on paper, too much debt can do more harm than good. Companies that are already carrying substantial levels of debt may threaten their overall financial stability by incurring more debt, even if it could be obtained at favorable interest rates. For companies that have historically carried little or no debt, assuming some debt at a low interest rate could enable them to make significant investments to boost earnings and profitability.

Another factor that creditors and investors can consider to determine whether borrowing would be profitable for a company is to determine the type of debt that the company is attempting to acquire. Generally, debt securities issued to public investors have longer maturities than the long-term loans that companies acquire from commercial banks and other financial institutions. However, both larger long-term loans with higher payments and long-term debt securities issued with high interest rates can erode a company's earnings.

Also, creditors and investors should determine the purpose for the debt to determine whether it is profitable for a company to incur long-term debt. If the new debt is being assumed to repay old debts that the company can no longer maintain, creditors and investors should weigh the benefits of profitable borrowing against the strain excess debt can create on a company’s viability. A company increasing its debt load should have a plan for repaying it. Thus, even if assuming long-term debt seems affordable, or even profitable, for a company, creditors and investors must also consider whether the company has a solid and reasonable plan to repay the debt in a timely fashion while maintaining its other corporate expenses.

Reading a Balance Sheet

A balance sheet reveals a company's assets, liabilities and shareholders' equity, or the owners' net worth. The balance sheet, income statement and cash flow statement, comprise a company's financial statements. Assets are the resources a company has available to finance and manage its business, while liabilities and equity are two way that firms support these assets. A company's liabilities are the financial obligations that it owes to outside parties. Long-term liabilities are debts and other obligations that are not due until at least one year from the date of the balance sheet. Owners' equity, or shareholders' equity in publicly traded companies, is the amount of money that was initially invested into the company to fund its start-up costs plus any retained earnings of the company.

Reading a balance sheet is an important means by which creditors and investors can assess how much long-term debt a company owes and the extent of its debt relative to its assets and shareholders' equity. The amount of long-term debt on a company's balance sheet is important because it refers to money the company owes but will not pay off in the 12 months. Creditors and investors can get an even better sense of a company's financial stability by examining a company's balance sheets for several consecutive years. Companies whose long-term debt is decreasing over time while cash reserves are remaining stable or increasing are considered financially stable with an improving financial outlook. When a company's debt is increasing and cash reserves are decreasing, its financial health is considered unstable or even deteriorating.

Companies with too much long-term debt face decreasing earnings and the possibility of defaulting on interest payments or even facing bankruptcy. Fortunately, before creditors decide to lend a company money and investors decide to purchase a company's bonds, the overall financial health of a company can be determined by carefully reading a company's current balance sheet and even comparing the balance sheets of the past several years. With this information in hand, creditors and investors can make far more informed decisions about the creditworthiness of the company and the degree of their risk should they lend money or invest in the company.

Comparing the Financial Positions of Various Companies

When creditors and investors are considering whether to extend credit or invest in a company, they may compare the financial position of one company against other companies in the same industry that are of approximately the same size and net worth. One way that creditors and investors can assess the relative financial positions of various companies is to compare their debt-to-equity ratios. For instance, if a company has long-term debt of $10 million and equity of $8 million, the debt-to-equity ratio is 1.25 (10/8=1.25). If another company has long-term debt of $10 million and only $1 million in equity, its debt-to-equity ratio is 10 (10/1=10). This company is in a dire financial position. If a third company has $10 million in long-term debt and $20 million in equity, its debt-to-equity ratio of 0.5 (20/10=0.5) is a good indication that the company is financially solid.

Thus, a low debt-to-equity ratio of 1 or lower means that a company has larger amounts of equity relative to its debt, which strengthens its financial soundness. However, a company with low levels of long-term debt may also be overlooking opportunities to make the investments necessary to help it grow in profitability. On the other hand, if a company has a high debt-to-equity ratio of 2 or greater, it has assumed such high levels of debt that its creditworthiness and financial stability are at risk.

Aside from looking at balance sheets and performing debt-to-equity calculations, investors and creditors can also assess the financial stability of various companies by comparing the credit ratings that they have been assigned by credit rating agencies, such as Moody's and Standard & Poor's. Investors and creditors can use these comparisons to determine whether a company is at risk of being downgraded in its credit rating because it is highly leveraged and carrying excessive levels of long-term debt.

Thus, there are resources and tools that are available to help creditors and investors make sound decisions based on the financial stability of companies. While debt-to-equity ratios have been rising for the past two decades, the fundamental assessment of a company's financial wellbeing based on its levels of long-term debt has remained constant. However, while the debt-to-equity ratio alone does not provide a final answer on the financial position of a company, it is a valuable tool that can give interested parties a good sense of a company's stability based on a relatively simple calculation.

Conclusion

Although debt is commonly considered to be negative and bad for businesses, moderate levels of debt can be an important part of financing a company's growth and development. When a company borrows money to make investments that create new opportunities, this can enable the business to grow in profitability. However, companies must be careful not to borrow too heavily. Companies that assume too much debt or that misuse the borrowed money can undermine their ability to grow, even to the point of insolvency. A company's management team must always remain alert to striking the proper balance between maintaining appropriate levels of assets and liabilities.

While long-term debt can be used to finance a company's growth objectives, companies may also assume long-term debt simply because the interest rates on borrowed funds are lower than their earnings, making it profitable for a company to borrow. However, even profitable borrowing can become excessive wherein a company has assumed too much debt to remain financially stable. The management for every company must strive to determine the point where debt levels shift from profitable to risky. There is no definitive point at which this happens for every company. The debt level that is appropriate for one company may be unhealthy for another company. Safe levels of debt are ultimately a function of a company's ability to repay the debts while still retaining the capacity to grow toward its profitability objectives. When companies take on too much debt, their earnings may begin to drop. Investors and creditors will look closely at falling earnings to determine whether the decrease is due to the company's debt structure, or simply the result of external causes, such as a cooling market or rising interest rates.

Creditors and investors are able to make informed decisions about a company's financial stability, by calculating the company's debt-to-equity ratio. The debt-to-equity ratio measures how much of a company's total capital is made up of debt. Most financial experts recommend that a company's debt-to-equity ratio should remain somewhere between 0.5 and 1.5. At these levels, the company has enough capital to finance its growth objectives, while retaining sufficient supplies of cash and other assets to allow the company to pay its debt obligations, grow at a steady pace and still be able to survive periods of time during which its earnings drop or the market slows. Thus, while a company's overall liability must be carefully monitored by its management, prudent assumption of some long-term debt can help a company finance significant projects, resources or acquisitions that will enable it to grow and expand in ways that it simply could not by relying solely on its earnings. There may even be times when a company should borrow long-term debt because it is profitable to do so. However, excessive levels of long-term debt can certainly be categorized as too much of a good thing and can erode the viability of a company's financial health.

Terms & Concepts

Assets: Economic resources acquired and owned by an entity.

Bond: An investment where the investor loans money to an entity (company or government) that borrows the money for a specified period of time at a preestablished interest rate.

Capital Structure: The total amount of a company’s long-term debt, short-term debt, common equity, and preferred quity. Companies use money from this fund to finance all general operations and expansion using different sources.

Cost of Debt: The current interest rate that a company pays on its debt. This cost can be accounted for either before- or after-tax returns, but is usually measured after taxes since interest rates are tax deductible. The cost of debt is one part of the company’s capital structure.

Cost of Equity: A firm’s cost of equity refers to the financial amount demanded by the market in exchange for owning certain asset and being responsible for the risk of ownership.

Credit Rating: A quantitative evaluation of the credit responsibility of individuals and corporations. It is calculated based on the history of borrowing and repayment as well as the current availability of assets and extent of liabilities.

Debt: An amount of money owed by one party and lent to another.

Debt Financing: When a firm finances capital expenditures by selling bonds, bills or notes to investors. In exchange for lending the money, the investors - individuals or institutions - become creditors and are assured that the principal and interest on the debt will be repaid.

Debt Ratio: A ratio that signifies what fraction of debt a company has proportionate to its assets. The measurement provides an idea regarding the influence of the company as well as the future risks the company faces.

Debt-to-Equity Ratio: A calculation of a company’s financial influence measured by dividing its total liabilities by stockholders’ equity. It signfies what fraction of equity and debt the company is using to support its assets.

Equity: In general, ownership in any asset after all debts connected to the asset are paid off.

Equity Financing: The process of raising money for company operations by selling common or preferred stock to investors. In exchange for the investment, shareholders receive ownership rights in the corporation.

Financing: The act of providing funds for business activities, making purchases or investing. Financial institutions and banks are major players in financing since they provide capital to businesses, consumers and investors to help them realize their organizational goals.

Leverage: In general, the amount of debt used to finance a firm's assets.

Loan: A transfer of an asset from a person or entity to another person or entity with the expectation it will be repaid.

Private Equity: Equity capital available to companies or investors, but not quoted on a stock market. The finances obtained through private equity can be used for a variety of company activities such as developing new products and processes, exanding available capital, making acquisitions, and strengthening a firm’s balance sheet.

Bibliography

Aivazian, V., Ying G. & Jiaping Q. (2005). Debt maturity structure and firm investment. Financial Management (2000), 34, 107-119. Retrieved April 30, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=19323984&site=ehost-live

Butler, A., Grullon, G. & Weston, J. (2006). Can managers successfully time the maturity structure of their debt issues? Journal of Finance, 61, 1731-58. Retrieved April 30, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=21796404&site=ehost-live

Custódio, C., Ferreira, M.A., & Laureano, L. (2013). Why are US firms using more short-term debt?. Journal of Financial Economics, 108, 182-212. Retrieved October 31, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=86665002&site=ehost-live

Eisinger, J. (2005). Hedge-fund activism wins plaudits, but the focus is really on firms' cash. Wall Street Journal — Eastern Edition,246, C1-C4. Retrieved April 30, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=18518934&site=ehost-live

Fan, J.H., Titman, S., & Twite, G. (2012). An international comparison of capital structure and debt maturity choices. Journal of Financial & Quantitative Analysis, 47, 23-56. Retrieved October 31, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=74405986&site=ehost-live

Finlay, S. (2007). Loan terms of endearment. Ward's Dealer Business,41, 74-75. Retrieved April 30, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=24040845&site=ehost-live

Foust, D., Grow, B., Cowan, C., Arndt, M. & Henry, D. (2006). Where's the beef? Business Week, 3979, 30-33. Retrieved April 30, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=20339370&site=ehost-live

Goyal, V.K., & Wang, W. (2013). Debt maturity and asymmetric information: Evidence from default risk changes. Journal of Financial & Quantitative Analysis, 48, 789-817. Retrieved October 31, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=90575787&site=ehost-live

Huyghebaert, N. & Van de Gucht, L. (2007). The determinants of financial structure: New insights from business start-ups. European Financial Management, 13, 101-133. Retrieved April 30, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=23615550&site=ehost-live

Kyereboah-Coleman, A. (2007). The impact of capital structure on the performance of microfinance institutions. Journal of Risk Finance (15265943),8, 56-71. Retrieved April 30, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=24467022&site=ehost-live

Sender, H. (2006). High-risk debt still has allure for buyout deals. Wall Street Journal: Eastern Edition,247, C1-C5. Retrieved April 30, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=21117213&site=ehost-live

Suggested Reading

Port of Tacoma refinances long-term debt. (2006). In Pacific Shipper, 81, 6. Retrieved April 30, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=23503179&site=ehost-live

Rastogi, A., Jain, P. & Yadav, S. (2006). Debt financing in India in public, private and foreign companies. Vision (09722629), 10, 45-58. Retrieved April 30, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=24186491&site=ehost-live

Schmukler, S. & Vesperoni, E. (2006). Financial globalization and debt maturity in emerging economies. Journal of Development Economics, 79, 183-207. Retrieved April 30, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=19061312&site=ehost-live