Reporting and Analyzing Long-Term Liabilities



Reporting Long-Term Liabilities

Debts that become due more than one year into the future are reported as long-term liabilities on the balance sheet.

Learning Objectives

Identify a long-term liability

Key Takeaways

Key Points

  • Debts due greater than one year (12 months) into the future are considered long-term.
  • If a classified balance sheet is being utilized, the current portion of the long-term liability, if any, needs to be backed out and reclassified as a current liability.
  • “Notes payable” and ” Bonds payable” are common examples of long-term liabilities.

Key Terms

  • long-term liabilities: obligations of the business that are to be settled in over one year
  • long-term investment: putting money into something with the expectation of gain, usually over multiple years
  • liability: An obligation, debt, or responsibility owed to someone.
  • Long-term: A length of time greater than one year (12 months) into the future.
  • current: A length of time less than one year (12 months) into the future.

Long-term liabilities are debts that become due, or mature, at a date that is more than a year into the future. An example of this is a student loan. Let’s say John, a freshman in college, obtains a student loan for 25,000 and the bank does not require loan payments until 6 months after he graduates, i.e. 4.5 years after the loan was originated. This is an example of a long-term liability.

“Notes Payable” and “Bonds Payable” are also examples of long-term liabilities, and they often introduce an interesting distinction between current liabilities and long-term liabilities presented on a classified balance sheet.

Let’s say Company X obtains a 100,000 Note Payable that requires 5 annual payments of 20,000 starting 1/1/14. On Company X’s 12/31/12 balance sheet, a long-term liability for 100,000 would be reported, but what about the balance sheet as of 12/31/13? Since Company X is required to make a 20,000 payment on 1/1/14, which is less than one year away, a current liability of 20,000 and a long-term liability of 80,000 would be reported on its balance sheet as of 12/31/13.

Continuing one year forward, Company X would report a current liability of 20,000 and a long-term liability of 60,000 on its balance sheet as of 12/31/2014.

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Sallie Mae facilitates several long-term liabilities: Student Loans are a prime example.

What this example presents is the distinction between current liabilities and long-term liabilities. Despite a Note Payable, Bonds Payable, etc., starting out as a long-term liability, the portion of that debt that is due within a year has to be backed out of the long-term liability and reported as a current liability.

See below for the balance sheet reporting treatment of the current and long-term liability portions of the Note Payable from initiation to final payment.

12/31/12……Current Liability: 0……………Long-Term Liability: 100,000

12/31/13……Current Liability: 20,000……Long-Term Liability: 80,000

12/31/14……Current Liability: 20,000……Long-Term Liability: 60,000

12/31/15……Current Liability: 20,000……Long-Term Liability: 40,000

12/31/16……Current Liability: 20,000……Long-Term Liability: 20,000

12/31/17……Current Liability: 20,000……Long-Term Liability: 0

12/31/18……Current Liability: 0……………Long-Term Liability: 0

Analyzing Long-Term Liabilities

Analyzing long-term liabilities combines debt ratio analysis, credit analysis and market analysis to assess a company’s financial strength.

Learning Objectives

Summarize how to analyze a company’s long-term debt

Key Takeaways

Key Points

  • Financial data used to calculate debt – ratios can be found on a company’s balance sheet, income statement and statement of owner’s equity.
  • Benchmarking a company’s credit rating and debt ratios will assist an analyst in determining a company’s financial strength relative to its peers.
  • Reading the footnotes contained in a company’s financial statements can be crucial as the footnotes often contain valuable information regarding long-term liabilities and other factors that could immediately impact the company’s ability to pay it’s long-term debt.

Key Terms

  • insolvent: 1. Unable to pay one’s bills as they fall due.2. Owing more than one has in assets.
  • Creditworthy: 1. Deemed likely to repay debts.2. Having an acceptable credit rating.

Analyzing Long-Term Liabilities

Long-term liabilities are obligations that are due at least one year into the future, and include debt instruments such as bonds and mortgages. Analyzing long-term liabilities is done for assessing the likelihood the long-term liability’s terms will be met by the borrower. After analyzing long-term liabilities, an analyst should have a reasonable basis for a determining a company’s financial strength. Analyzing long-term liabilities is necessary to avoid buying the bonds of, or lending to, a company that may potentially become insolvent.

How is Long-Term Liability Analysis Performed?

Analyzing long-term liabilities often includes an assessment of how creditworthy a borrower is, i.e. their ability and willingness to pay their debt. Standard & Poor’s is a credit rating agency that issues credit ratings for the debt of public and private companies. As part of their analysis Standard & Poor’s will issue a credit rating that is designed to give lenders and investors an idea of the creditworthiness of the borrower. The best rating is AAA with the worst being D. Please consult the figure as an example of Standard & Poor’s credit ratings issued for debt issued by governments all over the world.

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World countries Standard & Poor’s ratings: An example of the credit ratings prescribed by Standard & Poor’s as a result of their respective long-term liability analysis for debt issued at the national government level. Countries issue debt to build national infrastructure. Look how expensive it is to raise capital for such projects based on geographic region.

In addition to credit rating agencies such as Standard & Poor’s, analysts can use debt ratios to help benchmark a company to it’s industry peers. Comparing a company to its peers will give an analyst perspective about what is considered normal or abnormal for a respective industry. Popular debt ratios include: debt ratio, debt to equity, long-term debt to equity, times interest earned ratio (interest coverage ratio), and debt service coverage ratio. Data used to calculate these ratios are provided on a company’s balance sheet, income statement, and statement of changes in equity. Typically, company’s present liabilities with the earliest due dates first.

Debt Ratio:

[latex]\frac { Total\quad Liabilities }{ Total\quad Assets }[/latex]

Debt to Equity Ratio:

[latex]\frac { Long-Term\quad Debt\quad +\quad Value\quad of\quad Leases }{ Average\quad Shareholders\quad Equity }[/latex]

Long-Term Debt to Equity Ratio:

[latex]\frac { Long-Term\quad Debt }{ Total\quad Assets }[/latex]

Times Interest Earned Ratio (aka Coverage Ratio):

[latex]\frac { EBIT }{ Annual\quad Interest\quad Expense }[/latex]

Debt Service Coverage Ratio:

[latex]\frac { Net\quad Operating\quad Income }{ Total\quad Debt\quad Service }[/latex]

There is more to analyzing long-term liabilities than simply reading a company’s credit rating and performing independent debt ratio analysis. In addition, an analyst needs to consider the overall economy, industry trends and management ‘s experience when forming a conclusion about the strength or weakness of a company’s financial position. When gathering information, an analyst should always read the footnotes contained in financial statements to determine if there are any disclosures related to long-term liabilities or other factors that may impact the company’s ability to pay it’s long-term obligations.

Debt-to-Equity Ratio

The Debt-to-Equity Ratio is a financial ratio that compares the debt of a company to its equity and is closely related to leveraging.

Learning Objectives

Summarize how to calculate a company’s debt to equity ratio

Key Takeaways

Key Points

  • Debt and equity have very distinct pros and cons.
  • The composition of debt and equity and its influence on the value of a firm is a much debated topic.
  • Debt and equity book values can be found on a company’s balance sheet, and the debt portion of the ratio often excludes short-term liabilities.

Key Terms

  • equity: Ownership interest in a company, as determined by subtracting liabilities from assets.
  • debt: Money that one person or entity owes or is required to pay to another, generally as a result of a loan or other financial transaction.

Debt-to-Equity Ratio

The Debt-to-Equity Ratio is a financial ratio indicating the relative proportion of shareholder ‘s equity and debt used to finance a company’s assets, and is calculated as total debt / total equity.

In order to obtain assets used in operations, a company will raise capital through either issuing shareholder’s equity (e.g., publicly traded common stock) or debt (e.g., notes payable). Stakeholders, which include investors and lending institutions, provide companies with capital with an expectation that those companies generate net income through their respective operations.

Debt is typically a long-term liability that represents a company’s obligation to pay both principal and interest to purchasers of that debt.

Equity represents ownership of a company, and does not include any agreed upon repayment terms.

Each form of raising capital has its own set of pros and cons. Interest payments on debt are tax deductible, while dividends on equity are not. Returns to purchasers of debt are limited to agreed- upon terms (i.e., interest rates), however, they have greater legal protection in the event of a bankruptcy. The returns an equity holder can achieve have unlimited upside, however, they are typically the last to be paid in the event of a bankruptcy.

Calculating the Debt-to-Equity Ratio

Calculating a company’s debt to equity ratio is straight forward, and the debt and equity components can be found on a company’s respective balance sheet. For more advanced analysis, financial analysts can calculate a company’s debt to equity ratio using market values if both the debt and equity are publicly traded.

When used to calculate a company’s financial leverage, the debt-to-equity ratio includes only long-term liabilities in the numerator and can even go a step further to exclude the current portion of the long-term liabilities. This means that other short-term liabilities, such as accounts payable, are excluded when calculating the debt-to-equity ratio.

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Leverage Ratios: Graph of how infamous investment banks were leveraged prior to the credit crisis of 2008.

Times Interest Earned Ratio

Times Interest Earned Ratio = (EBIT or EBITDA) / (Required Interest Payments), and is indicative of a company’s financial strength.

Learning Objectives

Explain how a company uses the times interest earned ratio

Key Takeaways

Key Points

  • Times Interest Earned Ratio is the same as the interest coverage ratio.
  • The higher the Times Interest Earned Ratio, the better, and a ratio below 2.5 is considered a warning sign of financial distress.
  • A company will eventually default on its required interest payments if it cannot generate enough income to cover its required interest payments.

Key Terms

  • Interest: The price paid for obtaining, or price received for providing, money or goods in a credit transaction, calculated as a fraction of the amount of value of what was borrowed.
  • times interest earned ratio: either EBIT or EBITDA divided by the total interest payable
  • EBIT: Earnings before interest and taxes.
  • EBITDA: Earnings before interest, taxes, depreciation and amortization.

Times Interest Earned Ratio

The Times Interest Earned Ratio indicates the ability of a company to meet its required interest payments, and is calculated as:

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Long-Term Interest Rates: The Times Interest Earned Ratio is an indication of a company’s overall financial health.

Times Interest Earned Ratio = EarningsĀ before Interest and Taxes (EBIT) / InterestĀ Expense.

Earnings before Interest and Taxes (EBIT) can be calculated by taking net income, as reported on a company’s income statement, and adding back interest and taxes.

Analysts often use “Operating Income” as a proxy for EBIT when complex accounting situations, such as discontinued operations, changes in accounting principle, extraordinary items, etc., are reported in a company’s financial statements. Analysts will sometimes use EBITDA instead of EBIT when calculating the Times Interest Earned Ratio. EBITDA can be calculated by adding back Depreciation and Amortization expenses to EBIT.

The Times Interest Earned Ratio is used by financial analysts to assess a company’s ability to pay its required interest payments. The higher this ratio, or the more EBIT a company can produce relative to its required interest payments, the stronger the company’s creditworthiness and overall financial health are considered to be.

For example, if Company X’s EBIT is 500,000 and its required interest payments are 300,000, its Times Interest Earned Ratio would be 1.67. If Company A’s EBIT is 750,000 and its required interest payments are 150,000, itsTimes Interest Earned Ratio would be 5. Comparing the respective Times Interest Earned Ratios would lead an analyst to believe that Company A is in a much better financial position because its EBIT covers its required interest payments 5 times, relative to Company X, whose EBIT only covers its required interest payments 1.67 times.

If a company’s Times Interest Earned Ratio falls below 1, the company will have to fund its required interest payments with cash on hand or borrow more funds to cover the payments. Typically, a Times Interest Earned Ratio below 2.5 is considered a warning sign of financial distress.

Being Aware of Off-Balance-Sheet Financing

Off-Balance-Sheet-Financing represents rights to use assets or obligations that are not reported on balance sheets to pay liabilities.

Learning Objectives

Explain what constitutes an off-balance-sheet financing item

Key Takeaways

Key Points

  • Off-Balance-Sheet-Financing represents financial rights or obligations that a company is not required to report on their balance sheets.
  • Off-Balance-Sheet-Financing can have a substantial effects on a company’s financial health: Enron is a great example of this.
  • An analyst should always read the footnotes contained in the financial statements as they often either disclose off-balance-sheet-financing directly or provide enough information to determine if the company could potentially enter into off-balance-sheet-financing arrangements.

Key Terms

  • subsidiary: A company that is completely or partly owned and partly or wholly controlled by another company that owns more than half of the subsidiary’s equity.
  • operating lease: A lease whose term is short compared to the useful life of the asset or piece of equipment being leased.
  • off-balance-sheet financing: capital expenditures financed and classified it in such a way that it does not appear on the company’s balance sheet

Off-Balance-Sheet-Financing is associated with debt that is not reported on a company’s balance sheet. For example, financial institutions offer asset management or brokerage services, and the assets managed through those services are typically owned by the individual clients directly or by trusts. While these financial institutions may benefit from servicing these assets, they do not have any direct claim on them.

The formal accounting distinctions between on and off-balance sheet items can be complicated and are subject to some level of management judgment. However, the primary distinction between on and off-balance sheet items is whether or not the company owns, or is legally responsible for the debt. Furthermore, uncertain assets or liabilities are subject to being classified as “probable”, “measurable” and “meaningful”.

An example of off-balance-sheet financing is an unconsolidated subsidiary. A parent company may not be required to consolidate a subsidiary into its financial statements for reporting purposes; however the parent company may be obligated to pay the unconsolidated subsidiaries liabilities.

Another example of off-balance-sheet financing is an operating lease, which are typically entered into in order to use equipment on a short-term basis relative to the overall useful life of the asset. An operating lease does not transfer any of the rewards or risks of ownership, and as a result are not reported on the balance sheet of the lessee. A liability is not recognized on the lessee’s balance sheet even though the lessee has the obligation to pay an agreed upon amount in the future.

It is important to consider these off-balance-sheet-financing arrangements because they have an immediate impact on a company’s overall financial health. For example, if a company defaults on the rental payments required by an operating lease, the lessor could repossess the assets or take legal action, either of which could be detrimental to the success of the company.

Jeffrey Skilling: Jeffrey Skilling is the former CEO of Enron, which was notorious for it’s use of off-balance-sheet-financing.