Introduction to Long Term Liabilities Example
Long term liabilities are those liabilities which are due above a period of one year. Alternatively, they are not due in the operating cycle of a company. The operating cycle of a company is the time taken to convert its inventory into cash. Long term liabilities are stated in the Balance Sheet of the company.
Examples of Long Term Liabilities
Examples of Long Term Liabilities are as follows:
#1 – Long Term Loans
The long term loan is the debt held by a company that has a maturity of more than 12 months. However, when a portion of the long term loan is due within one year, that portion is moved to the current liabilities section.
Since the entire long term portion of capital may not be funded by shareholders funds, long term loans come into the picture. There are certain capital intensive industries like power and infrastructure which require a higher component of long term debt. However, an excessively high component of long term loans is a red flag and may even lead to the organization going into liquidation.
Long term loans can be taken from banks or financial institutions. They can also be taken from an individual, a group of individuals or some other organization. They can be used to fund fixed assets such as plant and machinery, equipment, etc. or working capital requirements of the company. Such loans require collateral in case the company defaults on the loan. These loans can be for at a fixed rate or a variable/ floating rate. The variable-rate loan is linked to a benchmark rate like the London Interbank Offered Rate (LIBOR).
#2 – Bonds
Bonds are a part of long term debt, but with certain special characteristics. A bond is a fixed income instrument. It represents a loan given by a borrower. Those who own the bond are the debtholders or creditors of the entity issuing the bond. Bonds are used by sovereign entities, municipal bodies, companies, etc. to raise capital. Governments issue bonds generally to fund their infrastructure requirements such as building roads, dams, airports, ports and undertaking other projects. Companies issue bonds generally to fund their Capex requirements or to fund their research and development activities. Corporate bonds generally carry a higher interest rate than government bonds. Many bonds can be traded through recognized exchanges and some are traded over the counter (OTC), making them freely transferable. In certain cases, bonds are repurchased before the maturity date by the issuer.
The interest payment on a bond is known as the coupon. These coupon payments are generally made regularly over the period of the bond. The date when the bond becomes due is known as the maturity date. Bond prices fall when there is a rise in interest rates and vice versa. Thus, bond prices and interest rates are inversely related. The initial price of a bond is generally $100 or $1,000. Bonds are generally issued as face value.
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Based on their risk, bonds are rated by rating agencies such as Standard and Poor, Fitch Ratings, Moody’s, etc. These ratings can be Investment grade or non-Investment grade. The rating given represents the degree of safety of principal and interest of that bond. For instance, AAA-rated bonds have a very high degree of safety of principal and interest.
#3 – Debentures
Debentures are fixed-income instruments that are unsecured. However, in certain countries, secured debentures are also issued. Debentures pay a fixed coupon rate and are redeemable on a fixed date. In some countries, the term debenture is used interchangeably with bonds. There are some convertible debentures, which can be converted into equity shares after a certain period. Non-convertible debentures cannot be converted into equity shares and carry a higher interest rate as compared to convertible debentures. Debentures, like bonds, are also given a credit rating depending on their risk.
Debentures carry interest rate risk. This implies that if interest rates are rising, debentures which are issued earlier may give lower interest than current debt instruments. The interest rate on debentures is either fixed or floating. Generally, 10 year Treasury bonds are used as a benchmark for floating rate debentures. Investors have to take care about the creditworthiness of an issuer while investing in debentures. If investors do not take into account the creditworthiness of the issuer, credit risk may materialize. In other words, the issuer may become incapable of paying the money due. Another disadvantage of debentures from an investor’s perspective is that the inflation rate may be higher than the interest rate on dentures.
Debenture interest payments are made before stock dividends are paid to shareholders. Similarly, debenture payments have a higher priority than payments to shareholders in the event of liquidation of a company. There are different categories of debentures. For instance, senior debentures have a higher priority of payment as compared to subordinated debentures.
#4 – Pension Liabilities
Pension commitments given by an organization lead to pension liabilities. Pension liability refers to the difference between the total money that is due to retirees and the actual amount of money held by the organization to make these payments. Thus, pension liability occurs when an organization has less money than it requires for paying its future pensions. When there is a defined benefit scheme followed by an organization, pension liabilities occur.
Conclusion
Long term liabilities require long term commitment. Hence, decisions to raise long term liabilities require careful planning. An estimate has to be made for the funds required for the long term. Then, a decision has to be taken as regards to the mix of funds. These funds can be raised through different sources such as long term debt, bonds, debentures, etc. Different sources of long term funds have their own advantages and disadvantages. These pros and cons should be carefully considered.
A company should take care that it keeps its long term liabilities in check. If long term liabilities are a high proportion of operating cash flows, then it could create problems for the company. Similarly, if long term liabilities show a rising trend, then it could be a red flag.
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