Money Research Collective’s editorial team solely created this content. Opinions are their own, but compensation and in-depth research determine where and how companies may appear. Many featured companies advertise with us. How we make money.
What Is Long-Term Debt?
By Rebecca Parson MONEY RESEARCH COLLECTIVE
Long-term debt refers to debt that takes more than a year to mature or be paid off. Lenders, investors and creditors look at long-term debt to assess a business’s financial health and liquidity. In this article, we’ll look at how it compares to short-term debt, some examples of what you can use long-term debt for and its pros and cons.
Long-term debt defined
Long-term debt (also called long-term liabilities) is a financial obligation that extends past a 12-month period. This is the opposite of short-term liabilities, which are loans due within a year. Let’s look at the main types of long-term debt and the pros and cons of paying the debt over a longer period.
Common types of long-term debt
Some commons types of debt that extend past one year include:
- Bonds: Bonds are loans corporations and governments issue to the general public to raise money. The bondholder buys the bond and, in return, receives interest from the bond issuer. On the bond’s maturity date, the issuer pays back the face value of the bond to the bondholder.
- Convertible bonds: The bondholders can convert these into company stock before the bond’s maturity date. Companies do this because convertible bonds have lower interest rates that they have to pay out to bondholders.
- Individual notes payable: Individual notes payable is a written agreement (a formal IOU) in which one party agrees to pay the other back within a specific time.
- Pension benefits: Pension payments that a company owes to employees are considered long-term debt because the company has to plan to have enough money to pay those pensions in the future.
- Leases: Commercial leases are often three to five years long. Because the company is on the hook for those future rent payments, that future rent is a debt.
- Contingent obligations: Contingent obligations are potential financial payouts a company might have to make depending on how something pans out in the future. Examples of contingent obligations include changes in foreign exchange rates, changes in government policy and lawsuits.
Long-term debt can help businesses finance large upfront outlays they would otherwise be unable to afford, such as equipment and real estate, as we detail below.
Equipment financing allows you to obtain the capital required to purchase heavy machinery or equipment for your business. These loans are popular among manufacturing and construction companies but can also finance software systems, vehicles, restaurant supplies and office materials. You might also be eligible for an equipment loan for repairs or upgrades to existing assets. Equipment financing is more cost-effective over the long term than equipment leasing and allows companies to increase equity in assets.
You might be able to finance 80% to 100% of equipment costs with an equipment loan. With long-term financing, you pay the entire cost in smaller regular payments. Additionally, the equipment itself can serve as collateral for the loan.
Commercial real estate loans can help business owners finance commercial spaces such as warehouses, retail locations and offices. You can also use commercial real estate financing to build a property, refinance real estate debt or renovate an existing property. These loans work similarly to residential mortgages because a portion of your payments goes toward building your equity in the property. A lien secures the loan against the commercial property, and the bank can seize the property if the business defaults on it.
Understanding the current portion of long-term debt
The current portion of long-term debt is the part that will come due within the next year. For example, a company may have a long-term loan with annual lump payments they must make toward the overall loan.
Investors and lenders use the current portion of long-term debt on a company’s balance sheet to determine whether it has enough liquidity to pay its short-term obligations. If a company has a high current portion of long-term debt compared to its cash on hand, it has a higher risk of default on its loans. In that case, lenders would be more wary of offering the company more loans.
The long-term debt ratio formula
The long-term debt ratio is the portion of a company’s assets that it would need to sell to pay off its long-term debt. The lower the long-term debt ratio, the more solvent the company is. If a company has more debt than capital, investors and lending institutions will likely see the company as high-risk and decline to lend it more money.
The long-term debt formula is the following:
Long-term debt / Total assets = Long-term debt ratio
For example, let’s say a company has $1,200,000 in long-term debt and $2,000,000 in total assets. Here’s how the formula would look:
$1,200,000 / $2,000,000 = 0.6
This company’s long-term debt ratio is 0.6. For every dollar of assets it has, it has 60 cents of long-term debt. Investors looking for a low-risk investment would likely look for a ratio of 0.5 or lower. Additionally, lenders and investors typically compare a company’s long-term debt ratio to similar companies and the entire industry. They also look at the overall trend: is the company’s ratio going up or down over time?
The benefits of paying longer
Long-term debt can impact a business positively in several important ways, which we cover below.
More affordable debt payments
Long-term debt has the advantage of lower monthly payments than short-term loans. Since the financial contract is spread out over a longer time, there will be a higher number of payments, but they will be smaller. This is helpful if your business is just starting, you want to keep your immediate expenses low or you need help with cash flow issues.
When you apply for a long-term loan, you and your lender will agree to payment terms that will stay fixed for the entire loan. That way, you’ll know exactly how much you’ll have to pay on the loan every month, so you can accurately plan your budget within the terms of the long-term debt cycle.
Adding to the affordability of long-term debt is that it often comes with lower interest rates and fees. The exact interest rate you get on a bank loan for your business depends on several factors, including your financial standing, business history and credit score.
Average interest rates for long-term business loans range from about 3.25% to upwards of 6%. Long-term debt requirements vary from industry to industry. But to increase your chances of getting reasonable rates, you’ll want to do things like wait to apply until you’ve been in business for six months or longer and improve your credit score.
The option to pay off debt sooner
Another benefit of long-term debt is that you get the advantage of lower monthly payments now with the option to pay off debt sooner if your business starts generating more revenue sooner than expected. The motivation here is typically to save money on the overall interest you’ll pay by paying down the debt early. There are several important things to consider, however.
If your business has an amortizing loan, most of your monthly payments will go toward interest to start. As time passes, more of your monthly payments will go to paying off the unpaid principal. Paying off this type of loan early would cost you less in interest over time. However, if your loan has a fixed-fee structure, you may not end up saving on overall borrowing costs. The reason is that you’ll have to pay the full amount of interest you would have paid if you’d taken the entire term of the loan to pay it back.
Additionally, you’ll want to look into whether your business loan has prepayment penalties. A prepayment penalty is usually calculated as a percentage of the loan’s remaining balance.
The drawbacks of paying longer
Long-term debt has downsides, however, which you’ll want to carefully weigh as you consider this method of financing your business.
Paying more interest
A longer loan term will result in paying more in total interest over time. Paying interest for 10 years instead of one year means paying more interest because of the additional nine years you’re paying interest.
For example, if you pay off a $10,000 loan in one year at 5% interest, you’ll pay a total of $273 in interest. If you pay off that same loan in 10 years, you’ll pay a total of $2,728 in interest — almost 10 times as much.
Being locked into a contract for long periods of time
Long-term debt is a substantial commitment for any business. You’re signing a long-term contract that decides how you spend a portion of your company’s revenues for the entire period of the loan. Every payment on the loan is money you can’t spend elsewhere in the business, and you might need to direct a significant percentage of your revenues toward the loan.
Additionally, locking yourself into a long-term contract for debt may make it harder to qualify for future financing. Lenders are wary of lending to businesses with high amounts of outstanding debt. If you have a business opportunity or crisis later on, you may not have the credit to respond as you would like to.
You might face other unforeseen events, too, such as changing market conditions or a recession. This could put you in a tough spot when you have a repayment schedule with inflexible terms.
Short-term debt vs. long-term debt
Business owners have two options for borrowing money to start or grow their business: short-term versus long-term debt. Long-term debt includes commercial mortgages, long-term bonds, individual notes payable, deferred taxes, pension benefits, long-term leases and contingent obligations. Examples of short-term debt include things like accounts payable, wages, lines of credit, short-term bank loans, bonds due within one year, lease payments, current taxes due and commercial paper.
The repayment period greatly impacts the interest rate you can expect to pay on a loan. Lenders tend to consider short-term debt riskier than long-term debt, so they charge a higher interest rate for short-term debt.
Businesses often use long-term debt to finance expansion projects and large purchases. Business owners often use short-term debt to cover things like emergency expenses, a gap in their cash flow or taking advantage of a new business opportunity.
Is long-term debt a current liability?
Long-term debt is not a current liability. However, the portion of long-term debt that’s due in the next year is a current liability. Companies will need to find the money in their current assets to pay off current liabilities. As a result, they won’t be able to use that money for other purposes, which will impact their daily operations. For example, a company might have to pay their suppliers within 60 days, in which case they’ll require their customers to pay them within 30 days.
What is a good debt-to-equity ratio?
The D/E ratio refers to how in debt a company is compared to its shareholder equity. It usually includes both long-term and short-term debt.
Here’s the formula for calculating the D/E ratio:
Total debt / total shareholder equity = D/E ratio
The higher the ratio, the riskier the company’s financial footing is. A D/E ratio in the range of 2 or 2.5 is optimal. A D/E ratio of 2 indicates that one-third of the company’s financing comes from its equity and two-thirds comes from debt.
Is long-term debt the better debt?
Long-term debt is better than short-term debt if you need immediate capital. However, you need to be willing to exchange lower monthly payments now for paying higher total interest over time. Long-term business debt can be a great way to finance these needs if you’re founding a startup or making large equipment or commercial real estate purchases.
Banks and credit unions typically offer the best interest rates on business loans, but they can be hard to qualify for. Online lenders usually have less strict lending requirements, and some consider those with poor credit, but the downside is that online lenders have much higher interest rates — twice or three times as much, if not more.