Bank Loans and Mortgages
Bank loans and mortgages are two common examples of long-term liabilities. By convention, the loan installments and mortgage payments made within 12 months count as current liability, and the outstanding debt or mortgage beyond 12 months as long-term liability. With the annual balloon-payment method of loan repayment, the balloon payments due within 12 months become current liability, and the rest long-term liability.
For instance, for a loan of $2,000 plus interest repayable in equated monthly installments of $100 for 24 months, the installments of the first 12 months, that is $100 x 12 = $1,200, are current liability; and the remaining 12 installments of $1,200 are long-term liability.
Image Credit: flickr.com/Ken Lund
A bond is a formal contract to repay borrowed money at a later committed date and interest or coupons at fixed committed intervals. Companies issue bonds when the amount required is too large to obtain from a single lender and when approaching the equity market is not a feasible or preferred option. Governments also isue bonds, the US Treasury Bonds being the most common example. The interest payable by the company in the form of coupons beyond the 12-month period and the repayment of the bond capital at the designated date in the future becomes long-term liability.
For example, a bond with a $1,000 maturity value paid in 10 years with 10 percent stated interest paid annually fixes the company’s liability at $100 every year.
The market value of bonds differs from the maturity value, and purchasing the bonds at market value increases or decreases the returns for the investor. The company, however, usually repays only the stated maturity value and interest rate, with changes in market value not changing its liabilities.
Some structured bonds, however, have a maturity value different than the face value. Such bonds link the maturity value to performance of particular assets such as a stock, commodity index, foreign exchange rate, or a fund. Other bonds have floating interest rates, based on reference rates such as LIBOR, or to inflation rates. Such bonds make the long-term liability of the company uncertain, and the balance sheet needs to reflect reserves to cater to expected liability. Equity-linked bonds that peg liabilities on the company’s performance make it easy to set aside liability as a portion of the earnings.
Some bonds have no maturity date. The UK Consols bonds issued in 1888 still trade today, and the West Shore Railroad bonds mature in 2361. The company does not redeem the capital of such perpetual bonds, and does not allocate long-term liabilities. They rather include the continuous payment of coupons or interest rate in current liabilities.
A lease is a contractual agreement between the owner of the property–usually land, building, equipment, or machinery–and the renter to use property for a period.
The two major types of lease are capital lease and operational lease.
In operating lease, the owner transfers the right to use the property to the lessee, and the lessee returns the property to the owner at the end of the lease period. The lease expense becomes operating expense in the income statement and does not affect the balance sheet.
A capital lease is a conditional sales contract that allows the lessee to start enjoying the product immediately after executing the lease agreement, while making payments over a period, with stipulations for terminating the agreement early. The lessee assumes some risks and enjoys some benefits of ownership, and as such the lease payments reflect as liability on the balance sheet. Capital lease payments that exceed 12 months become long-term liabilities.
The long-term liabilities included in the balance sheet might have some distortions.
- Common types of distorter in the balance sheet are overdrafts and other short-term debts, usually renewed continuously. These debts are long-term debts for all practical purposes but find mention in current liabilities.
- Preference shares are not debts but are, again, equivalent to long-term liabilities for practical purposes.
- Debt instruments that were originally long-term liabilities move to current liabilities when close to expiry.
The adequacy of a company’s profits relative to the ability to cater to long-term liabilities is a good indicator of a company’s financial health. Subtracting long-term liabilities from fixed assets and the net current assets reveals the net assets of the enterprise.