DIGESTING FINANCIAL STATEMENTS: LONG-LASTING LIABILITIES
Long-lived liabilities refer to obligations which are due more than a year. Some examples of long-term debt include convertible bond and capital lease obligations. Long-term liabilities are classified as either financing (debt instruments) or operating (operations related). Such liabilities stem from company’s funding discretion or financing mishaps, affecting its prospects in one way or another.
Realistically speaking, debt is not that bad. But holding too much debt load puts the company at risk. When assessing a company, investors look at its capital structure. It shows how an entity funds its operations and expansions by using all available financing methods. Capital structure is gauged using long-term debt to total capital ratio.
Debt is itemized in the financial statement, unlike the cost of equity. Therefore, traders often overlook the fact debt is a less expensive financing source than equity and also considered safer than equity. Two reasons: borrowers already have a claim should the firm declare bankruptcy and interest rate is deductible, resulting in a discounted tax rate.
What is the ideal capital structure of a company? While it is difficult to determine an optimal funding system for companies, be guided with these general principles:
A good capital structure trails the growth cycle of a firm. In some instances, startup companies and the like frequently support equity over debt since investors are willing to withhold dividend payments in exchange of price returns in the future.
A good capital structure differs from company to company and industry to industry. In general, the greater the investment in fixed assets, the higher the debt usage is.
Be wary of the following when reviewing the liability accounts of a firm. It is vital to determine the rationale for releasing new long-term debt. The most common purpose include modifying the capital structure, refinancing an existing debt, financing operating costs, and funding expansion. It also pays to evaluate the company’s exposure to interest rate. Entities hugely rely on hedge instruments and are susceptible to rates.
Before we wrap up the discussions, here’s a piece of advice: bear in mind that operating leases are liabilities in the financial statement.
We are going to look into pension plans in the next tutorial.
Digesting Financial Statements: Pension Plans
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