Debt

What is Debt?

Debt is a significant source of financing for many businesses. Debt is an amount of money borrowed from one party to another on the condition that the amount borrowed (principal) is repaid at a later date. The agreement almost always includes interest payments too. Both interest and principal must be paid on the date due regardless of the circumstances of the borrower. Failure to make a payment is called a ‘default’ and the consequences can be severe, including bankruptcy. The detailed lending terms are prearranged between the lenders and borrowers in the loan documentation.

Debt represents a present financial obligation and as such is reported as a liability on the balance sheet. The other side of the accounting equation will result in an equal increase in balance sheet cash (resource of funds).

Types of Debt

There are many different flavors of debt products. Debt can be secured or unsecured. Secured debt is backed by collateral, usually in the form of an asset or group of assets. Security is also referred to as a charge and if a specific asset is involved it is called a fixed charge, whereas a charge on a group of assets is generally referred to as a floating charge.

Short term debt

Short term debt is debt whose principal is payable within the next twelve months. These are categorized as a current liability on the borrower’s balance sheet.

Long term debt

Long term debt includes instruments whose term is longer than twelve months. This is reported on the balance sheet as a non-current liability until the final year of its term when it is categorized under current liabilities as long-term debt, currently due.

In the table below the items classified as debt are outlined in red. In the current liabilities we have three types of debt items:

• Current maturities of long-term debt: long-term debt, which was originally in long-term liabilities, but because it is being repaid within twelve months it moves up to current liabilities
• Notes payable: typically commercial paper which are bonds sold into the markets with very short maturities (typically under one year)
• Current operating lease liabilities: debt that is secured against a named asset where the borrower makes a fixed payment each year, quarter, or month and the final payments are due to be made within 12 months
• Long-term debt: debt that has a maturity date of more than 12 months from the balance sheet date
• Operating lease liabilities: debt that is secured against a named asset where the borrower makes a fixed payment each year, quarter, or month and the final payments are due to be made after 12 months

The main types of debt products are grouped into four categories depending on whether they are due to be repaid within or over twelve months at inception, and whether they are traded in the public securities markets or are created by a direct relationship between the borrower and lender.

Debt can be further divided into two more categories. These classifications are called private debt (borrowing from banks) and public debt (borrowing from capital markets).

Each of these debt products will favor different individuals and companies, depending on their financial interests. A small company facing cash flow problems may need to borrow cash for a short time period (revolving credit facility). However, a large company looking for sources of cash to acquire a target in an M&A deal would require a much larger long-term debt product.

Repayment of debt

The repayment of principal on a debt instrument can be spread over the term (or tenor) of the loan, in which case it is referred to as amortizing debt. If the principal repayment is due on the final day of the term, it is referred to as bullet debt.

As debt repayments are made, the loan liability will decrease. Interest is normally due in cash on a regular basis (usually quarterly for corporate bank loans) and this will represent an expense against the company’s profits. The other side of the equation is a reduction in cash. All interest is expensed into the income statement over the term of the loan.

Below represents the effect on the balance sheet for year 1 on a four-year loan of 100. The loan has straight-line repayment and an interest rate of 5% on beginning balance.

As the loan is repaid it will reduce the balance reported in the long-term liability of the loan. The current portion of long-term debt represents the debt repayment for the year. In this example, the balance sheet will report long term debt as 50 and the current liability as 25 at the end of year 1.

In the notes to the accounts, companies detail the individual repayment dates and interest rates of the different loans and bond issues they have outstanding, along with a five year repayment schedule.

Here is Kellogg’s debt note disclosure. The list of their outstanding bonds:

Kellogg Co. 2019 – Extract from notes to accounts

Note the total debt is 7,815m of which 620m is shown in the current liabilities and 7,195m in the long-term liabilities. Here is the projected repayment of the existing debt (assuming no new issuance of debt):

Debt and Ratios

Debt represents an interest-bearing liability and is used in the calculation of net debt.

Net debt is used in many frequently used leverage ratios, including net debt/equity and net debt/total capital (total debt plus shareholders’ equity) and also within the debt / LTM EBITDA ratio to measure a company’s ability to service its debt. Using net debt rather than total debt with regards to credit analysis assumes the company could use its surplus cash and short-term investments to pay back debt if the company were to experience financial distress.

Debt is also used in the calculation for return ratios. Return on Capital Employed (ROCE) is a common metric used that expresses the after-tax, pre-financing profits of a business as a percentage of the capital invested by the business’s capital holders. Debt is part of the capital invested along with shareholders’ equity. The metric helps analysts measure both the operational profitability and asset efficiency of a business.