Long Term Liabilities - definition & overview

In the realm of small business, the term 'Long Term Liabilities' holds significant importance. These are the financial obligations a company is expected to pay over a period exceeding one year. They form a critical part of a company's balance sheet and are essential for understanding the financial health of a business.

Long term liabilities can include loans, lease payments, bonds payable, deferred tax liabilities, and pension obligations among others. They are an integral part of a company's capital structure and play a crucial role in shaping the financial strategies of a business. Understanding these liabilities is vital for any small business owner, as it helps in making informed decisions about future investments and expansions.

Understanding Long Term Liabilities

Long term liabilities are financial obligations that a company is expected to pay after a year. They are usually incurred for significant expenditures like acquiring assets, buildings, or equipment which are expected to generate long-term income. These liabilities are not paid off immediately but are instead paid over an extended period.

They are different from short-term liabilities, which are due within a year. Long term liabilities are crucial for a company's growth and expansion as they provide the necessary funds for significant investments. However, they also represent a financial risk as they need to be paid back with interest.

Types of Long Term Liabilities

There are various types of long term liabilities that a company can incur. These include bonds payable, long term loans, deferred tax liabilities, pension obligations, and lease obligations. Each of these has different implications for the company's financial health and needs to be managed differently.

Bonds payable are issued by companies to raise funds. They are a form of debt where the company promises to pay back the principal amount along with interest after a certain period. Long term loans are borrowed from banks or other financial institutions and are paid back with interest over a specified period. Deferred tax liabilities arise when there is a difference between the tax calculated on the tax return and the tax based on the company's financial statements. Pension obligations are the amount a company owes to its employees as part of their retirement benefits. Lease obligations are the payments a company needs to make under a lease agreement.

Importance of Long Term Liabilities

Long term liabilities are important for several reasons. Firstly, they provide a source of funds for a company to make significant investments or acquisitions. This can help a company grow and expand its operations. Secondly, they impact a company's credit rating. A company with high long term liabilities may be seen as a financial risk by lenders and investors.

Furthermore, long term liabilities are important for tax purposes. Interest payments on these liabilities are usually tax-deductible, which can reduce a company's tax liability. Lastly, understanding long term liabilities is crucial for financial planning. It helps a company plan its cash flows and ensure it has sufficient funds to meet its future obligations.

Managing Long Term Liabilities

Managing long term liabilities effectively is crucial for the financial health of a company. This involves ensuring that the company has a plan in place to meet its future obligations. It also involves regularly reviewing the company's long term liabilities and making adjustments as necessary.

One of the key aspects of managing long term liabilities is ensuring that the company has sufficient cash flow to meet its obligations. This involves careful financial planning and budgeting. It also involves monitoring the company's income and expenses and making adjustments as necessary.

Debt Refinancing

Debt refinancing is a strategy that companies use to manage their long term liabilities. This involves replacing existing debt with new debt that has more favourable terms. This could mean lower interest rates, longer repayment periods, or a combination of both. Refinancing can help a company reduce its monthly payments, freeing up cash for other uses.

However, refinancing also has risks. It can extend the period over which the company is in debt, and it can also increase the total amount the company ends up paying in interest. Therefore, companies need to carefully consider the pros and cons before deciding to refinance their debt.

Debt Consolidation

Another strategy for managing long term liabilities is debt consolidation. This involves combining multiple debts into a single debt. This can make it easier to manage the debt as the company only has to make one payment instead of multiple payments. It can also potentially lower the interest rate if the consolidated debt has a lower rate than the individual debts.

However, like refinancing, debt consolidation also has risks. It can extend the period over which the company is in debt, and it can also increase the total amount the company ends up paying in interest. Therefore, companies need to carefully consider the pros and cons before deciding to consolidate their debt.

Impact of Long Term Liabilities on Financial Statements

Long term liabilities have a significant impact on a company's financial statements. They are listed on the balance sheet, which provides a snapshot of a company's financial position at a specific point in time. The balance sheet lists a company's assets, liabilities, and shareholders' equity. Long term liabilities are part of the liabilities section.

They also impact the income statement, which shows a company's revenues and expenses over a period. Interest expense on long term liabilities is listed as an expense on the income statement. This reduces the company's net income and, therefore, its earnings per share.

Balance Sheet

On the balance sheet, long term liabilities are listed under the liabilities section. They are usually listed after short-term liabilities and are often broken down into individual items. This provides a detailed view of a company's long term obligations and helps investors and lenders assess the company's financial risk.

The ratio of long term liabilities to total assets is a key indicator of a company's financial leverage. A high ratio indicates a high level of debt, which can be a sign of financial risk. However, it can also indicate that a company is using debt to finance growth, which can be a positive sign if the company is able to generate a higher return on the borrowed funds than the interest cost.

Income Statement

On the income statement, interest expense on long term liabilities is listed as an expense. This reduces the company's net income and, therefore, its earnings per share. However, interest expense is also tax-deductible, which can reduce a company's tax liability.

The ratio of interest expense to earnings before interest and taxes (EBIT) is a key indicator of a company's ability to service its debt. A high ratio indicates that a large portion of the company's earnings is going towards interest payments, which can be a sign of financial risk. However, a low ratio indicates that the company has sufficient earnings to cover its interest payments, which can be a positive sign.

Conclusion

Long term liabilities are a critical aspect of a company's financial health. They provide a source of funds for significant investments and acquisitions, but they also represent a financial risk. Therefore, understanding and managing long term liabilities effectively is crucial for the success of a small business.

By understanding the different types of long term liabilities, their impact on financial statements, and strategies for managing them, small business owners can make informed decisions that will help their business grow and succeed. So, let's embrace the challenge of understanding and managing long term liabilities, and use it as a stepping stone towards our business success.