By David Harper
Long-term liabilities are company obligations that extend beyond the current year, or alternately, beyond the current operating cycle. Most commonly, these include long-term debt such as company-issued bonds. Here we look at how debt compares to equity as a part of a company's capital structure, and how to examine the way in which a company uses debt.
The following long-term liabilities are typically found on the balance sheet:
You can see that we describe long-term liabilities as either operating or financing. Operating liabilities are obligations created in the course of ordinary business operations, but they are not created by the company raising cash from investors. Financing liabilities are debt instruments that are the result of the company raising cash. In other words, the company issued debt - often in a prior period - in exchange for cash and must repay the principal plus interest.
Operating and financing liabilities are similar in that they both will require future cash outlays by the company. It is useful to keep them separate in your mind, however, because financing liabilities are triggered by a company's deliberate funding decisions and, therefore, will often offer clues about a company's future prospects.
Debt is Cheaper than Equity
Capital structure refers to the relative proportions of a company's different funding sources, which include debt, equity and hybrid instruments such as convertible bonds (discussed below). A simple measure of capital structure is the ratio of long-term debt to total capital.
Because the cost of equity is not explicitly displayed on the income statement, whereas the cost of debt (interest expense) is itemized, it is easy to forget that debt is a cheaper source of funding for the company than equity. Debt is cheaper for two reasons. First, because debtors have a prior claim if the company goes bankrupt, debt is safer than equity and therefore warrants investors a lower return; for the company, this translates into an interest rate that is lower than the expected total shareholder return (TSR) on equity. Second, interest paid is tax deductible, and a lower tax bill effectively creates cash for the company.
To illustrate this idea, let's consider a company that generates $200 of earnings before interest and taxes (EBIT). If the company carries no debt, owes tax at a rate of 50% and has issued 100 common shares, the company will produce earnings per share (EPS) of $1.00 (see left-hand column below).
Say on the right-hand side we perform a simple debt-for-equity swap. In other words, say we introduce modest leverage into the capital structure, increasing the debt-to-total capital ratio from 0 to 0.2. In order to do this, we must have the company issue (borrow) $200 of debt and use the cash to repurchase 20 shares ($200/$10 per share = 20 shares). What changes for shareholders? The number of shares drops to 80 and now the company must pay interest annually ($20 per year if 10% is charged on the borrowed $200). Notice that after-tax earnings decrease, but so does the number of shares. Our debt-for-equity swap actually causes EPS to increase!
What Is the Optimal Capital Structure?
The example above shows why some debt is often better than no debt. In technical terms, it lowers the weighted average cost of capital. Of course, at some point, additional debt becomes too risky. The optimal capital structure, the ideal ratio of long-term debt to total capital, is hard to estimate. It depends on at least two factors, but keep in mind that the following are general principles:
- First, optimal capital structure varies by industry, mainly because some industries are more asset-intensive than others. In very general terms, the greater the investment in fixed assets (plant, property & equipment), the greater the average use of debt. This is because banks prefer to make loans against fixed assets rather than intangibles. Industries that require a great deal of plant investment, such as telecommunications, generally utilize more long-term debt.
- Second, capital structure tends to track with the company's growth cycle. Rapidly growing startups and early stage companies, for instance, often favor equity over debt because their shareholders will forgo dividend payments in favor of future price returns because these companies are growth stocks. High-growth companies do not need to give these shareholders cash today, whereas lenders would expect semi-annual or quarterly interest payments.
Examining Long-Term Liability
Below, we look at some important areas investors should focus on when analyzing a company's long-term liability accounts.
Ask Why the Company Issued New Debt
When a company issues new long-term debt, it's important for investors to understand the reason. Companies should give explanations of new debt's specific purpose rather than vague boilerplate such as "it will be used to fund general business needs." The most common purposes of new debt include the following:
- To Fund Growth - The cash raised by the debt issuance is used for specific investment(s). This is normally a good sign.
- To Refinance "Old" Debt - Old debt is retired and new debt is issued, presumably at a lower interest rate. This is also a good sign, but it often changes the company's interest rate exposure.
- To Change the Capital Structure - Cash raised by the debt issuance is used to repurchase stock, issue a dividend,or buyout a big equity investor. Depending on the specifics, this may be a positive indicator.
- To Fund Operating Needs - Debt is issued to pay operating expenses because operating cash flow is negative. Depending on certain factors, this motive may be a red flag. Below, we look at how you can determine whether a company is issuing new debt to fund operating needs.
Be Careful of Debt that Funds Operating Needs
Unless the company is in the early growth stage, new debt that funds investment is preferable to debt that funds operating needs. To understand this thoroughly, recall from the cash flow installment that changes in operating accounts (that is, current assets and current liabilities) either provide or consume cash. Increases in current assets - except for cash - are "uses of cash". Increases in current liabilities are "sources of cash." Consider an abridged version of RealNetworks' balance sheet for the year ending Dec 31, 2003:
From Dec. 2002 to Dec. 2003, accounts receivable (a current asset) increased dramatically and accounts payable (a current liability) decreased. Both occurrences are uses of cash. In other words, RealNetworks consumed working capital in 2003. At the same time, the company issued a $100 million convertible bond. The company's consumption of operating cash and its issue of new debt to fund that need is not a good sign. Using debt to fund operating cash may be okay in the short run but because this is an action undertaken as a result of negative operating cash flow, it cannot be sustained forever.
Examine Convertible Debt
You should take a look at the conversion features attached to convertible bonds (convertibles), which the company will detail in a footnote to its financial statements. Companies issue convertibles in order to pay a lower interest rate; investors purchase convertibles because they receive an option to participate in upside stock gains.
Usually, convertibles are perfectly sensible instruments, but the conversion feature (or attached warrants) introduces potential dilution for shareholders. If convertibles are a large part of the debt, be sure to estimate the number of common shares that could be issued on conversion. Be alert for convertibles that have the potential to trigger the issuance of a massive number of common shares (as a percentage of the common outstanding), and thereby could excessively dilute existing shareholders.
An extreme example of this is the so-called death spiral PIPE, a dangerous flavor of the private investment, public equity (PIPE) instrument. Companies in distress issue PIPES, which are usually convertible bonds with a generous number of warrants attached. (For more information, see What Are Warrants?) If company performance deteriorates, the warrants are exercised and the PIPE holders end up with so many new shares that they effectively own the company. Existing shareholders get hit with a double-whammy of bad performance and dilution; a PIPE has preferred claims over common shareholders. Therefore, it's advisable not to invest in the common stock of a company with PIPE holders unless you have carefully examined the company and the PIPE.
Look at the Covenants
Covenants are provisions that banks attach to long-term debt that trigger technical default when violated by the borrowing company. Such a default will lower the credit rating, increase the interest (cost of borrowing) and often send the stock lower. Bond covenants include but are not limited to the following:
- Limits on further issuance of new debt.
- Limits, restrictions or conditions on new capital investments or acquisitions.
- Limits on payment of dividends. For example, it is common for a bond covenant to require that no dividends are paid.
- Maintenance of certain ratios. For example, the most common bond covenant is probably a requirement that the company maintain a minimum 'fixed charge coverage ratio'. This ratio is some measure of operating (or free) cash flow divided by the recurring interest charges
Two things complicate the attempt to estimate a company's interest rate exposure. One, companies are increasingly using hedge instruments, which are difficult to analyze.
Second, many companies are operationally sensitive to interest rates. In other words, their operating profits may be indirectly sensitive to interest rate changes. Obvious sectors here include housing and banks. But consider an oil/energy company that carries a lot of variable-rate debt. Financially, this kind of company is exposed to higher interest rates. But at the same time, the company may tend to outperform in higher-rate environments by benefiting from the inflation and economic strength that tends to accompany higher rates. In this case, the variable-rate exposure is effectively hedged by the operational exposure. Unless interest rate exposure is deliberately sought, such natural hedges are beneficial because they reduce risk.
Despite these complications, it helps to know how to get a rough idea of a company's interest rate exposure. Consider a footnote from the 2003 annual report of Mandalay Resort Group, a casino operator in Las Vegas, Nevada:
Fixed-rate debt is typically presented separately from variable-rate debt. In the prior year (2002), less than 20% of the company's long-term debt was held in variable-rate bonds. In the current year, Mandalay carried almost $1.5 billion of variable-rate debt ($995 million of variable-rate long-term debt and $500 million of a pay floating interest rate swap) out of $3.5 billion in total, leaving $2 billion in fixed-rate debt.
Don't be confused by the interest rate swap: it simply means that the company has a fixed-rate bond and "swaps" it for a variable-rate bond with a third party by means of an agreement. The term 'pay floating' means the company ends up paying a variable rate; a 'pay fixed interest rate' swap is one in which the company trades a variable-rate bond for a fixed-rate bond.
Therefore, the proportion of Mandalay's debt that was exposed to interest rate hikes in 2003 increased from 18% to more than 40%.
Operating Versus Capital Lease
It is important to be aware of operating lease agreements because economically they are long-term liabilities. Whereas capital leases create liabilities on the balance sheet, operating leases are a type of off-balance sheet financing. Many companies tweak their lease terms precisely to make these terms meet the definition of an operating lease so that leases can be kept off the balance sheet, improving certain ratios like long term debt-to-total capital.
Most analysts consider operating leases as debt, and manually add operating leases back onto the balance sheet. Pier 1 Imports is an operator of retail furniture stores. Here is the long-term liability section of its balance sheet:
Long-term debt is a very tiny 2% of total assets ($19 million out of $1 billion). However, as described by a footnote, most of the company's stores utilize operating leases rather than capital leases:
The present value of the combined lease commitments is almost $1 billion. If these operating leases are recognized as obligations and are manually put back onto the balance sheet, both an asset and a liability of $1 billion would be created, and the effective long term debt-to-total capital ratio would go from 2% to about 50% ($1 billion in capitalized leases divided by $2 billion).
It has become more difficult to analyze long-term liabilities because innovative financing instruments are blurring the line between debt and equity. Some companies employ such complicated capital structures that investors must simply add "lack of transparency" to the list of its risk factors. Here is a summary of what to keep in mind:
- Debt is not bad. Some companies with no debt are actually running a sub-optimal capital structure.
- If a company raises a significant issue of new debt, the company should specifically explain the purpose. Be skeptical of boilerplate explanations; if the bond issuance is going to cover operating cash shortfalls, you have a red flag.
- If debt is a large portion of the capital structure, take the time to look at conversion features and bond covenants.
- Try to get a rough gauge of the company's exposure to interest rate changes.
- Consider treating operating leases as balance sheet liabilities.
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