High-growth companies usually take out loans to finance new developments, expand into other regions or secure their future growth. If the repayment period is longer than a year, it is called long-term debt, a form of debt that has both benefits and drawbacks for borrowing entrepreneurs. Knowing how to manage it properly can make or break a project’s success.
According to the Corporate Finance Institute, a specialised educational platform for finance professionals, long-term debt (LTD) is any amount of outstanding debt a company holds that has a maturity of 12 months or longer. If the loan repayment period is less than one year, it is considered short-term debt.
Long-term debt is classified as a non-current liability on a company’s balance sheet. However, when all or a portion of the LTD becomes due within a years’ time, that value will move to the current liabilities section of the balance sheet. Here’s an example to help you better understand this dynamic:
- A company requests a €500,000 loan from its bank, to be repaid in equal instalments over a period of 5 years (that is, €100,000 per year).
- In the first year, the company enters €400,000 in non-current liabilities and €100,000 in current liabilities, provided that the latter part matures in less than a year.
- Before the end of the year, and to open the new accounting year, what is known as a reclassification of debt (making the necessary entries to include those long-term debts that at the end of the year have a maturity of less than 12 months in the accounts) is required.
- Thus, out of €400,000 that were long-term liabilities, €100,000 are reclassified to the short term, while the remaining €300,000 remain in the long term. This process continues until the fifth year, when the debt is paid off.
Types of long-term debt
Long-term debts owed to financial institutions can belong to several types of loans:
- Bank debt. This is a long-term loan a business takes on by borrowing money from its bank or another financial institution, reflected in item 170 of Spain’s General Accounting Plan.
- Mortgages. These are loans that use the value of real estate, such as land or buildings, as collateral.
However, when a company’s need for financing is high, making obtaining a loan from a single lender difficult, it is also possible to apply for a loan through a borrowing arrangement known as a debenture.
A debenture is a macro-loan that is obtained by a high-growth company and is provided, in equal parts, by several lenders and is based in in securities. There are three players in this debt instrument:
- Borrower. The borrower that requests the loan and issues debentures to savers.
- Lender. The individual or legal entity that lends the money. Also known as bondholder because it buys bonds.
- Financial institution. The intermediary that matches the interests and needs of the company issuing the loan and those seeking to make their savings profitable. Usually, it is the banks that issue the securities of a bond to their clients, charging a commission.
What are the pros and cons of long-term debt?
To road to success for a high-growth company, particularly in climates where support from the investment ecosystem is more cautious, is not an easy one. These companies usually have several alternatives when it comes to raising funding, including venture debt, growth loans and non-repayable loans, although sometimes the only options is incurring long-term debt. This usually implies benefits for the entrepreneurs, but it is also subject to several considerations that entrepreneurs need to be aware of to ensure successful growth
On the one hand, when taking out a long-term loan, entrepreneurs can pay it off little by little. When a startup begins its journey, at first it is challenging to get the funds needed to pay for expenses like acquisitions. This type of debt makes it possible for the startup to gradually pay off the amount and adjust payments to the company’s budget. On the other hand, long-term debts provide ample room to renegotiate the loan conditions or make early repayments of capital, that is, to bring forward part or all of the payment of the contracted debt.
However, when taking on long-term debt, entrepreneurs should remember that, unlike other financing alternatives available (think venture debt), the startup will need to prove its solvency through the through the documentation requested by the lending. Not only that, but the longer the debt repayment period, the higher the interest to pay.
On the other hand, over-indebtedness can lead to another series of risks for the survival of the company. Too much debt has an impact on profitability, reduces cash flow cash flow and ups the demands for additional financing.
For entrepreneurs, securing long-term financing can be a critical part of their growth, although the choice will depend on the purpose, interest rates and credit rating of the institution lending the money. That said, using this type of financing and managing it properly helps startups chart a more prosperous future and meet the challenges along the innovative path that high-growth companies take.
