Question:
What is the difference between Short Term and Long Term debt? Why do I see my loans on the balance sheet twice?
Answer:
Short-Term Debt vs Long-Term Debt: What's the Difference?
First, let us answer the question of the difference between short term and long term debt. The obvious answer of length of time provides most of the information needed, but we will take a little deeper look at the difference. Short term debt is any debt that is payable within one year. Short-term debt shows up in the current liability section of the balance sheet. Long-term debt is debt that are notes payable in a period of time greater than one year. Long-term debt shows up in the long-term liabilities section of the balance sheet.
Example of Short/Current Long-Term Account
An example of short-term debt would include a line of credit payable within a year. One example of a long-term liability would be a five-year loan on a vehicle. The next twelve months of principal payments on the five-year vehicle loan would be included in current liabilities, while the remaining 48 months of principal would be included in long-term liability. So, that is why the same loan can show up on the balance sheet twice. The balance in the current liability section is the amount due within the next twelve months and the balance in the long-term liability section is the amount due in greater than twelve months. These two amounts added together would be the total balance of the debt.
The more detailed technical accounting answer will point out that the short-term liability and the long-term liability should change after every month (assuming payments are being made). The short term liability balance should include the principal only portion of the next twelve months of payments. The long-term liability would then include the remaining balance of the loan.
Ideally, your asset duration should match your loan duration. When you look at your financial statements, your total current assets should be less than your total current liabilities. Your long term assets should exceed your long-term financing.
Not aligning your debt terms to the underlying assets can negatively impact cash flow and your borrowing capacity.
When to Use Short-Term Debt
Short-term loans should be used for short-term assets. Short term assets include accounts receivable, inventory, and work in progress. The traditional vehicle for financing these assets are bank lines of credit, vendor financing, factoring or other asset based lending. All of these are short-term financing that have time periods of less than a year associated with their maturity.
Credit cards have replaced many of these sources for small businesses. Leases are also a financing option, but they don't always show up on the balance sheet. I know, accountants!
In most cases, these short term sources have no monthly payments other than interest. When considering your financing you want to review your loan terms to ensure that you can meet your financial obligations. The ideal is to have at least 20% more cash flow than the total of your payments on your short term debt instruments. When calculating this ratio include your lease payments.
When to Use Long-Term Debt
Long-term loans should be used to finance long term assets. This usually equipment and real estate. Again, you want your repayment period to match the life of the assets. Equipment is usually no more than seven years, while commercial real estate can extend to twenty years.
When financial institutions consider your company's financial health, the will look at common types of ratios, including the coverage ratio referenced above. They will also look at your debt ratios. Your debt ratio is computed by taking your total loans payable balances and dividing it by the amount of the equity in your business. The higher the number the higher the risk. Most businesses will want to be below 2 to 1, unless you're in a capital intensive industry such as manufacturing.
Conclusion
Debt can be used to drive profitable growth, but consult your financial professional to ensure that don't have unintended consequences. More debt means more risk.
