13.1 Long-Term Financial Liabilities: Overview
Most businesses will incur debt at some point during their existence. For example, new businesses may be required to borrow start-up cash to purchase revenue-generating assets as they do not yet have any cash holdings accumulated from profits. Or, existing companies may want to expand their operations, or they may want to replenish depleted cash holdings that resulted from a temporary downturn in business. Additionally, companies with large infrastructures, such as airlines or railways, may require more cash for their capital projects than what can be generated from normal operations. Whatever the case, businesses can obtain the additional cash they need through various financing activities. Three sources of such financing are:
- Using internally generated free cash flow: Cash from previous sales cycles → Purchase assets → Sales → Accounts receivable → Cash
Source of cash from within operations - Borrowing from creditors: Cash from borrowings → Purchase assets → Sales → Accounts receivable → Cash
Source of cash from acquiring debt (short-term or long-term) - Issuing capital shares: Cash from insurance → Purchase assets → Sales → Accounts receivable → Cash
Source of cash from investors (equity)
As shown above, cash obtained from any of the three financing sources can be invested into assets that a company hopes will generate sales and, ultimately, a cash profit. Additionally, each source of financing has its own advantages. For example, using internally-generated funds is the easiest to access but it misses the opportunity to maximize profits through leveraging, as explained in the opening story. As previously discussed, leveraging means using a creditor’s cash to generate a profit where the interest rate from the creditor is less than the return generated by operating profits. However, care must be taken to ensure that the best method is used from the choices available on a case-by-case basis. Consider that while borrowing from creditors can result in desirable leveraging, it can also increase the liquidity and solvency risk, as borrowings are obligations that must be repaid. Also, while issuing shares doesn’t affect liquidity or solvency, as they are not repayable obligations, issuing more shares results in diluted ownership for the shareholders, which could result in less dividends or a lower market price for the shares. There are also tax implications when choosing between debt and equity sourced financing since interest expense from holding debt is deductible for tax purposes while dividends paid for shares are not.
Long-term debt, such as bonds and long-term notes (including mortgages payable) are examples of financial liabilities. Financial liabilities are the financial obligation to deliver cash, or other assets, in a determinable amount to repay an obligation. They are also monetary liabilities because they represent a claim to cash where the amount is fixed by contract. Financial assets and liabilities share the same mirror image characteristic: that a long-term note payable reported on the balance sheet of the borrowing company will be reported as a long-term note receivable on the balance sheet of the creditor company.
