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Assets, Liabilities & Equity - An Intro (Part III)

Long-Term Liabilities

Long-term liabilities are debt obligations of the company that is not due for repayment within the next 12 months. Most companies will hold both short and long-term debt, with no limit on how "long-term" the debt may be. So while there are a minimum number of months for a liability to be considered long-term, there is no maximum time period.

Long-term liabilities are usually much larger in value than short-term liabilities and are usually non-trade debt. There are many differences between the two groups of debt (current and long-term), however most of the differences are not unique to any one group, but are instead more often used in one group and not the other. Collateral is a good example of a debt requirement often associated with long-term debt. This is not to say that a creditor offering short-term loans is prevented from requesting collateral, however this is usually more popular for debt with a life of more than one year. The same is true of covenants and convertibility.

Unlike short-term liabilities, long-term liabilities are often an important part of the capital structure of a company. It provides fund for the purchase of long-lived assets used to generate revenue over many years, and from which cash flow is not immediate. This source of fund can provide significant benefits to a company, but can also lead to significant problems. Many companies are forced into bankruptcy because of the difficulties in financing long-term debt and the heavy burden the interest charges bring to bear on the company’s operating cash flow and bottom line.

There are numerous types of long-term liabilities, with companies and creditors having the flexibility to negotiate hundreds of different variations of loans/debentures/bonds. A new type of long-term debt is maybe created everyday, however, the following are the ones you will probably find under the Long-Term Liabilities section of the next balance sheet you peruse:

  • Debt to Financial institutions
  • Bonds
  • Debentures
  • Mortgages
Each loan will have some kind of agreement for repayment, including the due dates and the specific amount. The loan contract may also include the following: Any applicable interest rate, a default clause, a listing of the collaterals being held by the creditor, any covenants associated with the loan and a convertibility clause. Prudent management will seek to understand the content of the loan contract before accepting the loan, and will continue to adhere to the contract throughout the life of the loan. Failure to do so may activate the default clause, which could result in a demand for immediate repayment for the entire debt by the creditors.

Equity

Businesses need to be financed, and although this financing is not necessarily required to come from the owners, most companies will have a portion of its financing fund coming from those owning the business. This funding that is supplied to the company by the owners is called "equity".

Equity is also provided when the company generates profit and retains that profit in the business. This is reflected on the balance sheet as Retained Earnings. By the same token, a company generating losses will reduce its equity by the value of the loss.

Equity by definition indicates the value of the company to its owners. It is therefore possible for the owners to contribute equity to the business but lose that equity during the life of the business. You will from time to time observe balance sheets with negative equity balances. Of course, business owners commit their funding to companies mainly to increase their wealth with the operating success of the company; it is therefore possible for owners to increase their equity significantly without actually contributing new funding to the business.

Just so you know, some writers do describe liability as the equity of creditors, a description that doesn't sit well with many, as it seems to transform the true meaning of the word "equity". The description is correct if equity is taken to mean, "rights to property", which is what the creditors have. Generally speaking, equity speaks to the property rights held by the owners of a business in the business they own.

Equity (also referred to as Capital, Shareholder's equity, Net Worth) can be mathematically stated as the difference between Total Assets and Total Liabilities. This difference is also known as Net Assets. Positive equity therefore implies that the sum of the company's assets is greater than the sum of its liabilities, while negative equity implies that the sum of its assets is less than the sum of its liabilities, in which case the business is completely "owned" by the creditors. Not a pleasant situation for any company to be in!

The Shareholders' Equity section of the balance sheet can be very crowded and it can also be sparse. A balance sheet with a sparse shareholders' equity section will probably only show the following:

  • Preferred Stock
  • Common Stock
  • Retained Earnings
A more complex balance sheet will show a more crowded section on shareholders' equity. It may look something like this:
  • Preferred Stock
  • Common stock, par value $1:
  • a. Authorized shares
    b. Issued shares
  • Additional Paid-In Capital
  • Retained earnings
  • Treasury stock
  • Foreign currency translation adjustment
Preferred stock Preferred stock is usually defined as a hybrid between debt and equity. It's a hybrid because it maintains the dividend-paying characteristic of common stock, as well as the fixed interest payment of debt. Unlike common stockholders, preferred stockholders are usually not given voting rights. Common stock Common Stock has no predetermined dividend payout rate or time, but the holders maintain the rights to vote and the right to share in the residual value of the company upon liquidation. Additional Paid-In Capital Additional Paid-In Capital represents the excess paid for the company's stock above the par value. Treasury stock Treasury stock, which is always a negative value, represents the company's purchase of its own stock.
Return to Part 1
Return To Part 2

Capital Structure

Capital: A company will constantly thrive to maintain the ideal mix of common stock, preferred stock and debt. Leverage (the use of debt & other fixed charge securities in the capital structure) is a common theme in any discussion on capital structure management.

Leverage (the use of debt & other fixed charge securities in the capital structure) is a common theme in any discussion on capital structure management. Capital: Long-term liabilities (debt) and shareholder’s equity combine to form the capital of the company.

Most companies are financed by both debt and equity and determining the cost of capital involves the calculation of the cost of both debt and equity. Preferred Stock: Preferred stock is a unique brand of stock that gives the holders a fixed return on their investment. Like common stock it has no maturity date, and like debt it has no voting rights. Additional Paid-In Capital: This comes about because companies will set a par value for their stock and then sell the stock above that value. The excess of the price of the stock above the par value times the number of stock sold is shown on the balance sheet as Additional Paid-In Capital (APIC).

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