What is Debt on Financial Statements that Investors Should Know?

When investing in stocks, real estate, or other assets, it's crucial to understand the health of the company or asset. Among these factors, 'debt' is one that you must always check. So today, let's explore what debt is and why it's important.

Financial Statements - Debt

Basic Concept

In financial statements, the term 'debt' refers to the obligations that a company must repay. This includes money borrowed from external entities or individuals to raise capital, as well as accounts payable, advances received, etc. Since these debts impact a company's financial health and future cash flow, investors should carefully examine them.

Debt typically has a specified maturity date and interest rate. The maturity date signifies when the company must repay the debt, and the interest rate determines the amount of interest the company must pay on the debt. High interest rates or short maturities can increase a company's financing costs and put financial pressure on them, so investors should consider these factors.

There are various types of debt, and understanding the characteristics of each is essential. For instance, short-term debt must be repaid within a year, whereas long-term debt can be repaid over a longer period. Current liabilities are debts that a company must repay immediately, while non-current liabilities can be deferred for a certain period. By understanding the nature and conditions of each type of debt, you can gain a more accurate understanding of a company's financial situation.

Classification and Types of Debt in Financial Statements

Debt is broadly classified into current liabilities and non-current liabilities.

• Current liabilities are debts that must be repaid within a year, including accounts payable, short-term borrowings, accrued expenses, and advances received. These debts are crucial indicators for evaluating a company's short-term financing and repayment capabilities.
• Non-current liabilities are debts that must be repaid after a year, including bonds payable, long-term borrowings, and retirement benefit obligations. These debts are related to a company's long-term financing and repayment plans, playing a crucial role in determining the company's stability and growth potential.

Types of debt include borrowings, bonds, accounts payable, and advances received.

Borrowings are loans taken from financial institutions such as banks, and they are categorized into short-term and long-term borrowings. Bonds are debt securities issued by companies, and they are a primary means of direct finance along with stocks. Accounts payable represent the amount a company owes for goods or services received but not yet paid for. Advances received are payments received from customers in advance.

All this debt information is recorded in the financial statements, and investors should carefully review it to evaluate the company's financial health and repayment ability.

Debt-to-Equity Ratio and Its Importance

The debt-to-equity ratio is a key indicator of a company's financial stability. It is calculated by dividing total debt by shareholder's equity. A higher ratio signifies a greater reliance on debt, indicating an increased financial risk for the company.

Generally, a debt-to-equity ratio of 100% or less is considered a healthy level. However, this can vary depending on the industry and the specific characteristics of the company. For example, manufacturing companies may have a slightly higher debt-to-equity ratio due to the need for significant capital investment in equipment, while financial institutions may have a relatively lower ratio because of their extensive use of debt in their operations.

Companies with high debt-to-equity ratios may experience decreased profitability due to higher interest expenses and other financing costs. If repayment pressures rise, the risk of default (failure to repay debts) may also increase. On the other hand, companies with low debt-to-equity ratios have a stable financial structure, making them more resilient to economic fluctuations. They also enjoy higher creditworthiness, allowing them to easily obtain financing.

Therefore, investors should always check a company's debt-to-equity ratio. This allows them to assess the company's financial health and repayment ability, and to use this information when making investment decisions. Furthermore, it's important to track changes in the debt-to-equity ratio over time to determine whether a company's financial health is improving or deteriorating.

Difference between Long-Term Debt and Short-Term Debt

Debt is categorized into long-term debt and short-term debt based on the repayment period.

• Long-term debt refers to debt with a repayment period of more than one year. Typically, it involves bonds or loans issued by companies for long-term funding purposes. While long-term debt provides companies with financial stability due to its extended repayment period, it can impact profitability because of higher interest expenses.
• Short-term debt refers to debt with a repayment period of less than one year. Companies typically use this to meet short-term funding needs by borrowing from banks or issuing commercial paper (CP). Due to its short maturity, it carries high repayment pressure and is sensitive to interest rate fluctuations, making it a significant factor influencing a company's financial stability.

Therefore, investors should analyze the size and composition of long-term and short-term debt in a company's financial statements. This helps them understand the company's funding and management methods and assess its financial stability.

Impact of Debt Management on Businesses

Debt management significantly impacts a company's financial health and operating performance. If not managed properly, it can lead to a decline in creditworthiness, difficulty in obtaining financing, and an increased risk of bankruptcy. On the other hand, proactive debt management can strengthen a company's financial stability, reduce financing costs, and improve profitability.

First, the debt-to-equity ratio is a key indicator of a company's financial stability, and a higher ratio indicates a lower debt repayment capacity, potentially leading to negative assessments in the capital markets. This can result in increased financing costs or difficulties in obtaining financing altogether.

The times interest earned ratio, which indicates whether operating income can cover interest expenses, is another crucial metric for debt management. If the ratio is less than 1, it implies that the company cannot cover interest expenses with its operating earnings, potentially jeopardizing its continued existence.

Finally, the debt repayment schedule is also important. If it's concentrated at specific points in time, it can lead to liquidity crises, so it's advisable to spread it out.

Debt-Related Indicators that Investors Should Know

Investors should check several indicators to understand a company's debt situation.

• Firstly, the debt ratio. This is calculated by dividing a company's total debt by its equity, and is one of the main indicators for assessing the financial health of a company. Generally, a ratio of 100% or less is considered healthy, but it can vary by industry.
• Secondly, the times interest earned ratio. This is calculated by dividing operating income by interest expense, and shows whether a company can adequately cover its interest expense. If it's less than 1, it means that the company cannot cover interest expense with operating income, and if it's less than 1 for three consecutive years, it's considered a distressed company.
• Finally, the debt-to-asset ratio (borrowings/total assets) also needs careful attention. If it exceeds 30%, it's considered excessive and the company may be vulnerable during economic downturns.

By analyzing these debt-related indicators, investors can gain a more accurate understanding of the financial condition of the company they intend to invest in.