For investors to make an informed decision about putting their money into a business, it is not enough to know how much debt the business owes. The debt obligations of a firm can be either short-term or long-term. How much of each type of debt a firm owes has a major impact on the firm’s liquidity, which is the business’s ability to meet its debt obligations.
Debts, or liabilities, are the claims creditors have against a firm’s assets. Assets consist of anything that the firm owns that is of monetary value, such as real estate, equipment, cash and inventory. You will find a business' debts listed on its balance sheet in the liabilities section immediately following the section listing the firm’s assets. Liabilities are always divided into short-term debt and long-term debt. Short-term debt is referred to as current liabilities and long-term debt as long-term liabilities.
Current liabilities include any obligations that are due within one year. Categories of short-term debt include accounts payable, accrued payroll and accrued payroll taxes. Current liabilities also include any payments in the upcoming year required to service long-term debt. For example, payments on a mortgage due in the next 12 months are considered current liabilities.
A long-term debt is any liability owed by a business that is not due for more than one year. The principal balance of a mortgage is one common type of long-term debt. Another is the principal balance, or face value, of bonds sold by the corporation that will not mature for more than one year. The unpaid balance of a long-term lease is also a long-term liability. In some cases, retirement benefits due to employees are considered long-term liabilities.
Savvy investors use several measures to examine a firm’s debt position. Debt-to-equity is a ratio that gives you a picture of a company’s long-term liquidity. The debt-to-equity ratio is calculated by dividing the owner’s equity (or shareholder’s equity) into total liabilities. The higher the ratio, the lees liquid the business is over the long-term. Of at least equal importance is short-term liquidity. A common measure of short-term liquidity is the quick ratio. To calculate a quick ratio, subtract a firm’s inventory from its current assets. Divide the remainder by the current liabilities. The resulting ratio tells you how much money the firm has available to pay short-term debt. For example, assume a firm has $100,000 in current assets after excluding inventory and has $80,000 in short-term debt. Dividing out, you get 1.25. This means the firm has $1.25 in cash or cash equivalents available for each dollar of short-term debt.
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