Current Debt

Types of Debt

The debt of a business is divided into two categories - financing debt and operating debt.

• The term financing debt refers to a debt obligation arising from a company borrowing funds to expand its business; an example of financing debt is a company taking large bank loans or issuing bonds to fund significant capital expenditure.
  Financing debt is usually long-term debt, as the company borrows huge sums of money to fund capex plans. These cannot be repaid within one financial year.
• Operating debt is usually short-term loans taken to manage daily business projects & operations. 

An accountant reports the operating debt in the statement of financial position ( balance sheet ); it is recorded as a credit vendor payable account.

The company takes operational debt levels very seriously because business partners such as customers, lenders, and suppliers often gauge a firm’s short-term economic robustness by calculating operational debt levels.

In most cases, this is a proxy for the firm’s short-term cash flow position or overall financial health.

Example - The best example of operating debt is trading payable (it is money owed to the business from providers or suppliers). Other common liabilities known are salaries, taxes, and pension liabilities.

Examples of Short-term/Current Debt

1. Lease Payments:

Lease payment is an agreement between two parties by which one party (landlord, owner) gives its possessions of land, buildings, property, etc., for use to another party for a specified time and fixed number of payments. 

Companies prefer to lease rather than purchase. The payment period for these leases is usually one year and thus is a component of a company’s short-term debt. 

For instance, if Company A owns a property but does not use the property and thus decides to lease it to Company B. Company A still owns the property, but Company B agrees to pay a fixed monthly amount to Company A to let them use their property.

• It is critical to comprehend lease payments to correctly record them in the accounts of the lessor and lessee.
• Lease payment provides the firm with tax benefits, quality assets, and no risk of obsolescence. 

2. Taxes Due: 

Taxes are levies imposed on individuals or entities by the government. Taxes are almost levied in every country of the world to primarily finance government expenditure, although it has other objectives as well, such as infrastructure development, healthcare provisions, education

The tax component of short-term debt is charged by local, state, or federal agencies. These usually have to be paid within one financial year. Therefore, taxes have a   direct and foreseeable impact on the cash flow.

3. Commercial Papers:

Commercial papers are unsecured short-term promissory notes issued by companies as a source for short-term finance. The money raised can be used to fund short-term business needs such as - accounts payables, wages, etc. They are issued at a discount, and the interest rate is similar to the market interest rates.

The repayment deadline for a commercial paper is usually 270 days, but it can range from a few weeks to several months. For issuing commercial documents, the company does not require collateral which makes it insecure compared to other sources. 

There are three types of commercial paper -

• Promissory notes - a written pledge to pay money. An individual, the maker of the note, promises to reimburse the holder.
• Drafts - three-party paper confirming the payment.
• Cheques - are drawn on a bank. It is either payable on demand to a person specified or the holder.
• Certificates of deposit - are an acceptance by the bank on acquiring a specific sum of money from a depositor for a particular time. The bank promises to repay the amount with interest after maturity.

4. Short-Term Loans:

Also known as short-term debt or creditors. Short-term loans are borrowings made by a business to meet its liquidity crunches. The period for repayment of these loans is usually within one year but ranges to a maximum of 5 years. 

Short-term loans are easy to qualify for as they do not need quality collateral. Thus businesses having poor credit ratings can still obtain funding. The application process for these loans is also straightforward, unlike the formal loan application process.

Short-term loans help in maintaining liquidity but also have specific limitations such as : 

• High-interest rates
• Frequent payments are required.
• Being a short-term loan, the repayment period is also minimal. Therefore, any disruption in cash flow will result in significant debt.

5. Accounts Payables: 

Accounts payables include the money owed by a business to its suppliers for goods or services purchased on credit. It includes items such as - raw materials, rent, freight/logistics expenses, etc. The repayment period for the account payable can differ depending on the goods, or, usually, the repayment period for account payables is a few months.

However, turning to accounts payable, which is a form of short-term debt, has its limitations, such as:

• Suppliers usually provide a short window for repayment since they expect the business to treat this as a short-term loan. Any delay is generally charged at a very high interest rate.
• Prolonged accounts payables reflected in financial statements may indicate the inability of the business to manage its cash flows.
• Any delay in payment can affect the relationship between supplier and business and thus can affect future credit arrangements.

6. Stock Dividends:

Dividends are the cash, funds, or stock distributed to the company's shareholders. The payments of dividends to its shareholders increase their confidence in a company's financial performance.

If a company has declared stock dividends but has not yet paid stock dividends to its shareholders, the payments are recorded as short-term debt and are placed under the current liabilities category.

Dividends are broad of four types - 

• Cash dividend - A cash dividend is a payment made to stockholders from a company's current earnings or accumulated profits.
• Stock dividend - A stock dividend is a dividend distributed to investors in the form of extra company shares instead of cash.
• Property dividend - A dividend distributed in the form of assets instead of cash.