Non-Current Liability
Long-term obligations are mentioned in the balance sheet as a liability.
What is a Non-Current Liability?
Non-current liabilities are long-term obligations mentioned in the balance sheet as a liability. They are mentioned after the current liabilities, sometimes, there is no bifurcation between current and non-current liabilities, but they are mentioned all together.
These liabilities refer to obligations expected to be settled beyond the current operating cycle or one year from the balance sheet date, whichever is longer.
Non-current assets, such as fixed assets, can fund non-current liabilities, such as long-term debt, pension obligations, deferred taxes, etc. A long-term asset could be purchased such that it provides cash flows in amount and on time needed to fund liabilities; this is called liability-driven investing.
Non-current liabilities can be illiquid or liquid but considered less liquid compared to current liabilities because they are not due within the short term, but they are still considered reasonably liquid compared to long-term equity investments or fixed assets.
Key Takeaways
- Non-current liabilities are obligations expected to be met beyond the current operating cycle or one year from the balance sheet date, whichever is longer.
- Non-current liabilities are also called long-term liabilities. They are mentioned in the balance sheet as a liability. They are long-term debt, pension obligations, deferred tax liability, bonds payable, and debentures
- Long-term debts are non-current and involve payment of periodic interests and principal repayment during the loan/debt term.
- Pension obligations are non-current liabilities of the employer for their employees.
- Deferred tax liability indicates deferring tax payment to subsequent periods, thereby minimizing the tax liability in the current period.
- Bonds payable is the issuer's liability towards the bondholders, which involves payment of periodic coupons over the bond's life and payment of par value at bond maturity.
- A debenture is similar to a bond but is a form of unsecured debt.
Types of Non-Current Liabilities
Non-current liabilities include the following types:
Long-Term Debt
Long-term debt can be summarized as a sum of money borrowed by the company in the form of a loan.
Long-term debt is long-term/non-current, and the borrower must make periodic interest payments and repay the principal during the loan period. Interest is calculated based on the interest rate and amount or sum borrowed.
Pension Obligations
These are mentioned on the employer’s or company’s balance sheet and are defined benefit pension obligations.
Pension plans are sponsored by the employer, which provides retirement income to the employees. In other words, Pension plans are payouts promised to employees and represent a liability for the employers.
In a defined benefit pension plan, the pension benefit is defined. The pension benefit is then paid to the employees after retirement until their death.
There are two parts to this plan, first is plan assets, and the other is plan liability.
Plan liability is also called pension liability. Pension liability is the present value of future pension obligations/benefits. Benefits are based on the employee’s last drawn salary, the fixed benefit percentage, and the years the employee served the company.
Pension plans can be overfunded with plan assets greater than plan liabilities, and such a plan will have a higher funding ratio of greater than 1. Pension plans can be underfunded with plan liabilities greater than plan assets, and such a plan will have a lower funding ratio of less than 1.
Deferred Tax Liability
Is a tax liability that is deferred to the next periods/years. Deferred tax liability is a form of aggressive accounting.
In aggressive accounting, the firm understates expenses (defers expenses to the next period) and overstates revenue/earnings in the current period to improve its current performance.
Bonds Payable
The company issues the bonds, also called the issuer, the bond company. The company is obligated to make periodic coupon payments during the bond term and pay face value at maturity to the bondholders. This liability is called bonds payable.
A bond will specify the following:
- Coupon rate: Coupon rate and face value is needed to calculate coupon payments.
- Maturity: A bond's maturity is also called bond term and specifies how long the bond will be maintained.
- Face value: The face value of a bond is also called par value. This amount should be paid at bond maturity by the issuer to the bondholder.
- Yield to maturity(YTM): Yield to maturity is the discount rate used to find the present value/price of the bond.
Bonds can be issued at par, premium, or a discount. Bonds are issued at par when the YTM of the bond equals the coupon rate of the bond.
Bonds are issued at a premium when the coupon rate is greater than the bond's YTM. Bonds are issued at a discount when the coupon rate is less than the bond's YTM.
Debentures
A debenture is a long-term unsecured debt. Unsecured loans are meant to have the highest risk, and the interest on such debt/loan is generally high to compensate investors for the high risk associated with such a type of debt/loan.
Valuation of Non-Current Liabilities
Valuation of non-current liabilities will be based on the following models/formulas.
Long-term debt is calculated based on the following variables
- Amount of total debt
- Amount of short-term debt
Let’s consider the following example and learn how to calculate long-term debt
| Short-term debt | $30,000 |
|---|---|
| Total debt | $100,000 |
To find the long-term debt, we will use the above-mentioned formula, therefore,
Long-term debt = $100,000 - $30,000
= $70,000
Long-term debt can also be based on:
- Long-term debt ratio
- Total assets
Which can be calculated as follows:
Let’s consider another Example for calculating long-term debt
| Long-term debt ratio | 0.7 |
| Total assets | $40,000,000 |
To find the long-term debt, we will use the above-mentioned formula, therefore,
Long-term debt = 0.7 * $40,000,000
= $28,000,000
Pension Obligations
The pension obligation is based on benefits promised by the employer to the employee.
The benefit is based on the employee’s final salary, the number of years the employee served the company, and the benefit percentage. The pension obligation is the sum of the present value of these future benefits.
Pension obligation = Sum of Benefits * Discounting factor
Benefit = Final salary * Benefits% * Number of service years
Discounting factor = 1/(1 + Discount rate)t
Where
- t = year
Let’s go over an Example illustrating pension obligations
PQR worked at ABC Ltd for 15 years. His final salary is $40,000. The benefits promised by ABC Ltd are 2%.
This benefit will start after PQR retires until his death, as well as his final benefit-receiving year. Life expectancy after his retirement is equal to 10 years. The discount rate is 10%.
Benefits = $40,000 * 2% * 15 = $12,000 per year for 10 years
| Year | Benefit | Discount Factor | Present Value |
|---|---|---|---|
| 1 | $12,000 | 0.9091 | $10,909.20 |
| 2 | $12,000 | 0.8264 | $9,916.80 |
| 3 | $12,000 | 0.7513 | $9,015.60 |
| 4 | $12,000 | 0.6830 | $8,196.00 |
| 5 | $12,000 | 0.6209 | $7,450.80 |
| 6 | $12,000 | 0.5645 | $6,774.00 |
| 7 | $12,000 | 0.5132 | $6,158.40 |
| 8 | $12,000 | 0.4665 | $5,598.00 |
| 9 | $12,000 | 0.4241 | $5,089.20 |
| 10 | $12,000 | 0.3855 | $4,626.00 |
| Total | $73,734 |
The formula for calculating pension obligation is,
Pension obligation = Sum of present value = $73,734
Deferred Tax Liability
The formula for calculating deferred tax liability is based on income tax payable and reported income tax.
Deferred tax liability = Income tax payable - Reported income tax
This Example will give an idea of how to calculate deferred tax liability
- Income tax payable = $40,000
- Reported income tax = $10,500
Finding Deferred tax liability =$40,000 - $10,500 = $29,500
Bonds Payable
Liability is the sum of the present value of future coupons (CF), discounted using the bond yield to maturity (YTM) over the bond's life.
For example,
A bond has 3 years to maturity. YTM is 8%, the Coupon rate is 5%, and the Face value of the bond is $100
Bonds payable = Cash flow in year 1/(1 + YTM)^1 + Cash flow in year 2/(1 + YTM)^2 + (Total cash flow in year 3)/(1 + YTM)^3
Note
This formula is based on the Discounted Cashflow Model (DCF model), wherein we discount future cash flows (which are coupon payments for bonds) using a discount rate (which is YTM for bonds) to find the present value/price of the bond.
Where,
- Cash flow = CF
- CF = Coupon payment = Coupon rate * Face value
- Total CF in year 3 = Coupon payment in year 3 + Face value
For this example, coupon payment = 0.05 * $100 = $5
The solution for bonds payable using the above formula would be,
Bonds payable = [($5/ (1 + 0.08)^1) + ($5/ (1 + 0.08)^2) + ($5 + $100/ (1 + 0.08)^3)]
= $4.63 + $4.29 + $83.35 = $92.27
$92.27 is also called the price of the bond, which represents a liability called a bond payable to the company.
Key Financial Ratios that Use Non-Current Liabilities
Long-term debt interest payment is determined based on the following:
- Principal loan amount
- Interest rate
- Loan term.
Let’s consider this Example for calculating long-term debt interest payment
| Principal loan amount | $1,000,000 |
| Interest rate per annum | 10.5% |
| Loan term | 5 years |
Long-term debt interest payment = Principal loan amount * Interest rate * Loan term
Long-term debt interest payment = $1,000,000 * 0.1050 * 5 = $525,000
The pension obligation funding ratio is based on the fair value of plan assets and the present value of pension obligation.
Funding ratio = Fair value of plan assets / Present value of pension obligation
Example A would solve for the funding ratio
- The fair value of plan assets = $5,000,000
- Present value of pension obligation = $6,000,000
The solution for finding the funding ratio,
Funding ratio = $5,000,000/ $6,000,000
= 0.83
In this example, the funding ratio is less than 1, which means this plan is underfunded as pension obligation is greater than the plan assets.
Example B would solve for the funding ratio
- The fair value of plan assets = $5,000,000
- Present value of pension obligation = $3,000,000
The solution for finding the funding ratio,
Funding ratio = $5,000,000/ $3,000,000
= 1.67
In this example, the funding ratio is greater than 1, which means this plan is overfunded as the pension obligation is less than the plan assets.
Example C would solve for the funding ratio
- The fair value of plan assets = $5,000,000
- The Present value of pension obligation = $5,000,000,
The solution for the funding ratio,
Funding ratio = $5,000,000/ $5,000,000
= 1
In this example, the funding ratio is equal to 1, which means this plan is fully funded, and pension obligations are equal to plan assets.
Comparison Between Debentures and Secured Debt
Debentures are not secured by any collateral and hence have high credit risk/ are of poor credit quality. In contrast, secured debt is safer and has less credit risk. Debentures are also considered debt. They are considered as long-term unsecured debt.
If the company issues debentures, then it creates a non-current liability for the company.
Because of high credit risk, debentures have a higher cost of debt and lower value. Secured debt has lower credit risk, lower cost of debt, and higher value. The cost of debt should be considered after tax as an interest on debt is tax-deductible.
A company with a greater percentage of its non-current liabilities as debentures will have a higher cost of capital.
A firm's cost of capital is the weighted average cost of capital (WACC).
WACC is based on the company's capital structure and is considered the cost of financing for the company.
A company with a lower percentage of its non-current liabilities as debentures will have a lower cost of capital as measured by the weighted average cost of capital (WACC).
WACC = (Weight of equity * Cost of equity) + (Weight of total debt * (1-T) * Total pre-tax cost of debt)
Where
- T = Tax rate
Finding the
Total debt = Long-term secured debt + Long-term unsecured debt + Short-term debt
Finding the
Weight of equity = Equity amount/ (Total debt amount + Equity amount)
Finding the
Weight of total debt = Total debt amount/ (Total debt amount + Equity amount)
Example A (Debentures 10% of the non-current liability, therefore, WACC will be lower than example B)
ABC Limited has debentures equal to 10% of its non-current liabilities. The firm has the following capital structure and cost of financing:
| Equity | $10,000,000 |
| Long-term secured debt | $9,000,000 |
| Debentures | $1,000,000 |
| Tax rate | 0.35 |
| Cost of equity | 0.08 |
| Cost of long-term secured debt | 0.05 |
| Cost of debentures |
0.075 |
In this example, the Cost of long-term secured debt is less than the cost of debentures, and hence it can be concluded that debentures are unsecured and risky.
Total debt = Long-term debt + Debentures
=$9,000,000 + $1,000,000 = $10,000,000
The weight of debt is
Total debt/ (Total debt + Equity)
= $10,000,000/ ($10,000,000 + $10,000,000)
= 0.50 Which can be written as 0.5 * 100= 50%
The weight of equity is
Equity/ (Total debt + Equity)
= $10,000,000/ ($10,000,000 + $10,000,000)
= 0.50 which can be written as 0.50 * 100 = 50%
The total cost of debt is the Cost of long-term secured debt + the Cost of debentures
= 0.05 + 0.075 = 0.125
Finding WACC
= 0.5 * 0.08 + 0.5*(1 - 0.35) * 0.125 = 0.04 + 0.0406
= 0.0806 or 8.06%
Example B (debenture is 30% of non-current liability therefore, now WACC will be higher than example A)
ABC Limited has debentures equal to 30% of its non-current liabilities. The firm has the following capital structure and cost of financing:
| Equity | $10,000,000 |
| Long-term secured debt | $9,000,000 |
| Debentures | $5,000,000 |
| Tax rate | 0.35 |
| Cost of equity | 0.08 |
| Cost of long-term secured debt | 0.05 |
| Cost of debentures | 0.08 |
In this example, the cost of long-term secured debt is less than the cost of debentures, and hence it can be concluded that debentures are unsecured and risky.
Total debt = Long-term secured debt + Debentures
= $9,000,000 + $5,000,000 = $14,000,000
Weight of debt = Total debt/(Total debt + Equity)
= $14,000,000/($14,000,000+$10,000,000) = 0.58 or 58%
Weight of equity = Equity/(Total debt + Equity)
= $10,000,000/($14,000,000+$10,000,000) = 0.42 or 42%
Total cost of debt = Cost of long-term secured debt + Cost of debentures
= 0.05 + 0.08 = 0.13
Finding WACC
= 0.42 * 0.08 + 0.58*(1 - 0.35) * 0.13
= 0.0336 + 0.0490 = 0.0826, which is 8.26%
Non-Current Liability FAQs
Non-current assets are long-term in nature. Similarly, non-current liabilities are long-term in nature, so cash inflow from non-current assets can be used to fund non-current liabilities.
The main reason is the duration/time match between non-current assets and liabilities. Another reason could be the same liquidity characteristics.
Long-term debt, debentures, pension obligations, deferred tax liability, etc.
This depends on the reporting standard the company follows, but this form of representation lacks transparency and is not preferred by analysts or users of financial reports.
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