What Is Long-Term Debt Financing and Why Do Companies Use It?

Companies often need significant funding to expand operations, invest in new projects, or manage cash flow. While they can raise capital through equity, many opt for long-term debt financing to secure funds without diluting ownership. This approach provides businesses with large sums upfront while allowing repayment over an extended period.

Role in Capital Structure

Long-term debt plays a crucial role in shaping a company’s financial stability and growth. Borrowing instead of issuing new shares allows businesses to fund expansion, acquisitions, or infrastructure improvements while maintaining control.

The debt-to-equity ratio measures a company’s reliance on debt and affects financial risk and capital costs. A higher ratio can enhance returns when investments perform well but also increases fixed obligations, complicating cash flow management. Investors and lenders monitor this ratio to assess a company’s ability to meet long-term obligations.

Interest payments on long-term debt are tax-deductible, reducing taxable income and lowering overall tax burdens. This advantage makes debt financing appealing compared to issuing new shares, which do not offer similar deductions. However, excessive borrowing can lead to financial distress, especially if economic conditions weaken or revenue declines.

Common Types

Long-term debt financing comes in various forms, each with distinct characteristics that influence a company’s financial strategy. The structure of the debt determines interest rates, repayment terms, and investor appeal. Businesses select debt types based on financial goals, risk tolerance, and repayment capacity.

Secured

Secured debt requires collateral, which lenders can seize if the company defaults. This reduces lender risk, often resulting in lower interest rates. Common examples include mortgage loans, where real estate serves as collateral, and equipment financing, where machinery or vehicles back the loan.

Lenders assess collateral value to ensure they can recover funds in case of default. Loan-to-value (LTV) ratios, comparing the loan amount to the asset’s market value, typically range from 50% to 80%. For example, a company securing a $5 million loan with real estate valued at $7 million would have an LTV ratio of 71%.

Secured debt appears on the balance sheet under long-term liabilities, with pledged assets disclosed in financial statement notes. Under Generally Accepted Accounting Principles (GAAP), companies must determine whether collateralized assets should be classified as restricted, meaning they cannot be freely used for other purposes.

Unsecured

Unsecured debt does not require collateral, making it riskier for lenders. As a result, interest rates are typically higher than those for secured debt. Companies with strong credit ratings and stable cash flows are more likely to qualify, as lenders rely on financial health rather than specific assets for repayment assurance.

Common forms include corporate bonds and term loans. Creditworthiness is assessed using ratings from agencies like Moody’s, S&P Global, and Fitch, which assign grades from AAA (highest quality) to D (default). A company with a BBB rating, for example, faces higher borrowing costs than one rated AA due to perceived risk differences.

Unsecured debt holders are general creditors in bankruptcy, meaning they are repaid only after secured lenders recover their claims. This lower priority increases investor risk, reflected in the higher yields required to attract buyers. Companies issuing unsecured bonds often include protective clauses, such as negative covenants restricting additional borrowing, to reassure investors about repayment ability.

Convertible

Convertible debt allows investors to convert their loan into company stock under predefined conditions. This hybrid structure benefits both borrowers and lenders. Companies secure financing at lower interest rates than traditional debt, as the conversion feature adds value for investors. Lenders gain the potential for equity appreciation if the stock price rises.

Conversion terms specify the price at which debt converts to shares, known as the conversion price. For example, if a company issues $10 million in convertible bonds with a conversion price of $50 per share, an investor holding $1,000 in bonds could convert them into 20 shares ($1,000 ÷ $50). If the stock price rises to $70, conversion becomes more attractive.

Convertible debt is often used by growth-stage companies anticipating future stock price increases but wanting to avoid immediate equity dilution. Under GAAP, companies must separate the debt and equity components of convertible instruments if they contain beneficial conversion features, affecting financial statement presentation.

Collateral Requirements

Lenders evaluate collateral based on liquidity, market value, and ease of disposal in case of default. Assets that can be quickly sold with minimal loss in value, such as publicly traded securities or high-demand real estate, are preferred. Specialized equipment or intellectual property may be discounted due to limited resale markets.

Financial institutions apply a haircut to collateral, reducing its recognized value to account for depreciation or market fluctuations. For example, if a company pledges inventory worth $2 million, a lender may recognize only 60% of that value, allowing the business to borrow up to $1.2 million against it.

Regulatory frameworks influence collateralization levels. Under Basel III banking regulations, financial institutions must maintain adequate capital buffers when extending secured loans to avoid excessive risk. In the U.S., the Uniform Commercial Code (UCC) governs security interests in personal property, requiring borrowers to file UCC-1 financing statements to establish lender claims on pledged assets. These filings determine creditor priority in liquidation scenarios.

Collateral arrangements also impact financial reporting. Under GAAP, pledged assets may need to be reclassified as restricted, affecting liquidity ratios such as the current ratio and quick ratio. If a company secures a loan with accounts receivable, it must assess whether the receivables should be derecognized or remain on the balance sheet. Impairment testing may be required if collateral value declines significantly, potentially triggering write-downs that affect earnings.

Debt Covenants

Lenders impose debt covenants to protect their interests and ensure borrowers maintain financial discipline. These contractual obligations set specific requirements, focusing on financial performance, operational restrictions, or reporting transparency.

Financial covenants often require companies to maintain certain leverage or coverage ratios to limit excessive risk-taking. For example, a lender may require an interest coverage ratio—calculated as earnings before interest and taxes (EBIT) divided by interest expense—above 3.0x. If the ratio falls below this threshold, it signals potential repayment difficulties, possibly triggering penalties or renegotiation. Similarly, net debt-to-EBITDA ratios are commonly capped between 2.0x and 4.5x, depending on the industry.

Non-financial covenants restrict actions that could impact creditworthiness. Borrowers may be prohibited from issuing additional secured debt, selling major assets without lender approval, or making large dividend payments that could deplete cash reserves. Public companies often must submit audited financial statements within a specified timeframe to ensure lenders receive timely financial insights.

Maturity Schedules

The repayment timeline of long-term debt influences financial planning and liquidity management. Maturity schedules outline when principal repayments are due, helping businesses align cash flows with debt obligations.

Amortizing debt requires periodic principal payments throughout the loan term, reducing the outstanding balance over time. This structure, common for term loans and mortgages, lowers refinancing risk since the debt gradually declines. For example, a company with a $10 million loan on a 10-year amortization schedule may have fixed monthly payments that include both interest and principal.

Bullet maturity loans defer principal repayment until the end of the term, preserving short-term liquidity but increasing refinancing pressure at maturity. Corporate bonds often follow this structure, requiring a lump-sum repayment upon maturity.

Callable and extendable debt structures provide flexibility. Callable bonds allow issuers to repay debt early if interest rates decline, reducing borrowing costs. Extendable debt gives borrowers the option to prolong repayment under predefined conditions, which can be beneficial if refinancing rates are unfavorable. Companies carefully evaluate these features to balance cost, risk, and financial flexibility.