A business can have different types of debt, but not all debt is created equal. Unsecured debt refers to debt that is not linked to a physical asset. A good example of unsecured debt is a credit card. Many businesses also have have short-term debt, which is debt with a repayment period of less than a year. A business also can have long-term debt, which has particular characteristics that distinguish it from any other kind.
The loan period for a long-term debt exceeds 12 months. The length of the term corresponds to the perceived value of the item. A car loan, for instance, would not receive financing over a 20-year period because the item does not have enough value to sustain such a loan. A mortgage, on the other hand, would because the inherent value of the property can justify such a loan term. After the property's appraisal, the value is stretched out for the length of that term minus any upfront downpayment.
Long-term debt is secured by some form of collateral. An example of this would be a mortgage on a building, a loan on construction equipment or a loan on a piece of land. If the borrower defaults, the holder of the loan receives the property and can dispose of it in such a way as to allow the holder to recoup some of the money owed by the borrower.
The interest rate for a long-term debt is relatively low and remains fixed for the duration of the loan. The reason for this is because the loan is secured by an asset, unlike unsecured loans, which tend to have a higher interest rate. As such, the payments on the loan remain the same throughout the life of the loan. The amount of interest that the borrower pays is consistently reduced month by month as the original principal becomes smaller. Such predictable payments increase the company's ability to budget accurately.
A business with a lot of long-term debt is considered risky. Long-term debt is calculated into the company's debt-to-equity ratio, which is the difference between its long-term debt, also known as its liabilities, and stockholder's equity. If the debt-to-equity ratio is low, analysts may consider that a good risk for investors. Consequently, if the opposite is true and the company's liabilities are higher than its equity, then most investors would surmise that an investment in it would not prove profitable. Such companies are considered top heavy when it comes to debt, and that is what makes them risky.
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