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Examining Long-Term Liability
Below, we look at some important areas investors should focus on when analyzing a company's long-term liability accounts.
Ask Why the Company Issued New Debt
When a company issues new long-term debt, it's important for investors to understand the reason. Companies should give explanations of new debt's specific purpose rather than vague boilerplate such as "it will be used to fund general business needs." The most common purposes of new debt include the following:
1. Tofundgrowth:Thecashraisedbythedebtissuanceisusedforspecific investment(s)--this is normally a good sign.
2. To refinance "old" debt: Old debt is retired and new debt is issued, presumably at a lower interest rate--this is also a good sign, but it often changes the company's interest rate exposure.
3. Tochangethecapitalstructure:Cashraisedbythedebtissuanceisusedto repurchase stock, issue a dividend, or buyout a big equity investor-- depending on the specifics, this may be a positive indicator.
4. Tofundoperatingneeds:Debtisissuedtopayoperatingexpensesbecause operating cash flow is negative. Depending on certain factors, this motive may be a red flag. Below, we look at how you can determine whether a company is issuing new debt to fund operating needs.
Be Careful of Debt that Funds Operating Needs
Unless the company is in the early growth stage, new debt that funds investment is preferable to debt that funds operating needs. To understand this thoroughly, recall from the cash flow installment that changes in operating accounts (that is, current assets and current liabilities) either provide or consume cash. Increases in current assets--except for cash--are "uses of cash" and increases in current liabilities are "sources of cash." Consider an abridged version of RealNetworks' balance sheet for the year ending December 31, 2003:
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