Definition and explanation
The current portion of long term debt (also referred to as current maturities of long term debt) is the portion of a long term debt or loan that is payable within one year period or operating cycle of the business, which ever is longer. It is regarded as current liability and is reported by companies in the current liabilities section of their balance sheet.
Some long term debts such as mortgage loans and serial bonds are retired in a series of annual, quarterly or monthly installments. Any portion of such long term debts or loans that matures within one year period of the balance sheet date (or operating cycle, if longer) no longer remains a long-term liability and should therefore be reclassified as current liability. The remaining portion of the long-term debts or loans which is payable after one year period continues to be a long term liability and should be reported in long-term or non-current liabilities section of the company’s balance sheet.
No journal entry is required when the classification of a liability is changed. The obligation is simply transferred from one section to another section of the balance sheet. For example if a portion of long-term debt becomes payable within one year period and is reclassified as current liability, the amount of that portion would be removed from the total long-term debt in long-term liabilities section and reported as current portion of long-term debt in current liabilities section of the balance sheet.
Consider the following example for a better understanding:
The Exell Company has a loan of $1,000,000 outstanding. The repayment schedule related to this loan shows that the company will pay $200,000 within one year period and the remainder in four equal installments in four year period following the current year. The current portion of this long term debt is $200,000 which the Exell Company would classify as current liability in its balance sheet. The remaining amount of $800,000 is the long term liability and would be reported as long-term debt in the long term liabilities section of the balance sheet.
The impact of current portion of long term debt on company’s liquidity position
The creditors and investors usually compare current portion of long term debt figure with the available cash and cash equivalents figure while evaluating the current debt paying ability of the company. If the current portion of long term debt is significantly higher than the cash and cash equivalents, the company may not actually be able to pay its debts on time. In such situation, the company’s liquidity position would suffer in the eyes of creditors and both actual and potential investors. The existing stockholders may prefer to sell their shares quickly and the lenders may reluctant to offer more credit to the company.
The current portion of long term debt should not be reported as a current liability if there exists a reasonable evidence that it will be
- paid off using a non-current or fixed asset specifically restricted for this purpose;
- paid off using the proceeds of a new long-term debt issue;
- converted into company’s common stock; or
- refinanced through a proper refinancing arrangement.
In all of the above situations, the classification as current liability is inappropriate because the retirement of debt does not require the usage of any current asset or the creation of a new current liability.
Classification of due on demand liabilities
A due on demand liability means a liability that is callable by the lender or creditor. The liabilities that are callable or are expected to become callable by the lenders or creditors within one year period (or operating cycle, if longer) should be reported as current liabilities in the balance sheet.
A liability usually becomes callable by the lender or creditor when the borrowing company commits a serious violation of the debt agreement. For example, a debt agreement requires the borrowing company to maintain a specific debt to equity ratio and current ratio (also known as working capital ratio) throughout the life of the debt. If the borrowing company fails to maintain these ratios to the level specified in the debt agreement, it will be regarded as the violation of the debt agreement and the debt would become callable by the lender. In such situation, the debt should be classified as current liability because there exists a sound reason to believe that the company’s existing working capital will be used to retire the debt.
However, if the company violating the debt agreement is able and plans to cure the violation within the grace period specified in the agreement, the debt can be classified as long-term or non-current rather than current liability.