Adjusted long term credit

What Is Adjusted Long-Term Credit?

Adjusted long-term credit refers to a modified view of an entity's long-term debt obligations, which goes beyond the standard figures presented in its financial statements. This adjustment aims to provide a more comprehensive and accurate picture of an organization's true indebtedness and overall financial health. It is a critical component of credit analysis, as analysts seek to understand all liabilities that could impact an entity's ability to meet its obligations. By making these adjustments, stakeholders can better assess the underlying credit risk associated with lending to or investing in a company.

History and Origin

The concept of adjusting credit figures evolved largely due to the limitations of traditional accounting practices, particularly regarding off-balance sheet financing. Historically, certain significant financial obligations, such as operating leases and some special purpose entity (SPE) debt, were not fully recognized on the corporate balance sheet as liabilities. This practice could obscure a company's true leverage and financial commitments, making it difficult for investors and creditors to accurately gauge risk.

A major shift occurred with the introduction of new accounting standards aimed at increasing financial reporting transparency. For instance, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02, Leases (codified as ASC 842), in 2016. This standard fundamentally altered how companies report leases by requiring lessees to recognize most leases with terms greater than 12 months as right-of-use assets and corresponding lease liabilities on their balance sheets.⁹ Prior to ASC 842, many operating leases were treated as expenses on the income statement rather than balance sheet obligations. This change, effective for many public companies with fiscal years ending after December 15, 2019, aimed to bring these significant commitments into full view.⁸ Rating agencies, like S&P Global Ratings, have acknowledged that while ASC 842 enhances transparency, the underlying lease obligations themselves haven't changed, and thus it generally has not led to widespread credit rating changes.⁷ Academic research has also shown that off-balance sheet debt, such as that related to asset securitizations, carries the same risk relevance as on-balance sheet debt.⁶ The ongoing evolution of global debt levels, monitored by organizations like the International Monetary Fund (IMF), further underscores the need for robust credit assessment methods that incorporate comprehensive views of all financial obligations.⁵

Key Takeaways

• Adjusted long-term credit provides a more accurate view of a company's total financial obligations, including items traditionally off the balance sheet.
• This adjustment is crucial for a thorough credit analysis and risk assessment.
• Key adjustments often include operating lease liabilities and certain off-balance sheet financing arrangements.
• The goal is to enhance financial reporting transparency and comparability among entities.
• Properly calculated adjusted long-term credit aids in evaluating a company's true leverage ratio.

Formula and Calculation

While there isn't one universal formula for "Adjusted Long-Term Credit" as it varies based on the specific adjustments an analyst makes, it generally begins with reported long-term debt and adds back certain off-balance sheet liabilities. A common example involves the adjustment for operating leases under the pre-ASC 842 accounting rules, or for liabilities that remain off-balance sheet under current rules (though fewer exist now).

A conceptual formula for adjusted long-term credit might look like this:

Where:

• Reported Long-Term Debt: The total long-term debt as reported on the company's balance sheet.
• Present Value of Operating Lease Obligations: Before ASC 842, this referred to the discounted value of future operating lease payments that were not capitalized. Post-ASC 842, most such leases are already on the balance sheet, but this component could apply to specific, rare exceptions or for historical analysis.
• Other Off-Balance Sheet Liabilities: This could include obligations from certain joint ventures, guarantees, or complex asset securitization arrangements that create debt-like exposures but are not explicitly on the balance sheet.

Calculating the present value of lease obligations requires discounting future lease payments using an appropriate discount rate, often the company's incremental borrowing rate.

Interpreting the Adjusted Long-Term Credit

Interpreting adjusted long-term credit is crucial for understanding a company's complete financial picture. A higher adjusted long-term credit figure, compared to the reported long-term debt, signifies that the company has substantial obligations that might not be immediately apparent from its primary financial statements. This broader view helps analysts assess the true extent of a company's capitalization and its capacity to take on additional debt.

For example, if a company has significant operating lease commitments, the adjusted long-term credit would reveal a higher effective leverage ratio than simply looking at reported debt. This is particularly relevant when assessing debt capacity, compliance with debt covenant requirements, and overall credit risk. A complete and transparent understanding of all long-term obligations allows investors and lenders to make more informed decisions.

Hypothetical Example

Consider "Horizon Airlines," a hypothetical company, before the widespread adoption of ASC 842.

Horizon Airlines' publicly reported financial statements show:

• Long-Term Debt: $500 million
• Operating Lease Commitments (undiscounted future payments over 10 years): $300 million
• Average remaining lease term: 5 years
• Horizon Airlines' incremental borrowing rate (discount rate): 5%

To calculate the adjusted long-term credit, an analyst would estimate the present value of the operating lease commitments. For simplicity, assume the $300 million represents the total future minimum lease payments over the remaining lease terms, and the present value of these payments, discounted at 5%, is approximately $250 million.

Adjusted Long-Term Credit for Horizon Airlines:

In this scenario, while Horizon Airlines reports $500 million in long-term debt, its adjusted long-term credit is $750 million. This difference of $250 million represents the debt-like nature of its operating lease commitments, which would have been recognized on the balance sheet under current accounting standards. This adjustment provides a more accurate reflection of the airline's overall financial burden and potential exposure to credit risk.

Practical Applications

Adjusted long-term credit is widely used in various financial contexts to provide a more accurate picture of a company's obligations:

• Investment Analysis: Equity analysts use adjusted figures to better assess a company's true leverage ratio and enterprise value, which can influence stock valuation models. A higher adjusted long-term credit might imply a riskier investment if not offset by strong cash flows.
• Credit Rating Agencies: Agencies performing credit rating assessments meticulously review all forms of debt, including off-balance sheet obligations, to determine a company's solvency and repayment capacity. They typically make their own adjustments to reported figures to achieve comparability across different companies and industries.⁴
• Lending Decisions: Banks and other lenders use adjusted long-term credit to evaluate a borrower's overall indebtedness before extending new loans. Understanding the full extent of existing obligations helps them set appropriate interest rates and loan terms.
• Mergers and Acquisitions (M&A): During due diligence, acquiring companies perform extensive adjustments to the target company's financials to uncover all hidden liabilities, ensuring a fair valuation and understanding of the true cost of acquisition.
• Regulatory Oversight: Regulators, like the International Monetary Fund (IMF), monitor global debt levels, including private and public debt, often requiring comprehensive data that extends beyond simple reported figures to assess financial stability and potential systemic risks.³ This reflects a broader need for comprehensive debt assessment.
• Financial Ratios Calculation: Key financial metrics, such as the debt-to-equity ratio or debt-to-EBITDA, become more meaningful when calculated using adjusted long-term credit, providing a clearer measure of financial risk.

Limitations and Criticisms

While adjusting long-term credit provides a more comprehensive view of a company's obligations, it also has limitations and can be subject to criticism:

• Subjectivity of Adjustments: The process of adjusting long-term credit often involves a degree of subjectivity. For instance, estimating the present value of certain obligations requires assumptions about discount rates and future cash flows, which can vary among analysts. Different analysts might apply different methodologies, leading to inconsistencies.
• Data Availability: Obtaining the precise data needed for all adjustments can be challenging, especially for smaller or privately held companies that may not disclose as much detail as public corporations. Information on all forms of off-balance sheet financing might not always be readily available in standard financial statements or their footnotes.
• Complexity: The calculation and interpretation of adjusted long-term credit can be complex, requiring a deep understanding of accounting standards and financial structures. This complexity can make it harder for non-specialist investors to grasp the true implications.
• Potential for Over-Adjustment: In some cases, overly aggressive adjustments or the inclusion of contingent liabilities that are remote could inflate the perception of a company's debt burden beyond what is realistic, potentially leading to an inaccurate assessment of credit risk.
• Evolving Accounting Standards: While standards like ASC 842 aimed to bring more liabilities onto the balance sheet, accounting rules continue to evolve. This means what constitutes "adjusted" today might become "reported" tomorrow, requiring continuous adaptation in analysis. Even after ASC 842, some academics suggest that firms with more abnormal operating leases before the standard experienced a greater reduction in perceived credit risk after implementation, implying prior opaqueness.² Research also highlights that investors may perceive gains from complex financial structures, like asset securitization, as less reliable, particularly when associated with high levels of off-balance sheet debt.¹

Adjusted Long-Term Credit vs. Total Debt

Adjusted long-term credit and total debt are related but distinct concepts in financial analysis. The key difference lies in their scope and the level of detail they capture regarding a company's financial obligations.

Total debt, as typically reported on a company's balance sheet, represents the sum of all short-term and long-term borrowings, including bonds, loans, and other financial liabilities explicitly recognized under prevailing accounting standards. It is a fundamental metric for assessing a company's leverage ratio and is directly pulled from the publicly available financial statements.

Adjusted long-term credit, on the other hand, takes the reported long-term debt as a starting point and then incorporates additional debt-like obligations that may not be fully presented on the balance sheet. These typically include off-balance sheet items such as the full economic impact of operating lease commitments (especially before new accounting rules like ASC 842 fully captured them) or liabilities associated with certain complex financing arrangements. The purpose of adjusted long-term credit is to provide a more holistic and economically realistic measure of a company's true long-term financial commitments, allowing for a deeper assessment of its financial health and capacity to service all forms of debt.

FAQs

Why is it important to adjust long-term credit?

Adjusting long-term credit is important because it provides a more accurate and comprehensive view of a company's true financial obligations. By including off-balance sheet items, analysts can better assess the company's actual leverage ratio, credit risk, and ability to meet all its long-term financial commitments. This enhanced transparency aids in more informed investment and lending decisions.

What are common items included in adjusted long-term credit?

Common items included in adjusted long-term credit are the present value of future operating lease payments (especially historically, before ASC 842 mandated their on-balance sheet recognition), certain guarantees, and obligations from specific off-balance sheet financing arrangements, such as those involving unconsolidated special purpose entities or complex joint ventures. The goal is to capture any debt-like commitments not fully reported on the main balance sheet.

How do accounting changes like ASC 842 affect adjusted long-term credit?

Accounting changes like ASC 842 (Leases) significantly impact adjusted long-term credit by bringing many previously off-balance sheet operating lease liabilities onto the balance sheet. This reduces the need for analysts to make their own adjustments for these items, as the reported total debt figures now more closely reflect these obligations. The standard enhances financial reporting transparency by providing a clearer view of a company's contractual obligations.

Who uses adjusted long-term credit?

Adjusted long-term credit is primarily used by credit rating agencies, financial analysts, investors, lenders, and corporate finance professionals. These stakeholders rely on these adjusted figures to conduct thorough credit analysis, evaluate investment opportunities, make lending decisions, and assess a company's overall financial health and risk profile.