A company is run by experts in their fields, but no person is smart enough to work without collected and organized data. Do you think this might be the reason why companies keep balance sheets?
Why Do Companies Keep Debt On Their Balance Sheets When They Have Enough Reserves To Pay Them?
There are several reasons for this, and I will get to them very quickly. Understandably, this question is asked by a person who lacks knowledge about the economic industry. Companies keep debt on their balance sheets even if they have enough resources to pay for it, and this is not unusual, and almost every company does the same. The reasons for keeping debt on balance sheets are:
To run financial operations efficiently:
According to economists, the ideal way to run a company is when it can keep itself running on leverage money or keeping leverage on its financial resources. Most of you might be owners of what the term leverage means. When a company borrows money from the bank or the government or pays someone a loan on interest, it is called leverage. It does not mean the company is making a loss for itself, but it means that it loans out money so that it can gain more money using profit.
I will explain this methodology using an example. A company has 200 dollars, and they account for all their assets. These 200 dollars are not utilized elsewhere because the company does not need them, as a result, the company will find ways to invest it and profit from it. The company invests the money further by loaning it to a person or another company for an interest rate of 5 percent.
Calculations: (5 / 100) * 200 = 10
200 + `10 = 210.
From the above calculations, we can conclude that the company earns a total of 10 dollars from it, and this means it will have 210 dollars at the end of the year because interest is applied every year.
Sometimes businesses face difficult situations, so they have to borrow or loan money. Suppose a company borrows a loan of 50 dollars, it would mean that the company does not have 250 dollars and 50 dollars in debt. If they succeed in generating income, or profit from it, they will be able to return the 50 dollars loan and generate an income from the money they already had. Suppose they now have 275 dollars. They will return the 50 dollars with some loan accounting for 3 to 4 dollars, and the rest would be their principal money and profits. These calculations seem very easy when you are talking about them, but in reality, they can become very complex and so they use balance sheets to organize their finances. Moreover, it also helps them in running the company smoothly that is avoiding any loss.
Acts as insurance to the company:
yes, we can say that balance sheets also act as insurance for several companies. The sole purpose of balance sheets is to calculate the money going out of the company and the money coming into the company. These calculations are compared and according to these results the company decides if they are going in loss of profit. These results determine the financial decisions that the company makes to survive.
Moreover, we always say that this world is very unfortunate, and many calamities can strike without the knowledge of the public. When calamities come, it is disastrous for these companies and also for the public. If the company utilizes all of its financial reserves it will lead to the destruction of the company when. Almost all companies take loans, and they have to return loans, but the companies do not always return the loan. If they were to use their reserves and return all the loans, they will have nothing left behind to keep the company running if they face losses due to any natural calamities.
These calamities will cause the company offices to shut down and hence they will not be able to generate profits and will close down. Currently, we are facing the same situation as the coronavirus. You must have heard in the news that multiple companies have shut down. It is due to the same reason. The company may also face lawsuits, and so sometimes the court will order them to halt operations for a while. Other extreme examples are the BP oil spill or the emission scandal of the Volkswagen Company.
In such situations, a lot of money is required instantly to cover up the costs of the losses. If the company utilizes the money allocated for paying the salaries of the workers, the workers will stop working, and so in any angle, the company will collapse. Moreover, if you go for immediately loaning the money, it will be very expensive as instant loans have very high-interest rates.
Maintains a good credit history for the company:
Companies do borrow loans for purposes, but it is utter foolishness if they borrow loans even if they do not have any financial problems. Moreover, most companies try their best to maintain their reputation with the banks or the sources that provides them their loan. There is a simple rule for maintaining this reputation in the market- give and return on time. It means that when you take a loan, you should pay the old loan first. In addition to that, you should also not take very long in returning the loan. Most loans are given for an exact duration, and if you return the loans before the due date, your reputation will further increase in the eyes of the banks. Moreover, it is also beneficial for you as it keeps the cycle of borrowing money and returning money in motion.
It improves your economical position, and also your reputation in the eyes of the banks or the sources that provide you with loans. Once you have a good reputation in the market, everyone will provide you with loans and they will provide it with lower interest rates also.
Helps in reducing taxes:
Did you know that companies pay around 6 percent of their total earnings to the government? Although sic percent may seem less, when you are running a company that is generating millions of dollars a year, it can become a lot of money. Companies consider tax money as losses because this money which is deducted from their profits. Companies have a straightforward rule, reduce losses and increase profits. As a result, the companies try their best to reduce their taxes so that they can increase their profits even more.
We should keep in mind that the government of the United States is a presidential system and each state has the authority to set its laws. So a company running in New York doesn’t need to have to pay the same amount of taxes when compared to a company that is functioning in New Jersey.
Keeping the debt on the balance sheets is beneficial for the companies as it helps them in reducing taxes. The company has to pay taxes on all transactions of money, so they consider it to keep them on their balance sheet even if they have the reserves to pay it. Once the situation of the company improves, they can pay back the debts along with taxes to the government.
It might be confusing for some newcomers, so I will explain it using an example. A soda company acquired loans worth 10 million dollars from the bank for some purpose. This loan does not have a time limit but has to be paid by the company anyways. Suppose the company faced a lawsuit due to health issues related to their products and the court orders them to stop their production. Now what happens is the company will try their best to reduce their losses, and as a result, they will not pay debts and keep them on their balance sheets so that they do not face any tax deduction when they pay back the loans.
Transactions inside the company:
Sometimes companies may face difficult situations, and so they decide to transfer their debts to other firms. These firms are called debt collecting firms. Their purpose is to collect debts from companies that cannot pay. These first are rich enough to take these debts and pay them to the bank. In return, the companies have to repay their debt to these debt-buying firms at a higher interest rate which is their source of profit.
Mostly, officials in charge of the company will deliberately transfer the debts to these firms who are operating in regions where the taxes are higher. It is maybe due to any strategic plans that the company is taking out. In these cases, the debt will remain on the debt sheets and will not be paid out until it is decided by the officials of the company.
Debt repayment issues:
Moreover, the company may analyze and feel that it will cost them more if they pay the debts early. Currently, the company might have lower credit than the time when the debt was first issued. As a result, it might cost the company extra payments if they pay back the debts too early.
Sometimes, the company requests a short-term debt, and this short-term debt issues because it has lower interest rates. Most of the time, the company faces a financial disadvantage when they pay back these short-term debts too early. As a result, they will halt their payments and save themselves from any losses.
To deal with financial issues in the future:
In simple words, the companies can make more when they borrow money for a project and earn more from that project. I will explain this using an example. Suppose I run a company named ABC and I am the CEO of it. As the CEO of my company, I will have to look at different angles when I borrow money.
The company wants to start a project and for that project the request for a loan from the bank. This loan will be able to pay for 4.5 percent of the project. Keep in mind that we already have 4.5 percent, but we are still loaning it from the bank. When the project is completed, the company will earn a profit of 20 percent from it. The debt will be on balance sheets and not paid by the company because it will increase the total value of the company in the market and the company can gain more from this.
They may gain more projects as people would consider that the company has great value in the market. Moreover, if in the future the company faces some financial issues, it can compensate for the losses by paying the 4.5 percent money it saved before.
Nonpayment due to solid debts:
Sometimes when the company buys loans from the bank, they do not keep them with themselves in cash. It will explain this by giving you an example. For instance, a company has a fire in one of their factories and due to that fire, most of their machines are damaged and not worthy of functioning. They have two options. The first option is to repair those machines or buy newer ones. The company needs instant cash to order these machines, and so they reach out to the bank. The bank provides them the loan, and they buy new machines with that money. They might ask for a lesser loan and use the money to repair the machines. It is cheaper but takes a lot of time and in the long run, is not beneficial for the company.
The company notes down the loan money in their balance sheets. The bank thinks that the loan money is with the company in cash, but that is not the case. As a result, the company can non return the debts of the bank and they keep their debts in their balance sheets. The reason for this is that the loan money is in the solid-state, meaning that it is in the form of machines.
Understanding reserves in a balance sheet:
These reserves on balance sheets are entered into in the form of liabilities. They are another name given to the funds that are used by the company when they need them. Insurance companies also have balance sheet reserves, and it represents the amount of money the insurance company saves to use in giving out claims to the people in the future. These claims are filed, but they are not yet retrieved as the customer linked with the insurance company has not met with an accident or a situation that causes damage to his health, wealth, or property.
There are several types of balance sheet reserves. One of them is called the unearned premium reserves, and it represents the premiums that are not earned yet. Another type of balance sheet reserve is the loss and adjustment reserve.
Expert tips for tackle business debt:
The first tip is to fight business debt is to reduce your expenses. These include both personal expenses and the expenses of the company. Refrain from spending money on lavish parties and use that money to pay for the salaries of your workers. Moreover, you can also cut down the facilities given to people on higher ranks, such as cutting off their gas money.
You may also cut down salaries, but it does not mean that you give salary cuts to the lower rank workers. Mostly, people in higher ranks have a higher salary, and so you can cut off some percentage of it.
Moreover, you will also have to take tough decisions in signing contracts in the future. It is a very sensitive case, and one wrong decision can lead to destruction.
From all the data, we can conclude that the companies do not pay their debts deliberately, and there are several reasons for that. Companies do it deliberately as they see a profit opportunity in it and so that they can benefit from it.