What is debt?
Debt is a sum of money borrowed by one party from another. Debt is used by many companies and individuals as a means of making large purchases that they could not afford under normal circumstances. A debt agreement authorizes the borrowing party to borrow money provided it is repaid later, usually with interest.
How Debt Works
The most common forms of debt are loans, including mortgages and auto loans, and credit card debts. Under a loan, the borrower is required to repay the loan balance before a certain date, usually several years in the future. The loan conditions also specify the amount of interest that the borrower is required to pay annually, expressed as a percentage of the loan amount. Interest is used as a means of ensuring that the lender is compensated for taking the risk of the loan while encouraging the borrower to repay the loan quickly to limit his total interest costs.
Credit card debt works the same way as a loan, except that the amount borrowed changes over time according to the needs of the borrower, up to a predetermined limit, and has a mobile repayment date or to undetermined duration. Certain types of loans, such as student loans, can be consolidated.
Key points to remember
- Debt is money borrowed from one party to another.
- Many companies and individuals use debt as a method of making large purchases that they could not afford under normal circumstances.
- In a debt-based financial arrangement, the borrowing party obtains permission to borrow money provided that it is repaid at a later date, usually with interest.
In addition to loans and credit card debt, companies that need to borrow funds have other debt options. Bonds and commercial paper are common types of corporate debt that are not available to individuals.
Bonds are a type of debt that allows a business to generate funds by selling the promise of repayment to investors. Individuals and institutional investment firms can buy bonds, which typically carry a fixed interest rate or coupon. If a company has to raise $ 1 million to finance the purchase of new equipment, for example, it can issue 1,000 bonds with a face value of $ 1,000 each. Bondholders are promised to redeem the face value of the bond by a certain future date, called the maturity date, in addition to the promise of regular interest payments throughout the intervening years. Bonds work like loans, except that the business is the borrower and the investors are the lenders or creditors.
Commercial paper is simply short-term business debt with a term of 270 days or less.
Good debt vs. Bad debt
In corporate finance, great attention is paid to the amount of a company’s debt. A business with large debt may not be able to pay interest if sales fall, putting the business at risk of bankruptcy. Conversely, a company that does not use any debt can miss significant expansion opportunities.
Different industries use debt differently, so the “right” amount of debt varies from company to company. When assessing the financial situation of a given company, various measures are therefore used to determine whether the level of debt or financial leverage that the company uses to finance its operations is within a healthy range.