Debt is the money borrowed by one party from another to serve a financial need that otherwise cannot be met outright. Many organizations use debt to procure goods and services that they can’t manage to pay for with cash.
Under a debt agreement, the borrower obtains authorization to get whatever amount of money is needed on condition it will be repaid on an agreed date. In most cases, the amount owed is serviced with some interest.
Based on the amount borrowed, debt can be an asset or a complication. Knowing the best way to manage debt is tricky, particularly for a borrower who is finding it hard to make scheduled payments.
Breaking Down Debt
There are many types of debt, but the most common ones are auto loans, mortgages, and credit card debt. Based on the terms agreed, the borrower must repay the outstanding amount by the set date. Also, the terms usually specify what interest the loan will accrue over the period it is being serviced, as a percentage of the principal amount.
Interest is an essential element of the loan as it ensures that lenders are repaid for the risks they take and encourages borrowers to make payments quickly to limit interest-based expenses.
Other than credit card and loans, companies wanting to borrow money can resort to other functional options. Corporate bodies can explore other debt types such as commercial paper and bonds, which are not available to an individual.
Bonds allow companies to raise funds by selling a repayment promise to interested investors. Institutions and individual investment organizations can procure bonds that typically come with a predefined interest rate, or coupon. If an entity wants to raise a million dollars to purchase new machinery, for instance, it can provide the public with 1,000 bonds each worth $1,000.
Once individuals or other companies purchase the bonds, the holders are guaranteed a face value on a given date, commonly known as the maturation date. Thise amount is in addition to regular interest on the bond throughout the period the bond is active.
Bonds work on a similar principle to that of conventional loans. However, a company is the one borrowing while investors are either creditors or lenders. Commercial paper is a short-term debt that comes with a repayment period of less than or equal to 270 days.
Good Debt vs. Bad Debt
In the field of corporate finance, a lot of attention goes to the amount of debt an entity owes.
If, for one reason or another, sales drop, and a company is no longer as profitable as it once was, then it may not be able to repay its loans. Such a company suffers the risk of going bankrupt. However, an entity that does not take out loans may be limiting its expansion potential.
There are many industries in the market, and each interacts with debt uniquely. Thus, each company defines the right amount of debt using scales unique to its industry. When evaluating a company’s financials, a variety of metrics come into play to assess whether its debt level is within an acceptable range.
Good debt lets an individual or company manage finances effectively so that it becomes easy to build on existing wealth, purchase what is needed, and prepare well for uncertainties. This includes mortgages, buying goods and services that save the buyer money, education loans, and debt consolidation.
Bad debt, on the other hand, is an engagement whose value decreases right after purchase. However, that description fits most of the vital things we need in life, such as cars, TVs, and clothes. Other examples are credit card loans or payday loans.
Secured vs. Unsecured Debt
Secured debts involve a repayment promise, as well as collateral. Securing a debt means providing an asset so that in the event a borrower defaults, it can be sold to recover the money that was lent out.
Real-life examples of secured loans include mortgages and auto loans because the item under financing is the collateral. For example, if the borrower is purchasing a car, and defaults on payment, the loaner can sell the vehicle to recover the remaining amount. Also, if an entity takes a mortgage, the property is used as collateral. The lender maintains interest, financially, over the asset until the borrower clears the mortgage.
Unsecured debt, on the other hand, does not involve collateral. However, if a borrower does not repay the loan, the lender can institute charges at a court of law to recover the amount loaned. Lenders use creditworthiness to assess a borrower’s repayment potential.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful: