Debt is an amount of money borrowed by one party from another. Debt is used by many corporations and individuals as a method of making large purchases that they could not afford under normal circumstances. A debt arrangement gives the borrowing party permission to borrow money under the condition that it is to be paid back at a later date, usually with interest.
How Debt Works
The most common forms of debt are loans, including mortgages and auto loans, and credit card debt. Under the terms of a loan, the borrower is required to repay the balance of the loan by a certain date, typically several years in the future. The terms of the loan also stipulate 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 way to ensure that the lender is compensated for taking on the risk of the loan while also encouraging the borrower to repay the loan quickly in order to limit his total interest expense.
Credit card debt operates in the same way as a loan, except that the borrowed amount changes over time according to the borrower’s need, up to a predetermined limit, and has a rolling, or open-ended, repayment date. Certain types of loans, like student loans, can be consolidated.
- Debt is money borrowed by one party from another.
- Many corporations 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 gets permission to borrow money under the condition that it must be paid back 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 instrument that allows a company to generate funds by selling the promise of repayment to investors. Both individuals and institutional investment firms can purchase bonds, which typically carry a set interest, or coupon, rate. If a company needs to raise $1 million to fund the purchase of new equipment, for example, it can issue 1,000 bonds with a face value of $1,000 each. Bondholders are promised repayment of the face value of the bond at a certain date in the future, called the maturity date, in addition to the promise of regular interest payments throughout the intervening years. Bonds work just like loans, except the company is the borrower, and the investors are the lenders, or creditors.
Commercial paper is simply short-term corporate debt with a maturity of 270 days or less.
Good Debt Vs. Bad Debt
In corporate finance, there is a lot of attention paid to the amount of debt a company has. A company that has a large amount of debt may not be able to make its interest payments if sales drop, putting the business in danger of bankruptcy. Conversely, a company that uses no debt may be missing out on important expansion opportunities.
Different industries use debt differently, so the “right” amount of debt varies from business to business. When assessing the financial standing of a given company, therefore, various metrics are used to determine if the level of debt, or leverage, the company uses to fund operations is within a healthy range.
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