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.
The borrower may be a sovereign state or country, local government, company, or an individual. Debt is generally subject to contractual terms regarding the amount and timing of repayments of principal and interest. A simple way to understand interest is to see it as the rent a person owes on money that they have borrowed, to the bank from which they borrowed the money. Loans, bonds, notes, and mortgages are all types of debt. The term can also be used metaphorically to cover moral obligations and other interactions not based on economic value. For example, in Western cultures, a person who has been helped by a second person is sometimes said to owe a debt of gratitude to the second person.
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.
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 give 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.
Debt service is the cash that is required to cover the repayment of interest and principal on a debt for a particular period. If an individual is taking out a mortgage or a student loan, the borrower needs to calculate the annual debt service required on each loan, and, in the same way, companies must meet debt service requirements for loans and bonds issued to the public. The ability to service debt is a factor when a company needs to raise additional capital to operate the business.
Before a company approaches a banker for a commercial loan or considers what rate of interest to offer for a bond issue, the firm needs to compute the debt service coverage ratio. This ratio helps to determine the borrower’s ability to make debt service payments because it compares the company’s net income to the amount of principal and interest the firm must pay. If a lender decides that a business cannot generate consistent earnings to service debt, the lender doesn’t make the loan.
How the Debt Service Coverage Ratio Works
The debt service coverage ratio is defined as net operating income divided by total debt service, and net operating income refers to the earnings generated from a company’s normal business operations. Assume, for example, that ABC Manufacturing makes furniture and that the firm sells a warehouse for a gain. The income generated from the warehouse sale is non-operating income because the transaction is unusual. Assume that operating income totaling $10 million is produced from ABC’s furniture sales and those earnings are included in the debt service calculation. If ABC’s principal and interest payments due within a year total $2 million, the debt service coverage ratio is ($10 million income / $2 million debt service), or 5. The ratio indicates that ABC has $8 million in earnings above the required debt service, which means the firm can take on more debt.
Debt financing occurs when a firm raises money for working capital or capital expenditures by selling debt instruments to individuals and/or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid.
The other way to raise capital in the debt markets is to issue shares of stock in a public offering; this is called equity financing.
When a company needs money, it can take three routes to obtain financing: equity, debt, or some hybrid of the two. Equity represents an ownership stake in the company. It gives the shareholder a claim on future earnings, but it does not need to be paid back. If the company goes bankrupt, equity holders are the last in line to receive money. The other route a company can take to raise capital for its business is by issuing debt – a process known as debt financing.
The Cost of Debt
Cost of debt refers to the effective rate a company pays on its current debt. In most cases, this phrase refers to after-tax cost of debt, but it also refers to a company’s cost of debt before taking taxes into account. The difference in cost of debt before and after taxes lies in the fact that interest expenses are deductible.
Cost of debt is one part of a company’s capital structure, which also includes the cost of equity. A company may use various bonds, loans and other forms of debt, so this measure is useful for giving an idea as to the overall rate being paid by the company to use debt financing. The measure can also give investors an idea of the riskiness of the company compared to others, because riskier companies generally have a higher cost of debt.
How to Calculate the Cost of Debt
To calculate its cost of debt, a company needs to figure out the total amount of interest it is paying on each of its debts for the year. Then, it divides this number by the total of all of its debt. The quotient is its cost of debt.
For example, say a company has a $1 million loan with a 5% interest rate and a $200,000 loan with a 6% rate. It has also issued bonds worth $2 million at a 7% rate. The interest on the first two loans is $50,000 and $12,000, respectively, and the interest on the bonds equates to $140,000. The total interest for the year is $202,000. As the total debt is $3.2 million, the company’s cost of debt is 6.31%.
How to Calculate the Cost of Debt After Taxes
To calculate after-tax cost of debt, subtract a company’s effective tax rate from 1, and multiply the difference by its cost of debt. Do not use the company’s marginal tax rate; rather, add together the company’s state and federal tax rate to ascertain its effective tax rate.
For example, if a company’s only debt is a bond it has issued with a 5% rate, its pre-tax cost of debt is 5%. If its tax rate is 40%, the difference between 100% and 40% is 60%, and 60% of 5% is 3%. The after-tax cost of debt is 3%.
The rationale behind this calculation is based on the tax savings the company receives from claiming its interest as a business expense. To continue with the above example, imagine the company has issued $100,000 in bonds at a 5% rate. Its annual interest payments are $5,000. It claims this amount as an expense, and this lowers the company’s income on paper by $5,000. As the company pays a 40% tax rate, it saves $2,000 in taxes by writing off its interest. As a result, the company only pays $3,000 on its debt. This equates to a 3% interest rate on its debt.
Debt load is the amount of debt or leverage that a company is carrying on its books. The amount of debt a firm is carrying can be found in the company’s balance sheet, which most firms provide on a quarterly basis. Companies may incur this debt for numerous reasons such as expanding their business or making an acquisition.
A very useful insight into the financial health of a company is to compare the amount of debt a company is carrying to the assets or equity the company has. Dividing the total debt a company has by the total assets a company has gives what is called a debt ratio. A low debt ratio is usually a sign of a healthy company.
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