What is Debt?

Debt is an amount owed for funds borrowed. The lender agrees to lend funds to the borrower upon a promise by the borrower to pay interest on the debt, usually with the interest to be paid at regular intervals. A person or business acquires debt in order to use the funds for operating needs or capital purchases. In a business, debt may also be used as the source of funds for buying back shares in the business or to acquire another organization.

Secured and Unsecured Debt

Debt may be secured by an entity's other assets, which will become the lender's property if the entity cannot pay back the debt. Alternatively, the debt may be unsecured. Debt may also be guaranteed by a third party, such as an owner or a corporate parent. If the borrower defaults on a loan, the guaranteeing party is obligated to pay for the outstanding amount of debt.

Debt Covenants

A lender may impose certain covenants as part of a debt agreement, such as a requirement that a current ratio of at least 2:1 be maintained, or that no dividends be paid as long as the debt is outstanding. If the borrower breaches a covenant, the lender is permitted to call the loan, thereby forcing its immediate repayment by the borrower.

Advantages of Debt

There are several advantages to the use of debt, which are as follows:

Maintain ownership interest. The borrower can use it to avoid selling additional ownership shares, so that ownership remains concentrated with the current set of investors. This is an especially important consideration for family-run businesses.
Interest tax deduction. Interest expense is tax deductible, so its net cost to the borrower can be comparatively low.
Possible incremental return on investment. If the borrower uses borrowed funds to purchase assets that generate a reasonable return, it can earn a net gain over the cost of the funds acquired.
Reduced cost of capital. Debt financing often costs less than equity financing. This is because lenders require lower returns than equity investors (as debt is usually less risky), making it a more affordable way to raise capital.
May improve creditworthiness. Managing debt responsibly can build creditworthiness, leading to better interest rates and borrowing terms in the future. A strong credit profile can be an asset when seeking larger loans or favorable financing terms.