BUS202: Principles of Finance

A debt is an obligation owed by one party (the debtor) to a second party (the creditor). Debt usually refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.

A debt is created when a creditor agrees to lend a sum of assets to a debtor. Debt is usually granted with expected repayment. In modern society, this typically includes repayment of the original sum, plus interest.

In finance, debt is a means of using anticipated future purchasing power in the present before it has actually been earned. Some companies and corporations use debt as a part of their overall corporate finance strategy.

Debt allows people and organizations to do things that they would otherwise not be able, or allowed, to do. People in industrialized nations commonly use it to purchase houses, cars, and many other things too expensive to buy with cash on hand. Companies also use debt in many ways to leverage the investment made in their assets, by "leveraging" the return on their equity. This leverage, the proportion of debt to equity, is considered important in determining the riskiness of an investment - the more debt per equity, the riskier. For both companies and individuals, this increased risk can lead to poor results, as the cost of servicing the debt can grow beyond the ability to pay due to either external events (income loss) or internal difficulties (poor management of resources).

A company uses various kinds of debt to finance its operations. The various types of debt can generally be categorized into:

1) secured and unsecured debt

A debt obligation is considered secured if creditors have recourse to the assets of the company on a proprietary basis or otherwise ahead of general claims against the company. Unsecured debt comprises financial obligations, where creditors do not have recourse to the assets of the borrower to satisfy their claims.

2) private and public debt

Private debt involves bank-loan type obligations, whether senior or mezzanine. Public debt is a general definition covering all the financial instruments that are freely tradeable on a public exchange or over the counter, with few if any restrictions

3) syndicated and bilateral debt

A syndicated loan is a loan that is granted to companies that wish to borrow more money than any single lender is prepared to risk in a single loan, an amount usually in the many millions of dollars. In such a case, a syndicate of banks can each agree to put forward a portion of the principal sum. Loan syndication is a risk management tool that allows the lead banks underwriting the debt to reduce their risk and free up lending capacity.

4) other types of debt

A bond is a debt security issued by certain institutions such as companies and governments. A bond entitles the holder to repayment of the principal sum, plus interest. Bonds are issued to investors in a marketplace when an institution wishes to borrow money. Bonds have a fixed lifetime, usually a number of years. Some long-term bonds, can last over 30 years, though they are less common. At the end of the bond's life the money should be repaid in full. Interest may be added to the end payment or can be paid in regular installments (known as coupons) during the life of the bond. Bonds may be traded in the bond markets and are widely used as relatively safe investments in comparison to equity.

Borrowing and repayment arrangements linked to inflation-indexed units of account are possible and are used in some countries. For example, the US government issues two types of inflation-indexed bonds, Treasury Inflation-Protected Securities (TIPS) and I-bonds. Inflation-indexed debt is one of the safest forms of investment available, since the only major source of risk – that of inflation – is eliminated. A number of other governments issue similar bonds, with some doing so for many years before the US government. In countries with consistently high inflation, ordinary borrowings at banks may also be inflation indexed.