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. One is that the borrower can use it to avoid selling additional ownership shares, so that ownership remains concentrated with the current set of investors. Second, interest expense is tax deductible, so its net cost to the borrower can be comparatively low. And finally, if the borrower uses the funds to purchase assets that generate a reasonable return, it can earn a net gain over the cost of the funds acquired.