Debt Finance
A company uses various kinds of debt to finance its operations . The various types of debt can generally be categorized into:
Debt
A company uses various kinds of debt to finance its operations.
- Secured and unsecured debt.
- Private and public debt.
- Syndicated and bilateral debt.
- Other types of debt that display one or more of the characteristics noted above.
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.
Private debt comprises bank loan sorts of obligations, whether senior or mezzanine. Public debt is a general definition covering all financial instruments that are freely trade-able on a public exchange or over the counter, with few if any restrictions. A basic loan or "term loan" is the simplest form of debt. It consists of an agreement to lend a fixed amount of money, called the principal sum, for a fixed period of time, with the amount to be repaid by a certain date. In commercial loans interest, calculated as a percentage of the principal sum per year, will also have to be paid by that date, or may be paid periodically in the interval, such as annually or monthly. Such loans are also colloquially called "bullet loans", particularly if there is only a single payment at the end – the "bullet" – without a "stream" of interest payments during the "life" of the loan.
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, usually 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. 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; with long-term bonds, lasting over thirty years, being 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 (also known as coupons) during the life of the bond. Bonds may be traded in bond markets, and are widely used as relatively safe investments in comparison to equity.
Lending to stable financial entities such as large companies or governments are often termed "risk free" or "low risk" and made at a so-called "risk-free interest rate". This is because the debt and interest are highly unlikely to be defaulted. A good example of such risk-free interest is a US Treasury security - it yields the minimum return available in economics, but investors have the comfort of the (almost) certain expectation that the US Treasury will not default on its debt. A risk-free rate is also commonly used in setting floating interest rates, which are usually calculated as the risk-free interest rate plus a bonus to the creditor based on the creditworthiness of the debtor (in other words, the risk of him or her defaulting and the creditor losing the debt). In reality, no lending is truly risk free, but borrowers at this rate are considered the least likely to default.
Debt allows people and organizations to do things that they would otherwise not be able, or allowed, to do. Commonly, people in industrialised nations 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, "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).