The Basics of Debt Capital - dummies

By Kenneth Boyd, Lita Epstein, Mark P. Holtzman, Frimette Kass-Shraibman, Maire Loughran, Vijay S. Sampath, John A. Tracy, Tage C. Tracy, Jill Gilbert Welytok

Debt-based capital is money contributed to the business in the form of a loan. It represents a liability or obligation to a business because it’s generally governed by set repayment terms as provided by the party extending credit. The loan document is likely to include a claim against specific assets.

As an example, suppose a bank lends $2 million to a company to purchase additional production equipment. The bank establishes the terms and conditions of the debt agreement, including the interest rate (for instance, 8 percent), repayment term (say, 60 months), the periodic payment schedule, collateral required, and other elements of the agreement. The company must adhere to these terms and conditions or run the risk of default.

But debt isn’t limited to just loans, leases, notes payable, and/or other similar agreements. Countless other sources of debt are used by a company to support daily operations. One example is to use payment terms (for example, due in 30 days) provided by vendors when purchasing products or services. This situation creates an account payable.

Businesses also ask customers to provide advances or deposits against future purchases. These payments are a liability for a company. The liability is removed when the business provides the product or service (the purchase is complete).

Debt is best evaluated by understanding its two primary and critical characteristics: maturity and security.

Debt maturity refers to the length of time the debt instrument has until the maturity date, which is the date the debt becomes due and payable. For example, in the case of trade accounts payable, vendors commonly extend credit terms of 30 days to their customers, which means payment is due within 30 days of receipt of the product or service.

Any debt instrument requiring payment within one year or less is classified as current (short-term) in the balance sheet. Logic then dictates that long-term debt is any obligation with a payment due beyond one year. For example, mortgage loans provided by banks for real estate purchases are often structured over a 30-year period.

Hence, the portion of the debt due past the first year is considered long term in nature. A balance sheet displays the current portion and the long-term portion of a debt separately.