What is Debt?
In the business world, debt is an amount borrowed.
How Does Debt Work?
For example, let's assume Company XYZ has invented a new product that capitalize on this tremendous opportunity and would thus be very limited in its output and profits (and would leave the market wide open for competitors to fill the void). With some debt, however, Company XYZ could build the factory and take advantage of the profit potential of its product. The debt essentially magnifies the profits.
Debt comes in several forms, but in the business world, bank loans and corporate or government bonds are the most common.
Why Does Debt Matter?
Debt is a liability, meaning that the lender has a claim on a company’s assets. Debt due within one is generally classified as short-term debt on a company’s balance sheet. Debt due in more than one is considered long-term debt. It is important to here that debt commonly comes to mind when one considers liabilities, but not all liabilities are debt. Companies may incur several other types of liabilities, including (but not limited to) upcoming payroll, bonuses, legal settlements, payments to vendors, certain derivatives, contracts, certain types of leases, and required redemptions. Common balance sheet categories for liabilities include accounts payable, accrued expenses and debt.
Information about a company’s debt is a key component of accurate financial reporting and a crucial part of thorough financial analysis. Excessive debt can ruin a company but is not always detrimental. The use of debt financing can magnify profits that would have otherwise gone unrealized.