Our e-bike shop needs £50,000 to expand its inventory. It secures a bank loan at a 5% annual interest rate, to be repaid over 5 years. This loan is the shop’s debt.

Each year, the shop pays part of the principal (£10,000) plus interest (£2,500 in the first year, decreasing annually), totalling £62,500 over 5 years.

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Debt is a fundamental concept in both personal and business finance, acting as a lever to accelerate growth, investment, and personal expenditures. It’s a powerful tool but, if mismanaged, can lead to financial distress.

At its core, debt involves borrowing money with a promise to repay the original amount (the principal) along with interest over a specified period. This interest is the cost of borrowing and is determined based on the risk profile of the borrower and the prevailing market rates.

Debt comes in various forms:

Loans: Borrowed sums from financial institutions or individuals.

Bonds: Debt instruments issued by corporations or governments to raise capital, repaid at a fixed interest rate.

Lines of Credit: Flexible borrowing options, like a credit card, offering access to funds up to a certain limit.

Mortgages: Loans specifically for purchasing property, secured by the property itself.

Why take on debt?

Capital Expenditures: Purchasing long-term assets to grow the business.

Working Capital: Financing day-to-day operations.

Refinancing: Replacing existing debt with new debt, often to benefit from lower interest rates.

What are the advantages?

Leverage: Debt can amplify returns on investment. If the return on the borrowed money is higher than the cost of the debt, it results in increased profitability.

Tax Benefits: Interest payments on business debt are often tax-deductible, reducing the overall tax burden.

Retained Ownership: Unlike equity financing, debt doesn’t dilute the owner’s stake in the business.

What are the risks?

Repayment Obligation: Debt must be repaid regardless of business performance, creating a financial burden.

Interest Costs: High-interest rates can significantly increase the cost of borrowing.

Credit Implications: Failure to repay debt can damage the borrower’s credit rating.

Bankruptcy Risk: Excessive debt can lead to insolvency or bankruptcy

Though debt is a useful financing mechanism it needs to be managed. Things to consider are:

Understanding Capacity: Assessing the ability to repay, considering cash flow and financial health.

Choosing the Right Type of Debt: Selecting terms and types of debt that align with the business’s needs and repayment ability.

Refinancing: Restructuring debt when beneficial.

Maintaining Good Credit: Ensuring timely repayments to build a strong credit history

It is imporant to understand the longterm and short term implictions.  In the short term debt can affect liquidity and operational cash flow whilst in the long term it influences growth prospects, investment capacity, and financial sustainability.

In financial statements, debt is reflected in all three statements:

Balance Sheet: Long-term and short-term liabilities.

Income Statement: Interest expenses.

Cash Flow Statement: Cash flows from financing activities.

It is important we understand the key ratios around debt whcih can show us the exposure, how leveraged a business is and size of the risk:

Debt-to-Equity Ratio: Measures the proportion of debt to shareholders’ equity, indicating the degree of financial leverage.

Interest Coverage Ratio: Assesses the ability to meet interest obligations from operational earnings.

Debt Service Coverage Ratio (DSCR): Evaluates cash flow availability to service debt.

Conclusion

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