What it means
Debt comes in many shapes: term loans, overdrafts, revolving credit facilities, bonds, invoice finance, asset finance and lease obligations. What they share is a contractual promise to repay a fixed amount on a schedule, which is what makes debt fundamentally different from equity.
That fixed obligation is both the appeal and the danger. Debt is usually cheaper than equity because lenders take less risk and interest is normally tax deductible, but the repayments do not pause when trading is poor.
The core measures are how much debt exists relative to equity or earnings, and how comfortably profits cover the interest. Lenders typically look at net debt to earnings before interest, tax, depreciation and amortisation, and at interest cover, then set covenants around both.
Debt is also ranked. Senior secured debt is repaid first and is backed by specific assets, while subordinated or mezzanine debt sits behind it, carries a higher interest rate and is repaid only once the senior lenders are satisfied.
The judgement call is matching the debt to the purpose. Borrowing over seven years to buy a machine that lasts ten is sensible, whereas funding an ongoing cash shortfall with short term borrowing usually postpones a problem rather than solving it.
Personal debt follows the same logic on a smaller scale. A mortgage against a long lived asset behaves very differently from a credit card balance carried month to month, and the useful question in both cases is whether the borrowing buys something that outlasts the repayments.
In practice
Real-world examples.
Example
A haulage company finances 12 new trucks with asset backed loans repaid over five years, matching the repayment period to the useful life of the vehicles. The monthly cost is covered by the contract revenue the trucks were bought to service.
Example
A seasonal retailer uses a revolving credit facility that is drawn heavily from August to November and repaid by February. Because the borrowing is short term and self liquidating, the bank is comfortable even though the peak balance looks large.
Example
A software business with a covenant limiting net debt to three times earnings sees earnings fall after losing a major client. Net debt of $9,000,000 against earnings of $2,800,000 gives 3.21 times, breaching the covenant and forcing a renegotiation with the lender, which agrees to a waiver in exchange for a higher margin and a temporary block on dividends.
Formula
Calculation
Debt to equity = total debt / shareholders equity, and interest cover = operating profit / interest expense
A manufacturer has a $3,000,000 term loan at 7% and $1,000,000 drawn on a revolving facility at 9%. Shareholders equity is $5,000,000, cash is $500,000 and earnings before interest, tax, depreciation and amortisation are $1,500,000, with depreciation of $300,000.
Total debt: $3,000,000 + $1,000,000 = $4,000,000
Annual interest: ($3,000,000 x 0.07) + ($1,000,000 x 0.09) = $210,000 + $90,000 = $300,000
Blended interest rate: $300,000 / $4,000,000 = 7.5%
Debt to equity: $4,000,000 / $5,000,000 = 0.8
Net debt: $4,000,000 - $500,000 = $3,500,000
Net debt to earnings before interest, tax, depreciation and amortisation: $3,500,000 / $1,500,000 = 2.33 times
Operating profit: $1,500,000 - $300,000 = $1,200,000
Interest cover: $1,200,000 / $300,000 = 4.0 times
At a 25% tax rate the after tax cost of that debt is 7.5% x 0.75 = 5.625%, because the interest reduces taxable profit.Case study
Seen in the real world.
Trelawn Packaging is a fictional, illustrative producer of moulded packaging with $12,000,000 of revenue. It funded a $2,600,000 factory extension using its overdraft and a two year loan, because the finance director wanted to avoid the arrangement fees on longer term facilities.
The building had a useful life of over 25 years, but the repayments had to be met within 24 months. In this illustrative case the annual debt service reached about $1,400,000 against operating cash flow of roughly $900,000, and the company began delaying supplier payments to bridge the gap.
Trelawn refinanced into a ten year commercial mortgage at 6.5%, cutting annual debt service to about $360,000. Nothing about the business had changed, but matching the repayment term to the life of the asset turned an unsustainable position into a manageable one.
Watch out
Common mistakes.
- Treating all debt as bad. Debt used to fund assets that generate more than they cost is a normal and sensible part of running a business.
- Judging debt only by the interest rate. Term, security, covenants and repayment profile often matter more than a difference of one or two percentage points.
- Funding long life assets with short term borrowing. Repayments then fall due long before the asset has generated the cash to cover them.
Questions
People also ask.
What is the difference between debt and equity?
Debt must be repaid on a schedule and carries interest, while equity is permanent capital that carries no repayment obligation but dilutes ownership.
What is a debt covenant?
It is a condition in a loan agreement, such as a maximum leverage ratio or a minimum interest cover, and breaching it can make the loan repayable on demand.
Is net debt more useful than total debt?
Usually yes for assessing risk, because netting off available cash shows what the business would owe if it repaid what it could today.
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