Debt

Definition

Debt is a financial obligation where one party (the borrower) receives capital from another (the lender) and agrees to repay the principal plus interest over time.

In corporate finance, debt refers to borrowed funds that can be used to finance operations, acquisitions, or capital expenditures. It is a key component of a company’s capital structure and typically appears as a liability on the balance sheet.

Origins

Debt has existed since ancient civilizations, with formal lending and interest systems recorded as far back as Babylonian times (~2000 BCE). The modern debt markets developed during the Medieval period, evolved with bond markets in the 17th century, and became formalized through central banks, securities exchanges, and global credit rating systems in the 20th century.

Usage

Industry Applications:

• Corporate Finance – Raising capital via bonds, term loans, credit facilities.

• Public Sector – Sovereign and municipal debt to fund infrastructure and budgets.

• Private Equity – LBOs use debt as a lever to enhance equity returns.

• Banking – Asset-liability matching, lending, capital adequacy.

• Project Finance – Structured debt tied to the cash flows of specific assets.

How Debt Works

Debt typically involves:

• Principal – The original amount borrowed.

• Interest Rate – Cost of borrowing (fixed or floating).

• Maturity – When the debt must be repaid.

• Repayment Schedule – Periodic payments of interest and/or principal.

• Covenants – Conditions and restrictions imposed by lenders.

• Collateral (if secured) – Asset backing the loan.

Debt reduces immediate cash needs but creates future obligations.

Key Takeaways

• Debt is a leveraging tool—can amplify returns but increases risk.

• It’s cheaper than equity due to tax deductibility of interest.

• Excessive debt leads to financial distress or bankruptcy.

• Managed properly, debt supports growth, capex, and strategic flexibility.

   

Types & Variations of Debt

Context in Financial Modeling

Debt is central to:

• Capital Structure Modeling: Determines balance of debt and equity.

• WACC Calculation: Cost of debt (after tax) contributes to enterprise valuation.

• Interest Schedule: Drives interest expense in income statement and cash flows.

• Debt Covenants: Built into models to ensure compliance under scenarios.

• LBO Models: Debt is layered by type and priced to simulate returns.

Nuances & Complexities

• Interest Rate Risk: Floating-rate debt exposes borrowers to rising rates.

• Covenant Risk: Violations can trigger defaults or penalties.

• Refinancing Risk: Firms may face high costs or capital shortages at maturity.

• Subordination Risk: Affects recoveries in bankruptcy.

• Debt Overhang: Too much debt can deter equity investment and growth.

Mathematical Formulas

1. Interest Expense:

$$\text{Interest} = \text{Outstanding Debt} \times \text{Interest Rate}$$

2. Debt-to-Equity Ratio:

$$\text{D/E} = \frac{\text{Total Debt}}{\text{Shareholders' Equity}}$$

3. Leverage Ratio:

$$\text{Leverage} = \frac{\text{Total Debt}}{\text{EBITDA}}$$

4. Coverage Ratio:

$$\text{Interest Coverage} = \frac{\text{EBIT or EBITDA}}{\text{Interest Expense}}$$

5. Net Debt:

Net Debt =Total Debt - Cash & Equivalents

Related Terms

• Equity

• Leverage

• Debt Service

• Interest Expense

• Bond

• Loan

• Covenant

• WACC

• Capital Structure

   

Real-World Applications

1. Corporate Debt Issuance

A Fortune 500 firm issues a $1 billion 10-year bond at 4.5% to refinance existing higher-interest debt, reducing annual interest costs by $15M.

2. LBO Financing

A private equity firm finances a $500M acquisition with $350M in debt, targeting a 20% IRR for its equity portion through cash flow-based debt repayment.

3. Sovereign Debt Crisis

A country with high public debt-to-GDP ratio (~130%) sees credit rating downgrades, raising borrowing costs and triggering a fiscal austerity program.

4. Startup Credit Facility

A SaaS startup secures a $5M revolving credit line with a 1-year draw period, paying only interest until maturity, helping manage working capital volatility.

References & Sources

• FASB ASC 470 – Debt

• IFRS 9 – Financial Instruments

• Moody’s & S&P – Corporate Debt Ratings Methodology

• BIS – Global Debt Statistics and Systemic Risk Reports

• McKinsey & Co. – “Balancing Debt and Growth”