Definition: Money that is owed, which is usually because it was previously borrowed.
Example: DIST Corp. borrowed $10 million to build a warehouse. Over the next 5 years, in addition to interest, it paid off $2 million of this loan. At that point, it borrowed another $5 million to expand the warehouse. DIST’s debts related to the warehouse are $8 million + $5 million, or $13 million in total.
Investeach explains: There are basically two ways for businesses to acquire money to get started or to grow: sell investors a portion of company ownership (ie, sell stock) or borrow money from them (ie, sell bonds). Borrowing money obviously causes a business’ debts to grow. The higher the debt, the more the company is at risk of failure. If the investments in new products the business makes with the borrowed money wind up not creating highly popular and profitable products, the company may not be able to pay the interest on its debts. This is not to mention paying the borrowed money back when it’s due.
In contrast to this, when stock is sold no recurring payment is owed to stockholders. Sure, the company may pay a portion of profits to shareholders (ie, dividends) each quarter, but these can be cut or eliminated by the company if times get tough. And, companies never have to take buy back their stockholders’ shares, so that’s another thing that makes selling stock a much safer method of raising money than borrowing it.
So, why do companies take on debt? Because if they don’t do it in excess and they are profitable enough to make the debt payments, they can raise money without taking on more owners among whom company profits would have to be shared. They avoid dilution of their current shareholders.
Finally, debts that are due within one year are considered short-term, while debts are that due in a year or later are considered long-term.
Riddle me this:
1. Identify two ways that a business can wind up with debts.
2. Identify two ways companies can raise money to start or to grow a business.
3. Explain why borrowing money is much more risky for a company than selling stock.
4. Why, despite the risks involved, do some companies still choose to borrow when they need money to grow?
5. What is the time threshold that separates a long-term debt from a short-term debt?