Question

Describe what Debt is, how it affects cash flow and the risks to both the lender and the debtor.

Answer 1

Here is what debt is:

• Debt is the money which is owed by one person or party to another. The debt is classified into two aspects - secured & unsecured.
• Secured debt means that the borrow has given / pledges some form of asset for getting the loan. The loan related to automobiles & mortgages is a great example. In case the borrower fails to repay the same the creditor can take the ownership of the asset to get the returns.
• On the other side unsecured debt is not having any backing of the asset. The example would involve credit card debt.

How it affects cash flow:

• Once the debt is secured the impact is positive on the finance sector of the cash flow statement but it also increases the liabilities section on the balance sheet.
• The debt has to be paid back with both principal & interest amount.
• It doesn't take or dilute the ownership but the interest payment can reduce the overall income & cash flows.
• Reduction in income can be represented via benefits in taxes as the business/ person falls in lower taxable income.

Risks to both lender & debtor:

• The debt can cause a rise in leverage ratios such as debt to equity & debt to capital. The debtor has to meet interest coverage & principal debt level requirements.
• Any risk, failure or a challenge can cause the default in payment leading to more interest & penalty charges.
• If the repayment of debt is not done in the time it can impact the brand & credibility of the debtor.
• If the firm is getting liquidated the debt holders are above and treated senior to equity holders.
• Even if the business fails, the obligation to the lender remains and that is the biggest risk. The lenders will have the right to claim for repayment before the equity investment.
• Another risk is that even after discounted interest rates the high-interest might still be high because of the macro-economic conditions.
• Another risk is that it impacts your credit rating - the loan or the debt gets noted in your credit rating.
• The risk to ensure cash flows and collateral management is another important task.

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