Debt is that part of your business finance which is made by way of loans and borrowings, it is usually secured on business assets and sometimes personal assets of the owner.
The debt is provided by a lender and your business is called the borrower. The debt will be subject to lending criteria which need to be satisfied before the loan is provided.
Debt finance is normally evidenced by a note or document which specifies the amount, interest rate, and date of repayment. Failure to make repayments on debts can result in penalties or ultimately winding up proceedings against the business.
Short Term Debt
Long Term Debts
Long term debts are repayable in more than one year and are included as part of long term liabilities in the balance sheet. Long term debt finance normally falls within one of two categories, bank loans or mortgages which are long term loans used to purchase property.
Types of Debt
There are different types of business finance available including:
Fixed rate debt has a fixed interest rate throughout the term of the loan.
Fixed installment debt has fixed amount, scheduled repayments made throughout the term of the loan.
Secured debt is as the name implies secured on the assets of the business and on occasions on the personal assets of the owner. A mortgage is a particular type of secured loan which is used to purchase property.
Variable rate debts have an interest rate which changes throughout the term of the loan and is usually set in relation to an underlying bank rate such as Base rate or LIBOR (London Inter Bank Offered Rate).
Unsecured debts do not require any security and includes such items as credit cards and occasionally bank overdrafts.
Convertible debts are loans which can be changed from one type to another during the term of the loan.
How do you Record Debts?
Debts are recorded in the General Ledger.
If for example, a business obtains a loan from a lender of 10,000, and the amount is paid into the business current account at the bank, the journal entry to record the loan arrangment would be.
|Bank Current Account||10,000|
This reflects the cash being received into the bank account, and the liability of the business to the lender under the terms of the loan agreement.
Debt service is a term given to mean the amount of principal and interest a business pays on a loan. Debt service is normally referred to on an annual basis but can be for any period.
As an example of how to calculate debt service, suppose a business has a loan of 120,000 repaid over 10 years in equal installments at an interest rate of 6%, then the principal and interest repayments for each year would be 16,304. The business would say that it’s debt service is 16,304.
The ability of a business to service its debt is estimated by comparing cash flow with its required debt repayments.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.