What Is Debt?

At its simplest, debt is simply borrowed money. Looking at a balance sheet such as Widget Co Ltd’s (as shown in Chapter 2) some borrowings are easy to both see and understand. These are what could be regarded as formal borrowings, such as the overdraft and the mortgage, and are likely to be familiar to most people who have ever had a bank account or bought a house.

However, in addition to these formal borrowings, as discussed in the last section, essentially every liability on your balance sheet represents a source of cash that you have used and which you will eventually have to repay. So in addition to the obvious formal borrowings, all of the other current and long-term liabilities shown on your balance sheet, such as trade creditors and the tax man, should be regarded as sources of funding or debt to be used and managed to support your business.

Off Balance Sheet Debt

Going even beyond this, debt can also take forms which are more complex and difficult to spot at first sight as they do not appear on the balance sheet at all. In fact some borrowings, such as the two examples below, are sometimes described as ‘off balance sheet debt’.

It is easiest to see this by taking a couple of practical examples. So, if your business needs a machine, the shareholders could either invest their own funds in order to buy it or you could borrow money with which to buy it. If you were to borrow money you will have bought an asset, so putting an asset on the balance sheet; but you will also have to show the corresponding liability for the loan.

Alternatively, you might find a finance company which will be prepared to buy the machine for you and put it into your factory. It won’t be your machine, so the asset will not appear on your books but neither will you be taking out a formal loan that does so either. The finance company, however, will only have undertaken this transaction on the basis that you have signed up to an agreement that you will rent the machine over a period of time, at a cost that will cover the cost to them of the machine, plus their charges and an interest rate that is their profit on the deal. As a rental agreement stretching into the future this will not normally appear on your balance sheet as a liability.

Yet really this is still debt.

• The funding to buy the machine for your business’s use has come from someone and it isn’t the shareholders, who would otherwise have had to put up shareholders’ funds to do so.
• Your business will be committed to making the rental payments over the next few years as if it were repayments of a loan.
• You are committed to a set level of payments every month or quarter the way you are with any loan (as opposed to dividends which you might choose not to pay to the shareholders if they had funded the machine) so the financial risk to the business is the same as a loan.
• The rental cost includes an element which is undoubtedly interest on the sum ‘borrowed’.

 

As a second example, if you have a valuable asset such as a property and your business needs some funds, you might arrange to borrow money against this by way of a commercial mortgage at say 70% of the property’s value. Again this will show up clearly on the balance sheet as cash having come into the business, matched by a liability for a new loan.

Taking this further, however, in order to raise more cash for your business than you could get through a normal mortgage, you might enter into a sale and leaseback arrangement instead. This is where you arrange to sell one of the business’s assets, such as plant and machinery or property, to a finance company or investor at its full open market value. This enables you to release the entire value of the asset into the business as cash, but at the same time you agree to rent it back for a specified period (in some cases with an option to buy the assets back again at the end of the arrangement) so that you can continue to use the asset.

In this case what would appear on the balance sheet would again be an inflow of cash, but this time matched not by a loan but by the disposal of the asset involved.

Essentially, as in the ‘rental’ scenario discussed above, this type of transaction is still really a form of loan.

• Your business has the cash without the shareholders having to put up funds.
• Your business still has use of the asset.
• The lender has the security of the asset (it’s just that they actually have ownership of it rather than the mortgage company’s claim to seize it and sell it if they are not paid).
• Your business has a regular stream of payments that it needs to make monthly or quarterly that will include an element of what is clearly interest on the sums involved.

 

For the sake of this book, these types of financing sources, which might be described as quasi debt, such as say operating leases, are included in the section on debt as they are ways of obtaining assets for your business, are clearly not equity sources and are usually provided by very similar financial institutions to more mainstream lending.

So debt can involve:

• formal borrowings such as a loan or an overdraft;
• informal borrowings such as credit extended by a supplier;
• arrangements which provide the equivalent of a loan in terms of cash or an asset received, with a matching obligation to make payments, even if they do not appear as a liability on the balance sheet.

 

What you can see from the balance sheet is that debt divides into short- and long-term funding. For accounting purposes, anything due for repayment on demand (such as an overdraft), or due within the next 12 months (such as trade creditors or the next year’s worth of lease instalments), will count as current liabilities on the company’s balance sheet, whilst money not due in until over a year’s time will count as long-term liabilities.

This chapter will therefore give a brief overview of the main sources of borrowings and types of lending available.

The following chapters will look more closely at bank borrowings, and issues such as security, before then reviewing the alternatives to banks that are now increasingly available in respect of borrowings for both investment and working capital.