Debt - What is debt?
Debt refers to an amount of money that is borrowed and meant to be repaid
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Companies and individuals go into debt in instances when they make purchases on credit or take out loans, for example. The amount that they owe back is the amount of their debt. Debt is common among businesses when large purchases are made.
The amount borrowed is usually paid back at a later date or over time in installments. With most debt comes interest, usually charged as a percentage of the total owed on a monthly basis.
Different kinds of debt
Both individuals and businesses can have debt. The most common sources of debt for individuals includes: credit card debt, mortgages, and loans. For businesses: loans, credit cards, and bonds.
Individual debt example:
Roger is tired of trying to make his old TV works so decides it’s time to buy a new one for £489. He charges the full amount to his credit card because he doesn’t currently have the cash on hand. This balance will stay on his credit card until it is paid off. Credit cards generally have notoriously high interest, so should be paid off as quickly as possible.
Business debt example:
Julie is looking to launch her business but needs a bit more capital. She does some research and finds a good rate on a small business loan, so she takes out a loan of £2,000. Her business now has £2,000 of debt, which will need to be paid back over time. This balance will grow with interest and might incur penalty fees if regular payments are not made.
While going into debt might not seem like an appealing option, it can provide the added boost to get a business or product off the ground and earn the necessary profits to get the debt paid off and more.
Is all debt bad?
Many people have a general avoidance of debt. While this can generally be a good rule-of-thumb, there are (both in business and in personal finance) types of debt that can be considered ‘good’.
For individuals, good debt can come in the form of mortgages or even student loans. Otherwise, debt can wreak havoc on financial records and affect their future opportunities for loans, mortgages, credit cards, etc. The reason debt such as mortgages can be considered ‘good’ is because in this case, for example, it involves an asset (property) that should generally appreciate over time. Combined with low interest rates, it can even have a positive impact on credit worthiness.
For businesses, debt is equally as important. A business with too much debt might not be able to make their payments - from payroll to loan payments, it will start to add up. The accounts payable side will begin to grow, and bank accounts dwindle. This can affect shareholder interest, as well as make any potential financing more costly.
When it comes to business, it is in fact common to have some debt, especially when starting out. Ensuring that this debt remains a ‘healthy’ amount is the important part. Generally, the debt ratio for a business should less than 1 if they wish to be granted additional financing.
Managing debt and payments
When it comes to accounting, debt is considered a liability. On the balance sheet, debt can refer to a variety of different numbers - from wages payable to tax payable. However, debt is often used to refer more specifically regarding short-term and long-term loans, as well as bonds in the case of a business.
Debt should be recorded correctly as well as any payments made and interest accrued. Managing debt like a small business loan can be made significantly simpler with accounting software like Debitoor.