Debt

Lesson

Debt is a crucial component of a company's capital structure, representing the borrowed funds used to finance its operations and growth.

Practice Question #1

Which type of debt has priority over other debts in the event of liquidation?

Terms

Debt:

Borrowed funds to finance a company's operations and growth.

Capital Structure:

The mix of debt and equity used to finance a company's assets.

Liquidation Priority:

The order in which a company's debts and obligations are paid off in the event of liquidation.

Senior Debt:

Debt that has priority over other debts in the event of liquidation.

Subordinated Debt:

Debt that ranks below senior debt in liquidation priority.

Secured Debt:

Debt backed by collateral, such as property or other assets.

Unsecured Debt:

Debt that is not backed by collateral.

Practice Question #2

What is the primary difference between secured and unsecured debt?

Do Not Confuse With

Equity:

Ownership interest in a company, typically represented by shares of stock.

Preferred Stock:

A type of equity security with a higher claim on a company's assets and earnings than common stock.

Practice Question #3

Which type of risk is most closely associated with a borrower's ability to repay their debt obligations?

Historical Example

In the early 2000s, a large telecommunications company faced financial difficulties due to a high level of debt and declining revenues. The company eventually filed for bankruptcy, and its debt holders received only a fraction of their initial investment during the liquidation process. This example highlights the importance of understanding a company's debt structure and the risks of investing in debt securities.

Real-World Example

A small business owner takes out a loan to expand their operations. The company's assets, such as equipment and inventory, secure the loan. If the business fails and cannot repay the loan, the lender can seize the assets to recover their investment. This example illustrates the concept of secured debt.

Rhyme

First are the seniors, old and wise, They're the first to claim their prize. Then comes secured, with collateral in hand, Standing next in line as the bandstand. Subordinated debts are the next in line, They wait their turn, as is their design. Unsecured debt, the last one to board, Only gets paid when others can afford. Shareholders, alas, at the end of the line, If anything's left, then they will dine. This is the order, as best as can be, In times of liquidation, this is the decree.