The term "outstanding debt" means the total amount of money a business owes its lenders, including accrued interest. This measure is among the most important metrics for lenders, investors and managers. Businesses have credit ratings just as do individuals. Excessive debt or a poor payment rating can damage a firm's credit, making borrowing more expensive or impossible. By contrast, a business that manages its outstanding debt well has access to necessary financing to facilitate its operations, expand the business and take advantage of opportunities.
The outstanding debt definition includes two components. First is the principal, which is the portion of money originally borrowed that hasn't been repaid. When you define outstanding debt, include any interest that has been charged by the lender that hasn't been paid. For example, a business may have a credit card account with a balance of $1,000 that includes $50 in interest and $950 in principal.
Debt for businesses falls into two categories. Short-term debt is due in one year or less. Long-term debt doesn't have to be repaid for one year or more. Another way of organizing outstanding debt is by type. Like individuals, businesses use credit cards, lines of credit and similar financing vehicles. Businesses may also get short-term funding via inventory financing. Businesses also raise money by taking out bank loans. Finally, many businesses finance operations and expansion by selling bonds to investors.
Some businesses find borrowing money to purchase additional inventory is useful. For example, a retailer that expects strong sales during the holiday season often turns to inventory financing to make sure it has enough stock on hand. Inventory financing is generally short term and accomplished through credit cards, lines of credit or bank loans. Banks typically will lend up to 50 percent of the liquidation value. Liquidation value is the amount the business can expect to recover if anticipated revenues don't materialize and the firm must liquidate the goods at low prices.
Bank loans are another source of business financing. Firms often turn to banks for a variety of funding needs, including replacing worn-out equipment and the purchase of land, buildings and new equipment to expand operations. Banks typically include restrictions on additional borrowing until the loan is paid off.
Bonds are a major source of capital for many companies. A bond is essentially an IOU and must be repaid at its face value when it matures. Maturity dates may be as short as a few weeks. Short-term bonds are used for financing inventory, raising cash and other immediate needs. Long-term bonds may have maturities of up to 30 years and are typically used to fund company growth.
Each corporate bond pays a fixed sum called the coupon. For example, a bond with a $1,000 face value may pay a coupon of $50 per year. Interest is usually paid twice each year and does not accrue. The principal amount, meaning the face value, isn't paid until the bond matures.
A key feature of corporate bonds is that they're traded as securities on bond markets, and their values may vary widely from the face value. Bond prices vary for several reasons. Two of the most important causes of bond price fluctuation are changes in interest rates and changes in the credit rating of the bonds.
Suppose prevailing interest rates on the bond market go up or the credit rating of the company's bonds is downgraded. In either case, the bond price will fall. Since the coupon amount is fixed, this decrease in price has the effect of increasing the interest rate an investor receives.
For example, suppose a bond is downgraded from a top AAA rating to an A rating. The bond price falls to $800. The bond continues to pay a coupon of $50, which is 5 percent of the face value. However, an investor now pays only $800. By dividing the coupon of $50 by $800, you find the bond now pays a yield or effective interest rate of 6.25 percent. This higher interest rate offsets the added risk the investor incurs by purchasing a bond that's now rated as less creditworthy.