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do debt collectors report information to credit bureaus | yes a debt collector may report a debt to the credit bureaus but only after it has contacted the debtor about it 7 the delinquent debt may also be reflected on the person s credit report under the name of the original creditor both can remain on credit reports for up to seven years and have a negative effect on the individual s credit score a large portion of which is based on their payment history 8 | |
does the fair debt collection practices act cover business debts | no the fair debt collection practices act applies only to consumer debts such as mortgages credit cards car loans student loans and medical bills 4 | |
does the internal revenue service use debt collectors | yes the internal revenue service irs uses private agencies to collect outstanding tax debts in some instances when that happens the irs sends the taxpayer an official notice called a cp40 9 because scams are common taxpayers should be wary of anyone purporting to be working on behalf of the irs and check with the irs to make sure | |
are debt collectors licensed | whether a debt collector is licensed depends entirely on the state where they re employed some states have licensing requirements for debt collectors while others do not all debt collectors in the u s whether licensed or not must comply with the federal fair debt collection practices act and some states have specific laws in place to regulate collectors and protect resident borrowers the bottom linedebt collectors provide a useful service to lenders and other creditors that want to recover all or part of the money that is owed to them at the same time the law provides certain consumer protections to keep debt collectors from becoming too aggressive or abusive | |
how debt consolidation works | you can roll old debt into new debt in several different ways such as by taking out a new personal loan a new credit card with a high enough credit limit or a home equity loan then you pay off your smaller loans with the new one if you are using a new credit card to consolidate other credit card debt for example you can transfer the balances on your old cards to your new one some balance transfer credit cards even offer incentives such as a 0 interest rate on your balance for a period of time in addition to the possibility of lower interest rates and smaller monthly payments debt consolidation can be a way to simplify your financial life with fewer bills to pay each month and fewer due dates to worry about creditors are often willing to work with you on debt consolidation to increase the likelihood that you will repay what you owe them an example of debt consolidationsuppose you have three credit cards and owe a total of 20 000 on them with a 22 99 average annual interest rate you would need to pay about 1 048 a month for 24 months to bring the balances down to zero and you d pay about 4 601 in interest during that time if you consolidated those credit cards into a lower interest card or loan at an 11 annual rate you would need to pay about 933 a month for the same 24 months to erase the debt and your interest charges would total about 2 157 with a 0 credit card your payments would be even lower at least while the promotional period was in effect risks of debt consolidationdebt consolidation also has some downsides to consider for one when you take out a new loan your credit score could suffer a minor hit which could affect whether you qualify for other new loans depending on how you consolidate your loans you could also risk paying more in total interest for example if you take out a new loan with lower monthly payments but a longer repayment term you may end up paying more in total interest over time you can also hire a debt consolidation company to assist you however they often charge hefty initial and monthly fees it s usually easier and cheaper to consolidate debt on your own with a personal loan from a bank or a low interest credit card types of debt consolidation loansyou can consolidate debt by using different types of loans or credit cards which will be best for you will depend on the terms and types of your current loans as well as your current financial situation there are two broad types of debt consolidation loans secured and unsecured loans secured loans are backed by an asset like your home which serves as collateral for the loan unsecured loans on the other hand are not backed by assets and can be more difficult to get they also tend to have higher interest rates and lower qualifying amounts with either type of loan interest rates are still typically lower than the rates charged on credit cards and in most cases the rates are fixed so they won t rise over the repayment period with any type of loan you ll want to prioritize which of your debts to pay off first it often makes sense to start with the highest interest debt and work your way down the list here are a few more details about the most common ways to consolidate your debt a personal loan is an unsecured loan from a bank or credit union that provides a lump sum payment you can use for any purpose you repay the loan with regular monthly payments for a set period of time and with a set interest rate personal loans generally have lower interest rates than credit cards so they can be ideal for consolidating credit card debt some lenders offer debt consolidation loans specifically for consolidating debt they are designed to help people who are struggling with multiple high interest loans a new card can help you reduce your credit card debt burden if it offers a lower interest rate as mentioned earlier some credit cards offer an introductory period with 0 apr when you transfer your existing balances to them these promotional periods often last from six to 21 months or so after which the interest rate can shoot up into double digits so it s best to pay off your balance or as much of it as you can as soon as possible note that these cards may also impose an initial fee often equal to 3 to 5 of the amount you are transferring if you are a homeowner who has built up equity over the years a home equity loan or home equity line of credit heloc can be a useful way to consolidate debt these secured loans use your equity as collateral and typically offer interest rates slightly above average mortgage rates which are generally well below credit card interest rates order your copy of investopedia s what to do with 10 000 magazine for more tips about managing debt and building credit the federal government offers several consolidation options for people with student loans including direct consolidation loans through the federal direct loan program the new interest rate is the weighted average of the previous loans consolidating your federal student loans can result in lower monthly payments by stretching out the repayment period to as long as 30 years however that can also mean paying more in total interest over the long term 1private loans don t qualify for this program although you may be able to consolidate them with another private loan 2debt consolidation and your credit scorea debt consolidation loan may help your credit score in the long term by reducing your monthly payments you should be able to pay the loan off sooner and reduce your credit utilization ratio the amount of money you owe at any given time compared to the total amount of debt you have access to this in turn can help boost your credit score making you more likely to get approved by creditors and for better rates however rolling over existing loans into a brand new one may hurt your credit score credit scores favor older debts with longer more consistent payment histories qualifying for debt consolidationborrowers must meet the lender s income and creditworthiness standards to qualify for a new loan for example for a debt consolidation loan you may need to provide a letter of employment two months worth of statements for each credit card or loan you wish to pay off and letters from creditors or repayment agencies | |
does debt consolidation hurt your credit score | debt consolidation could temporarily affect your credit score negatively because of a credit inquiry but it can help your credit score in the long term if you use it correctly most people who make their new payments on time find their credit score increases significantly as they avoid missing payments and decrease their credit utilization ratio | |
what are the risks of debt consolidation | consolidating debt could potentially lead to you paying more in the long run particularly if you consolidate credit card debt but then continue to use the cards you paid off there may also be a minor short term ding to your credit score | |
what is the best way to consolidate debt | the best way to consolidate your debt will depend on the amount you need to pay off your ability to repay it and whether you qualify for a relatively inexpensive loan or credit card fortunately you have a number of options | |
what is debt settlement | not to be confused with debt consolidation debt settlement aims to reduce a consumer s financial obligations rather than the number of creditors they have consumers can work with debt relief organizations or credit counseling services to settle their debts these organizations do not make actual loans but try to renegotiate the borrower s current debts with creditors the bottom linedebt consolidation can be a useful strategy for paying down debt more quickly and reducing your overall interest costs you can consolidate debt in many different ways such as through a personal loan a new credit card or a home equity loan | |
what is the debt to ebitda ratio | debt to earnings before interest taxes depreciation and amortization ebitda is a ratio that measures the amount of income generated and available to pay down debt before a company accounts for interest taxes depreciation and amortization expenses a high ratio result could indicate a company has a debt load that might be too high banks often include a certain debt to ebitda target in the covenants for business loans and a company must maintain this agreed upon level or risk having the entire loan become due immediately credit rating agencies commonly use this metric to assess a company s probability of defaulting on issued debt firms with a high debt to ebitda ratio may not be able to service their debt appropriately leading to a lowered credit rating formula and calculationdebt to ebitda debt ebitda text debt to ebitda frac text debt text ebitda debt to ebitda ebitdadebt | |
where | debt long term and short term debt obligationsebitda earnings before interest taxes depreciation and amortizationto determine total debt add the company s long term and short term debt obligations you can find these numbers in the company s balance sheet in the liabilities section you can calculate ebitda using data from the company s income statement find its net income on the income statement then add any interest expenses taxes depreciation and amortization divide the debt by the company s ebitda the debt to ebitda ratio is similar to the net debt to ebitda ratio the main difference is the net debt to ebitda ratio subtracts cash and cash equivalents while the standard ratio does not ebitda is a non gaap measurement if you learn a company is using it in its reports you should investigate further to learn more about their debt and actual earnings or income | |
what the debt to ebitda ratio can tell you | the debt to ebitda ratio compares a company s total obligations to the actual cash the company brings in from its operations it reveals how capable the firm is of paying its debt and other liabilities if taxes and the expenses from depreciation and amortization are deferred the ratio can also be used to compare companies without considering their financing methods and non cash assets this is useful because it provides a clearer picture of how debts can be paid a declining debt to ebitda ratio is better than an increasing one because it implies the company is paying off its debt and or growing earnings likewise an increasing debt to ebitda ratio means the company is increasing debt more than earnings limitations of the debt to ebitda ratiosome analysts like the debt to ebitda ratio because it is easy to calculate debt can be found on the balance sheet and ebitda can be calculated from the income statement the issue however is that it may not provide the most accurate measure of earnings in fact companies often use ebitda to hide or disguise losses over a period depreciation and amortization are non cash expenses that do not really impact cash flows but interest on debt can be a significant expense for some companies banks and investors looking at the debt to ebitda ratio to gain insight into how well the company can pay its debts may want to consider the impact of interest on debt repayment ability even if that debt will be included in new issuance some industries are more capital intensive than others so a company s debt to ebitda ratio should only be compared to the same ratio for other companies in the same industry in some industries a debt to ebitda of 10 could be completely normal while a ratio of three to four is more appropriate in other industries example of debt to ebitda ratioas an example if company a has 100 million in debt and 10 million in ebitda the debt to ebitda ratio is 10 if company a pays off 50 of that debt in the next five years while increasing ebitda to 25 million the debt to ebitda ratio falls to two | |
what is a good debt to ebitda | it depends on the industry in which the company operates anything above 1 0 means the company has more debt than earnings before accounting for income tax depreciation and amortization some industries might require more debt while others might not before considering this ratio it helps to determine the industry s average | |
what is a good debt to equity ratio | debt to equity measures how much debt a company has to its shareholders equity because shareholders equity is part of total liabilities it shows how much of a business s debt is equity financing lower ratios are ideal but good depends on a business s financial structure and how other companies in the same industry structure themselves | |
what is the rule of thumb for debt to ebitda | it depends on the business and the industry it operates in some analysts might say 3 0 is the limit while others might go as high as or higher than 4 5 or 5 0 the bottom linethe debt to ebitda ratio tells you how much income is available to pay debts before taxes depreciation and amortization are considered the ratio is used by some analysts but since certain expenses are not accounted for before the calculation the metric is limited because it doesn t demonstrate the ability to pay debts from earnings after all expenses are paid | |
what is a debt equity swap | a debt equity swap is a transaction in which the obligations or debts of a company or individual are exchanged for something of value namely equity in the case of a publicly traded company this generally entails an exchange of bonds for stock the value of the stocks and bonds being exchanged is typically determined by the market at the time of the swap understanding debt equity swapsa debt equity swap is a refinancing deal in which a debt holder gets an equity position in exchange for the cancellation of the debt the swap is generally done to help a struggling company continue to operate the logic behind this is an insolvent company cannot pay its debts or improve its equity standing however sometimes a company may simply wish to take advantage of favorable market conditions covenants in the bond indenture may prevent a swap from happening without consent in cases of bankruptcy the debt holder does not have a choice about whether he wants to make the debt equity swap however in other cases he may have a choice in the matter to entice people into debt equity swaps businesses often offer advantageous trade ratios for example if the business offers a 1 1 swap ratio the bondholder receives stocks worth exactly the same amount as his bonds not a particularly advantageous trade however if the company offers a 1 2 ratio the bondholder receives stocks valued at twice as much as his bonds making the trade more enticing | |
why use debt equity swaps | debt equity swaps can offer debt holders equity because the business does not want to or cannot pay the face value of the bonds it has issued to delay repayment it offers stock instead in other cases businesses have to maintain certain debt equity ratios and invite debt holders to swap their debts for equity if the company helps to adjust that balance these debt equity ratios are often part of financing requirements imposed by lenders in other cases businesses use debt equity swaps as part of their bankruptcy restructuring debt equity and bankruptcyif a company decides to declare bankruptcy it has a choice between chapter 7 and chapter 11 under chapter 7 all of the business s debts are eliminated and the business no longer operates under chapter 11 the business continues its operations while restructuring its finances in many cases chapter 11 reorganization cancels the company s existing equity shares it then reissues new shares to the debt holders and the bondholders and creditors become the new shareholders in the company debt equity swaps vs equity debt swapsan equity debt swap is the opposite of a debt equity swap instead of trading debt for equity shareholders swap equity for debt essentially they exchange stocks for bonds generally equity debt swaps are conducted in order to facilitate smooth mergers or restructuring in a company example of a debt equity swapsuppose company abc has a 100 million debt that it is unable to service the company offers 25 percent ownership to its two debtors in exchange for writing off the entire debt amount this is a debt for equity swap in which the company has exchanged its debt holdings for equity ownership by two lenders | |
what is debt financing | debt financing occurs when a firm raises money for working capital or capital expenditures by selling debt instruments to individuals and or institutional investors in return for lending the money the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid investopedia jake shi | |
when a company needs money there are three ways to obtain financing sell equity take on debt or use some hybrid of the two equity represents an ownership stake in the company it gives the shareholder a claim on future earnings but it does not need to be paid back if the company goes bankrupt equity holders are the last in line to receive money the other way to raise capital in debt markets is to issue shares of stock in a public offering this is called equity financing | a company can choose debt financing which entails selling fixed income products such as bonds bills or notes to investors to obtain the capital needed to grow and expand its operations when a company issues a bond the investors that purchase the bond are lenders who are either retail or institutional investors that provide the company with debt financing the amount of the investment loan also known as the principal must be paid back at some agreed date in the future if the company goes bankrupt lenders have a higher claim on any liquidated assets than shareholders special considerationsa firm s capital structure is made up of equity and debt the cost of equity is the dividend payments to shareholders and the cost of debt is the interest payment to bondholders when a company issues debt not only does it promise to repay the principal amount it also promises to compensate its bondholders by making interest payments known as coupon payments to them annually the interest rate paid on these debt instruments represents the cost of borrowing to the issuer the sum of the cost of equity financing and debt financing is a company s cost of capital the cost of capital represents the minimum return that a company must earn on its capital to satisfy its shareholders creditors and other providers of capital a company s investment decisions relating to new projects and operations should always generate returns greater than the cost of capital if a company s returns on its capital expenditures are below its cost of capital the firm is not generating positive earnings for its investors in this case the company may need to re evaluate and re balance its capital structure the formula for the cost of debt financing is kd interest expense x 1 tax rate | |
where kd cost of debt | since the interest on the debt is tax deductible in most cases the interest expense is calculated on an after tax basis to make it more comparable to the cost of equity as earnings on stocks are taxed one metric used to measure and compare how much of a company s capital is being financed with debt financing is the debt to equity ratio d e for example if total debt is 2 billion and total stockholders equity is 10 billion the d e ratio is 2 billion 10 billion 1 5 or 20 this means for every 1 of debt financing there is 5 of equity in general a low d e ratio is preferable to a high one although certain industries have a higher tolerance for debt than others both debt and equity can be found on the balance sheet statement creditors tend to look favorably on a low d e ratio which can increase the likelihood that a company can obtain funding in the future other types of debt financingin addition to just issuing a bond here is a list of the more common types of debt financing note that some options may be harder for small businesses to secure especially if they haven t been in operations for long or if their financial position is not as strong as larger companies debt financing vs interest ratessome investors in debt are only interested in principal protection while others want a return in the form of interest the rate of interest is determined by market rates and the creditworthiness of the borrower higher rates of interest imply a greater chance of default and therefore carry a higher level of risk higher interest rates help to compensate the borrower for the increased risk in addition to paying interest debt financing often requires the borrower to adhere to certain rules regarding financial performance these rules are referred to as covenants debt financing can be difficult to obtain however for many companies it provides funding at lower rates than equity financing particularly in periods of historically low interest rates another advantage to debt financing is that the interest on the debt is tax deductible still adding too much debt can increase the cost of capital which reduces the present value of the company debt financing vs equity financingthe main difference between debt and equity financing is that equity financing provides extra working capital with no repayment obligation debt financing must be repaid but the company does not have to give up a portion of ownership in order to receive funds most companies use a combination of debt and equity financing companies choose debt or equity financing or both depending on which type of funding is most easily accessible the state of their cash flow and the importance of maintaining ownership control the d e ratio shows how much financing is obtained through debt vs equity creditors tend to look favorably on a relatively low d e ratio which benefits the company if it needs to access additional debt financing in the future advantages and disadvantages of debt financingone advantage of debt financing is that it allows a business to leverage a small amount of money into a much larger sum enabling more rapid growth than might otherwise be possible another advantage is that the payments on the debt can be tax deductible debt financing also allows businesses to retain ownership and control unlike equity financing where ownership stakes are sold to investors the business owners do not have to give up any control or decision making power in the company like we talked about earlier debt financing can be more cost effective compared to equity financing additionally once the debt is repaid the relationship with the lender ends and there are no further obligations in contrast equity investors typically expect ongoing dividends and a share of the profits which can be more expensive in the long run the only way to extinguish this is through share reacquisition the main disadvantage of debt financing is that interest must be paid to lenders which means that the amount paid will exceed the amount borrowed payments on debt must be made regardless of business revenue and this can be particularly risky for smaller or newer businesses that have yet to establish a secure cash flow high levels of debt can negatively impact a company s balance sheet and financial ratios this can make the business appear riskier to investors and lenders potentially leading to higher borrowing costs in the future high debt levels can also limit a company s flexibility as much of its revenue will be tied up in servicing debt also debt financing often involves restrictive covenants lenders may impose conditions that restrict additional borrowing dictate certain financial ratios that must be maintained or limit the types of investments or expenditures a company can undertake this is a risk management strategy to make sure the lender has security in how the company is being run debt financing allows a business to leverage a small amount of capital to create growthdebt payments are generally tax deductiblea company retains all ownership controldebt financing is often less costly than equity financinginterest must be paid to lenderspayments on debt must be made regardless of business revenuedebt financing can be risky for businesses with inconsistent cash flow | |
what are examples of debt financing | debt financing includes bank loans loans from family and friends government backed loans such as sba loans lines of credit credit cards mortgages and equipment loans | |
what are the types of debt financing | debt financing can be in the form of installment loans revolving loans and cash flow loans installment loans have set repayment terms and monthly payments the loan amount is received as a lump sum payment upfront these loans can be secured or unsecured revolving loans provide access to an ongoing line of credit that a borrower can use repay and repeat credit cards are an example of revolving loans cash flow loans provide a lump sum payment from the lender payments on the loan are made as the borrower earns the revenue used to secure the loan merchant cash advances and invoice financing are examples of cash flow loans | |
is debt financing a loan | yes loans are the most common forms of debt financing | |
why would a company choose debt financing over equity financing | some companies may prefer to keep the equity ownership intact and not dilute stakes in the company by issuing more shares it may also be more cost effective to raise capital with debt compared to issuing stock and having to potentially pay dividends in the future | |
is debt financing good or bad | debt financing can be both good and bad if a company can use debt to stimulate growth it is a good option however the company must be sure that it can meet its obligations regarding payments to creditors a company should use the cost of capital to decide what type of financing it should choose the bottom linemost companies will need some form of debt financing additional funds allow companies to invest in the resources they need in order to grow small and new businesses especially need access to capital to buy equipment machinery supplies inventory and real estate the main concern with debt financing is that the borrower must be sure that they have sufficient cash flow to pay the principal and interest obligations tied to the loan | |
what is a debt fund | a debt fund is an investment pool such as a mutual fund or exchange traded fund in which the core holdings comprise fixed income investments a debt fund may invest in short term or long term bonds securitized products money market instruments or floating rate debt on average the fee ratios on debt funds are lower than those attached to equity funds because the overall management costs are lower often referred to as credit funds or fixed income funds debt funds fall under the fixed income asset category these low risk vehicles are customarily sought by investors looking to preserve capital and or achieve low risk income distributions debt fund riskdebt funds may invest in a wide swath of securities with varying associated risk levels u s government debt is generally considered to pose the least risk the risk profile of corporate debt issued by businesses as part of their capital structures is generally classified by the company s credit rating investment grade debt is issued by companies with stable outlooks and high credit quality high yield debt which is mainly issued by lower credit quality companies with potential emerging growth prospects offers higher returns along with higher prospective risk other debt categories include developed market debt and emerging market debt debt fund investinginvestors may choose from a wide range of low risk debt fund options in both passive and active products passivesome of the largest and most actively traded passive fixed income investment funds seek to replicate the top fixed income benchmark indexes including the bloomberg u s aggregate bond index and the ice u s treasury core bond index passive etfs replicating these indexes include ishares core u s aggregate bond etfthe ishares core u s aggregate bond etf agg is a passively managed index replication fund that tracks the bloomberg u s aggregate bond index the fund has a net expense ratio of 0 03 its 5 year average annual return as of aug 4 2022 is 0 83 ishares u s treasury bond etfthe ishares u s treasury bond etf govt is a passively managed index replication fund that tracks the ice u s treasury core bond index it has a net expense ratio of 0 05 and its 5 year average annual return through aug 4 2022 is 0 61 activethe debt fund market also includes a wide range of active managers who seek to outperform debt fund indexes such as the bloomberg u s aggregate bond index and the ice u s treasury core bond index the first trust tactical high yield etf hyls is an example of an actively managed debt fund that invests for income and capital appreciation its 5 year nav return as of aug 4 2022 is 0 89 while the fund is not outperforming its selected index year to date it is one of the top performing funds in the u s high yield bond universe overall investors in debt funds should understand the return calculation measurements that are used as performance indicators since debt funds involve income generation funds may pay scheduled monthly or quarterly dividends total return calculations account for income payouts while general return calculations may not global debt fundscountries issue debt in various forms to support their governmental fiscal policies in the u s government issued debt is generally considered to be the lowest risk fixed income investment in the market u s debt fundsthe u s government issues a wide range of securities for investment these securities can be invested directly or investors may choose to invest in diversified debt funds that include these securities blackrock s ishares is one of the market s leading managers for indexed u s government debt fund etfs u s corporate debt funds are typically segregated by the credit quality of the corporate issuer u s companies have some of the highest credit ratings globally placing u s debt funds in high demand global debt fundsmany countries offer debt investments to support government fiscal policies risks and returns of government debt funds vary depending on a nation s political and economic environment similar to equities global corporate bond funds can be segregated by developed and emerging market indexes credit ratings are assigned to both government bonds and corporate bonds using globally standardized credit rating analysis although debt funds are comparatively lower risk than equity funds investors should be mindful of interest rate risk | |
what is a debt instrument | a debt instrument is any financial tool used to raise capital it is a documented binding obligation between two parties in which one party lends funds to another with the repayment method specified in a contract some are secured by collateral and most involve interest a schedule for payments and time frame to maturity if it has a maturity date investopedia xiaojie liuunderstanding debt instrumentsany type of instrument primarily classified as debt can be considered a debt instrument generally the instruments used are some form of term debt credit or other revolving debt credit instruments that you can continually draw on with repayment conditions defined in a contract credit cards lines of credit loans and bonds can all be considered debt instruments a debt instrument typically focuses on debt capital raised by governments and private or public companies the issuance markets for these entities vary substantially by the type of debt instrument credit cards and lines of credit can be used to obtain capital these revolving debt lines usually have a simple structure and only one lender they are also not typically associated with a primary or secondary market for securitization more complex debt instruments involve advanced contract structuring multiple lenders and investors usually investing through an organized marketplace types of debt instrumentsdebt is typically a top choice for raising capital because it comes with a defined schedule for repayment this comes with less risk for the lender and borrower which allows for lower interest payments debt securities are a more complex debt instrument involving greater structuring if a business structures its debt to obtain capital from multiple lenders or investors through an organized marketplace it is usually characterized as a debt security instrument these are complex as they are structured for issuance to multiple investors some common debt security instruments are these debt security instruments allow capital to be obtained from multiple investors they can be structured with either short term or long term maturities short term debt securities are paid back to investors and closed within one year long term debt securities require payments to investors for more than one year treasury bonds come in many forms denoted across a yield curve the u s treasury issues three types of debt security instruments bills notes and bonds each of these offerings is a debt security instrument the u s government offers to the public to raise capital to fund the government municipal bonds are a type of debt security instrument issued by state and local governments to fund infrastructure projects municipal bond security investors are primarily institutional investors such as mutual funds corporate bonds are a type of debt security instrument used to raise capital from the investing public corporate bonds are structured with different maturities which influence their interest rate mutual funds are usually some of the most prominent corporate bond investors however retail investors with a brokerage account may also be able to invest in corporate bonds through their broker corporate bonds also have an active secondary market that retail and institutional investors can use alternatively structured debt security productsthere are also various alternatively structured debt security products in the market primarily used as debt security instruments by financial institutions these offerings include a bundle of assets issued as debt security financial institutions and agencies may choose to bundle products from their balance sheet such as debt into a single security which is then used to raise capital while segregating the assets | |
what is a debt instrument | a debt instrument is used to raise capital it involves a binding contract in which an entity borrows funds from a lender and promises to repay them according to the terms outlined in the contract | |
what is a debt security | a debt security is a more complex form of debt instrument with a complex structure the borrower can raise money from multiple lenders through an organized marketplace | |
what are treasury bonds | the u s government issues treasury bonds to raise capital to fund the government they come in maturities of 20 or 30 years the government also issues treasury bills which have maturities ranging from a few days to 52 weeks and treasury notes which have maturities of two three five seven or 10 years all are debt instruments the bottom linedebt instruments are any form of debt used to raise capital for businesses and governments there are many types of debt instruments but the most common are credit products bonds or loans each comes with different repayment conditions generally described in a contract | |
what is a debt issue | a debt issue refers to a financial obligation that allows the issuer to raise funds by promising to repay the lender at a certain point in the future and in accordance with the terms of the contract a debt issue is a fixed corporate or government obligation such as a bond or debenture debt issues also include notes certificates mortgages leases or other agreements between the issuer or borrower and the lender understanding debt issues | |
when a company or government agency decides to take out a loan it has two options the first is to get financing from a bank the other option is to issue debt to investors in the capital markets this is referred to as a debt issue the issuance of a debt instrument by an entity in need of capital to fund new or existing projects or to finance existing debt this method of raising capital may be preferred as securing a bank loan can restrict how the funds can be used | a debt issue is essentially a promissory note in which the issuer is the borrower and the entity buying the debt asset is the lender when a debt issue is made available investors buy it from the seller who uses the funds to pursue its capital projects in return the investor is promised regular interest payments and also repayment of the initial principal amount on a predetermined date in the future corporations and municipal state and federal governments offer debt issues as a means of raising needed funds debt issues such as bonds are issued by corporations to raise money for certain projects or to expand into new markets municipalities states federal and foreign governments issue debt to finance a variety of projects such as social programs or local infrastructure projects in exchange for the loan the issuer or borrower must make payments to the investors in the form of interest payments the interest rate is often called the coupon rate and coupon payments are made using a predetermined schedule and rate by issuing debt an entity is free to use the capital it raises as it sees fit special considerations | |
when the debt issue matures the issuer repays the face value of the asset to the investors face value also referred to as par value differs across the various types of debt issues for example the face value on a corporate bond is typically 1 000 municipal bonds often have 5 000 par values and federal bonds often have 10 000 par values | short term bills typically have maturities between one and five years medium term notes mature between five and ten years while long term bonds generally have maturities longer than ten years certain large corporations such as coca cola and walt disney have issued bonds with maturities as long as 100 years the process of debt issuanceissuing debt is a corporate action which a company s board of directors must approve if debt issuance is the best course of action for raising capital and the firm has sufficient cash flows to make regular interest payments on the issue the board drafts a proposal that is sent to investment bankers and underwriters corporate debt issues are commonly issued through the underwriting process in which one or more securities firms or banks purchase the issue in its entirety from the issuer and form a syndicate tasked with marketing and reselling the issue to interested investors the interest rate set on the bonds is based on the credit rating of the company and the demand from investors the underwriters impose a fee on the issuer in return for their services the process for government debt issues is different since these are typically issued in an auction format in the united states for example investors can purchase bonds directly from the government through its dedicated website treasurydirect a broker is not needed and all transactions including interest payments are handled electronically debt issued by the government is considered to be a safe investment since it is backed by the full faith and credit of the u s government since investors are guaranteed they will receive a certain interest rate and face value on the bond interest rates on government issues tend to be lower than rates on corporate bonds the cost of debtthe interest rate paid on a debt instrument represents a cost to the issuer and a return to the investor the cost of debt represents the default risk of an issuer and also reflects the level of interest rates in the market in addition it is integral in calculating the weighted average cost of capital wacc of a company which is a measure of the cost of equity and the after tax cost of debt one way to estimate the cost of debt is to measure the current yield to maturity ytm of the debt issue another way is to review the credit rating of the issuer from the rating agencies such as moody s fitch and standard poor s a yield spread over u s treasuries determined from the credit rating can then be added to the risk free rate to determine the cost of debt there are also fees associated with issuing debt that the borrower incurs by selling assets some of these fees include legal fees underwriting fees and registration fees these charges are generally paid to legal representatives financial institutions and investment firms auditors and regulators all of these parties are involved in the underwriting process frequently asked questions | |
why do companies issue debt | by issuing debt e g corporate bonds companies are able to raise capital from investors using debt the company becomes a borrower and the bondholders of the issue are the creditors lenders unlike equity capital debt does not involve diluting the ownership of the firm and does not carry voting rights debt capital is also often cheaper than equity capital and interest payments may be tax advantaged | |
what is the cost of a debt issuance | aside from fees paid to the underwriters who help a firm issue debt the direct cost to the company is the coupon or interest rate on the bond this represents the amount of cash that must be paid to bondholders on a regular basis until the bond matures if this coupon rate the bond s yield is higher the cost to the issuer will also be higher | |
what are some risks or drawbacks of debt issuance | if a company issues too much debt and they are unable to service the interest or repay the principal it can default on the debt this can lead to bankruptcy and a decrease to the issuer s credit rating which can make it more difficult or costly to raise further debt capital | |
what is debt overhang | debt overhang refers to a debt burden so large that an entity cannot take on additional debt to finance future projects this includes entities that are profitable enough to be able to reduce indebtedness over time a debt overhang serves to dissuade current investment since all earnings from new projects would only go to existing debt holders leaving little incentive and ability for the entity to attempt to dig itself out of the hole understanding debt overhang | |
when an entity has an excessive amount of debt and cannot borrow more capital that entity is said to be in a debt overhang the burden is so large that any and all earnings go directly to pay off existing debt rather than fund new investment projects making the potential for default higher in most cases shareholders may be reluctant to approve new stock issuances because shareholders may be on the hook for losses | debt overhangs also apply to sovereign governments in these cases the term refers to a situation in which the debt of a nation exceeds its future capacity to repay it this can occur from an output gap or economic underemployment repeatedly plugged by the creation of additional credit a debt overhang can lead to stagnant growth and a degradation of living standards from reduced funds to spending in critical areas such as healthcare education and infrastructure because of the way they affect balance sheets and bottom lines debt overhangs can distress entities in different ways they can cause companies and countries to put a pause on further spending and or investment in fact they can lead to underinvestment because they can stunt growth debt overhangs can make recovery even more difficult there are several ways to get out of a debt overhang debtors can enroll in debt cancellation programs to get a portion of or the entirety of their debts forgiven by creditors nations can default on their debt companies may go insolvent or bankrupt or existing debt may be repurchased and converted into equity the risk of defaulting on debt is greater when a company or country experiences a debt overhang special considerationsa debt overhang can trap companies as a greater proportion of revenues or cash flow simply goes toward servicing its existing debt this widening deficit can only be filled through incremental debt which only increases a company s burden a debt overhang is particularly difficult as it straps companies aiming to take advantage of new opportunities with positive net present value npv although under more normal conditions these potential projects would repay themselves over time a ballooning existing debt position in a company could likely turn off would be investors in the project given that the company s debt holders can be reasonably expected to lay claim to a portion or all of the new project s profits the npv would in effect be negative to solve the debt overhang in many developing nations debt cancellation programs are occasionally implemented by intergovernmental organizations such as the world bank and international organizations such as the international monetary fund imf programs have covered c te d ivoire the democratic republic of the congo gabon namibia nigeria rwanda senegal and zambia another program the jubilee 2000 campaign was an international movement by 40 countries which called for the cancellation of debt of developing nations by the year 2000 although the campaign didn t meet all of its goals it was well received and was generally considered to be successful | |
what is the debt ratio | the term debt ratio refers to a financial ratio that measures the extent of a company s leverage the debt ratio is defined as the ratio of total debt to total assets expressed as a decimal or percentage it can be interpreted as the proportion of a company s assets that are financed by debt a ratio greater than 1 shows that a considerable amount of a company s assets are funded by debt which means the company has more liabilities than assets a high ratio indicates that a company may be at risk of default on its loans if interest rates suddenly rise a ratio below 1 means that a greater portion of a company s assets is funded by equity 1investopedia zoe hansendebt ratio formula and calculationas noted above a company s debt ratio is a measure of the extent of its financial leverage this ratio varies widely across industries capital intensive businesses such as utilities and pipelines tend to have much higher debt ratios than others like the technology sector the formula for calculating a company s debt ratio is debt ratio total debt total assets begin aligned text debt ratio frac text total debt text total assets end aligned debt ratio total assetstotal debt so if a company has total assets of 100 million and total debt of 30 million its debt ratio is 0 3 or 30 is this company in a better financial situation than one with a debt ratio of 40 the answer depends on the industry a debt ratio of 30 may be too high for an industry with volatile cash flows in which most businesses take on little debt a company with a high debt ratio relative to its peers would probably find it expensive to borrow and could find itself in a crunch if circumstances change conversely a debt level of 40 may be easily manageable for a company in a sector such as utilities where cash flows are stable and higher debt ratios are the norm a debt ratio greater than 1 0 100 tells you that a company has more debt than assets meanwhile a debt ratio of less than 100 indicates that a company has more assets than debt used in conjunction with other measures of financial health the debt ratio can help investors determine a company s risk level 1the concept of comparing total assets to total debt also relates to entities that may not be businesses for example the united states department of agriculture keeps a close eye on how the relationship between farmland assets debt and equity change over time 2advantages and disadvantages of the debt ratiothe debt ratio is a simple ratio that is easy to compute and comprehend it gives a fast overview of how much debt a firm has in comparison to all of its assets because public companies must report these figures as part of their periodic external reporting the information is often readily available the debt ratio aids in determining a company s capacity to service its long term debt commitments as discussed earlier a lower debt ratio signifies that the business is more financially solid and lowers the chance of insolvency with this information investors can leverage historical data to make more informed investment decisions on where they think the company s financial health may go last businesses in the same industry can be contrasted using their debt ratios it offers a comparison point to determine whether a company s debt levels are higher or lower than those of its competitors as is the story with most financial ratios you can take the calculation and compare it over time against competitors or against benchmarks to truly extract the most valuable information from the ratio there are also several downsides to the debt ratio as well the debt ratio doesn t reveal the type of debt or how much it will cost the periods and interest rates of various debts may differ which can have a substantial effect on a company s financial stability in addition the debt ratio depends on accounting information which may construe or manipulate account balances as required for external reports the debt ratio does not take a company s profitability into account if its assets provide large earnings a highly leveraged corporation may have a low debt ratio making it less hazardous contrarily if the company s assets yield low returns a low debt ratio does not automatically translate into profitability it s great to compare debt ratios across companies however capital intensity and debt needs vary widely across sectors the financial health of a firm may not be accurately represented by comparing debt ratios across industries bear in mind how certain industries may necessitate higher debt ratios due to the initial investment needed last the debt ratio is a constant indicator of a company s financial standing at a certain moment in time acquisitions sales or changes in asset prices are just a few of the variables that might quickly affect the debt ratio as a result drawing conclusions purely based on historical debt ratios without taking into account future predictions may mislead analysts | |
is a pretty simple ratio can be easily calculated | leverages fairly accessible information from public companiesprovides useful insights into how a company s long term health is positionedcan be used to compare companies timeframes or benchmarks | |
does not consider or reflect on a company s profitability | can t always be used to compare across companies in different industriesmay not appropriately consider future implications of business decisionsspecial considerationssome sources consider the debt ratio to be total liabilities divided by total assets this reflects a certain ambiguity between the terms debt and liabilities that depends on the circumstance the debt to equity ratio for example is closely related to and more common than the debt ratio instead using total liabilities as the numerator financial data providers calculate it using only long term and short term debt including current portions of long term debt excluding liabilities such as accounts payable negative goodwill and others in the consumer lending and mortgage business two common debt ratios used to assess a borrower s ability to repay a loan or mortgage are the gross debt service ratio and the total debt service ratio the gross debt ratio is defined as the ratio of monthly housing costs including mortgage payments home insurance and property costs to monthly income while the total debt service ratio is the ratio of monthly housing costs plus other debt such as car payments and credit card borrowings to monthly income acceptable levels of the total debt service ratio range from the mid 30s to the low 40s in percentage terms 3the higher the debt ratio the more leveraged a company is implying greater financial risk at the same time leverage is an important tool that companies use to grow and many businesses find sustainable uses for debt debt ratio vs long term debt to asset ratiowhile the total debt to total assets ratio includes all debts the long term debt to assets ratio only takes into account long term debts the debt ratio total debt to assets measure takes into account both long term debts such as mortgages and securities and current or short term debts such as rent utilities and loans maturing in less than 12 months 4both ratios however encompass all of a business s assets including tangible assets such as equipment and inventory and intangible assets such as copyrights and owned brands because the total debt to assets ratio includes more of a company s liabilities this number is almost always higher than a company s long term debt to assets ratio examples of the debt ratiolet s look at a few examples from different industries to contextualize the debt ratio starbucks sbux listed 1 92 million in short term and current portion of long term debt on its balance sheet for the fiscal year ended oct 2 2022 and 13 1 billion in long term debt the company s total assets were 28 billion 5 this gives us starbuck s debt ratio of 15 billion 28 billion 0 5357 or 53 6 to assess whether this is high we should consider the capital expenditures that go into opening a starbucks including leasing commercial space renovating it to fit a certain layout and purchasing expensive specialty equipment much of which is used infrequently the company must also hire and train employees in an industry with exceptionally high employee turnover adhere to food safety regulations for its more than 18 253 stores in 2022 6perhaps 53 6 isn t so bad after all when you consider that the industry average was about 75 7 the result is that starbucks has an easy time borrowing money creditors trust that it is in a solid financial position and can be expected to pay them back in full | |
what about a technology company for the fiscal year ended dec 31 2022 meta meta formerly facebook reported | using these figures meta s debt ratio can be calculated as 14 69 billion 185 7 billion 0 079 or 7 9 the company does not borrow from the corporate bond market it has an easy enough time raising capital through stock 10 | |
what are some common debt ratios | all debt ratios analyze a company s relative debt position common debt ratios include debt to equity debt to assets long term debt to assets and leverage and gearing ratios | |
what does a debt to equity ratio of 1 5 indicate | a debt to equity ratio of 1 5 would indicate that the company in question has 1 50 of debt for every 1 of equity to illustrate suppose the company had assets of 2 million and liabilities of 1 2 million since equity is equal to assets minus liabilities the company s equity would be 800 000 its debt to equity ratio would therefore be 1 2 million divided by 800 000 or 1 5 can a debt ratio be negative if a company has a negative debt ratio this would mean that the company has negative shareholder equity in other words the company s liabilities outnumber its assets in most cases this is considered a very risky sign indicating that the company may be at risk of bankruptcy the bottom linedebt ratio is a metric that measures a company s total debt as a percentage of its total assets a high debt ratio indicates that a company is highly leveraged and may have borrowed more money than it can easily pay back investors and accountants use debt ratios to assess the risk that a company is likely to default on its obligations | |
what is debt restructuring | debt restructuring is a process used by companies individuals and even countries to avoid the risk of defaulting on their existing debts such as by negotiating lower interest rates debt restructuring provides a less expensive alternative to bankruptcy when a debtor is in financial turmoil and it can work to the benefit of both borrower and lender | |
how debt restructuring works | some companies seek to restructure their debt when they are facing the prospect of bankruptcy the debt restructuring process typically involves getting lenders to agree to reduce the interest rates on loans extend the dates when the company s liabilities are due to be paid or both these steps improve the company s chances of paying back its obligations and staying in business creditors understand that they would receive even less should the company be forced into bankruptcy or liquidation debt restructuring can be a win win for both sides because the business avoids bankruptcy and the lenders typically receive more than they would have through a bankruptcy proceeding the process works much the same for individuals and for nations although on vastly different scales individuals hoping to restructure their debts can hire a debt relief company to help in the negotiations but they should make sure they re dealing with a reputable one not a scam types of debt restructuringbusinesses have a number of tools at their disposal for restructuring their debts one is a debt for equity swap this occurs when creditors agree to cancel a portion or all of a company s outstanding debts in exchange for equity part ownership in the business the swap is usually a preferred option when both the outstanding debt and the company s assets are significant and forcing the business to cease operations would be counterproductive the creditors would rather take control of the distressed company if that s necessary as an ongoing concern a company seeking to restructure its debt might also renegotiate with its bondholders to take a haircut meaning that a portion of the outstanding interest payments will be written off or a portion of the balance will not be repaid a company will often issue callable bonds to protect itself from a situation in which it can t make its interest payments a bond with a callable feature can be redeemed early by the issuer in times of decreasing interest rates this allows the issuer to restructure debt in the future because the existing debt can be replaced with new debt at a lower interest rate in rare cases a company can issue income bonds that promise to repay the principal only without coupon or dividend payments countries can face default on their sovereign debt and this has been the case throughout history in modern times some countries opt to restructure their debt with bondholders this can mean moving the debt from the private sector to public sector institutions that might be better able to handle the impact of a country s default sovereign bondholders may also have to take a haircut by agreeing to accept a reduced percentage of what they are owed perhaps 25 of their bonds full value the maturity dates on bonds can also be extended giving the government issuer more time to secure the funds it needs to repay its bondholders unfortunately this type of debt restructuring doesn t have much international oversight even when restructuring efforts cross borders individuals facing insolvency can try to renegotiate terms with their creditors and the tax authorities for example someone who is unable to keep making payments on a 250 000 mortgage might reach an agreement with the lending institution to reduce the mortgage to 75 or 187 500 75 x 250 000 187 500 in return the lender might receive 40 of the house sale proceeds when it is sold by the mortgagor individuals can attempt to negotiate on their own or with the help of a reputable debt relief company this is an area that s rife with scams so they should make sure they know whom they re involving 1 investopedia publishes a regularly updated list of the best debt relief companies | |
what is a debt security | a debt security is a debt instrument that can be bought or sold between two parties and has basic terms defined such as the notional amount the amount borrowed interest rate and maturity and renewal date examples of debt securities include a government bond corporate bond certificate of deposit cd municipal bond or preferred stock debt securities can also come in the form of collateralized securities such as collateralized debt obligations cdos collateralized mortgage obligations cmos mortgage backed securities mbss issued by the government national mortgage association gnma and zero coupon securities 1 | |
how debt securities work | a debt security is a type of financial asset that is created when one party lends money to another for example corporate bonds are debt securities issued by corporations and sold to investors investors lend money to corporations in return for a pre established number of interest payments along with the return of their principal upon the bond s maturity date 2government bonds on the other hand are debt securities issued by governments and backed by faith in that government which are sold to investors investors lend money to the government in return for interest payments called coupon payments and a return of their principal upon the bond s maturity 3debt securities are also known as fixed income securities because they generate a fixed stream of income from their interest payments unlike equity investments in which the return earned by the investor is dependent on the market performance of the equity issuer debt instruments guarantee that the investor will receive repayment of their initial principal plus a predetermined stream of interest payments 4of course this contractual guarantee does not mean that debt securities are without risk since the issuer of the debt security could declare bankruptcy or default on their agreements risks of debt securitiesbecause the borrower is legally required to make these payments debt securities are generally considered to be a less risky form of investment compared to equity investments such as stocks of course as is always the case in investing the true risk of a particular security will depend on its specific characteristics 5for instance a company with a strong balance sheet operating in a mature marketplace may be less likely to default on its debts than a startup company operating in an emerging marketplace in this case the mature company would likely be given a more favorable credit rating by the three major credit rating agencies standard poor s s p moody s corporation and fitch ratings in keeping with the general tradeoff between risk and return companies with higher credit ratings will usually offer lower interest rates on their debt securities and vice versa for example as of july 2023 moody s seasoned aaa corporate bond yield is 4 66 whereas its seasoned baa corporate bond yield is 5 74 67since the aaa rating denotes a lower perceived risk of credit default it makes sense that market participants are willing to accept a lower yield in exchange for these less risky securities debt securities vs equity securitiesequity securities represent a claim on the earnings and assets of a corporation while debt securities are investments in debt instruments for example a stock is an equity security while a bond is a debt security when an investor buys a corporate bond they are essentially loaning the corporation money and have the right to be repaid the principal and interest on the bond in the event a corporation goes bankrupt it pays bondholders before shareholders in contrast when someone buys stock from a corporation they essentially buy a piece of the company if the company profits the investor profits as well but if the company loses money the stock also loses money | |
what is an example of a debt security | the most common example of a debt security is a bond whether that be a government bond or corporate bond these securities are purchased by an investor and pay out a stream of income in the form of interest payments at the bond s maturity the issuer buys back the bond from the investor 3who issues debt securities the most common issuer of debt securities are corporations and governments both issue debt securities to raise money governments to finance projects or for day to day operations and corporations to fund growth pay down other debt and also to finance day to day operations | |
what is the risk of a debt security | the risk of a debt security is that the issuer defaults on their debt if the issuer experiences financial hardship they may no longer be able to make interest payments on their outstanding debt they may also not be able to repurchase their outstanding debt at maturity particularly if they go bankrupt the bottom linedebt securities are debt instruments that investors purchase seeking returns they are issued by corporations governments and other entities in order to raise money to finance various needs they are an alternative option to equity securities such as stocks and are generally considered safer investments debt securities such as bonds can be a good way for investors to diversify their portfolios | |
what is debt service | debt service refers to the money required to cover the payment of interest and principal on a loan or other debt for a particular time period the term can apply both to individual debts such as a home mortgage or student loan and corporate or government debt such as business loans and debt based securities such as bonds the ability to service debt is a key factor when a person applies for a loan or a company needs to raise additional capital to operate its business to service a debt means to make the necessary payments on it zoe hansen investopedia | |
how debt service works in business | before a company approaches a bank or other lender for a commercial loan or decides what rate of interest to offer on a new bond issue it will need to consider its debt service coverage ratio dscr this ratio compares the company s net operating income with the amount of principal and interest that it is obligated to pay on its current debts if a lender decides that a business cannot generate consistent earnings to service the new debt along with its existing debts then the lender won t make the loan both lenders and bond investors are interested in a firm s leverage that refers to the total amount of debt a company uses to finance asset purchases if a business intends to take on more debt it needs to generate higher profits to service the debt and it must be able to consistently generate profits to carry a high debt load a company that is generating excess earnings may be able to service additional debt but it must continue to produce a profit every year sufficient to cover the year s debt service a company that has taken on too much debt relative to its income is said to be overleveraged decisions about debt affect a company s capital structure which is the proportion of total capital raised through debt vs equity i e selling shares a company with consistent reliable earnings can raise more funds using debt while a business with inconsistent profits must issue equity such as common stock to raise funds for example utility companies have the ability to generate consistent earnings in part because they often have no competitors these companies raise the majority of their capital using debt with less of it raised through equity example of a debt service coverage ratio calculationas mentioned the debt service coverage ratio is defined as net operating income divided by total debt service net operating income refers only to the earnings generated from a company s normal business operations suppose for example that abc manufacturing makes furniture and that it sells one of its warehouses for a gain the profit it receives from the warehouse sale is nonoperating income because the transaction is unusual if abc s furniture sales produced annual net operating income totaling 10 million then that number would be used in the debt service calculation so if abc s principal and interest payments for the year total 2 million its debt service coverage ratio would be 5 10 million in income divided by 2 million in debt service because of that relatively high ratio abc is in a good position to take on more debt if it wishes to do so | |
what is a good debt service coverage ratio | generally speaking the higher the better but business lenders will usually want to see a ratio of at least 1 25 a debt service ratio of 1 for example means that a company is devoting all of its available income to paying off debt a precarious position that would likely make further borrowing impossible companies can also have a debt service coverage ratio of less than 1 meaning that it costs them more to service their debt than they are generating in income however a business in that situation might not survive for long | |
what is a debt to income dti ratio | a debt to income dti ratio is similar to a debt service coverage ratio although typically used in personal nonbusiness borrowing the dti ratio measures an individual s ability to service their debts by dividing their gross income by their debt obligations for the same time period for example someone who earns 5 000 a month and pays 2 000 a month on their mortgage will have a dti of 40 an acceptable dti will vary from lender to lender and according to the type of loan product 1 | |
is loan servicing the same as debt servicing | while they sound similar loan servicing and debt servicing are two different things loan servicing refers to administrative work performed by lenders or by other companies they hire such as sending out monthly statements to borrowers and processing their payments 2 debt servicing refers to the process of a borrower paying down a loan or other debt the bottom linedebt service refers to the money that a person business or government needs to cover the payments on a loan or other debt for a particular time period a company s debt service coverage ratio measures its ability to handle additional debt by comparing its available income to the amount it is currently paying to service its debts | |
what is the debt service coverage ratio dscr | the debt service coverage ratio dscr measures a firm s available cash flow to pay its current debt obligations the dscr shows investors and lenders whether a company has enough income to pay its debts the ratio is calculated by dividing net operating income by debt service including principal and interest mira norian investopediaunderstanding the debt service coverage ratio dscr the debt service coverage ratio is a widely used indicator of a company s financial health especially for companies that are highly leveraged with debt debt service refers to the cash necessary to pay the required principal and interest of a loan during a given period the ratio compares a company s total debt obligations to its operating income lenders stakeholders and partners target dscr metrics and dscr terms and minimums are often included in loan agreements calculating the dscrthe formula for the debt service coverage ratio requires net operating income and the total debt servicing for a company net operating income is a company s revenue minus certain operating expenses coe not including taxes and interest payments it s often considered equal to earnings before interest and tax ebit dscr net operating income total debt service where net operating income revenue coe coe certain operating expenses total debt service current debt obligations begin aligned text dscr frac text net operating income text total debt service textbf where text net operating income text revenue text coe text coe text certain operating expenses text total debt service text current debt obligations end aligned dscr total debt servicenet operating income where net operating income revenue coecoe certain operating expensestotal debt service current debt obligations total debt service refers to current debt obligations including any interest principal sinking fund and lease payments that are due in the coming year this will include short term debt and the current portion of long term debt on a balance sheet 1income taxes complicate dscr calculations because interest payments are tax deductible and principal repayments are not a more accurate way to calculate total debt service would be to compute it like this tds interest 1 tax rate principal where tds total debt service begin aligned text tds text interest times 1 text tax rate text principal textbf where text tds text total debt service end aligned tds interest 1 tax rate principalwhere tds total debt service lender considerationsthe debt service coverage ratio reflects the ability to service debt at a company s income level the dscr shows how healthy a company s cash flow is and it can determine how likely a business is to qualify for a loan lenders routinely assess a borrower s dscr a dscr of 1 00 indicates that a company has exactly enough operating income to pay off its debt service costs a dscr of less than 1 00 denotes a negative cash flow the borrower may be unable to cover or pay current debt obligations without drawing on outside sources or borrowing more a dscr of 0 95 means there s only enough net operating income to cover 95 of annual debt payments the entity may appear vulnerable and a minor decline in cash flow could render it unable to service its debt if the debt service coverage ratio is too close to 1 00 lenders might require the borrower to maintain a minimum dscr while the loan is outstanding a dscr of at least 2 00 is typically considered to be very strong even though there s no industry standard it shows that a company can cover two times its debt many lenders will set minimum dscr requirements of 1 2 to 1 25 2interest coverage ratio vs dscrthe interest coverage ratio indicates the number of times that a company s operating profit will cover the interest it must pay on all debts for a given period this is expressed as a ratio and is most often computed annually divide the ebit for the established period by the total interest payments due for that same period the ebit is often called net operating income or operating profit it s calculated by subtracting overhead and operating expenses such as rent cost of goods freight wages and utilities from revenue the higher the ratio of ebit to interest payments the more financially stable the company this metric only considers interest payments and not payments made on principal debt balances that may be required by lenders the debt service coverage ratio assesses a company s ability to meet its minimum principal and interest payments including sinking fund payments ebit is divided by the total amount of principal and interest payments required for a given period to obtain net operating income to calculate the dscr it takes principal payments into account in addition to interest so the dscr is a more robust indicator of a company s financial fitness advantages and disadvantages of dscrthe dscr is a commonly used metric when negotiating loans but it does come with some pros and cons the dscr has value when calculated consistently over time just like other ratios a company can calculate monthly dscr to analyze its average trend and project future ratios a declining dscr might be an early signal for a decline in a company s financial health or it can be used extensively in budgeting or strategic planning the dscr can also have comparability across different companies management might use dscr calculations from its competitors to analyze how it s performing relative to others this might include analyzing how efficient other companies are in using loans to drive company growth the dscr is also a more comprehensive analytical technique when assessing the long term financial health of a company the dscr is a more conservative broad calculation compared to the interest coverage ratio the dscr is also an annualized ratio that often represents a moving 12 month period other financial ratios are typically a single snapshot of a company s health the dscr may be a truer representation of a company s operations the dscr calculation can be adjusted to be based on net operating income ebit or earnings before interest taxes depreciation and amortization ebitda it depends on the lender s requirements the company s income is potentially overstated because not all expenses are being considered when operating income ebit or ebitda are used income isn t inclusive of taxes in any of these three examples another limitation of the dscr is its reliance on accounting guidance debt and loans are rooted in obligatory cash payments but the dscr is partially calculated on accrual based accounting guidance there s a little bit of inconsistency when reviewing both a set of financial statements based on generally accepted accounting principles gaap and a loan agreement that stipulates fixed cash payments can be calculated over some time to better understand a company s financial trendmay be used to compare operational efficiency across companiesincludes more financial categories i e principal repayments than other financial ratiosmight be a more comprehensive analysis of a company s financial health as it is often calculated on a rolling annual basismay not fully incorporate a company s finances as some expenses i e taxes may be excluded | |
has heavy reliance on accounting guidance that may widely vary from actual timing of cash needs | may be considered a more complex formula compared with other financial ratios | |
does not have consistent treatment or requirement from one lender to another | an example of dscrlet s say a real estate developer seeks a mortgage loan from a local bank the lender will want to calculate the dscr to determine the ability of the developer to borrow and pay off their loan as its rental properties generate income the developer indicates that net operating income will be 2 150 000 per year and the lender notes that debt service will be 350 000 per year the dscr is calculated as 6 14 the borrower can cover their debt service more than six times given their operating income dscr 2 150 000 350 000 6 14 begin aligned text dscr frac 2 150 000 350 000 6 14 end aligned dscr 350 000 2 150 000 6 14 mk lending corp has outlined its debt requirements for new mortgages the columns highlighted in yellow represent investors with a dscr greater than or equal to 1 00 the orange columns represent investors with a dscr of less than 1 00 the yellow investors are less risky so their loan terms and ltv cltv terms are more favorable than those of the orange investors mk lending corp sun country inc entered into an agreement with the u s department of the treasury and the bank of new york mellon sun country agreed to several financial covenants as part of the loan and guarantee agreement 3certain trigger events will occur should sun country s dscr fall below a specified level certain stopgaps will be enacted to protect the lenders when triggers occur the lenders will receive 50 of select revenues for a specific amount of time should sun country s dscr drop below 1 00 | |
how do you calculate the debt service coverage ratio dscr | the dscr is calculated by taking net operating income and dividing it by total debt service which includes both the principal and interest payments on a loan a business s dscr would be approximately 1 67 if it has a net operating income of 100 000 and a total debt service of 60 000 | |
why is the dscr important | the dscr is a commonly used metric when negotiating loan contracts between companies and banks a business applying for a line of credit might be obligated to ensure that its dscr doesn t dip below 1 25 the borrower could be found to have defaulted on the loan if it does dscrs can also help analysts and investors when analyzing a company s financial strength in addition to helping banks manage their risks 4 | |
what is a good dscr | a good dscr depends on the company s industry its competitors and its growth a smaller company that s just beginning to generate cash flow might face lower dscr expectations compared with a mature company that s already well established a dscr above 1 25 is often considered strong as a general rule however ratios below 1 00 could indicate that the company is facing financial difficulties the bottom linethe dscr is a commonly used financial ratio that compares a company s operating income to the company s debt payments the ratio can be used to assess whether a company has sufficient income to meet its principal and interest obligations the dscr is commonly used by lenders or external parties to mitigate risk in loan terms | |
what is the debt to capital ratio | the debt to capital ratio is a measurement of a company s financial leverage the debt to capital ratio is calculated by taking the company s interest bearing debt both short and long term liabilities and dividing it by the total capital total capital is all interest bearing debt plus shareholders equity which may include items such as common stock preferred stock and minority interest investopedia crea taylorthe formula for debt to capital ratiodebt to capital ratio debtdebt shareholders equity text debt to capital ratio frac debt debt text text shareholders equity debt to capital ratio debt shareholders equitydebt the debt to capital ratio is calculated by dividing a company s total debt by its total capital which is total debt plus total shareholders equity | |
what does debt to capital ratio tell you | the debt to capital ratio gives analysts and investors a better idea of a company s financial structure and whether or not the company is a suitable investment all else being equal the higher the debt to capital ratio the riskier the company this is because a higher ratio the more the company is funded by debt than equity which means a higher liability to repay the debt and a greater risk of forfeiture on the loan if the debt cannot be paid timely however while a specific amount of debt may be crippling for one company the same amount could barely affect another thus using total capital gives a more accurate picture of the company s health because it frames debt as a percentage of capital rather than as a dollar amount example of how to use debt to capital ratioas an example assume a firm has 100 million in liabilities comprised of the following of these only notes payable bonds payable and long term liabilities are interest bearing securities the sum of which total 5 million 20 million 55 million 80 million as for equity the company has 20 million worth of preferred stock and 3 million of minority interest listed on the books the company has 10 million shares of common stock outstanding which is currently trading at 20 per share total equity is 20 million 3 million 20 x 10 million shares 223 million using these numbers the calculation for the company s debt to capital ratio is assume this company is being considered as an investment by a portfolio manager if the portfolio manager looks at another company that had a debt to capital ratio of 40 all else equal the referenced company is a safer choice since its financial leverage is approximately half that of the compared company s as a real life example consider caterpillar nyse cat which has 36 6 billion in total debt as of december 2018 1 its shareholders equity for the same quarter was 14 billion 2 thus its debt to capital ratio is 72 or 36 6 billion 36 6 billion 14 billion the difference between debt to capital ratio and debt ratiounlike the debt to capital ratio the debt ratio divides total debt by total assets the debt ratio is a measure of how much of a company s assets are financed with debt the two numbers can be very similar as total assets are equal to total liabilities plus total shareholder equity however for the debt to capital ratio it excludes all other liabilities besides interest bearing debt limitations of using debt to capital ratiothe debt to capital ratio may be affected by the accounting conventions a company uses often values on a company s financial statements are based on historical cost accounting and may not reflect the true current market values thus it is very important to be certain the correct values are used in the calculation so the ratio does not become distorted | |
what is the debt to equity d e ratio | the debt to equity d e ratio is used to evaluate a company s financial leverage and is calculated by dividing a company s total liabilities by its shareholder equity the d e ratio is an important metric in corporate finance it is a measure of the degree to which a company is financing its operations with debt rather than its own resources the debt to equity ratio is a particular type of gearing ratio investopedia katie kerpelformula and calculation of the d e ratiodebt equity total liabilitiestotal shareholders equity begin aligned text debt equity frac text total liabilities text total shareholders equity end aligned debt equity total shareholders equitytotal liabilities the information needed to calculate the d e ratio can be found on a listed company s balance sheet subtracting the value of liabilities on the balance sheet from that of total assets shown there provides the figure for shareholder equity which is a rearranged version of this balance sheet equation assets liabilities shareholder equity begin aligned text assets text liabilities text shareholder equity end aligned assets liabilities shareholder equity these balance sheet categories may include items that would not normally be considered debt or equity in the traditional sense of a loan or an asset because the ratio can be distorted by retained earnings or losses intangible assets and pension plan adjustments further research is usually needed to understand to what extent a company relies on debt to get a clearer picture and facilitate comparisons analysts and investors will often modify the d e ratio they also assess the d e ratio in the context of short term leverage ratios profitability and growth expectations melissa ling investopedia 2019business owners use a variety of software to track d e ratios and other financial metrics microsoft excel provides a balance sheet template that automatically calculates financial ratios such as the d e ratio and the debt ratio 1or you could enter the values for total liabilities and shareholders equity in adjacent spreadsheet cells say b2 and b3 then add the formula b2 b3 in cell b4 to obtain the d e ratio | |
what does the d e ratio tell you | the d e ratio measures how much debt a company has taken on relative to the value of its assets net of liabilities debt must be repaid or refinanced imposes interest expense that typically can t be deferred and could impair or destroy the value of equity in the event of a default as a result a high d e ratio is often associated with high investment risk it means that a company relies primarily on debt financing debt financed growth may serve to increase earnings and if the incremental profit increase exceeds the related rise in debt service costs then shareholders should expect to benefit however if the additional cost of debt financing outweighs the additional income that it generates then the share price may drop the cost of debt and a company s ability to service it can vary with market conditions as a result borrowing that seemed prudent at first can prove unprofitable later under different circumstances changes in long term debt and assets tend to affect the d e ratio the most because the numbers involved tend to be larger than for short term debt and short term assets if investors want to evaluate a company s short term leverage and its ability to meet debt obligations that must be paid over a year or less they can use other ratios for example the cash ratio evaluates a company s near term liquidity cash ratio cash marketable securitiesshort term liabilities begin aligned text cash ratio frac text cash text marketable securities text short term liabilities end aligned cash ratio short term liabilities cash marketable securities so does the current ratio current ratio short term assetsshort term liabilities begin aligned text current ratio frac text short term assets text short term liabilities end aligned current ratio short term liabilities short term assets example of the d e ratiolet s consider an example from apple inc aapl we can see below that for q1 2024 ending dec 30 2023 apple had total liabilities of 279 billion and total shareholders equity of 74 billion 2using the above formula the d e ratio for apple can be calculated as debt to equity 279 billion 74 billion 3 77the result means that apple had 3 77 of debt for every dollar of equity but on its own the ratio doesn t give investors the complete picture it s important to compare the ratio with that of other similar companies modifying the d e rationot all debt is equally risky the long term d e ratio focuses on riskier long term debt by using its value instead of that of total liabilities in the numerator of the standard formula long term d e ratio long term debt shareholder equityshort term debt also increases a company s leverage of course but because these liabilities must be paid in a year or less they aren t as risky for example imagine a company with 1 million in short term payables wages accounts payable notes etc and 500 000 in long term debt compared with a company with 500 000 in short term payables and 1 million in long term debt if both companies have 1 5 million in shareholder equity then they both have a d e ratio of 1 on the surface the risk from leverage is identical but in reality the second company is riskier as a rule short term debt tends to be cheaper than long term debt and is less sensitive to shifts in interest rates meaning that the second company s interest expense and cost of capital are likely higher if interest rates are higher when the long term debt comes due and needs to be refinanced then interest expense will rise finally if we assume that the company will not default over the next year then debt due sooner shouldn t be a concern in contrast a company s ability to service long term debt will depend on its long term business prospects which are less certain the d e ratio for personal financesthe d e ratio can apply to personal financial statements as well serving as a personal d e ratio here equity refers to the difference between the total value of an individual s assets and their aggregate debt or liabilities the formula for the personal d e ratio is slightly different debt equity total personal liabilitiespersonal assets liabilities begin aligned text debt equity frac text total personal liabilities text personal assets text liabilities end aligned debt equity personal assets liabilitiestotal personal liabilities the personal d e ratio is often used when an individual or a small business is applying for a loan lenders use the d e figure to assess a loan applicant s ability to continue making loan payments in the event of a temporary loss of income for example a prospective mortgage borrower is more likely to be able to continue making payments during a period of extended unemployment if they have more assets than debt this is also true for an individual applying for a small business loan or a line of credit if the business owner has a good personal d e ratio it is more likely that they can continue making loan payments until their debt financed investment starts paying off d e ratio vs gearing ratiogearing ratios constitute a broad category of financial ratios of which the d e ratio is the best known gearing is a term for financial leverage gearing ratios focus more heavily on the concept of leverage than other ratios used in accounting or investment analysis the underlying principle generally assumes that some leverage is good but that too much places an organization at risk the debt to equity ratio is most useful when used to compare direct competitors if a company s d e ratio significantly exceeds those of others in its industry then its stock could be more risky limitations of the d e ratio | |
when using the d e ratio it is very important to consider the industry in which the company operates because different industries have different capital needs and growth rates a d e ratio value that s common in one industry might be a red flag in another | utility stocks often have especially high d e ratios as a highly regulated industry making large investments typically at a stable rate of return and generating a steady income stream utilities borrow heavily and relatively cheaply high leverage ratios in slow growth industries with stable income represent an efficient use of capital companies in the consumer staples sector tend to have high d e ratios for similar reasons 3analysts are not always consistent about what is defined as debt for example preferred stock is sometimes considered equity since preferred dividend payments are not legal obligations and preferred shares rank below all debt but above common stock in the priority of their claim on corporate assets on the other hand the typically steady preferred dividend par value and liquidation rights make preferred shares look more like debt including preferred stock in total debt will increase the d e ratio and make a company look riskier including preferred stock in the equity portion of the d e ratio will increase the denominator and lower the ratio this is a particularly thorny issue in analyzing industries notably reliant on preferred stock financing such as real estate investment trusts reits | |
what counts as a good debt to equity d e ratio will depend on the nature of the business and its industry generally speaking a d e ratio below 1 would be seen as relatively safe whereas values of 2 or higher might be considered risky companies in some industries such as utilities consumer staples and banking typically have relatively high d e ratios | note that a particularly low d e ratio may be a negative suggesting that the company is not taking advantage of debt financing and its tax advantages business interest expense is usually tax deductible while dividend payments are subject to corporate and personal income tax | |
what does a d e ratio of 1 5 indicate | a d e ratio of 1 5 would indicate that the company in question has 1 50 of debt for every 1 of equity to illustrate suppose the company had assets of 2 million and liabilities of 1 2 million because equity is equal to assets minus liabilities the company s equity would be 800 000 its d e ratio would therefore be 1 2 million divided by 800 000 or 1 5 | |
what does a negative d e ratio signal | if a company has a negative d e ratio this means that it has negative shareholder equity in other words the company s liabilities exceed its assets in most cases this would be considered a sign of high risk and an incentive to seek bankruptcy protection | |
what industries have high d e ratios | in the banking and financial services sector a relatively high d e ratio is commonplace banks carry higher amounts of debt because they own substantial fixed assets in the form of branch networks higher d e ratios can also tend to predominate in other capital intensive sectors heavily reliant on debt financing such as airlines and industrials | |
how can the d e ratio be used to measure a company s riskiness | a steadily rising d e ratio may make it harder for a company to obtain financing in the future the growing reliance on debt could eventually lead to difficulties in servicing the company s current loan obligations very high d e ratios may eventually result in a loan default or bankruptcy the bottom linethe debt to equity d e ratio can help investors identify highly leveraged companies that may pose risks during business downturns investors can compare a company s d e ratio with the average for its industry and those of competitors to gain a sense of a company s reliance on debt however not all high d e ratios signal poor business prospects in fact debt can enable the company to grow and generate additional income but if a company has grown increasingly reliant on debt or inordinately so for its industry potential investors will want to investigate further | |
what is the debt to gdp ratio | the debt to gdp ratio is a metric that compares a country s public debt to its gross domestic product gdp it reliably indicates a country s ability to pay back its debts by comparing what the country owes with what it produces the debt to gdp ratio is often expressed as a percentage and it can also be interpreted as the number of years necessary to pay back debt if gdp is dedicated entirely to debt repayment formula and calculation of the debt to gdp ratiothe debt to gdp ratio can be calculated by this formula debt to gdp total debt of country total gdp of country begin aligned text debt to gdp frac text total debt of country text total gdp of country end aligned debt to gdp total gdp of countrytotal debt of country a country that s able to continue paying interest on its debt without refinancing and without hampering economic growth is generally considered to be stable a country with a high debt to gdp ratio typically has trouble paying off external debts also called public debts these are any balances owed to outside lenders creditors are apt to seek higher interest rates when lending in such scenarios 1extravagantly high debt to gdp ratios may deter creditors from lending money altogether | |
what the debt to gdp ratio can tell you | it often triggers financial panic in domestic and international markets alike when a country defaults on its debt the higher a country s debt to gdp ratio climbs the higher its risk of default generally becomes governments strive to lower their debt to gdp ratios but this can be difficult to achieve during periods of unrest such as wartime or economic recession governments tend to increase borrowing to stimulate growth and boost aggregate demand in such challenging climates this macroeconomic strategy is attributed to keynesian economics economists who adhere to modern monetary theory mmt argue that sovereign nations capable of printing their own money can t ever go bankrupt because they can simply produce more fiat currency to service debts this rule doesn t apply to countries that don t control their monetary policies however such as the european union eu nations that must rely on the european central bank ecb to issue euros 2world population review has reported that countries whose debt to gdp ratios exceed 77 for prolonged periods experience significant slowdowns in economic growth 3 every percentage point of debt above this level reduces annual real growth by 1 7 4the u s debt to gdp for q4 2023 was 121 62 almost double early 2008 levels but down from the all time high of 132 96 seen in q2 2020 5the u s has had a debt to gdp of more than 77 since q1 2009 the u s s highest debt to gdp ratio before that year was 106 in 1946 at the end of world war ii debt levels gradually fell from their post world war ii peak before plateauing between 31 and 40 in the 1970s ratios have steadily risen since 1980 they jumped sharply following 2007 s subprime housing crisis and the subsequent financial meltdown ratios then spiked during the covid 19 pandemic to reach new highs and have only slightly come down since then 51special considerationsthe u s government finances its debt by issuing u s treasuries which are widely considered to be the safest bonds on the market 6the countries and regions with the 10 largest holdings of u s treasuries as of april 2024 were | |
what is the main risk of a high debt to gdp ratio | high debt to gdp ratios could be a key indicator of increased default risk for a country country defaults can trigger financial repercussions globally | |
how does modern monetary theory view national debt | modern monetary theory mmt suggests that sovereign countries don t have to rely on taxes or borrowing for spending because they can print as much as they need their budgets aren t constrained such is the case with regular households so their policies aren t shaped by fears of rising national debt | |
which countries have the highest debt to gdp ratios | japan had the highest debt to gdp ratio of 264 as of 2024 next is venezuela at 241 followed by sudan at 186 3the bottom linethe debt to gdp ratio is a metric that helps understand a country s ability to pay back its debts a lower debt to gdp ratio is generally ideal because it signals a country is producing more than it owes placing it on a strong financial footing | |
what is debt to income dti ratio | debt to income dti ratio is the percentage of your monthly gross income that goes to paying your monthly debt payments and is used by lenders to determine your borrowing risk ellen lindner investopediaunderstanding debt to income dti ratioa low debt to income dti ratio demonstrates a good balance between debt and income in other words if your dti ratio is 15 this means that 15 of your monthly gross income goes to debt payments each month conversely a high dti ratio can signal that an individual has too much debt for the amount of income earned each month typically borrowers with low debt to income ratios are likely to manage their monthly debt payments effectively as a result banks and financial credit providers want to see low dti ratios before issuing loans to a potential borrower the preference for low dti ratios makes sense since lenders want to be sure a borrower isn t overextended meaning they have too many debt payments relative to their income as a general guideline 43 is the highest dti ratio that a borrower can have and still get qualified for a mortgage ideally lenders prefer a debt to income ratio lower than 36 with no more than 28 to 35 of that debt going toward servicing a mortgage payment 1the maximum dti ratio varies from lender to lender however the lower the debt to income ratio the better the chances that the borrower will be approved or at least considered for the credit application debt to income formula and calculationdebt to income dti ratio is a personal finance measure that compares an individual s monthly debt payment to their monthly gross income your gross income is your pay before taxes and other deductions are taken out the debt to income ratio is the percentage of your monthly gross income that goes to paying your monthly debt payments the dti ratio is one of the metrics that lenders including mortgage lenders use to measure an individual s ability to manage monthly payments and repay debts order your copy of investopedia s what to do with 10 000 magazine for more tips about managing debt and building credit debt to income ratio limitationsalthough important the dti ratio is only one financial ratio or metric used in making a credit decision a borrower s credit history and credit score will also weigh heavily in a decision to extend credit to a borrower a credit score is a numeric value of your ability to pay back a debt several factors impact a score negatively or positively including late payments delinquencies number of open credit accounts balances on credit cards relative to their credit limits or credit utilization the dti ratio does not distinguish between different types of debt and the cost of servicing that debt credit cards carry higher interest rates than student loans but they re lumped in together in the dti ratio calculation if you transferred your balances from your high interest rate cards to a low interest credit card your monthly payments would decrease as a result your total monthly debt payments and your dti ratio would decrease but your total debt outstanding would remain unchanged debt to income ratio is an important ratio to monitor when applying for credit but it s only one metric used by lenders in making a credit decision debt to income ratio examplejohn is looking to get a loan and is trying to figure out his debt to income ratio john s monthly bills and income are as follows john s total monthly debt payment is 2 000 john s dti ratio is 0 33 in other words john has a 33 debt to income ratio | |
how to lower a debt to income ratio | you can lower your debt to income ratio by reducing your monthly recurring debt or increasing your monthly gross income using the above example if john has the same recurring monthly debt of 2 000 but his monthly gross income increases to 8 000 then his dti ratio calculation will change to 2 000 8 000 for a debt to income ratio of 0 25 or 25 similarly if john s income stays the same at 6 000 but he is able to pay off his car loan then his monthly recurring debt payments would fall to 1 500 since the car payment was 500 per month john s dti ratio would be calculated as 1 500 6 000 0 25 or 25 if john is able to both reduce his monthly debt payments to 1 500 and increase his monthly gross income to 8 000 his dti ratio would be calculated as 1 500 8 000 which equals 0 1875 or 18 75 the dti ratio can also be used to measure the percentage of income that goes toward housing costs which for renters is the monthly rent amount lenders look to see if a potential borrower can manage their current debt load while paying their rent on time given their gross income real world example of dti ratiowells fargo co wfc is one of the largest lenders in the united states the bank provides banking and lending products that include mortgages and credit cards to consumers below is an outline of their guidelines of the debt to income ratios that they consider creditworthy or need improvement | |
why is debt to income ratio important | debt to income dti ratio is the percentage of your monthly gross income that goes to paying your monthly debt payments and is used by lenders to determine your borrowing risk a low dti ratio demonstrates a good balance between debt and income conversely a high dti ratio can signal that an individual has too much debt for the amount of income earned each month typically borrowers with low debt to income ratios are likely to manage their monthly debt payments effectively as a result banks and financial credit providers want to see low dti ratios before issuing loans to a potential borrower | |
what is a good debt to income ratio | as a general guideline 43 is the highest dti ratio a borrower can have and still get qualified for a mortgage ideally lenders prefer a debt to income ratio lower than 36 with no more than 28 35 of that debt going toward servicing a mortgage 1 the maximum dti ratio varies from lender to lender however the lower the debt to income ratio the better the chances that the borrower will be approved or at least considered for the credit application | |
what are the limitations of debt to income ratio | the dti ratio does not distinguish between different types of debt and the cost of servicing that debt credit cards carry higher interest rates than student loans but they re lumped in together in the dti ratio calculation if you transferred your balances from your high interest rate cards to a low interest credit card your monthly payments would decrease as a result your total monthly debt payments and your dti ratio would decrease but your total debt outstanding would remain unchanged | |
how does debt to income ratio differ from debt to limit ratio | sometimes the debt to income ratio is lumped in together with the debt to limit ratio however the two metrics have distinct differences debt to limit ratio which is also called the credit utilization ratio is the percentage of a borrower s total available credit that is currently being utilized in other words lenders want to determine if you re maxing out your credit cards dti ratio calculates your monthly debt payments compared to your income whereby credit utilization measures your debt balances compared to the amount of existing credit you ve been approved for by credit card companies the bottom linedebt to income dti ratio is the percentage of your monthly gross income your pay before taxes and other deductions are taken out that goes to paying your monthly debt payments lenders use your dti ratio to determine your borrowing risk a dti of 43 is usually the highest ratio that a borrower can have and still get qualified for a mortgage however lenders generally seek ratios of no more than 36 a low dti ratio indicates sufficient income relative to debt servicing and it makes a borrower more attractive | |
what is a debtor | a debtor is a company or individual who owes money the debtor is referred to as a borrower when the debt is in the form of a loan from a financial institution and as an issuer if the debt is in the form of securities such as bonds someone who files a voluntary petition to declare bankruptcy is also considered a debtor investopedia theresa chiechipenalties for debtorsit s not a crime to fail to pay a debt debtors can prioritize their debt repayments as they like except in certain bankruptcy situations they may face fees and penalties as well as drops in their credit scores if they fail to honor the terms of their debt however a creditor may also take a debtor to court for failure to pay and this can lead to liens or encumbrances debtors can t be sent to jail for unpaid consumer debts but a court can send a debtor to jail for unpaid child support in some cases debtor vs creditorcreditors are the opposite of debtors they re institutions businesses or individuals that extend credit to debtors creditors can be persons or entities just like debtors they can also be companies that provide supplies a company acts as a creditor when it offers supplies or services and agrees to accept payment at a later time family or friends can also be considered creditors if they ve lent money they re personal creditors real creditors are banks or finance companies with legal contracts creditors make money off debtors by charging them fees or interest can debtors go to jail for unpaid debts debtors prisons were relatively common in the u s until the civil war era when most states started phasing them out debtors don t go to jail for unpaid consumer debt such as credit cards or medical bills in contemporary times the laws governing debt collection practices activities are included in the fair debt collection practices act fdcpa they forbid bill collectors from threatening debtors with jail time 1the court can send debtors to jail for unpaid child support in some cases child support arrears cases become a federal court issue when the amount owed exceeds 10 000 and or the payments are more than a year overdue this type of debt is otherwise handled by state and local courts 2there are some exceptions to this rule a debtor who has been ordered by the court to pay a debt and misses a payment can be held in contempt of court in some states and this can result in jail time and could indirectly send the person to jail for being a debtor | |
what laws protect debtors | the fdcpa is a consumer protection law that s designed to protect debtors it outlines when bill collectors can call debtors where they can call them and how often they can call them it also emphasizes elements related to the debtor s privacy and other rights but this law only pertains to third party debt collection agencies companies that are trying to collect debts on behalf of other companies or individuals 1 | |
what can a creditor do if a debtor doesn t pay | creditors do have some recourse to collect when a debtor fails to pay a debt they can attempt to repossess the collateral if the debt is backed by it such as mortgages and car loans that are backed by houses and cars the creditor can also take the debtor to court in an attempt to have the debtor s wages garnished or to secure another type of repayment order example of a debtorconsider sal who s looking to take out a mortgage to buy a home sal works with a bank to finance a property the resulting loan is for 250 000 sal now owes the bank 250 000 and is in debt to them making them a debtor the bank is the creditor sal s home is used as collateral for the mortgage loan the bank can take possession of the property through foreclosure and sell it to recoup the money owed if sal defaults on the mortgage 3 | |
what does debtor mean | debtors are individuals or businesses that owe money to banks individuals or companies debtors owe a debt that must be paid at some point who is a debtor and who is a creditor debtors and creditors can be individuals or businesses individuals and companies are typically debtors who borrow money from banks or other financial institutions creditors can be any individual or company but they re often banks | |
is a customer a creditor or a debtor | bank customers are debtors if they have a loan or owe the bank customers who buy goods or services and pay on the spot aren t debtors customers of companies that provide goods or services can be debtors if they re permitted to make payment at a later date after accepting the goods | |
is a debtor an asset | a debtor is a person or a business the money owed by a debtor is considered an asset of the creditor money owed by a debtor can be an account receivable in some cases if it s for goods or services bought on credit or a note receivable if it s a loan | |
are debtors income | debtors aren t considered to be income the money owed by debtors to creditors isn t recorded as income but rather as an asset such as a note or an account receivable any interest or fees charged by the creditor are recorded as income for the creditor however and they re reported as an expense for the debtor the bottom linedebtors owe money to individuals or companies such as banks they can be individuals or companies and are referred to as borrowers if the debt is from a bank or a financial institution debtors can also be someone who files a voluntary petition to declare bankruptcy debtors can t go to jail for unpaid consumer debts debt collectors can t threaten debtors with jail time but courts can put debtors in jail for unpaid child support in some cases | |
what is a debtor in possession dip | a debtor in possession dip is a business or an individual that has filed for chapter 11 bankruptcy protection but still holds property to which creditors have a legal claim under a lien or other security interest a dip may continue to do business using those assets however it is required to seek court approval for any actions that fall outside the scope of regular business activities the dip must also keep precise financial records insure any property and file appropriate tax returns | |
how debtor in possession dip works | debtor in possession dip is typically a transitional stage in which the debtor most often a business attempts to salvage value from assets after bankruptcy the most obvious reason for obtaining dip status is that the assets can be used as part of a functioning business with higher resale value than the assets themselves dip status lets bankrupt companies and individuals avoid liquidation at fire sale prices which benefits both the bankrupt party and their creditors consider a mom and pop restaurant that was forced into bankruptcy during a recession the restaurant may still have talented staff a good reputation and loyal customers these could all be more valuable to the right buyer than the restaurant s building and equipment however it may take months or even years to find that buyer a debtor in possession might be able to continue operating the restaurant until they find the right buyer alternatively debtor in possession status can be used to reorganize a business returning to the bankrupt restaurant example the owners could eventually find a local investor willing to buy their building and rent it back to them the funds from the sale might be used to pay off all their creditors and emerge from bankruptcy the restaurant would then be back in business on a different basis although dips often exercise substantial control over the assets in their possession it is essential to realize that they no longer own those assets creditors can ultimately use the courts to force a sale of the dip assets advantages of debtor in possession dip the key advantage to dip status is of course being able to continue running a business while with the obligation to do so in the best interest of any creditors a dip may also be able to secure debtor in possession financing dip financing that can help to keep the business afloat until it can be sold a debtor in possession can sometimes even retain property by paying the creditor its fair market value if the court approves the sale for example an individual debtor may seek to buy back their car so they can use it to work or find work to pay off the creditor the ability to continue doing business as a debtor in possession is naturally limited by the financial interests of creditors they will eventually demand to be paid and can force the sale of assets in the debtor s possession disadvantages of debtor in possession dip after filing for chapter 11 bankruptcy the debtor must close the bank accounts they used before the filing and open new ones that name the dip and their status on the account from that point on many decisions the debtor might previously have made alone must be approved by a court 1a debtor in possession must act in the best interests of creditors and in the case of a business its employees a business must pay wages make appropriate withholdings deposit the withheld taxes and pay both the employee and employer share of social security and medicare taxes or fica as before other spending is carefully regulated for example the debtor usually cannot pay off debts that arose before filing for bankruptcy unless doing so is permissible under the bankruptcy code or approved by the court the dip also cannot put up company assets as collateral or employ and pay professionals without court permission similarly unless the court rules otherwise federal state and local tax returns must continue to be filed when due or with extensions sought by the dip as needed the dip must also maintain adequate insurance on the assets and be able to document that coverage in addition it must provide periodic reporting on the financial health of the business | |
what is chapter 11 bankruptcy | chapter 11 is a type of bankruptcy most often filed for by businesses in particular corporations and partnerships sometimes referred to as a reorganization bankruptcy it allows the business to continue operating under court supervision while it attempts to pay its creditors individuals can also file for chapter 11 but they more typically use chapter 7 or chapter 13 2 | |
what is a small business case in bankruptcy | a small business case is a type of simplified chapter 11 bankruptcy for businesses with debts of 3 024 725 or less it was created by the bankruptcy abuse prevention and consumer protection act bapcpa in 2005 small businesses that qualify can use either it or the more recent subchapter v 1 | |
what is subchapter v | subchapter v is a special category of chapter 11 for small businesses created in 2019 by the small business reorganization act sbra its goal is to speed up and streamline the bankruptcy process for businesses that qualify currently those with debts of 7 5 million or less 1the bottom linedebtor in possession dip status can allow a business or in some cases an individual to maintain possession of certain assets while they work to pay off their creditors in the cases of a business the owners will be more restricted than before in their autonomy because they must now act in the interests of their creditors rather than their own interests | |
what is debtor in possession dip financing | debtor in possession dip financing is a special kind of financing meant for companies that are in bankruptcy only companies that have filed for bankruptcy protection under chapter 11 are allowed to access dip financing which usually happens at the start of a filing dip financing is used to facilitate the reorganization of a debtor in possession the status of a company that has filed for bankruptcy by allowing it to raise capital to fund its operations as its bankruptcy case runs its course dip financing is unique from other financing methods in that it usually has priority over existing debt equity and other claims understanding debtor in possession dip financingsince chapter 11 favors corporate reorganization over liquidation filing for protection can offer a vital lifeline to distressed companies in need of financing in debtor in possession dip financing the court must approve the financing plan consistent with the protection granted to the business oversight of the loan by the lender is also subject to the court s approval and protection if the financing is approved the business will have the liquidity it needs to keep operating | |
when a company is able to secure dip financing it lets vendors suppliers and customers know that the debtor will be able to remain in business provide services and make payments for goods and services during its reorganization if the lender has found that the company is worthy of credit after examining its finances it stands to reason that the marketplace will come to the same conclusion | as part of the great recession two bankrupt u s automakers general motors and chrysler were the beneficiaries of debtor in possession dip financing obtaining debtor in possession dip financingdip financing usually occurs at the beginning of the bankruptcy filing process but often struggling companies that may benefit from court protection will delay filing out of failure to accept the reality of their situation such indecision and delay can waste precious time as the dip financing process tends to be lengthy once a company enters into chapter 11 bankruptcy and finds a willing lender it must obtain approval from bankruptcy court providing a loan under bankruptcy law provides a lender with much needed comfort in providing financing to a company in financial distress dip financing lenders are given first priority on assets in case of the company s liquidation an authorized budget a market or premium interest rate and any additional comfort measures that the court or lender believes warrant inclusion current lenders usually have to agree to the terms particularly in taking a back seat to a lien on assets the approved budget is an important aspect of dip financing the dip budget can include a forecast of the company s receipts expenses net cash flow and outflows for rolling periods it must also factor in forecasting the timing of payments to vendors professional fees seasonal variations in its receipts and any capital outlays once the dip budget is agreed upon both parties will agree on the size and structure of the credit facility or loan this is just a part of the negotiations and legwork necessary to secure dip financing dip financing is frequently provided via term loans such loans are fully funded throughout the bankruptcy process which means higher interest costs for the borrower formerly revolving credit facilities were the most utilized method which allows a borrower to draw down the loan and repay as needed such as a credit card this allows for more flexibility and therefore the ability to keep interest costs lower as a borrower can actively manage the amount of the loan borrowed | |
what is debtor in possession dip financing used for | dip financing is used to facilitate the reorganization of a debtor in possession the status of a company that has filed for bankruptcy by allowing it to raise capital to fund its operations as its bankruptcy case runs its course | |
what differentiates debtor in possession dip financing from other financing methods | dip financing is unique from other financing methods in that it usually has priority over existing debt equity and other claims | |
when a company secures dip financing it lets vendors suppliers and customers know that the debtor can stay in business provide services and make payments for goods and services during its reorganization | the bottom linedebtor in possession dip financing is meant for firms in chapter 11 bankruptcy it s a special kind of financing that allows them to continue operating only companies that file for bankruptcy protection under chapter 11 are allowed to access dip financing which usually happens at the start of a filing | |
what are decentralized applications dapps | decentralized applications or dapps are software programs that run on a blockchain or peer to peer p2p network of computers instead of on a single computer rather than operating under the control of a single authority dapps are spread across the network to be collectively controlled by its users they are often built on the ethereum platform and have been developed for various purposes including wallets exchanges gaming personal finance and social media understanding decentralized applications dapps a web app such as uber or x formerly twitter runs on a computer system that is owned and operated by a company with authority over the app and its workings no matter how many users there are the backend is controlled by the company dapps operate a bit differently they run on a p2p or a blockchain network for example bittorrent tor and popcorn time are applications that run on computers that are part of a p2p network which allows multiple participants to consume feed or seed content dapps are similar but run on a blockchain network in a public open source decentralized environment they are free from control and interference by any single authority for example a developer can create an x like dapp and put it on a blockchain where any user can publish messages once posted no one except the message originator can delete the messages a centralized app has a single owner the application software for a centralized app resides on one or more servers controlled by the owner users interact with the app by downloading a copy of it and then sending and receiving data back and forth from the company s server a decentralized app operates on a blockchain or peer to peer network of computers users engage in transactions directly with one another rather than relying on a central authority to facilitate them the dapp might be free or the user might need to pay the developer in cryptocurrency to download and use the program s source code the source code nearly always uses smart contracts which complete transactions between people smart contracts remove the need to trust that the other party will execute their part of a transaction the apps also rely on blockchain protocols that hide personal information importance of dappsthere are several dapp features that can dramatically change the facilitation of information or resources because dapps operate on decentralized networks there is no need for an intermediary this can lead to reduced costs increased efficiency and greater accessibility for example instead of having to rely on a bank imagine having nearly 100 control of every aspect of your finances this can have major implications for many industries especially the financial sector because dapps leverage blockchain technology these solutions can also help improve security in many business and personal processes blockchains make data immutable by leveraging cryptographic techniques and distributed automated consensus because the ledger is shared and compared across all users data cannot be altered dapps are accessible to anyone with an internet connection it doesn t matter where you live all you need is internet access this global accessibility democratizes access to many different types of services digital assets and information blockchain based dapps maintain transparent records of transactions meaning users can verify the integrity of data without relying on centralized authorities this transparency is critical for distributed and anonymous networks because users need to know the system is trustworthy dapp usesdapps have been developed to decentralize a range of functions and applications and eliminate intermediaries examples include self executing financial contracts multi user games and social media platforms dapps have also been developed to enable secure blockchain based voting and governance they can even be integrated into web browsers to function as plugins that help serve ads track user behavior or solicit crypto donations some examples of practical uses for dapps include scams involving dappsscams have been perpetrated through dapps ponzi schemes in which early investors are paid using the investments of more recent investors to create the appearance of big profits have been known to occur on dapps fake initial coin offerings icos have been used to raise funds for developing a new cryptocurrency or dapp that the fundraisers have no intention of creating phishing attacks which use fake websites or emails to trick people into revealing sensitive information have been seen on dapps in addition some dapps have been used to distribute malware or viruses which can compromise users devices and steal sensitive information users should be cautious and do their due diligence when interacting with dapps as the decentralized nature of these applications can make it difficult to track or hold perpetrators accountable industry analytics group dappradar found that 312 hacks and vulnerabilities affected dapps in 2022 leading to losses of around 48 billion 1 financial losses decreased by 96 to 1 9 billion in 2023 but the frequency with which hacks and exploits were used increased by 17 3 2 in the first quarter of 2024 losses increased by 9 to 407 million compared to q1 2023 s 373 million 3advantages and disadvantages of dappsmany of the advantages of dapps center around their ability to safeguard user privacy dapps use smart contracts to complete transactions between two anonymous parties free speech proponents point out that dapps can be developed as alternative social media platforms a decentralized social media platform is resistant to censorship because no single participant on the blockchain can delete or block messages ethereum is a flexible platform for creating new dapps providing the infrastructure needed for developers to focus their efforts on finding innovative uses for digital applications this could enable the rapid deployment of dapps in several industries including banking and finance gaming social media and online shopping american cryptographer and computer scientist nick szabo introduced the term smart contract in 1996 as a graduate student at the university of washington 4dapps are still in the early stages so they are experimental and prone to certain problems and unknowns questions arise about whether the applications will be able to scale effectively also there are concerns that too many applications requiring computational resources will overload a network causing congestion the ability to develop a user friendly interface is another concern most apps developed by traditional centralized institutions have an ease of use expectation that encourages users to use and interact with the app getting people to transition to dapps will require developers to create an end user experience and level of performance that rivals popular and established programs because they are decentralized dapps are not subject to the oversight and auditing most centralized applications are exposed to if the application s programming is rushed unaudited or sloppy hackers will find it easy to break into it once deployed a dapp is likely to need ongoing changes to make enhancements or correct bugs or security risks according to ethereum it can be challenging for developers to update dapps because the data and code published to the blockchain are hard to modify 5promotes user privacyresists censorshipflexible platform enables dapp developmentexperimental may not be able to scalechallenges in developing a user friendly interfacedifficult to make needed code modificationssecurity issues if programming is sloppyregulatory considerations for dappsone of the primary challenges regulators face with dapps is their decentralized nature traditional regulatory considerations are usually based on a specific location since dapps are not centralized it s tougher to regulate activity based on where transactions occur consider the general data protection regulation gdpr and its implementation within the european union dapp providers that serve the eu audience must comply with gdpr requirements regardless of their home jurisdiction in december 2023 a european subnet of the internet computer protocol icp a blockchain dao was launched that provides an infrastructure and set of tools developers can use to create compliant dapps 6 if using the icp becomes the standard way of ensuring compliance the apps lose their decentralized standing because the icp is centralized nodes must be voted in by the dao and can only be located in the eu 7some dapps issue tokens or conduct token sales to raise money this may raise regulatory concerns as authorities work to protect investors it is viewed by regulators as an unregistered securities issuance in a similar manner dapps involved in financial services such as decentralized exchanges dexs or lending platforms must adhere to anti money laundering or know your client regulations to prevent money laundering and terrorist financing there is also a consumer protection element even if the user is not exchanging money or goods this includes personal data privacy and security protection agreeing to the transactions via signature puts users at risk platforms such as metamask warn users to be aware that they could lose funds if they re unaware of what they agree to when using dapps 8example of dappsone popular example of a dapp is cryptokitties 9 cryptokitties is a blockchain based virtual game that allows players to adopt raise and trade virtual cats the game is one of the world s first forms of interactive blockchain dapps 9each cryptokitty is unique owned by the user and validated through the blockchain like other types of tradeable assets its value can appreciate or depreciate based on the market cryptokitties are considered crypto collectibles because each digital pet is one of a kind and verified on a blockchain another example is uniswap a decentralized exchange protocol built on ethereum 10 uniswap enables users to trade directly with each other without needing an intermediary like a bank or broker this dapp uses automated smart contracts to create liquidity pools that facilitate trades users can trade their tokens directly from their wallets providing a seamless and secure trading experience again the existence of uniswap is made possible by the decentralized nature of the application |
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