A company that needs external financing to meet operating needs can borrow from a financial institution or engage in securities exchange transactions such as stock, bond or preferred share issuance. A firm often resorts to bank debt, depending on economic conditions, regulatory requirements, industry practices and business relationships between the lender and the borrower.
Bank debt represents a group of loans that a corporation must repay to a bank. A bank debt is usually a secured loan--that is, a borrower must provide collateral, or financial guarantees, before receiving loan proceeds. In case of bankruptcy, bank debt is repaid before other lender claims.
Types of bank debts vary, depending on the industry, the company's size or regulatory guidelines. A firm may apply for a private bank loan after submitting current and historical data. A company can also sign a line of credit or overdraft arrangement with a bank.
A corporation can hire a specialist, such as an investment banker or certified public accountant, to gauge corporate cash needs and propose adequate funding options. An investment bank often recommends financing products based on general economic criteria and developments on securities exchanges.
Bank debt plays a significant role in modern economies. All organizations need short-term or long-term financing because internal funds usually are insufficient to meet operating commitments. Even profitable firms need funding because customers do not always pay for goods on delivery.
Credit risk is the loss probability resulting from a borrower's default or inability to meet other financial commitments. A business partner defaults because of bankruptcy or temporary economic difficulties. Credit risk is inherent in all lending activities, including transactions with government entities and charitable institutions.
Regulators often monitor loan levels that a bank or an insurance company can have in its balance sheet. The U.S. Securities and Exchange Commission and the Federal Reserve Bank usually require financial institutions to have a set percentage of cash versus client loans; this percentage is called a "required reserve ratio."
Accounting for Bank Debt
Accounting procedures, such as U.S. generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS), require a borrower to record bank loans at market values. To illustrate, a large tire manufacturer receives $150 million in revolving loan proceeds from a bank. To record the transaction, a corporate accounting manager debits the cash account (asset) for $150 million, and he credits the bank loan account (liability) for the same amount. (In accounting parlance, debiting an asset account means increasing its amount, while crediting it means reducing the account balance.)