In financial accounting, how is 'debt' best defined, and why can it create financial risk and instability for a company?

• A. Debt is the amount of cash a company holds; it creates risk because holding too much cash can reduce profitability.
• B. Debt refers to the total value of a company's assets; it creates risk because assets can depreciate over time.
• C. Debt is the revenue generated from sales; it creates risk because sales can fluctuate seasonally.
• D. Debt is money borrowed by a company that must be repaid with interest; it creates financial risk because failure to meet repayment obligations can lead to insolvency.

Answer: (D)

Verified step by step guidance

1. Step 1: Define 'debt' in financial accounting terms. Debt refers to money borrowed by a company, typically through loans or bonds, which must be repaid over time along with interest.
2. Step 2: Explain why debt creates financial risk. Debt creates risk because the company is obligated to make regular repayments (principal and interest). If the company fails to generate sufficient cash flow, it may struggle to meet these obligations.
3. Step 3: Discuss the concept of insolvency. Insolvency occurs when a company cannot meet its financial obligations, including debt repayments, which can lead to bankruptcy or liquidation.
4. Step 4: Highlight the importance of managing debt levels. Companies must carefully manage their debt to ensure they can meet repayment obligations while maintaining operational stability and profitability.
5. Step 5: Provide an example of financial instability caused by debt. For instance, if a company takes on excessive debt during a period of economic downturn, reduced revenue may make it difficult to meet repayment obligations, increasing the risk of insolvency.