A Definitive Guide To Senior Debt and How It Works

By Indeed Editorial Team

Published December 14, 2021

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Many companies finance their projects or operations through financial loans. Finance professionals often track, settle and document these loans to improve payment and financial reporting accuracy. Learning about different debt, including senior debt, can help you document these types of transitions for your organization. In this article, we discuss what senior debt is, review how it works, examine the differences between senior and subordinated debt and analyze other types of company debt.

What is senior debt?

Senior debts are debts and obligations that take priority over other types of debt a company might incur. Companies with senior debt pay these accounts first over other types, such as junior, subordinated and hybrid debt. Many companies offer collateral to financial agencies, equipment, vehicles or properties, which can help reduce interest rates applied to financing activities. Some examples of senior debt include:

  • Large property purchases

  • Capital expenditure projects

  • Research and development initiatives

  • Equipment or vehicle purchases

Related: How To Calculate Total Debt (With Example)

How does senior debt work?

Senior debt is an organization's first responsibility when repaying debts. It works similar to other loan types because it involves set payment amounts that apply to the loan's principal and interest values. Review these steps to help you understand how you can apply for senior loans for your organization and settle senior debts:

  1. Analyze potential collateral asset values

  2. Create a loan proposal for a financial institution

  3. Request a senior loan from a commercial bank or other institution

  4. Receive loan approval

  5. Complete senior loan documents

  6. Apply loan to the predetermined project, equipment or another profit-generating plan

  7. Generate revenue and profits

  8. Apply profits to the loan's principal and interest values before repaying other loan types

  9. Follow loan repayment plan until your company settles the loan

  10. Close senior loan account with the financial institution

Related: Equity vs. Debt: Definitions, Types, Pros and Cons

What's the difference between senior debt and subordinated debt?

There are several key differences between senior debt and subordinated debt. Learning about these differences can help you track, document and manage these debts for your company. Some differences between these two kinds of debt include:

Priority

Senior debt is the first priority for companies and financing agencies. This means if a company defaults on a payment, experiences a merger or acquisition or experiences bankruptcy, the company sells its assets to repay the senior loan first. A subordinated debt is the second priority for a company and financing agency. If all sold assets settle the senior debt, then the company can apply its funds to the subordinated debt.

For example, if a company has $2 million in senior debt and $1 million in subordinated debt and the company sells an asset for $2.5 million. The company applies $2 million from the asset's sale to senior debt and the remainder to subordinated debt. If the company sells an asset for more than its total senior and subordinated debt, then it can apply the rest of the asset sale to other junior debts.

Related: Liabilities vs. Debt: Definitions and Examples

Funding agency

Commercial banks, insurance companies or other large financial institutions typically fund senior loans. This is because senior debts are typically larger amounts than other debt types and large financial institutions can fund these projects easier. Investment companies, individual investors or other financial institutions typically fund subordinated debt activities. This is because these funds or projects are riskier or involve smaller amounts.

Risk

Senior debt is less risky for financial agencies because the company commonly supports the loan with collateral. This collateral enables banks to recover funds from a company in case of financial hardship or other fiscal matters. Subordinated debt has a higher risk associated with it because it doesn't require collateral support from a company.

Related: 10 Types of Equity Account (With Definitions and Examples)

Amount

The loan amount a company might receive from a financial institution relates to the collateral price. If the collateral has a higher value, such as property or land, a company might receive a higher loan. If the collateral has a lesser value, such as company vehicles or equipment, then the company might receive a loan closer to the collateral's value. Subordinated debt is typically smaller amounts than senior debt because a company might receive this loan without offering collateral assets.

Interest rate

Senior debt interest rates are generally lower than all other debt types because of their low risk for financial institutions. The financial institution and company also agree on a payment schedule, which helps a bank and company understand more about how soon the company might settle the loan. Subordinated debt has a higher interest rate because of the increased risk banks accept with this type of business loan.

Uses

Companies often apply larger loans, or senior debt, to capital expenditure or other high-value projects. This is useful if the organization has large value assets to fund these projects. Subordinated debt is useful for companies with minimal or lesser value assets. These companies can use smaller loans classified as subordinated debt to expand operations and improve profits.

What other kinds of debt can a company accrue?

Also known as junior debt, here are some other common types of debt a company can accrue:

Preferred equity

Preferred equity is a financing structure commonly used for commercial real estate purchases that involve private lenders or private equity firms. Companies repay these investments through cash flow and company profits. This type of debt holds a higher risk than subordinated debt, but lower risk than common equity investments.

Common equity

Common equity, otherwise known as common stock, is a financing structure that enables public investors to own shares in a company, which helps the company fund its projects and manufacturing operations. If a company defaults on its other loans and applies for bankruptcy, the company settles these shares after it pays all other shareholders. This type of debt holds the highest risk for financing agencies or investors.

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