Certified Financial Management Specialist Practice Exam

What is an essential characteristic of debt in capital structure?

1. It requires profit sharing with investors

2. It consists of borrowed money with interest expense

3. It does not need to be paid back

4. It is a form of retained earnings

The correct answer is: It consists of borrowed money with interest expense

An essential characteristic of debt in capital structure is that it consists of borrowed money with an associated interest expense. When a company takes on debt, it incurs an obligation to repay the principal amount borrowed along with interest. This creates a fixed obligation that impacts the company’s cash flow and financial statements. Debt plays a critical role in a firm’s capital structure because it can be used to finance operations, invest in new projects, or improve liquidity. The interest paid on debt is usually considered an expense, which can reduce taxable income, making this financing option attractive to many businesses. Additionally, because interest payments are generally required regardless of business performance, debt can increase financial risk but also offers the potential for higher returns on equity when managed correctly. The other characteristics associated with capital structure do not accurately describe debt. For instance, profit sharing with investors typically relates to equity financing, where dividends are paid to shareholders based on profits. Also, debt must be repaid, unlike retained earnings, which are generated from profits and do not require repayment to shareholders. Therefore, understanding that debt consists of borrowed money with interest expense is fundamental for grasping the dynamics of capital structure in financial management.