Collateral

Collateral is an asset a borrower pledges to a lender as security for a loan. If the borrower stops paying, the lender can take the asset and sell it to recover what it is owed. A loan backed this way is called secured debt; a loan backed only by the borrower's promise to pay is unsecured. The same idea applies in trading: buying on margin, holding a futures position or borrowing shares all require posting cash or securities as collateral, which the broker or lender can use to cover losses the trader doesn't pay.

What makes a good piece of collateral is that it holds its value and can be sold. Buildings, land, equipment, inventory and receivables are common examples. A company whose value sits mostly in its brand, software or customer relationships has much less to pledge, which is one reason asset heavy businesses such as utilities and real estate can usually borrow more relative to their size than a software company can.

For an investor, collateral matters in two ways. Secured lenders are repaid first from the pledged assets in a bankruptcy, so the more of a company's debt is secured, the less is left for unsecured lenders and shareholders if things go wrong. And because secured debt carries less risk for the lender, it usually costs the borrower a lower interest rate, so a company's mix of secured and unsecured debt says something about both its borrowing costs and how much room it has left to borrow.