A file system path where the files will be stored. This directory has to exist and be writable by Drupal. If the download method is set to public this directory has to be relative to the Drupal installation directory, and be accessible over the web. When download method is set to private this directory should not be accessible over the web. Changing this location after the site has been in use will cause problems so only change this setting on an existing site if you know what you are doing.
By default Drupal will automatically attempt to create a /files directory at the root of your site if it doesn't exist. In most configurations automatic creation will be fine, in some LAMP configurations this will grant the web server service account rights to the folder and exclude your account direct access. To correct this you will generally need to contact your web host.
There exists a configuration practice that is to put the files directory in your sites directory. This helps centralize the files unique to your site that need to be backed up. For the first site this would be "/sites/default/files". This can be very useful if you plan on using multi-site configurations or wish to simply your sites backups.
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