What are “Loans”?
Loans are a form of credit in which one party lends money to another party. The term “debt” can also be used for loans. The borrower is obligated to repay the money (or principal) to the lender (typically a bank or any other financial institution). In addition, the borrower is usually required to pay interest periodically or as scheduled to the lender. Depending on the length, loans can either be short-term or long-term. Short-term loans, which usually need to be paid back within a year, are used for meeting short-term financing requirements, such as working capital, improving cash flow etc. Long-term loans, which usually last from just over a year to 25 years, are used for long-term financing requirements such as the purchase of long-term assets (property, plant and equipment), making acquisitions, opening a new production facility, etc. Loans can be of different types, such as secured, unsecured, revolving and term loans.
Key Learning Points
- Loans are when one party borrows from another, with repayment agreed for a future date, and the reward to the lender is in the form of interest payments
- Loans can be of different types, such as secured, unsecured, revolving, and term loans
- The repayment of the loan can be spread gradually over the term of the loan (amortized debt) or on the last day of the loan term (bullet debt)
- Interest is normally paid in cash. The borrowing company expenses interest in their income statement over the term of the loan
- Loans can be found either in the balance sheet or in the notes to financial statements
Types of Loans
Many loans to companies will be secured against collateral, including physical assets such as real estate, inventory or equipment. If the borrower cannot pay back the money, the lender can seize the asset used as collateral and sell it to recover the amount due. This provides protection or security to the lender, hence the term “secured loan”.
Unsecured loans are not secured against any asset/collateral. The lender provides a loan based on other factors such as the company’s cash flows and other existing debt. For example, if the borrower has strong cash flows and no existing debt, they may be willing to provide an unsecured loan. If the borrower already has high levels of debt, the lender will be more cautious of the borrower not being able to pay back the loan. Many companies do not have the credit quality that is sufficient to get an unsecured loan.
A revolving loan is a line of credit or credit facility that a company can use to withdraw funds, repay them, and withdraw again if needed. Revolving loans are subject to a pre-agreed borrowing limit. Such loans help businesses deal with short-term cash fluctuations and meet their working capital requirements. Revolving loan facilities are agreed in advance and often remain in place for a long time, so when the company comes to a point when it actually needs to draw down some of the facility, access to the cash is fast. Revolving loans tend to allow borrowing for the short term only.
A term loan is a credit facility that enables the borrower to borrow a fixed amount for a set period, with an agreed schedule of repayment. Term loans are usually used for long-term financing needs, such as purchasing fixed assets, setting up machinery and equipment or modernization of equipment. Before granting term loans, banks evaluate the project for technical and economic viability.
Repayment of Loan and Interest Payments
The repayment of a term loan can either be spread over the term of the loan or be due on the final day of the term. If the repayment is spread over the loan’s term, it is termed as amortizing debt. If the principal repayment is due on the final day of the term, it is referred to as bullet debt.
Interest is normally due in cash on a regular basis, as specified in the loan documentation. All interest is expensed in the income statement of the borrowing company over the term of the loan.
Example: Amortization of a Loan
Based on the information given below, the amortization schedule for a term loan has been prepared.
The loan amount is 9,000.0 for a term of 5 years at an interest rate of 5.0%. The lenders and the borrower have agreed to follow the amortization expense percentage given in the table above. This means that in FY23 (year 23), 10.0% of the loan/principal will be repaid and in FY24 (year 24), 15.0% will be repaid, and so on. Over the 5 years, 100.0% is repaid.
Next, in FY23, the borrower pays an interest of 450.0 (9,000.0 * 5.0%) and the loan/principal repayment is 900.0 (9,000.0 * 10.0%). After deducting the principal repayment, the ending balance is 8,100.0, which becomes the beginning balance of the next year (FY24).
In FY24, the interest of 405.0 (8,100.0 x 5.0%) is charged on the beginning balance and in the same year 15.0% of the loan/principal is repaid (i.e. 1,350.0 = 9,000.0 * 15.0%). The ending balance in FY24 is 6,750.0. The same process continues for 5 years until the loan is fully repaid in FY27, and the ending balance is 0.0.