Loan Capital Definition Types Advantages Disadvantages

Loan Capital Definition

Explanation

Loan capital is considered where the business requires funds for a longer period, i.e., they are not preferable for a shorter duration, carry periodic payment of interest or some charges, and are not involved in the company’s profits. They are of various types amongst all of the debenturesDebenturesDebentures refer to long-term debt instruments issued by a government or corporation to meet its financial requirements. In return, investors are compensated with an interest income for being a creditor to the issuer.read more are considered the safest and less riskiest way to provide funds as one can see that bank overdraftOverdraftOverdraft is a banking facility that offers short-term credit to the account holders by allowing them to withdraw money from their savings or current account even if their account balance is or below zero. Its authorized limit differs from customer to customer.read more or bank loan does not secure the lender fully, by taking the funds from loan capital and timely repayment of such amounts will create the goodwill in the eyes of bank and the lender which helps the business in the long run so that we get the funds as and when required.

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Types

The loan capital may be divided into three categories: –

#1 – Debentures

These instruments are liabilities to the company and must be repaid along with fixed interest payments. The debenture-holders will earn a fixed interest on the amount advanced to the company, and they did not have any decision-making right in the company.

#2 – Bank Overdraft

These are the agreements entered into by the banks and the person seeking such a facility. After examining the person’s or entity’s creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more, the bank grants them a fixed limit, and the person can use such limit funds. In return, they have to pay a fixed interest on the amount they have used from the limitation.

#3 – Bank Loan

A bank loan is the most commonly used type of raising funds through industry grants by taking something valuable as collateral. The funds are used to cost the company some fixed rate of interest, which is usually lower than the other two sources of raising funds.

How to Record Loan Capital?

To record the transaction, we have to pass the following recording entries: –

We must pass on the second entry in the event of interest payment or principal amount of loanPrincipal Amount Of LoanLoan Principal Amount refers to the amount which is actually given as the loan from the lender of the money to its borrower and it is the amount on which the interest is charged by the lender of the money from the borrower for the use of its money.read more taken by the business.

Loan Capital vs Equity

The differences are as follows: –

In liquidationLiquidationLiquidation is the process of winding up a business or a segment of the business by selling off its assets. The amount realized by this is used to pay off the creditors and all other liabilities of the business in a specific order.read more, Loan funds are given priority over equity.The interest levied on loan capital needs to be paid whether the business is profitable. But on the other hand, equity does not place much burden on the company.Every business needs more and more funds from equity sources than loans. In other words, priority is given to equity compared to the loan.

Loan Capital Markets

The loan capital market includes but is not limited to borrowing and lending the funds to the borrower from one lender to another to earn interest incomeEarn Interest IncomeInterest Income is the amount of revenue generated by interest-yielding investments like certificates of deposit, savings accounts, or other investments & it is reported in the Company’s income statement. read more.

In providing such facilities, the following instruments are included: –

Both operating leaseOperating LeaseAn operating lease is a type of lease that allows one party (the lessee), to use an asset held by another party (the lessor) in exchange for rental payments that are less than the asset’s economic rights for a particular period and without transferring any ownership rights at the end of the lease term.read more and financing leaseFinancing LeaseFinance lease simply refers to a method of providing finance in which the leasing company purchases the asset on behalf of the user and rents it to him for a set period of time. The leasing company is referred to as the lessor, and the user is referred to as the lessee.read more.Loan against mortgaging some property or asset of the borrowerProviding advisory services to the person who needs funds and providing intermediary services to provide the funds to the borrower.These markets also allow the lender to underwrite the loans already granted by some other borrower to reduce such borrowers’ liability.

Advantages

The company gets funds to use in business without transferring the ownership of assets, i.e., funds on pledging such investments to the bank.It does not give any ownership or decision-making rights to the fund provider or the lender as granted under the option of equity.As the repayment of interest and the principal amount is prefixed, one could easily plan their expenses and funds accordingly.

Disadvantages

The first and foremost disadvantage of loan capital is that the repayment of interest and the principal amount is to be made on the date prefixed whether the business is in a good situation or not.As the funds are taken on pledging the company’s assets to the lender, then in this situation, if the company wants to sell off the assets to some other third party, they cannot do so until the loan amount is repaid.

Conclusion

Loan capital is one option the business uses to raise funds, as every business needs funds. One may either raise funds required through the equity option (internal source such as shareholders, retained earnings Retained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more, surpluses, etc.) or raise it through external sources such as debentures, etc. Part of the company’s capital is taken through external sources by bearing some cost such as interest or some other cost such as issuing sharesIssuing SharesShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner’s equity on the Company’s balance sheet.read more for redeeming the debentures issued, etc.