Loan Capital Definition
Loan Capital refers to that amount of capital which is required to manage the operations of the business raised from the external sources of the company such as financial institutions, by issuing debentures, etc. It is one of the option of raising fund as it only includes long term funds which can be utilized by the company for the goal of business by bearing some sort of interest or charge.
Explanation
Loan capital is considered where funds are required by the business for a longer period i.e. they are not preferable for a shorter duration, they carry periodic payment of interest or some charges and did not have any involvement in the profits of the company. They are of various types amongst all of the debentures are considered the safest and less riskiest way to provide fund as it can be seen that bank overdraft 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.
Types
The loan capital may be divided into three categories:
#1 – Debentures
These are the instruments that are liabilities to the company and are required to be repaid along with the payment of fixed interest thereupon. 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. The bank after examining the creditworthiness of the person or entity grants them a fixed limit and the person can use such limit funds and in return, they have to pay a fixed amount of interest on the amount which they have used from the limit.
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#3 – Bank Loan
This is the most commonly used type of raising funds by a business which is granted by the business by taking something valuable as collateral, the funds used costs the company some fixed rate of interest which usually is lower as compared to the other two sources of raising funds.
How to Record Loan Capital?
To record the transaction we have to pass the following recording entries:
The second entry needs to be passed on the event of payment of interest or principal amount of loan taken by the business.
Loan Capital vs Equity
The differences are as follows:
- In the event of liquidation, Loan funds are given priority over equity.
- The interest levied on loan capital needs to be paid whether the business is in profits or not but on the other hand, equity does not place much burden on the company.
- Every business needs more and more funds from equity sources as compared to loan, in other words, priority is given to equity as compared to the loan.
Loan Capital Markets
The Loan Capital Market includes but not limited to providing the facility of borrowing and lending the funds to the borrower from one lender to another for the sake of earning interest income by the lender.
In providing such facilities, the following instruments are included:
- Both Operating Lease and Financing Lease
- Loan against mortgaging some property or asset of the borrower
- Providing Advisory services to the person who is in need of funds and providing intermediary services in order to provide the funds to the borrower.
- These markets also provide the lender to underwrite the loans already granted by some other borrower in order to reduce the liability of such borrowers.
Advantages
- The company gets funds to use in business without transferring the ownership of asset i.e. gets funds on pledging such assets to the bank.
- It does not give any ownership or decision making a right to the fund provider or say to the lender as granted under the option of equity.
- As the repayment of interest, as well as 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 profitable situation or not.
- As the funds are taken on pledging the assets of the company 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 of the options which is used by the business to raise funds as every business needs funds and the funds required may be either raised through equity option (internal source such as shareholders, retained earnings, surpluses, etc. or it could be raised through external sources such as debentures, etc. It is that part of capital which the company has raised through external sources by bearing some cost such as interest or some other cost such as issuing shares for redeeming the debentures issued, etc.
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