Loan Capital

Loan capital refers to the amount of money required to manage the business's operations raised from external sources such as financial institutions, issuing debentures, etc. It is one option of raising funds as it only includes long-term funds that the company can utilize for business by bearing some interest or charge.

• Loan capital means the money needed to manage the business's operations received from external sources like financial institutions, issuing debentures, etc. 
• It is one praising funds option as it only includes long-term funds that the company may use for business by paying some interest or charge.
• Loan capital has three types: debentures, bank overdrafts, and bank loans.
• The loan capital market includes but is not limited to borrowing and lending funds to the borrower from one lender to another for earning interest income.

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 debentures are considered the safest and less riskiest way to provide funds as one can see 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.

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 creditworthiness, 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.

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 loan taken by the business.

The differences are as follows: -

• In liquidation, 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.

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 income.

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 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.

• 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.

• 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.

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, 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 shares for redeeming the debentures issued, etc.

This article is a guide to Loan Capital definition. We discuss how to record loan capital, along with its types, advantages, disadvantages, and differences. You can learn more about it from the following articles: -

• Loan Note
• Recourse Loan
• Loan Stock
• Loan Servicing