What is Long term Loans or Long Term Financing?

What is Long term Loans or Long Term Financing?

Businesses can raise capital internally through the issuance of shares or retaining profits. At the same time, business capital can be raised through financial institutions in the form of long term loans. In practice, external financing is more popular than share capital due to the following reasons:

  • Share capital is usually limited by investors’ capacity and willingness to invest
  • The cost of loans (i.e interest cost ) is cheaper than the cost of share capital (i.e. dividend) due to lesser risk and claim ability of interest as a business expense
  • Loans can be returned once the project is complete to avoid further interest payments, however, shares one issued are difficult to but back and shareholder’s constantly expected dividend payments in perpetuity

Depending upon the terms and duration of the financing agreement, loans are classified between:

  • Long term loans (amounts payable after the 12 months from balance sheet date) are usually used for financing of major project e.g. business expansion, purchase of plant and machinery, etc.
  • Short term loans (amounts payable within 12 months from balance sheet date) are used where businesses’ need for external funds is temporary.

Disclosures:

Financial statement includes a detailed note on all long terms loans where the following information is disclosed for users of financial statements:

  • Sanctioned and availed amount of loan
  • Type and extent of security given to obtain a loan
  • Terms of repayment
  • The interest rate at which financing has been obtained

Secured/ unsecured loan

Secured loans are the ones where the borrower needs to provide security (land & buildings, plant & machinery, inventories, future receivables, etc.) to the lending financial institution which is called the collateral and is pledged/hypothecated with the lender for the entire duration of the loan arrangement and is released on complete repayment of the loan.

Unsecured loans on the other hand are not secured through a pledge of borrower’s assets, rather these are usually given based on market repute and/or creditworthiness of the borrower.

Collateral

As discussed above, secured loans are backed by collateral assets/ security. Following are the common methods of arranging collateral asset/ security for the lender:

Pledge Under this method, secured asset goes in physical possession of the lender(E.g. Company’s cash, stock in trade, vehicle, machinery is  physically handed over to lender)
Hypothecation This method is used for moveable assets of the borrower. Under this method physical possession of the moveable assets,stock in trade, vehicles etc. remains with the borrower but a charge is created in favour of lender.
Mortgage This method is used in case of immoveable assets of the borrower.eg. land & buildings, plant & machinery etc.The physical possession of the immoveable assets remains with the borrower but a charge is created in favour of lender.

Subordinated loan

The subordinated loan is the one which is ranked after other loans in case of bankruptcy of the borrower i.e. other loans will be prioritized for payment in case of liquidation of a company and recovery of subordinated loan will depend on the availability of funds after paying off other loans.

Example:

A company had the following obligations at the time it went into liquidation.

Secured loan from bank

$ 500,000

Subordinated loan

$ 300,000

Taxes payable

$ 50,000

Shareholder’s equity

$ 250,000

Suppose the proceeds from the disposal of assets of the company are $ 800,000. The proceeds will be disbursed in the following order:

  • Payment of taxes and any other regulatory dues
  • Secured loans
  • Subordinated loan
  • Shareholders’ equity

If proceeds from the disposal of assets of the company are less than actual obligations, shareholders and subordinated loan providers will be the ones at stake. In the above example, the amount left after payment of taxes and secured loans is only $ 250,000 and providers of the subordinated loans will bear the loss of $50,000.

Bonds/Debentures

Bonds/ debenture is a form of obtaining a loan where borrower issues bonds/ debentures which are purchased by investors (general public, financial institutions, etc.)

Bonds/ debentures usually have a defined maturity date after which the borrowing company purchases back the bonds/ debenture after repaying the sum. These instruments are subject to interest payments to bond/ debenture holders just like any other loan arrangement.

Bonds/ debentures can be exchange-traded. Similarly, like preference shares these may also contain a convertibility option in which case, at a specific date, the bond/ debenture holder can get the company’s shares in exchange for bonds/debentures held by him in accordance with the pre-defined formula.

Liabilities against finance lease

The lease is an arrangement between the lessor (person who provides asset/ lease facility) and the lessee (person who obtains the lease facility) whereby the lessor allows the lessee the right to use an asset against a periodic payment.

For accounting purposes, leases are classified into two types:

  • Finance lease:

A lease is classified as a Finance Lease if the following conditions are fulfilled:

  • Risk and rewards incidental to ownership to the asset are substantially transferred to the lessee;
  • The lease period covers the major part of the useful life of the asset
  • The present value of lease payments equals the fair value of asset
  • The lease agreement contains the option for the lessee to purchase the asset at the end of the lease term

Under a finance lease arrangement, the lessee recognizes the leased asset as well as the related lease liabilities on its balance sheet.

Example:

An entity obtained a commercial vehicle worth $50,000 from a bank under a lease arrangement. The useful life of the vehicle is 4 years. The lease term is also 4 years during which the entity has to pay $ 1,200 on a monthly basis after which the entity has the option of buying the vehicle at $2,000.

This is an example of a finance lease arrangement and will be recorded as follows:

Description

Debit

Credit

Motor Vehicles (Leasehold)

50,000

 

Finance Lease Liability

 

50,000

  • Operating lease

A lease where the above conditions are not met is classified as an operating lease. Under an operating lease, annual rental payments are recorded as an expense.

Example:

An entity obtained a commercial vehicle for 2 years period at a yearly rental of $15,000. This is an example of an operating lease and the yearly payment will be recorded as follows:

Description

Debit

Credit

Operating lease expense

15,000

 

Bank

 

15,000

Vendor Financing

These represent finances provided on a deferred repayment basis by vendors to purchase goods from them. These loans are usually availed when a business is setting up or expanding its production facilities but does not have the required funds available and/or other financial institutions are not awarding financing facilities for making such transactions. As a result, the interest rate on vendor financing arrangements is usually higher than the market rates.

Example:

A company wants to purchase a plant & machinery unit from Company ABC for expanding its production capacity. The cost of machinery is $ 1 million, however, the purchasing company currently has only $ 400,000. The selling company ABC doesn’t want to miss out on the opportunity of selling high-value items and offers to provide a loan of $600,00 to the purchasing company.

One thought on “What is Long term Loans or Long Term Financing?”

  1. Crypto Hix says:

    good article very hopeful

Related Post