Chapter 22 Notes
Business Loans and Financing Costs
- Understand what capital structure means
- Recognize four sources of capital
- Explain an amortization schedule
- Understand loan costs
Business loans represent debts incurred to assist in running a business. Whether to take on debt and how much to take on are common and necessary parts of financial planning. Capital Structure plays an important role in financial planning.
Overview of Capital Structure
Capital is the financial resources of the organization and is generally considered to be a combination of debt and equity. “Capital Structure” refers to the debt-equity relationship. An example is if a physician practice partnership owed $500,000 in debts and also has $500,000 in partner’s equity, the partnership capital structure or debt-equity relationship would be 50-50.
Sources of Capital
Sources of capital traditionally include four methods of obtaining funds:
- Borrowing from a lending institution
- Borrowing from investors
- Retaining the excess of revenues over expenses
- Selling an additional interest in the organization
Borrowing from a lending institution is classified by the length of the loan. Short term borrowing will be paid back with 12 months. Long term borrowing is usually to finance land, buildings and/or equipment.
Borrowing from investors assumes the organization is big enough and has the proper legal structure to do so. A common example of borrowing from investors is the selling of bonds. The investor expects to receive interest payments annually and expects that the bonds will be repaid at a future point in time.
The Cost of Financing
Financing costs typically involve interest expense and usually also involve loan costs.
Payments on a business typically consist of two parts: principal and interest expense. The principal portion of the loan payment reduces the loan itself, while the rest of the payment is made up of interest on the remaining balance due on the loan.
Review Table 22-1, Loan Amortization Schedule, and Appendix 22-1-A.
Covers expenses necessary to close the loan. Loan costs generally include some expenses that would be reported in the current year and some other expenses that should be spread over several years.