Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Loan

What it is:

In the business world, a loan is an amount borrowed.

How it works (Example):

Let's assume Company XYZ has invented a new product that will revolutionize the widget market. The company is sure there will be demand from billions of people around the world, and therefore it needs to build a new factory. If Company XYZ's funds for constructing the factory were limited to its cash on hand, say $200,000, it certainly could not build the kind of factory it needs to capitalize on this tremendous opportunity and would thus be very limited in its output and profits (and would leave the market wide open for competitors to fill the void). With a loan, however, Company XYZ could build the factory and take advantage of the profit potential of its product. The debt essentially magnifies the profits.

In the business world, bank loans and corporate or government bonds are the most common. For individuals, loans can be personal loans, mortgages or lines of credit.

Why it Matters:

A loan is a liability, meaning the lender has a claim on a company’s assets. Loan payments due within one year are generally classified as short-term debt on a company’s balance sheet. Loan payments due in more than one year are considered long-term debt. It is important to note that loans commonly come to mind when one considers liabilities, but not all liabilities are loans. Companies may incur other types of liabilities, including (but not limited to) upcoming payroll, bonuses, legal settlements, payments to vendors, certain derivatives, contracts, certain types of leases, and required stock redemptions. Common balance sheet categories for liabilities include accounts payable, accrued expenses, and debt.

Information about a company’s debt is a key component of accurate financial reporting and a crucial part of thorough financial analysis. Excessive debt can ruin a company but is not always detrimental. The use of debt financing can magnify profits that would have otherwise gone unrealized.