What is Loan Capital?

Loan capital is funding that must be repaid. This form of funding is comprised of loans, bonds, and preferred stock that must be paid back to investors. Unlike common stock, loan capital requires some type of periodic interest payment back to investors for use of the funds. However, these investors do not share in the profits earned by the organization, though they have payment preference over shareholders in the event of a business default.

Example of Loan Capital

A manufacturing company plans to expand its operations by building a new production facility. To finance the $5 million construction cost, it secures a long-term loan from a commercial bank, repayable over 10 years at a fixed interest rate of 6% per year. This borrowed amount is considered loan capital, since it provides the company with the necessary funds to invest in capital assets without issuing additional shares. The company uses the facility to increase its production capacity, expecting the higher output to generate enough revenue to cover loan repayments and boost overall profitability. In this case, loan capital supports strategic growth while preserving the existing ownership structure.

Advantages of Loan Capital

Loan capital offers several advantages for businesses seeking to finance operations or expansion. It provides immediate access to substantial funds without diluting ownership, thereby allowing existing shareholders to retain full control of the company. Interest payments on loan capital are typically tax-deductible, reducing the effective cost of borrowing. Additionally, loans can be structured with fixed repayment schedules, aiding in financial planning and budgeting. For growing firms, loan capital can support investment in assets or projects that generate returns exceeding the borrowing cost, enhancing profitability over time.

Disadvantages of Loan Capital

There are several disadvantages associated with the use of loan capital, which are as follows:

Increased risk of default. An excessive amount of loan capital can present an increased risk of default for a business, since the interest liability associated with the loan capital may exceed the ability of the entity to make these payments on a timely basis.
Not suitable for variable profit situations. The use of loan capital is a particular concern in cases where a business has highly variable profits, since it may not be able to make loan payments during a low-profit year. This is a common concern when product cycles are short and the barriers to entry are low, since both conditions allow low-cost providers to enter the market and undercut your business.