How a Business Loan Affects Your Accounting Equation

If you’re already a business owner or are thinking about starting one, taking out a business loan can help your enterprise reach its goals. More than just a financial lifeline, loans can also help paint a picture of a company’s health. For instance, a good debt to equity ratio is an indicator of your business’s financial conditions. Here we will dive into business loans and borrowing. We will also discuss how a business loan can and will affect your accounting equation.

Intro on Business Loans

The pros and cons of taking out a business loan depend mainly on your company goals and financial capacity. Thus, you must think about proceeding with your plan of borrowing cash for your operations. Before doing so, you must know where and how to get a small business loan. Companies with minimal business assets and credit scores may find it hard to take out a loan. 

Just because you are a new business doesn’t mean you can’t borrow money at favorable rates. Although, your very first borrowing may come with costly repayment terms. However, think of your initial loan as a test from lenders. If you can pay your loan as agreed under the terms, then more doors will open for you. You’ll then have access to better lending opportunities. Use your loans as stepping stones to build your credit score. 

If you play your cards right, you can get better business loans within a few years or even months of operating your enterprise. Also, the most important proof to show you’re ready to borrow more funding to grow your company is contained in your accounting books. This is why it’s important to have organized and accurate accounting records. The good news is you don’t need to be an accountant to understand how a business loan affects the accounting equation. Just read on to learn more.

The Accounting Equation

Suppose you have successfully qualified and obtained a business loan. In that case, the bigger question you need to tackle is how borrowing will affect your books.  This will also affect the accounting equation that serves as the cornerstone of all accounting principles. 

Keeping your business records organized and balanced will give you a clearer picture of where your enterprise stands. It will tell you if your business is profitable.  Also, it informs you if you’re able to reach your targets and pay off your loan on time.

At its essential core, accounting is a record of all your business transactions. It lists the changes in the assets, liabilities, and owner’s equity.  It could also detail shareholders’ equity depending on your business structure. Under accounting principles, the total assets should equal total liabilities plus owner’s equity at any given time. 

Some examples of assets are cash, inventory, accounts receivable, property, plant, and equipment. Meanwhile, liabilities include accounts payable to suppliers and business loans. Under equity, you can list contributions from owners or shareholders, plus retained earnings.  These earnings are the portion of business profits held for future use and not distributed to owners.

All these items and their changes, at any given time, are included in the company’s balance sheet. This must always be balanced, thus total assets must equal total liabilities and equity.

If you are starting a business, these concepts may not be new to you. That being said, lets dive a little deeper into how these statements are related and their changes throughout the life of a loan.

Movements in the Balance Sheet

In the balance sheet, a business loan will always affect two main accounts.

Assets

Let’s say that you’re fortunate enough to qualify for a business loan. Your next task is to record your business loan in your books. The first part is adding the cash or loan proceeds you received to the assets section of your balance sheet. You may be wondering why you need to list an amount you owed as an asset. Well, when you borrowed money, you received cash.  Cash is an asset account by default. 

Liabilities

So, supposed you borrowed $10,000. In this case, you need to make an entry of $10,000 under cash. This will then move your assets section in the balance sheet by $10,000.

As mentioned earlier, a balance sheet always needs to have balanced or equal totals.  You’ll have total assets on one side and total liabilities plus owner’s equity on the other. So, if you added $10,000 in your assets section, there must be a corresponding movement in the liabilities and owner’s equity section.  This is needed to maintain the accounting equation. 

Your borrowed funds are not part of the owner’s contribution. You have borrowed the money under your business’s name. Hence, it’s a liability you need to pay for at future dates based on the loan agreement. 

So, for the next step, you will add the loan amount under the liabilities section of the balance sheet. In this example, record $10,000 under liabilities to keep the accounting equation balanced.

What happens when you repay the loan?

Loan repayment is typically made up of two payment entries. The first would be for the loan principal. This directly reduces the loan amount under the liabilities section of the balance sheet.

The other part would be the payment for interest charges based on the loan terms. Interest charges or expenses do not directly affect the balance sheet. Expense accounts are under the income statement.  This income statement is another financial document showing the profit or loss summary of the business.

Time to Get a Business Loan

A business loan can help your company acquire equipment, raw materials, and more that will grow your operations. The moment you obtain a loan, your assets and liabilities sections should increase by the amount you borrowed to maintain balance in the accounting equation.

For more articles like this, check out the accounting and small business section of the site!