Borrowing money is one of three ways that a company can generate cash, along with issuing stock and generating revenue. A company can borrow money to finance its expansion, to acquire assets or to pay existing obligations. Companies must be careful about borrowing money, particularly if the company is struggling to make sales. This may mean the company will have a difficult time paying outstanding debts and obligations.
When a company borrows money, it must pay the creditor interest on the principal according to the terms of the loan. For example, a company that borrows $5,000 may be required to pay 9 percent interest on the loan. This means the company will have to pay $450 in interest, assuming the loan will be repaid in 12 months. Borrowing money does not increase revenue, but it does increase a company’s interest expense.
A company can increase revenue from operating activities and non-operating activities. For instance, a company that manufactures car parts generates operating revenue by selling car parts. A company generates non-operating income when a gain is realized concerning an activity outside the scope of the company’s normal operating activities. For example, a manufacturing company that sells car parts may realize a gain as a result of selling stock. Expenses decrease a company’s revenue and appear on the income statement. The interest expense accumulated on a company’s loan will decrease a company’s revenue.
Borrowing money increases the amount in the company’s cash account. The extra cash allows the company to purchase equipment and other needed assets that can generate additional revenue. The company should have a plan regarding what to do with the cash acquired from the loan: determine if it will be better to pay off some of the company’s accounts and notes payable, or if the company will be better served by purchasing assets. A company must debit its cash account for the amount of the loan to indicate an increase in cash in the general journal.
Taking out a loan increases a company’s liability, which means the loan will show up on the company’s balance sheet. A liability places an obligation on a company’s resources. If the loan must be repaid within 12 months, the company must credit the accounts payable account for the amount of the loan. The credit amount will match the debit amount, since credits must always equal debits. If the loan will be paid in over 12 months, the company must credit the notes payable account, as opposed to accounts payable. This indicates that the loan is a long-term obligation.