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.

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.