To capitalize upon the opportunities belonging to over the years the companies often fulfill funding requirements through long term debts from banks or financial institutions. These long-standing loans are repaid in yearly installments usually. Annual installments include principle repayments and interest payments both. For the purpose of financial accounting and matching interests over the period to that year revenues the segregation of interest and principle payments is necessary. Interest payment is charged as expense to the income statement and principle payment reduces the liability standing in the balance sheet each year.
This separation of principle and interest is not a simple job rather it requires understanding of loan covenant and financial management including time value of money. Amortization table is constructed to determine the annual installment and disintegration of the installment into principle and interest payments.
The step wise procedure for creation of amortization table is as follows:
• Determine the annual installment payment which is computed through dividing the total amount of loan by the present value interest factor of annuity calculated on the cost of capital.
• A year wise and column wise schedule of payments is constructed where first column shows no of years, second total installment, third loan/principle at the beginning of each year, fourth interest on loan, fifth principal repayment, and sixth loan/principal outstanding at the end of each of year.
• Interest is calculated by multiplying the cost of debt to the opening balance of loan/principal for each year.
• Principal repayment is determined by subtracting the interest payment calculated in step 3 from the total installment.
• Principal outstanding at the end of each year is determined by subtracting principal as calculated in step 4 from the opening balance of the loan each year.
• The above steps are repeated each year until the mutually agreed period of loan is exhausted.
A financial institution grants loan of $2,000,000 to an industrial unit at a cost of debt of 16% per annum. The lender requires the loan to be repaid in ten equal annual installments becoming due at the beginning of each year.
Work out the amortization table for the loan repayment.
Annual Installment = $2,000,000 / (PVIFAD) 16% , 10
Or through excel formula which is:
=PMT (0.16,10,2000000,0,1) = $356,726
An important use of amortization is in lease financing, mortgage loans, auto loans, consumer loans, and certain business loans. Periodic payment should not necessarily be annually it can monthly, quarterly, semiannually, or annually as per the loan indenture.