Principal

What it means

The principal is the amount borrowed or owed itself, without interest, fees or penalties. For a loan it is the sum the bank provided and that must be repaid. For an invoice receivable it is the amount invoiced, to which late payment interest and collection costs are added if payment is late.

Interest is charged on the outstanding principal. The faster the principal is repaid, the less interest the company pays in total. With annuity repayment the monthly instalment stays the same but its make-up changes: at first it is mostly interest, towards the end mostly principal.

The bank’s repayment schedule shows for each instalment how much goes to principal and how much to interest. That split matters for the books, because each part is treated differently.

How it works in practice

In the books, repaying principal reduces the liability to the bank and is not an expense. Only the interest is an expense and tax-deductible. When posting loan repayments it is therefore important to have the bank’s breakdown, or the whole instalment is easily expensed by mistake.

On the balance sheet the outstanding principal is split into long-term and short-term parts: the portion due within a year is a current liability. Banks and analysts look at this for liquidity, and on a new loan application they check how much principal falls due in the coming year, for instance through DSCR.

An extra repayment of principal reduces future interest. On fixed-rate loans, however, the bank may charge an early repayment fee. Before making one we recommend comparing the interest saved with the fee and with what else the company needs the money for.

What to watch out for

The most common mistake is expensing the whole loan repayment. Profit is then understated, the liability on the balance sheet overstated and income tax wrong. At an audit the difference is easy to spot by comparing with the bank’s confirmation.

With loans between a company and its shareholder or related companies, interest is often forgotten. A loan with no interest or unusual interest is assessed under transfer pricing rules, and principal with no contract or repayment plan may be challenged altogether.