What are notes payable? A quick business guide

In corporate finance, notes payable are formal agreements where one party borrows money and repays it over time, usually with interest. Understanding these commitments is crucial for maintaining a company’s financial health and operational capabilities. 

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This article will explain what notes payable are, how they affect financial statements, and how they differ from accounts payable and notes receivable. We’ll also explore common uses and their implications for a company’s financial success. 

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Let’s dive in.

What are notes payable?

A note is a financing agreement between two parties where one party loans money to another, and the other party repays it in installments over time.

How do they work?

The party who loans money is known as the “creditor” and the party receiving money is the “debtor”. Because the debtor has an obligation to repay the creditor, the debtor is said to have a note payable.

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A debtor might use the proceeds from a note to:

• Refinance debt
• Secure working capital
• Buy equipment or real estate
• Acquire businesses or other assets

Notes can either be short-term or long-term in nature. Short-term notes are due within one year, while long-term notes have repayment periods ranging from 1 year to 30 years or more. The repayment period (commonly called the “term”) depends on the loan’s purpose and the collateral securing it.‍

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For example, a working capital loan might have a repayment term of 18-24 months, while a real estate loan might have a term of 25 years or more.

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Repayment periods are outlined in the note’s credit agreement, which is a legal contract that governs the relationship between the debtor and the creditor. Credit agreements also specify the loan’s interest rate, payment frequency, late payment penalties, fees, covenants, and the lender’s specific rights if the borrower can’t pay.

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Notes which are secured by collateral are known as “secured debt”, while notes which are not secured by collateral are known as “unsecured debt”.

What information do they include?

Here are the main components of a note payable:

• Principal Amount: The original sum of money borrowed, which the borrower agrees to repay.
• Interest Rate: The percentage charged on the principal amount, representing the cost of borrowing.
• Repayment Schedule: The timeline for repaying the principal and interest, often broken down into monthly, quarterly, or annual payments.
• Maturity Date: The specific date by which the entire note must be fully repaid.
• Parties Involved: The borrower (who issues the note) and the lender (who receives the note), including their legal names and addresses.
• Promissory Note: A formal document that outlines the terms of the note payable, including the principal, interest rate, repayment schedule, and maturity date.
• Collateral (if applicable): Any assets pledged by the borrower to secure the note, which the lender can claim if the borrower defaults.
• Penalties and Fees: Any additional charges that may apply if the borrower fails to meet the repayment terms, such as late fees or penalties for early repayment.
• Legal Jurisdiction: The legal framework or jurisdiction under which the note is governed, specifying which laws apply in case of disputes.
• Signatures: The signatures of both parties, indicating their agreement to the terms outlined in the note.

Where do notes payable appear on financial statements?

Notes payable are recorded as long-term liabilities on a company’s balance sheet because they represent debts with repayment periods that extend beyond the next 12 months. 

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On a balance sheet, you might also see notes payable referred to as “long-term debt”, “promissory notes”, or just simply “loans”.

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When you come across notes payable on a balance sheet, you’ll also probably find the following entries on its financial statements:

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• Current Portion of Debt (CPLTD): this entry represents the loan principal payable in the coming 12 months. CPTLD is reported under current liabilities on the company’s balance sheet.
• Interest Expense: this entry represents the cost of borrowing debt for the selected reporting period. Interest expense appears on the income statement.
• Fixed Assets: this entry represents the company’s tangible long-term assets which are detailed on the balance sheet. Some examples of fixed assets include real estate, equipment, and vehicles. Intangible assets, such as goodwill, are typically shown separately.

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Large private and public companies also publish debt schedules, which provide detail on a company’s indebtedness. Debt schedules typically contain names of lenders, the current balance of each note, respective interest rates, the collateral securing each note, and so on.

How do notes payable differ from accounts payable?

Notes payable and accounts payable are both liabilities on a company’s balance sheet, but they differ significantly in their nature and terms.

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Accounts payable represent short-term obligations to pay for goods or services received during the ordinary course of business. Accounts payable are commonly used by capital-intensive businesses (like manufacturers and retailers) that regularly work with suppliers.

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Unlike notes payable, accounts payable don’t typically involve an upfront exchange of capital. Instead, the seller extends credit to the buyer, which allows the buyer to pay at a later date without incurring interest or penalties.‍

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Accounts payable are typically settled according to “net terms” which specify the length of time a buyer has to pay for goods or services received. For example, “net 30” means that a buyer must pay the full balance within 30 days of receipt. Once payment is made, the liability is satisfied and the account is cleared.

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While accounts payable are not typically governed by credit agreements, the supplier may impose late fees or stop providing goods or services if the buyer fails to pay on time.

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Regarding accounting treatment, accounts payable appear as current liabilities on the balance sheet as they are typically short-term in nature. Other common names for accounts payable include “trade payables” or “vendor payables”.

How do notes payable differ from notes receivable?

While notes payable represent a debtor’s obligation to repay borrowed capital, a note receivable represents a creditor’s right to receive payment for capital lent. 

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As previously discussed, the terms of repayment are outlined within a credit agreement between the two parties.

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Notes receivable can be short-term or long-term in nature and are recorded on the balance sheet. If a note is collectible in full within 12 months, you’ll find it classified as a current asset. If a note is collectible over a period longer than 12 months, it’s a non-current asset.

Notes payable examples

Example 1: Short-Term Business Loan

• Scenario: A small business needs $10,000 to purchase new equipment. The business owner approaches a local bank for a loan.
• Note Payable: The bank agrees to lend the $10,000 with an interest rate of 5% over one year. The business owner signs a promissory note outlining the terms, including monthly payments of principal and interest.
• Illustration: Over the next year, the business makes monthly payments to the bank according to the terms of the note. This loan is recorded as a note payable on the business’s balance sheet. Each payment reduces the principal owed, and interest is recognized as an expense.

Example 2: Long-Term Equipment Financing

• Scenario: A manufacturing company wants to purchase a new machine worth $100,000. The company decides to finance the purchase through a supplier.
• Note Payable: The supplier offers financing at an interest rate of 6% over five years. The company signs a note payable agreeing to make annual payments, including interest, until the debt is fully repaid.
• Illustration: The company records the $100,000 as a note payable on its balance sheet. Each year, as the company makes payments, it reduces the note payable and records the interest expense. This helps the company acquire the necessary equipment without depleting its cash reserves immediately.

Managing notes payable commitments

Whether you’re a financial analyst or a manager, understanding notes payable is crucial in effective financial management and strategic planning.‍

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Effectively managing these commitments is essential in maintaining a business’s financial health and supporting its long-term objectives:

• Review Repayment Terms Carefully: Ensure you fully understand the repayment schedule, interest rates, and any potential penalties associated with your notes payable.
• Monitor Your Cash Flow: Regularly assess your cash flow to ensure you have sufficient funds to meet your note obligations without straining other areas of your business.
• Keep Communication Open: Maintain clear and consistent communication with your lenders. This can be crucial if you need to renegotiate terms or discuss payment extensions.
• Differentiate from Accounts Payable: Recognize that notes payable are more formal and carry legal obligations that differ from accounts payable. Treat them with the appropriate level of attention and priority.
• Track Due Dates and Amounts: Use financial management tools to track when payments are due and the exact amounts owed. This helps avoid missed payments and keeps your credit in good standing.‍
• Plan for Future Obligations: Anticipate the financial impact of upcoming note payments in your strategic planning to avoid surprises and ensure long-term stability.

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