What Is Prepayment?

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Liabilities are legal obligations that entities must uphold. There are many kinds of financial commitments in business, and one of those is called the long-term liability. Paying these long-term liabilities in advance is what you refer to as prepayment.

What is prepayment?

However, before we discuss what prepayments are, it is important to understand what long-term liabilities are.

Long-term or non-current liabilities refer to a company’s financial obligations that do not require them to pay within the next twelve months. These are debts payable for more than a year or two or within an enterprise’s operating cycle, provided that it is longer than a year.

In accounting, the non-current liability account stays at the right side of the balance sheet next to the current ones. They are listed separately to have a clear view of the company’s current liquidity.

Organizations use their assets—funds and other valuable resources they own (tangible or intangible)—to settle all kinds of liabilities. However, firms pay their non-current obligations differently than current ones, where the use of liquid cash is advisable.

Here, they use net income, funds from new debt agreements, or future investment earnings to resolve it.

Understanding Long-Term Liabilities

Believe it or not, long-term debts are significant facets of a business. It is normal for companies to resort to non-current liabilities when they need a large upfront capital to finance company growth.

It allows expansion without the immediate sales obligation. Some examples include operational growth, infrastructure expansion, and branching out.

Companies, especially huge ones, prefer long-term liabilities than short ones because of their low interest, stability, and opportunity. It also allows them to get the time they need to bounce back from such large investments.

However, even cash-strapped enterprises fall prey to the seemingly harmless liability. Ensure that current assets are still way higher than liabilities. If not, then you will face a solvency crisis that can get you premium seats into a bankruptcy court.

One way to determine if you have too much long-term debt is through the debt to equity ratio. This measures how much debt a company has relative to its assets and net worth. It also provides perspective into an organization’s financial leverage and financing structure.

Examples Of Long-term Liabilities

Here are the most frequent non-current liabilities listed on a balance sheet.

  • Bonds Payable

In finance, a bond is an instrument that represents a debt agreement between the issuer and the holder.

Bonds payable pertain to a formal agreement between two parties to pay interest (usually semi-annually) and the maturity at a much later date (two or more years). Corporations, governments, and hospitals typically issue these kinds of loans.

  • Deferred Tax Responsibilities

These pertain to “underpaid” levies that will be accounted for in the future. It does not mean that the company neglected its tax obligations; it simply means that it will be paid in a different timetable. It is only reported as deferred to rectify the time difference.

  • Mortgage payable

This is a long-term financing loan due to a property owner. The principal amount due within 12 months of the business operating cycle must be reported under current liabilities. The principal amount remaining after that is reported as a non-current liability.

Why Prepayment? 

There are mainly two reasons why businesses would opt to prepay long-term liabilities. Even if financial responsibility is not due immediately, there are some benefits when you pay in advance. One of the biggest reasons is that opting to prepay long-term liabilities (e.g. loans) will result in discounts and/or diminished interest. For most businesses, lower interest rates could mean more profits, so prepaying is desirable for them. 

Another reason is that prepaying liabilities in advance could take a load off their backs. If they are earning high revenues, paying off debts and other loans in full could mean fewer problems to think about. It also opens up more opportunities for refinancing.

If you want to learn more about prepayments and how you can strategically utilize them in your business, reach out any time to the Annette & Co. team. We’d be more than happy to help! You can also follow us on any of our social media channels and subscribe to our YouTube channel.

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Annette Ferguson

Annette Ferguson

Owner of Annette & Co. - Chartered Accountants & Certifed Profit First Professionals. Helping Online service-based entrepreneurs find clarity in their numbers, increase wealth and have more money in their pockets.

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