Classification of loans and borrowings: Overview, definition, and example
What is classification of loans and borrowings?
The classification of loans and borrowings refers to the categorization of a business’s or individual’s financial obligations based on factors such as purpose, duration, source, or terms of repayment. Loans and borrowings can typically be classified as short-term or long-term, secured or unsecured, and based on specific purposes like working capital, asset acquisition, or operational expenses.
For example, a short-term loan used to cover payroll might be classified as a working capital loan, while a mortgage for a property purchase would be classified as a long-term secured loan.
Why is classification of loans and borrowings important?
The classification of loans and borrowings is important because it helps businesses and lenders organize, track, and manage financial obligations effectively. For SMBs, proper classification provides clarity about repayment schedules, interest obligations, and the purpose of each loan, which aids in financial planning, risk management, and compliance with accounting or regulatory standards.
Accurate classification also helps stakeholders—such as investors, lenders, and auditors—understand the financial health of the business and evaluate its ability to meet its obligations.
Understanding classification of loans and borrowings through an example
Imagine an SMB takes out two loans: a $20,000 loan for equipment purchase and a $10,000 line of credit to cover short-term operational expenses. The $20,000 loan is classified as a long-term secured loan because it is tied to a repayment term of five years and secured by the equipment. The $10,000 line of credit is classified as a short-term borrowing because it is expected to be repaid within one year and is used for immediate working capital needs.
In another scenario, a real estate business borrows $500,000 to purchase property, classified as a mortgage loan, while simultaneously securing a $100,000 revolving credit facility for cash flow management, classified as a revolving borrowing.
An example of a classification of loans and borrowings clause
Here’s how a classification of loans and borrowings clause might appear in a financial agreement:
“The Borrower agrees to classify loans and borrowings as follows: (a) short-term borrowings, defined as obligations with repayment terms of less than 12 months; (b) long-term borrowings, defined as obligations with repayment terms exceeding 12 months; (c) secured loans, defined as borrowings backed by collateral; and (d) unsecured loans, defined as borrowings not backed by collateral. The Borrower shall maintain accurate records reflecting the classification and purpose of each borrowing in compliance with applicable accounting standards.”
Conclusion
The classification of loans and borrowings provides a structured approach to organizing and managing financial obligations, ensuring clarity for all parties involved. For SMBs, proper classification is essential for effective financial planning, risk management, and compliance with regulatory and accounting standards. A well-drafted classification clause in agreements or policies ensures transparency, accountability, and alignment between borrowers, lenders, and stakeholders.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.