Question

You are reviewing the most recent three years financial statements of a potential partner and notice that their loan balances and their interest expense is declining slowing over the three-year period. They have told you that they have had the same loans outstanding over the three-year period (no loans paid off and no new loans signed). What is the likely explanation for the decrease in loan balances and interest expense?

Their loans only require interest payments until maturity.

They have periodic payment (installment) notes.

They have only bonds with market interest rates declining.

They have lump sum payment (non-interest bearing) loans.

Answer 1

• The correct answer is Option #2 They have periodic payment (instalment) notes. This would have resulted in decrease in loan balances as well as decrease in Interest Expense.
• This is because when instalment payments are made, principal portion of loans outstanding also gets reduced or amortised.
• Installment amount paid = Principal portion + Interest Portion.
• Interest expense in the initial years or periods are MORE and as the principal gets paid with each instalment, the interest expense automatically decrease.