You have several debts and 30 mln soum of spare cash: which debt is it better to repay first?
"Bahmal Tikuv" LLC has three short-term debts, all with monthly interest. After the seasonal receipts, 30 mln soum is left over. We calculated how much the interest expense over 6 months differs if the money goes to the most expensive debt, the largest, the smallest, or is split among all of them. Receiving and repaying a loan, and accruing and paying interest, follow the NAS No. 21 table rows.
"Bahmal Tikuv" LLC sews shirts and work clothes. After the seasonal orders were paid, the director, Xurshid aka, saw 30 000 000 soum more than planned in the settlement account. The company has three short-term debts, and the first thought was: "Let's put the extra money on the largest debt." The accountant stopped him and asked to calculate first. The question is precise: if spare money is given to one of several debts, which one cuts the interest expense the most?
The example below was composed by the author: the company, the lenders and the rates are hypothetical. The aim is not to teach rates but to show the method of calculation.
The terms of the three debts
All debts are shorter than 12 months, interest is accrued each month on the outstanding balance, and the principal is repaid in equal parts over 6 months. The spare money is used now, at the beginning of the first month. The schedule of monthly payments does not change: that is, if more is paid on one debt, that debt is closed earlier.
| Debt | Who lent | Balance, soum | Monthly interest | Monthly principal payment, soum |
|---|---|---|---|---|
| A | Bank (loan) | 60 000 000 | 1.5% | 10 000 000 |
| B | Partner firm (borrowing) | 24 000 000 | 1.0% | 4 000 000 |
| C | Bank (loan) | 42 000 000 | 2.2% | 7 000 000 |
Here A and C are bank loans, so they are kept in account 6810, while B was received from a lender other than a bank and is kept in account 6820 (NAS No. 21, paragraphs 292 and 293).
Five decisions: how much does the interest expense differ?
We used the same 30 000 000 soum in five ways and calculated 6 months of interest. The "We give it to none" option is the baseline for comparison.
| Method | Interest on A | Interest on B | Interest on C | Total interest over 6 months | Savings |
|---|---|---|---|---|---|
| We give it to none | 3 150 000 | 840 000 | 3 234 000 | 7 224 000 | 0 |
| All to C (highest rate) | 3 150 000 | 840 000 | 374 000 | 4 364 000 | 2 860 000 |
| Split in proportion to the debt balances | 1 928 571 | 514 286 | 1 980 000 | 4 422 857 | 2 801 143 |
| All to A (largest balance) | 900 000 | 840 000 | 3 234 000 | 4 974 000 | 2 250 000 |
| Close B in full, the rest to C (smallest balance first) | 3 150 000 | 0 | 2 442 000 | 5 592 000 | 1 632 000 |
The result is striking in two respects. First, neither repaying the largest debt A nor closing the smallest one to "reduce the number of debts" gave the best outcome. Second, the best method matched a simple rule: the money went to the debt with the highest rate.
Why does exactly the highest rate win?
Every soum paid on a debt stops interest from being accrued on that debt in the following months. The saving depends on that debt's monthly rate and on the number of months it stays on the books. In the example all three debts have the same term (6 months), so the rate decided the difference: on C, 1 soum saves 2.2 tiyin a month, on A 1.5 tiyin, on B 1.0 tiyin.
The size of the debt is secondary here, because the amount of interest is found by multiplying the balance by the rate. A large balance gives a large amount of interest, but every soum paid saves at the level of the rate. That is why giving 30 mln soum to A (savings of 2 250 000) yields 610 000 soum less benefit than giving it to C (2 860 000).
When does this rule stop working?
The rule is simplest when the terms are the same. In practice there are situations that change it:
- If the terms differ. The future saving depends on the rate together with how many more months the debt will stay on the books. A debt with a high rate that ends in two months may save less than a debt with a lower rate that stays for a year. In that case calculate each debt separately.
- If a fee is charged for early repayment. Such a condition is written in the loan agreement, so read the agreement first. In the example the advantage of C is 2 860 000 − 2 250 000 = 610 000 soum. So if the early repayment fee on C exceeds 610 000 / 30 000 000 ≈ 2.03 percent of 30 000 000 soum, giving the money to A becomes cheaper (assuming A has no fee). This number is hypothetical and only shows the comparison method.
- Collateral and additional conditions. Sometimes closing a small debt releases pledged property or changes other conditions with the bank. This does not show up in the interest, but it can affect the decision.
- Cash reserve. If you send all the extra money and nothing is left for next month's wages or a supplier payment, the interest saving turns into a different problem. First prepare a cash flow forecast.
How does this look in the accounts?
Xurshid aka used 30 000 000 soum for a partial repayment of loan C. The entries for the first month (NAS No. 21 rows are shown):
| Transaction | Dt | Ct | Amount, soum | NAS No. 21 |
|---|---|---|---|---|
| Part of bank loan C repaid | 6810 | 5110 | 30 000 000 | paragraph 296, row 4 |
| Month 1 interest accrued (A 900 000 + B 240 000 + C 264 000) | 9610 | 6920 | 1 404 000 | paragraph 309, row 4 |
| Accrued interest paid | 6920 | 5110 | 1 404 000 | paragraph 309, row 5; paragraph 226, row 24 |
| Monthly principal payment: A 10 000 000 and C 7 000 000 (bank loans) | 6810 | 5110 | 17 000 000 | paragraph 296, row 4 |
| Monthly principal payment: B (partner borrowing) | 6820 | 5110 | 4 000 000 | paragraph 296, row 4 |
In calculating the interest on C, the balance was taken as 12 000 000 soum (42 000 000 − 30 000 000), so 12 000 000 × 2.2% = 264 000 soum. Analytical records for 6810 are kept by each loan, bank, amount and term, and for 6820 by lender and repayment date (paragraphs 292 and 293). So keep A and C under one account, but on separate cards.
Practical advice
- First make a list. For each debt: balance, monthly rate, remaining months, early repayment conditions, collateral. Only then make the decision.
- Compare rates on the same scale. If one is given per month and another per year, bring both to one unit. If there is a fee, take it into account too: more on that in the article "Loan fee...".
- Show the decision in a table. To a director, "let's close the largest debt" seems natural. A table with the 610 000 soum difference makes the decision convincing.
- Do not send all the money. Leave a reserve for at least the next payment period; a 13-week cash flow forecast is needed for this.
- Check the result against the accounting policy and the agreements. The procedure for recording an early repayment fee as an expense is not covered in this article: set it in the accounting policy.
Test yourself
5 questions on this topic: pick an option or reveal the answer.
The annual net profit of a joint-stock company was 90 mln soum, of which 36 mln soum was allocated to dividends (hypothetical example). What is the dividend payout ratio (dividends / net profit × 100%) and what does it mean?
A joint-stock company's annual net profit is 90 mln soum, of which 10 mln soum is directed to dividends on preferred shares. The weighted average number of ordinary shares outstanding during the year is 40 000. What are the earnings per ordinary share (EPS = (net profit − preferred dividends) / number of ordinary shares)?
A furniture factory's capital: equity of 60 mln soum (required rate of return 20%) and debt of 40 mln soum (rate 15%). Ignoring the tax effect, what is the weighted average cost of capital (WACC)?
An investor spread spare money not over one company's shares but over the shares and bonds of several companies in different industries (diversification). What is the main purpose of this approach?
A company's total liabilities are 400 mln soums and its equity is 500 mln soums. What is the debt-to-equity ratio (liabilities / equity)?
Answered: 0 / 50 of 5 correct
All tests →See also
- Finance section
- How are a short-term bank loan and its interest recorded?
- How much does a one-off fee increase the real cost of a loan?
- A 13-week cash forecast: how can you see in advance when the money in the bank account will run out?
- Interest rate
- Short-term bank loan
- Short-term borrowing
- Accrued interest
- 6810 Short-term bank loans
Sources
- NAS No. 21 "Chart of Accounts and Instructions for Its Application for Business Entities": paragraphs 291, 292, 293 and 296 · accounts 6810 "Short-term bank loans" and 6820 "Short-term borrowings"; table in paragraph 296, rows 1 and 4: receiving a borrowing (Dt 5110 — Ct 6810–6820) and repaying it (Dt 6810–6820 — Ct 5110)
- NAS No. 21: paragraph 309, rows 4 and 5; paragraph 423 · accruing interest on borrowings (Dt 9610 — Ct 6920) and paying the accrued interest (Dt 6920 — Ct 5110)
- NAS No. 21: paragraph 226, row 24 · settling the debt for accrued interest from the settlement account (Dt 6920 — Ct 5110)
- Example: company name, debts, interest rates and amounts · prepared by the author, hypothetical; calculations checked by the author