What Is Notes Payable: Everything You Need to Know [with Examples]

21 May, 2024
10 mins
Rachelle Fisher, AVP, Digital Transformation

Table of Content

Key Takeaways
Introduction
What Is Notes Payable?
What Are Different Types of Notes Payable?
Notes Payable Example 
How to Find Notes Payable on a Balance Sheet
Notes Payable Vs Accounts Payable: What's the Difference
How to Calculate Notes Payable
How HighRadius Can Help You Improve Your Business Financial Management?
FAQs

Key Takeaways

  • Notes payable are written agreements where a borrower promises to repay a lender a set amount with interest. Depending on the repayment timeline, it is recorded on the balance sheet as either a short-term or long-term liability.
  • There are four main types of notes payable: single-payment, amortized, negative amortization, and interest-only notes payable.
  • Notes payable involve written agreements with specific terms and are typically long-term liabilities. In contrast, APs are short-term debt obligations with less formal agreements and shorter payment terms.
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Introduction

If you are part of a finance or accounting team, you must have heard the term notes payable. You may be even aware of what they are. But do you know how notes payable differ from accounts payable and how to find them on a balance sheet?

Well, we’re here to remove any confusion or complications around notes payable. Once you know how they work, you can leverage notes payable to fund your short-term and long-term business needs, such as buying equipment, tools, vehicles, etc. 

To help you do that, we will cover everything about notes payable in this article. Let’s get to it.

What Is Notes Payable?

Notes payable are written promissory notes where a borrower agrees to repay a lender a specific amount of money over a predetermined period, typically with interest. They represent a liability for the borrower and are usually reflected in the long-term liability section.

However, they are recorded in the current liability section when they’re due within the next 12 months. 

Notes payable differ from accounts payable because they involve a formal written agreement with specific terms, including interest rates and maturity dates. In contrast, accounts payable are debts owed to suppliers for goods or services received.

What Are Different Types of Notes Payable?

There are four main types of notes payable. To help you understand your options, we’ll share the benefits of each, along with the drawbacks of using them.

Different Types of Notes Payable

  1. Single-payment notes payable: These notes require a single lump-sum payment at maturity of both the borrowed and interest amounts.

    Advantages:

    • Simplicity: Single-payment notes payable have a straightforward structure, with a single lump-sum payment due at the maturity date. This simplifies the repayment process for the borrower.
    • Predictable cash flow: With a single payment due at the end, the borrower can more easily plan and budget for the repayment, providing predictability in their cash flow management.

    Disadvantages:

    • Lump-sum repayment: The need to make a large, single payment at maturity can be challenging for the borrower, especially if they do not have sufficient funds available at that time. This can create potential cash flow issues.
    • Higher interest rates: Single-payment notes payable may carry higher interest rates compared to amortized notes, as the lender takes on more risk with a single, larger payment.
    • Carries refinancing risk: If the borrower is unable to pay the due amount at maturity, they may need to refinance the note, which can prove costly and difficult.
    • Lack of gradual repayment: Without the option for gradual, periodic payments, the borrower does not benefit from the gradual reduction of the principal balance over time, which can be the case with amortized notes payable.
  2. Amortized notes payable: These notes involve periodic payments covering principal and interest.

    Advantages:

    • Flexibility: This method lets borrowers pay off both the principal and interest over time, with more of each payment going toward the principal balance as time goes on. 
    • Structured: This repayment method helps borrowers manage their finances effectively, budget for regular payments, and build equity in the assets being financed.

    Disadvantage: 

    Higher interest cost: They can result in higher total interest costs over the life of the loan. As a result, borrowers may pay more in total interest than loans with different repayment structures.

  3. Negative amortization notes payable: These notes have payments that do not fully cover the interest, causing the principal balance to increase over time.

    Advantages:

    • Lower payments: This method offers lower initial monthly payments than traditional fixed-rate or adjustable-rate mortgages, making it beneficial for borrowers facing temporary financial constraints.
    • Tax benefits: Sometimes, leveraging this method can help save taxes as potential tax benefits are associated with deducting interest on these loans.

    Disadvantage: 

    Financial risk: This method has the potential for escalating debt. As unpaid interest accumulates and is added to the principal balance, borrowers end up owing more than they initially borrowed, leading to financial strain in the long run. 

  4. Interest-only notes payable: These notes require only interest payments, with the full principal due at maturity.

    Advantages:

    • Lower initial monthly payments: This method makes it easier for borrowers to make the payments as the borrower is only required to pay the interest, not the principal initially.
    • Flexibility in cash flow management: This method offers flexibility to the borrower in managing their finances and allocating funds towards other financial goals.
    • Potential tax benefits: This method can provide a possible tax advantage; sometimes, the interest paid may be tax deductible during the interest-only period.

    Disadvantages:

    • Higher interest rates: These loans typically come with higher interest rates as lenders consider them riskier due to the lack of principal reduction during the interest-only period.
    • Payment shock: Once the interest-only period ends, the monthly payments will increase significantly as the borrower starts paying both principal and interest. This can lead to payment shock, especially if the borrower has not prepared or budgeted for the higher payments.

Notes Payable Example 

Suppose a company wants to buy a vehicle & apply for a loan of $ 10,000 from a bank. The bank approves the loan & issues notes payable on its balance sheet; the company needs to show the loan as notes payable in its liability. Also, it must make a corresponding “vehicle” entry in the asset account.

When the company pays off the loan, the amount in its liability under “notes payable” will decrease. Simultaneously, the amount recorded for “vehicle” under the asset account will also decrease because of accounting for the asset’s depreciation over time.

How to Find Notes Payable on a Balance Sheet

Now that the above example has clarified that notes payable will reflect in your balance sheet’s liability section let’s look at the journal entry example of the same to make it even easier to understand. 

Also, it is crucial to remember that notes payable can reflect in “long-term liabilities” or “current liabilities” depending on when it’s getting matured – it will go in current liabilities if the loan is due within one year and in long-term liabilities if it’s set to mature after a year.

Continuing with the above example, let’s assume the loan company applied to buy that vehicle is from Bank of America. The promissory note is payable two years from the initial issue of the note, which is dated January 1, 2021, so the note would be due December 31, 2023. In addition, there is a 5% interest rate, payable quarterly.

For the first journal entry, you would debit your cash account with the loan amount of $10,000 since your cash increases once the loan has been received. You will also credit notes payable to record the loan.

Date

Account

Debit

Credit

1-1-2021

Cash in Bank

$10,000

1-1-2021

Notes Payable

$10,000

The interest on notes payable needs to be recorded separately. In our example, a 5% interest rate is paid quarterly to the bank.

The interest will be recorded in the interest payable account and will reflect in the current liabilities section as the interest is paid quarterly, which is considered short-term. The journal entry of the interest for the first year will look like this:

Date

Account

Debit

Credit

3-31-2021

Interest Expense

$125

Interest Payable

$125

6-30-2021

Interest Expense

$125

Interest Payable

$125

9-30-2021

Interest Expense

$125

Interest Payable

$125

12-31-2021

Interest Expense

$125

Interest Payable

$125

Interest expense will need to be entered and paid each quarter for the life of the note, which is two years.

In the end, you need to pay the principal amount of the promissory note; in this case, you will pay off the principal in December of 2023, which is indicated on the promissory note. The journal entry for it would look like this:

Date

Account

Debit

Credit

12-31-2023

Notes Payable

$10,000

12-31-2023

Cash in Bank

$10,000

Notes Payable Vs Accounts Payable: What's the Difference

Notes payable and accounts payable play an essential role in a business’s financial management. NP involve written agreements with specific terms and are typically long-term liabilities. In contrast, APs are short-term debt obligations with less formal agreements and shorter payment terms.

To understand the differences between notes payable and accounts payable, let’s delve deeper into this.

Aspect

Notes Payable

Accounts Payable

Definition

Written promises made by the borrower to the lender, stating a borrower’s payment obligation to the lender on a specified date.

Short-term debt obligations to suppliers and creditors that support normal business operations, representing money owed for goods or services received on credit.

Duration

Typically long-term liabilities, payable beyond 12 months, though many are paid within five years.

Always short-term liabilities, typically paid within a year, and appear on the balance sheet as current liabilities.

Structure

Involves formal written agreements with specific terms, including interest rates, payment schedules, and clauses for late payment or default.

Involves informal agreements with verbal understandings between the buyer and seller, often including specific due dates and late payment fees.

Impact on Working Capital

Can impact working capital, especially if they are short-term liabilities, which can be used to estimate current working capital.

Balances directly impact working capital and play a crucial role in cash flow management.

How to Calculate Notes Payable

To calculate notes payable, you need to consider the principal amount borrowed, the interest rate, and the period for which the note is issued. 

The formula to calculate the interest on a note payable is: Interest = Principal x Rate x Time 

Where: 

Principal is the amount borrowed 

Rate is the interest rate 

Time is the time period for which the note is issued

For example, if you borrow $10,000 at an interest rate of 8% for 5 years, the calculation would be: 

Interest = $10,000 x 0.08 x 5 = $4,000. 

Therefore, the total notes payable would be the principal amount borrowed plus the interest calculated. In this case, the notes payable would be $10,000 (principal) + $4,000 (interest) = $14,000.

How HighRadius Can Help You Improve Your Business Financial Management?

HighRadius offers an AP automation solution. By leveraging it, you can streamline invoice processing, vendor payments, and improve your AP workflows. Wondering how? Well, our automation software can help you diagnose problems in your AP workflow and provide insights into your payments with analytics tools. Also, AP automation can improve your payment accuracy by capturing invoice data at 99.5% accuracy.

We also offer solutions to automate your accounts receivable. By leveraging AR automation, you can reduce human intervention in generating invoices, sending payment reminders, and reconciling payments. 

In short, by automating both AP and AR, businesses can boost efficiency, minimize errors, and allocate more time for finance teams to engage in strategic initiatives. By streamlining workflows, automation enhances efficiency and accuracy, reducing the risk of errors associated with manual tasks. 

Real-time visibility into AR and AP activities allows for better control over cash flow and working capital while enabling proactive decision-making.

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FAQs

1). How do you calculate the present value of a note payable?

The formula to calculate the present value of a note payable is: PV = FV / (1 + i)^n

Where: 

PV = Present Value

FV = Future Value (the total amount of the note payable, including principal and interest)

i = Interest rate (expressed as a decimal)

n = Number of periods (e.g., years)

2). Is notes payable a liability or an asset?

Notes payable appear as liabilities on a balance sheet. They can be found in current liability when the balance is due within one year. They would be classified under long-term liabilities in the balance sheet if the note’s maturity is after a year.

3). Is notes payable recorded as a debit or credit entry?

Notes payable is a liability (debt). It represents the amount owed by the business to the lender. It is recorded by debiting the Notes Payable account and crediting the cash account, reflecting an increase in liabilities and a decrease in assets.

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