So the other day I was in a debate with 2 of my friends Anish & Baboo with them arguing Loan/Leverage is good, actually better for business and me patiently trying to explain that Debt is something a company should run away from as far as possible.
One of the major arguments they made is Debt is a 'win big if you are right' & 'lose nothing/minimum' if you are wrong, with Anish giving the analogy of many industrialists he knows personally & Baboo relying on the more than 900 Harvard Business Reviews he has read so far.
My argument was & is that the only way a business family can lose everything is if they have debt. A loss making venture seldom leads to ruins if there is no debt involved.
So Baboo wanted me to do a financial comparison for analyzing the Risk/Reward ratio to see what would happen in the scenarios where things go right & things go wrong.
So to do the test we first make some assumptions as following
1. Baboo has 30 lakh cash
2. Baboo has a land parcel of 1cr which he can either sell to raise equity or place as collateral to get a term loan for 5years @ 12.75%. (Though banks generally give loan upto 60% of collateral here I am considering that the bank gives loan upto 70% of the collateral)
3. On selling the land Baboo raises 1 Crore. Since we don't know the tax implications, we are not considering them, also given the fact the bulk of land transactions in India are not accounted, the tax implications we believe would be minimum so not considering them.
4. The income generated from the venture is just enough to repay the term loan & taxes. The personal expenses of Baboo are taken care of from other sources.
5. In case of venture being unprofitable the loss is to extent of interest being paid to the bank, with no principal repayments.
5. Income Tax is considered at a flat rate of 30%.
So now we do a comparative analysis of various scenarios both with debt and without debt. Basically we will see what happens 'at the end of 5 years - your venture is successful & you are able to repay and close your term loan' & 'at the end of 2 years-the venture is unsuccessful & you are forced to close your unit prematurely.'
3 Scenarios when the venture is successful.
Land is given as collateral to bank & Term loan is raised (Debt) - Venture Profitable:
Baboo raises debt of Rs. 70 Lakh, with land as collateral. Add that with the margin money Baboo already has of Rs. 30 Lakh, Baboo has just enough money to start his venture.
Here is the table of total loan repayment, interest paid & Taxes for 5 Years, by the end of which the total Loan is repaid.
So by the end of 5 Years the networth of Baboo would be Rs. 2 Crore. That's 1 Crore of investment in the debt free company & 1 Crore worth of Land.
Please note the Earnings considered are after depreciation in the company's assets & also the networth would be higher or lower depending on the appreciation or depreciation in the value of the land at the end of 5 years.
Land is sold to raise equity. Margin Money & Profits are Deposited @ 8% (No Debt) - Venture Profitable:
On selling the land Baboo raises 1 Crore. Now Baboo has 1.30 Crores (1 Crore from land & 30 lakh Cash). Baboo invests 1 Crore into the business and puts the 30Lakh away in a FD. Also the profits realised from the Business & Interest are ploughed back in to further more FD's. The interest on FD is calculated at 8% before taxes. Below is the tabulated scenario for the 5 Years.
So by the end of 5 Years the networth of Baboo would be Rs. 2.38 Crore. That's 1 Crore of investment in the debt free company & 1.38 Crore of FDs.
Land is sold to raise equity. Margin Money & Profits are Invested @ 20% (No Debt) - Venture Profitable:
Scenario 3 is same as Scenario 2 just that the Margin money and profits from the business are ploughed back into business for further expansion. Pls note in the above mentioned venture we believe the return to be in the range of 23.5% - 28% of capital before Interest & Taxes. If Baboo manages to find ways to invest incremental amounts of capital at a marginally lower return rate of 20%, this is how things will pan out.
So by the end of 5 Years the networth of Baboo would be almost Rs. 2.75 Crore. That's 1 Crore of investment in the debt free company added with 1.75 crores of further margin money & profits reinvested @ 20% returns.
2 Scenarios when the venture is unsuccesful
Land is given as collateral to bank & Term loan is raised (Debt) - Venture Unprofitable:
In the unfavorable scenario where the venture turns out to be a breakeven(including depreciation) but loss to the extent of interest to be payed to the bank. We will have the following scenario where at the end of 2 Years networth would be 1.12 Crores. Ofcourse the networth would be higher or lower depending on appreciation / depreciation of the land parcel.
In this case at the end of 2 Years you are either forced to close the business or sell your land & it doesnt take a genius to say that we dont make good decisions when forced.
Land is sold to raise equity. Margin Money is Deposited @ 8% (No Debt) - Venture UnProfitable:
In the unfavorable scenario where the venture turns out to be a breakeven(including depreciation) but there is no loss a there is no interest to be payed to the bank. We will have the following scenario where at the end of 2 Years networth would be 1.35 Crores.
Here you are not forced into selling your business, you can keep running it till you find a suitable buyer who is willing to give you the suitable price and offload it then.
So when we take debt the land value has to
1. appreciate by 23% in 2 years to match the returns in scenario 5.
2. appreciate by 38% in 5 years to match the returns in scenario 2.
3. appreciate by 75% in 5 years to match the returns in scenario 3.
Now I let Baboo to take his decision based on this analysis. Ofcourse there are a lot of permutations and combinations possible here in these calculations & there are many considerations in the above calculations which can change the results dramatically. The most primary of them being that things wont be as linear as projected here.
I personally, in the above scenario would not prefer going through the loan/debt route but actually preferring liquidating the land parcel and investing the proceeds into business. I know thats a easier thing to say but harder to do, selling a land has a lot of emotional trauma attached to it, but I would rather not let my rational decisions be controlled by my emotions. Then you would argue what are humans worth without their emotions, so I rest my case saying ' To each his own'.
There are a few conditions where I would consider having debt, here are the following
1. When the rental yield on land is above 6% - 8%. If the land parcel can generate rents in the range of 6% - 8% I would consider debt but provided my business stands on that land. I wouldn't keep a land disconnected with my business by leveraging my business.
2. There are strategic reasons to consider debt. Often government provides many subsidies likes TUFS, CLCS, etc... which can be availed only on having a bank loan. In such a scenario debt is favorable as the cost of debt goes down.
3. Strategic reasons to own the land - Sometimes the business needs the land bank for strategic reasons like further expansions or if the capital expenses on the land in the form of customised buildings/plants is too high that makes renting the land unfeasible for the business.
So debt may be taken for strategic reasons but taking EXPENSIVE debt when you have other assets that can be monetised, in my opinion is plain foolish.
I read somewhere that the Promoter of SUZLON Energy has a business philosphy which reads as, to do a business all you need is 'some soojh-boojh & lots of Loan'. That is where the company name SUZ-LON has been derived from. I don't know if thats true, but looks like the company has been run on that philosphy and its condition now is no news. So my philosphy is
Tread on the path of debt with extreme caution - its generally the path to ruins.