Debt: A powerful tool

January 19, 2013
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Debt, a source of capital

A key issue today with companies is to raise money. They need this money to run their operations or achieve higher growth or more profits. Now, debt is easily available to those who have assets which banks can value. Let’s say a startup needs capital to build new product. They can go to a VC for this but the funding process will take time. It is much easier to borrow this money. However, bank will not offer loan because they do not have any collateral or long credit history. This means that startup do not have assets which can be valued by banks to act as collateral and no history of loans.  So, they borrow from friends/family and repay once their product is sold. On the other hand, a hair oil manufacturer needs capital to set up new factory. They can easily borrow money because bank can issue debt against the assets such as land, machines etc. purchased by the manufacturer. Further banks know that hair oil business is going to grow. Do I need to explain this?

Interest rate vs borrowing period

A student asked me whether the interest on debt is linked with the borrowing period. I am interested in using a graph* here because a picture is worth 1000 words. In short answer is yes, the interest rate for long term is high and short term is less. We will discuss more on interest rate in next article.

 

*Graph is representative and may not represent current market conditions

Whenever bank lends money, it also checks if company can produce steady stream of revenues for long term. The risk is high that the company may not withstand vicissitudes of economy. For high risk, they demand higher return in the form of interest payments. This is why we see automobile manufacturer such as Ford (debt = $103.8 B**) can borrow money owing to their business type which continues to generate revenues in long term.

**You can read more about the level of debt on automobile manufacturers at following link:

http://www.fool.com/investing/general/2012/03/12/should-fords-debt-worry-you.aspx

Debt is cheap

It is the cheapest source of capital. Today if a company wants to issue new shares, shareholders require higher return. It is riskier to invest in a business which is not obliged to pay back. In a market where share prices are fluctuating, investor stands to lose their money. Instead, when they lend money, the borrower is obliged to pay back the amount with interest. Let me ask you a question. I borrow Rs. 100 from you and promise to pay back Rs. 110. Alternatively, I promise to pay back Rs. 50 or Rs. 150 depending on the company’s performance. In which case, you are more likely to lend money. Most of us will choose 1st case. In addition, debtors will be paid first when a company goes bankrupt. This further ensures the safety of their investment and lowers risk.  It should be noted that interest rate in developing countries is typically higher compared to developed countries. Hence debt is not so cheap in India.  

Debt has tax benefits

You must be thinking how debt is good. Now you will know why company raises debt even if they have capital with them. The reason is that the interest paid by the company is deducted from the income before tax is applied on it. In simple words, my profits are Rs. 100 before tax and interest. The interest expense in that year is Rs. 20 then the tax will be applied on the amount Rs. 100 – Rs. 20 = Rs. 80. If the tax rate is 30% then total tax paid is 30% x Rs. 80 = Rs. 24. If there was no interest expense, then tax paid is 30% x Rs. 100 = Rs. 30. The company saved Rs. 30 – Rs. 24 = Rs.6 in taxes by using debt. 

In next article, I will take up more examples to show why companies have varying interest rates and discuss performance of business with high debt.

 

 

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Devendra Mangani

Devendra Mangani

Devendra is working in curriculum development and assisting finance faculty at Sunstone. He has worked with RBC capital markets, an investment bank in Canada and global manufacturing organization in various roles.
He is a graduate from IIT Bombay and holds an MBA from Queen’s School of Business, Canada.

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Comments

  1. raveesh rai says:

    Can we relate it that banks are not judgemental enough to evaluate a business idea than a well growing industrial intake?When we can see that multiple organizations from varied industries including e-commerce,web structures have been pouring enough revenue and they have eventually been an idea itself?

  2. Banks are not judgemental about evaluating business idea. Its just that early stage startups do not fit their criteria for funding.   

    It is true that businesses in ecommerce and other technology startups have raised debt through banks. The prerequisite is steady source of revenues. Only few startups achieve the necessary scale to generate such revenues. Alternatively, there are various government schemes outlined at following link where startups can raise funds - http://www.venturecenter.co.in/funding/. Banks do provide funds to budding entrepreneurs. However, this is limited and they need collateral such as land, inventory etc. In absence of collateral, startups rely on VC route for funding. Essentially risk is high for startups because idea itself is not a guarantee for success. Initially, they can use incubators to build prototype and later, raise funds from traditional sources such as banks once product starts generating revenues. 

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