Monday, September 02, 2019

Some Thoughts on Debt

Remember as an entrepreneur the music stops if you don’t have access to cash so in general, you must always ensure that you have cash on hand - whether that cash is equity or debt makes no difference - the only two areas that it makes a difference are in figures of IRR and in taxation. Taxation is real and IRR is virtual.

However the basic principle is for every business venture you have to measure ROCE - Return on Capital Employed - ROCE for startup businesses is essentially profits divided by the total capital required - debt + equity. In general, you must have ROCE very quickly - ie within 3-4 years touching 40-50% for a startup to be viable. Of course the trick here is that many startups will use very little capital and so 40-50% is no big deal so if you want to think big you have to look at trying to create a business which will have ROCE of 40-50% while using at least 1cr and then moving to 5cr and then going onwards to 30-40cr in capital. This is the first place where many entrepreneurs fumble - they are able to create ROCE of 40-50% but at a very small scale. Their abilities and management skill don’t allow them to imagine how to employ larger amounts of capital with sustained ROCE.

Now onto debt and why it is interesting. Debt is interesting as it is essentially someone’s else’s money and so if you have a high ROCE business you can expand your capital employed by using other people’s money and supercharge the return on your money. Let me give an example - if you had a business with ROCE 30%. Let’s assume the business was able to employ 3cr. If you put 1cr if your own money and borrowed 2cr at 15% per year - the business would turn 3cr into 0.9cr in profits and you would pay interest of 30L in interest on the 2cr and so you would have made 90L -30L = 60L on your 1cr in that year - a whopping 60% return on equity.

Note that if you could borrow at 10% per year your interest payable would be 20L and your return on 1cr would become 70L or 70%. If you could borrow at 5% you would make 80L on your 1cr.

So effectively for a business person, your aims have to be:-
1. Find businesses that have high ROCE
2. Design them to be where they can employ larger and larger amounts of capital as they scale and you are confident of the results.
3. Ensure you can borrow at the lowest possible rate so as to supercharge the return on your equity capital.

1 and 2 are an art in themselves and require luck and persistence in seeking opportunities. 3 let us analyze in some more detail:-

Kinds of debt:-
1. Secured against liquid capital. I would call this more of tax planning - the lowest I have been able to get is 1 month ago at 7.9%. I doubt if anyone can get a lower rate.
2. Mortgages - typically you can get 8.75% with a very strong credit rating.
3. Personal loan - 11%
4. Business loan - 11-14%
5. Real estate loans - 15-18%
6. Unorganized sector loans - 24%

What are low ROCE businesses:-
1. Real estate / hotels
2. Capital goods
3. Finance businesses

As such entrepreneurs who get into above businesses with debt - esp high-cost debt are dead in general unless they are very lucky. Even then they are enriching the bank. So in general taking on debt to deploy into such businesses is a bad idea. The only way in which the above businesses are viable is if you are into flipping the capital asset and you have a very strong thesis for why it will appreciate. Even then, you have to be able to flip fast or else the debt overhang in my opinion will kill you.

So bottom line:-
Whenever you design a business, do the math on what ROCE you expect.
Build reputation, credit worthiness, relationships where you are able to get debt at the cheapest possible interest rate.
Only take on debt if you are confident of high ROCE. Even then balance it with equity.
Be very conscious of time when debt meter is ticking.

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