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Building Reserves v/s Debt Reduction – A Choice Worth Examining Date: August 27, 2016

This post has been contributed by Subhashini Attalani with editorial assistance from Team Fintuned.

Before you begin reading this article, let me tell you that this is not one of those traditional personal money management article(s) that you have been consuming. Yet, this article will afford you some amazing insights that will not only help you manage your money smarter but be super helpful when you make the decision about a crucial aspect regarding your business and that’s the debt appearing in your books.

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Thomas Fuller once remarked, “Debt is the worst poverty.” And, don’t we strive to minimize/end poverty? But should we always try minimizing debt when we have extra cash? That is an interesting question to address and let us try doing that in this post.

There can be two of ways of looking at this. One is the well-defined objective way and the other is the subjective way. The objective way is pretty easy to understand – the interest on your debt is tax deductible and if the return generated from reinvestment of funds is greater than the post tax cost of debt, then you should certainly choose to reinvest. This is commonly termed as arbitrage. Wasn’t that simple?

However, the subjective response to this question is the more interesting aspect in my view. Here are my observations on the subjective perspective of thinking about this:

  • Do the retro check

In earlier days, the mode of doing business was much more conservative and business owners would try to abide by the ideal debt: equity mix and maintain high debt/liquidity coverage ratios. Considering that times are changing and so are the ways of operating a business, one should definitely run an assessment on the leverage levels of the entity. Since the ideal debt equity ratio would vary for different business types, there would be a visible difference in parameters for an infrastructure company as compared to a trading house. Therefore, the best way to run a check would be a comparison to other players in your industry. The leverage for your business should be closer to the best players in your industry. In addition, one should also use the different debt ratios (a full series done by Investopedia can be found here) to understand the propensity of debt in the business and plan accordingly.

  • Do the Pro check

Even though you work for the best but be prepared for the worst. So before you decide to utilize the kitty in your hand do not forget to run a shock absorption check for your business. This is to say that in case the business does not do as well as planned, what is the cushion available to you to cover yourself through the downturn? The easiest way to do that is to sensitize your budget for the next year in terms of any one parameter keeping others constant, i.e. sensitize either the projected profit margin or the projected sales growth. The check run should give you a view on if the business is indeed ending up in a cash crunch, and at what interest rate is the crunch being funded (Well, our good friends at Investopedia have also defined how to do a sensitivity analysis and here you go with that link)

  • Why re-pay when you can re-fin

The actual cost of debt is the rate at which you borrow today and not the ongoing rate of your debt. If your business is generating surplus cash then one of the good ideas is to attempt and lower your finance cost is by refinancing your existing debt at a cost that is about 40-50 bps lower than your ongoing rate of interest. The pool of surplus which you build will add strength to your balance sheet and make your business attractive to debt investors.

  • Diversify your revenue source

By making a conscious choice to reinvest rather than pre-pay, you are diversifying your income sources. Imagine the vast number of companies that are thriving only on the mode of financial investments.

  • Be the boss – choose your terms

To one’s surprise you will get debt at your own terms and best rates when you don’t quite need it. Always remember, borrow money when you do not need it because your cost of borrowing can definitely bring a cheer to the business.  Meanwhile, you can use your earnings to build your treasury chest.

All said and done the biggest factor would be the risk appetite of the promoter. In personal finance management as well, our portfolio boils down to our risk appetite and it would not be wrong to say that there is no one clear way of dealing with risk. I believe these points will help though!

Cheers

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy of any agency, organization, employer, or any company. Fintuned Co. LLP shall not be held responsible in any manner whatsover, for any decision/action taken by readers on the basis of the content mentioned in the article. Readers are requested to exercise their best judgement before taking any decision/action. Fintuned Co. LLP shall also not be held responsible for any copyright infringement committed by the author in the process of writing and/or publishing this article and in the event any such offence is found, cooperate with necessary authorities to take remedial action

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