Rich people use debt to leverage investments and grow cash flows. Poor people use debt to buy things that make rich people richer ~ Grant Cardone.
The world of finance is exceptionally dynamic and one of the most interpretative industries. Composed of numerous elements, policies, regulations, and structures, acquiring sound knowledge about the financial sector and its operations is vital. The primary task is to gain reasonable control and understanding of situations and conditions that help us analyse finance’s anatomy. More or less, the two words which are candies to finance are Debtors and Creditors. For any entity sustaining over a long period or any new entrant, it is essential to decipher the nitty-gritty of its financial position. Businesses make their Financing, Investment, and Dividend decisions to offer services, produce and manufacture goods, overcome competitors, and meet basic requirements. These three form the core practices of any firm, and having a clear strategy and optimal goal identification creates a smooth passage over a period.
Constructing a practical, feasible, optimal, and adequate capital structure is integral to the Financing decision. The firm must choose from various viable options to fund its operations and acquire assets. The primary funding sources: retained earnings (profits from day-to-day operations), debt capital (debt securities, corporate bonds, debentures, leases, and mortgages) and equity capital(issue of shares). Other sources of financing are private equity and venture capital, also known as crowdfunding or soft funding.
These financing methods have a considerable implication for a company’s Return on Investment (ROI) and Earnings Per Share (EPS) as their composition makes a huge difference in how the funds will be acquired into the business and their effect on the earnings of the company. The firm must have eyes for the details to understand the repayment structure. The interest paid on borrowings must always remain less than the Rate of Return to amplify the advantage of using debt as leverage. Liabilities and equities constitute the entire financial structure of the company. However, only long-term debt considers to evaluate the capital, as short-term debts are not present for an extended period. Capital structure describes the proportionate relationship between long-term debt and equity1.
Debt as a financial leverage
Advantages:
- The interest rate on debt is fixed irrespective of the company’s Rate of Return.
- The rate of preference dividend will be fixed, but these will be paid when the company is earning profits.
- The leverage employed by a company intends to earn more return on the “fixed charge funds” than the costs.
- The interest paid on taxes provides a shield to earn more revenue. The difference between the two plans (capital structure composed of different Debt to Equity ratios) equals the amount of tax saved.
- Under the presence of debt, the number of outstanding shares is less than the all-equity plan, which results in higher EPS.
Disadvantages:
- Financial leverage is only favourable when the Rate of Return on investment is higher than the rate of interest payable on the borrowings.
- Even as the firm buys more in the form of debt to reduce the tax burden, it is essential to cover the deficit when the rate of interest is higher than the Rate of Return on investment.
Example: Housing Development Finance Corporation (HDFC) stands at the third place on the list with a combined debt of Rs 2.79 lakh crore. HDFC is a financial services company having presence across multiple domains such as banking, insurance, asset management, realty and many more. HDFC was founded in 1977 and was the first mortgage company in India. In the last four years HDFC’s debt has increased by 28.7 per cent from Rs 2.17 lakh crore in FY15 to Rs 2.79 lakh crore till the end of FY19. HDFC had consolidated revenue of Rs 96,195 crore and a net profit of Rs 10,191 crore in FY19.
Conclusion: Debt is leverage to any firm, provided the interest rate is below the rate of return in the long run. It gives the firm an advantage over all equity-planned capital structures; in that case, they will not be geared toward tax savings. It is essential to comprehend-
- How to schedule investment projects with a proper mix of debt and equity?
- The financing effect on shareholders, returns on investment and valuation of the firm.
- They are using the funds to their optimum level.
Glossary:
- Equity- Paid up share capital + Share premium + Reserves and Surplus (retained earnings)
- Shareholder’s Equity- Shareholders’ equity is the owners’ claim on a company’s assets after settling debts. It is also known as share capital.
References:
Essay on Debt: Top 12 Essays on Debt | Public Finance | Economics (economicsdiscussion.net)
Sources of Funding – Overview, Types, and Examples (corporatefinanceinstitute.com)
