Debt helps in business growth, but too much of it can also hurt the company. How to judge when it's good and when it's not?
03-Oct-2022 •Dhirendra Kumar
If you type the word 'neither' into a Google search box and wait for a moment for the autocomplete to kick in, one of the top suggestions is going to be 'Neither a borrower nor a lender be'. It's a famous line from Shakespeare's play 'Hamlet', which forms part of the advice given by a father to a son. Of the many pithy lines of poetry that Shakespeare wrote, this is among the ones that has become a widely recognised proverb, one whose essential truth no one argues against.
Of all the types of normal financial activities and transactions that form part of routine commerce, both personal and professional, debt is the only one that has historically been considered a moral failing, often as something that is a sin, one that destroys people and relationships. This underlying moral judgement about debt also carries on in our modern business and financial system.
Even though the modern economy's foundation is in debt, there is a moral judgement implicit in taking too much debt and not being able to repay it. The names are familiar - Indian tycoons who borrowed too much and could not repay it had their empires destroyed. Some had to run away from the country, while others had to swallow their pride and beg for help from family members with whom they did not get along.
Interestingly, unless some dishonesty is involved, the same moral judgement is not brought upon the head of those who destroy capital they have raised from shareholders. Look at these new-age digital businesses that have raised money from private and public investors and whose businesses are now floundering. They are criticised as incompetent business people or as overly ambitious ones, but it's not considered to be a shameful thing. Destroying equity is apparently fine, destroying borrowed money is a moral failing.
However, debt is actually a great convenience for the equity investor and the analyst. Surprised? Don't be. Read our cover story of 'Wealth Insight' October 2022 issue along with the accompanying analysis and data. You will realise that in the context of modern businesses, debt is an analyst's friend. Anyone trying to evaluate a company makes a nice indicator that tells you a lot of things about a company, its management and its future prospects. For the smart investor, debt-related numbers in a company's financial statements are like a stethoscope in the hands of a doctor, maybe even an MRI scan. They tell you a lot that would otherwise be hidden.
However, there's an important caveat. Debt-related analysis of stock can, at best, be a negative indicator. It can tell you whether a stock should be avoided. It cannot, by itself, tell you whether a stock is worthy of investing. This is fine, of course. It's something that will save you from losses, which is a stepping stone for profits.
For the cautious investor, the problem is that one can get carried away by the anti-debt rhetoric. The modern economy and most modern businesses cannot function without adequate debt. At a conceptual level, if everyone could only use the actual money that existed, then economic growth would be very slow, perhaps stagnant. The interest rates in an economy are now considered a major input to the economy - witness the global concern about rising US rates in recent days. To say that interest rates are central to growth is to really say that debt is central to the economy. Otherwise, why would interest rates matter?
The art of running a capital-intensive business is to walk the fine line on debt. Take neither too much nor too little, take at the right rates, at the right terms and at the right time. Judging all this is the hard part of investors' job, and what we at 'Wealth Insight' are doing is to help you get it right.
Suggested read: Why financial leverage is a double edget-sword
This editorial appeared in Wealth Insight October 2022 issue. To read the cover story and other insightful analyses, columns and articles