The very thought of debt has been considered a taboo for a while now. A finance classic “Debt: The First 5,000 Years” by David Graeber carries this quote: The criminalization of debt, then, was the criminalization of the very basis of human society.
Many investors believe this is the finest way to earn high investment returns. But in reality, zero debt companies although tend to book a higher profit margin are also likely to have a higher cost of financing.
Having a higher level of debt on books does not make the companies unworthy investments as long as the borrowed capital is used towards incremental Capex or entering new product segments because these can boast a high growth trajectory. L&T and Thermax, for instance, are high on borrowings, but boast strong fundamentals to navigate the slowdown.
Anything which leads to growth & expansion from the small amount of debt taken can actually work in the company’s favour. However, having a negative cash flow situation is not good but having a small level of debt can be good for the company.
Debt can also expand ROE for equity investors. By taking on debt, a company increases its assets, thanks to the cash that comes in. But since equity equals assets minus total debt, a company decreases its equity by increasing debt and when the Return on Investment (ROI) on capital is higher than the borrowing cost, this leverage works in favor of equity shareholders and Return on Equity expands.
In other words, when debt increases, equity shrinks, and since equity is the ROE’s denominator, ROE, in turn, gets a boost.
A further interest of debt also helps companies in saving taxes.
Good debt is a representation of an investment the company has made for the future of the business, ie that debt does not have an overall negative impact on the company’s financial situation, and it can be repaid.
Recently, Reliance made the announcement of raising $4 Billion via forex bonds of 40 years at an amazingly low price of 2.8% to 3.75%. They also have big plans in three future growth areas – gigafactories for Green Hydrogen (~ INR 75,000 cr), bidding for 5G spectrum, and omnichannel retail.
They plan to use these proceeds to pay off the existing debt, including a USD 1.5 billion loan that is due to mature in February.
Raising this bond will help the company to reduce the interest cost as the new loan will have a lower interest rate than the old one and increase profitability. This cost is significantly lower than the Banking MCLR rate which is currently 7%+ for Indian banks.
Does it make more sense for investors to stick to zero or low-debt stocks? Is it good to be debt-free? or is debt a good idea?
- Debt is good
- No to Debts.