Debt and Equity

In one of business meetings I attended last week, we came to conclusion that for a high debt industry, it is fine to have low margins as what really matters is return of Equity. After meeting, I found out that it is not as straightforward as it looks, hence this post on my thoughts...

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For ease of understanding let me first define the terms. (not because I think I know more than you, but just to make sure that we are all at the same level of understanding. My knowledge is more from practice and not from books as much hence would like to be corrected if any of my definitions are faulty)

Equity - deployed capital by the investors who expect profits from the venture to be shared.
Debt - Loan taken for doing business. Debtor expects interest gains no matter how good or bad the business is doing.
RoE (Return on equity) - return on equity - profits made by business per $ invested in equity.
RoCe (Returrn on Capital employeed) - return on all the capital (equity + debt) deployeed.
Liability - all returnable/payable amount (Debt, interests, payments to be made etc...)
Profit Margin (margin) - profit per $ of revenue
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Lets take case of a business. A Business is a venture undertaken to improve value for every stakeholder. For Investors what really matters is returns he gets for every $ he invests int he venture. In other words it is nothing but RoE that investor is concerned about. In old times when banks, financial institutions, stock markets were far less active, one would invest his own cash to do a business expecting pure returns on the capital.

With time, theories came to have break even point of about 5 years. This has duel meaning. If you consider human life span of about 40 - 50 years of work time, I would like no investments going more than 10% of my life. An intelligent businessperson puts maximum of 20% of his wealth in any business and hence he expects 5 years of breakeven (5 year cycle of starting new venture every year)

with time, businessmen wanted to have as high RoE as possible with shorter and shorter time to break even. Firstly to see ways to increase your margins thereby increasing returns. another way is to look at increasing revenue itself. To increase revenue, one of the chosen path is to go debt way. If with $100 I have, I can make $100 or revenue, Can I raise debt of $100 on top to make revenue of $200? Lets look at the math -

Assuming I have 10% margins. Earlier I was making $10 with RoE of 10%. In the second scenario, I am making RoE of 20%!!! Sounds great!!! If I can fool my DEBTOR and raise $1000 in stead ($100 from me and $900 from DEBTOR), I make RoE of 100% :) Now as I have such huge gains possible, can I get into business giving less margin? Lets say even if I make 5% margin, my RoE if whooping 50%...

Too good to believe....

After doing little argument with self, I figured out an anomaly in this calculation. firstly, I did not consider all the liabilities while calculating. For instance, interests. Lets say I can raise money at 10% interest (which is the minimum in my area), What ever debt I raise, I end up paying all my excess profits only as interest and I am unnecessarily taking risks.

Lets talk about Risks. Risk is unexpected (+ve or -ve) outcome of any task, venture etc. When I talked about those the expected numbers in terms of revenue, margin etc. All were mere assumptions. these assumptions are mostly called estimates to make it sound more scientific. And in a business venture, many things can affect to change the assumptions. even if I am in a business as stable as healthcare, I may see a sudden drop in number of patients to have much lesser revenues or dip in profit margin. Even if the probability is low, there is a probability and when this happens, I have to pay the interest from my base profits...

Lets say, for some reason, I can only make revenue of $100 in stead of $200, Then my RoE is zero and if it were to fall below, I will have to accept erosion of my capital which will lead me to a downward spiral.

And that is exactly happened couple of years back. there were businesses which were making huge profits with over leverage. Showing the RoE and such indications, they raised more debt. All was good till the economy was growing. (Was is really growing?) But when all of a sudden the spending pattern of customers change, the first organizations to hit were the once who were over leveraged. And even those who were marginally leveraged had difficult time because of the downward spiral.

It was a double edged sword for low margin organizations as they could not even reduce price points as reduced margins at reduced revenue hit them from both sides...

For a healthy business I strongly believe to have 0 debt (max to 50% of equity). and high profit margins. and there is nothing like having cash (& cash equivalent) on your balance sheet by which you could afford to have -ve margin to stay in business or even take over your competitors who have working capital issues.

Cheers...