What is the appropriate level of borrowing for my enterprise?- A lingering question for many SMEs in India

Prudent borrowing is as important as growing business for SMEs. Uncontrolled borrowing without reference to income generation may slowly eat into liquidity and eventually stress the business beyond revival.

Recently I had a chance to interact with one entrepreneur in services sector who have successfully built his business from scratch and made to scale the height of Rs 60 crores turnover.  Though the growth and profitability were good, he was restless and looking for raising fresh debt to meet the working capital. He needed increasing working capital as more ordered starting flowing in. He was complaining about brokers who have taken his file and not reverted. He requested me to look at his financials.

When I started analysing the financials, I was taken aback at the level of debt and diversity of sources. Almost all the leading NBFCs have extended the various types of loans against various different collateral securities. The total debt is nearly half of the turnover. The level of interest servicing of loan is more than half of EBITDA margin.

Another aspect is most of these debts are mortgages not related to book-debts or stocks.  Apparently, t is clear that he is facing severe liquidity stress and finding difficult to meet the trade creditors’ demand as most of the liquid cash is consumed by payment of EMI for which he had already extended mandate. Delay is raising fresh debt is causing discomfort to him. His credit rating is the first casualty of excessive borrowing which impedes further debt rising.

Diagnosis of the situation:

When I took a comprehensive view of debt position including the borrowing of self along with business, it was observed a significant portion had been diverted to buying real estate. It is fact that value of the property is on the upward trend for nearly one decade in India. This is fuelling frequent revision of value of collateral and tempting to raise more funds.  Many entrepreneurs are leveraging their net worth to raise funds to buy properties which are leading to more debts on the books.

Secondly, the borrowing is more linked to the value of collaterals than business income. Many entrepreneurs are resorting to borrowing to spend elsewhere without reference to their income. Increasing debt without incremental income will eat into liquidity and if unabated may threaten the sustainability of business.

Thirdly he has not taken a comprehensive view of debt profile rather focussing on firefighting and raising new debt to beat the stress. The decision to borrow is made without analysing the cash flow position of the firm. Many a time the decisions are not based on rational grounds and look like emotional exuberance.

Fourthly excessive borrowing and concomitant financial mismanagement are causing unintentional damage to credit rating. The borrowing without reference to improving cash flow hurt the risk rating of the entrepreneurs. It is a fact that borrowing will increase the capacity to do more business. In the instant case, the borrowing has not directly contributed to the growth of business, rather the credit rating built over the years has been leveraged to raise the funds to invest elsewhere and eventually contributed to declining in credit rating. It is a fact that the rating of an entrepreneur is not static, it changes with time and business circumstances.

Fifthly tax benefit of Debt: One of the key arguments for preferring debt is the availability of tax breaks compared to equity funding.  However one should not forget that debt is advantageous during the boom period in the economy and/or the sector; whereas in the period of downturn, the high debt can threaten the very existence of the firm.

Lastly treating new loan sanction as a vindication of creditworthiness. People who have borrowed from institutional sources are considered creditworthy. Sometimes it may prompt many entrepreneurs to not to refuse the offer of loans from different sources. Such loans which are not meant to improve the business normally find a way to speculative investment. However, repayment is expected from existing business. This sort of situation unnecessarily drags the business into distress.

Please read: Symptoms of distress

New Trend emerging in financial services- A major cause  of aggressive borrowing:

When we tried to understand the reasons for an aggressive build up of liabilities in the books of business we observe that market dynamics have changed in favour of borrowers than lenders. We observe that following trends have reshaped the market for borrowing:

Too many lenders: There is a sudden surge of lenders in the form of new private banks, NBFCs, Coop Banks etc. In addition, many old generations banks otherwise doing a conservative lending also have changed their strategy and have become very aggressive. New technologies and default estimation tools have helped the lenders to refine their lending strategy.

Direct Selling Agents(DSAs): Presence of new cult of agents in the form of DSA has realigned the credit marketing strategy. The market dynamics further shifted to empower borrowers as DSAs have an inherent capability to assist the borrower in securing the best deal in terms of amount & flexible terms in a quick manner.

Relaxed lending norms: Many banks have relaxed the lending norms to accommodate the borrowers’ request fearing migration of customers. Till recently Bankers had been frugal in the assessment of borrowing capacity and by & large it used to be linked to income generation than the value of the collateral. Nowadays, this element is being emphasised lesser and lesser resulting in higher borrowing.

Diverse products: Innovations have been the hallmark of the credit market in recent years due to legal reforms, technologies and a better understanding of Client’s business. Further competition is driving lenders to innovate the products much faster than ever. These innovations are opening up new opportunities to borrow without reference to the comprehensive view of the financial situation.

Contra view- Can we choose to remain extremely cautious? 

So for we have discussed that an aggressive financial strategy often renders a company less capable of responding vigorously to market conditions. The question is whether the extremely frugal financial strategy is sensible.

Entrepreneurs fearful of incurring liquidity constraints or of violating debt covenants will usually trim strategic expenditures, be unaggressive in exploiting market & investment opportunities, and base operating policies on the lower end of potential sales opportunity. At the same time, competitors are more likely to mount an attack on its market share and the firm may be dislodged in the competition. It implies that an extremely cautious financial strategy has unintended consequences.

Means to keep watch on the financial strategy to ensure it remains prudent:  

Many have suggested that entrepreneurs should be mindful of change in Debt: Equity Ratio, a simple tool. However, it is static and can be used to analyse the situation at a point of time.

We suggest that SMEs should build a comprehensive financial plan and keep watch on the impact of new borrowings on cash flow and financial leverage.  It must take into account the borrowing at personal as the business and personal life inseparable for entrepreneurs.

Such comprehensive approach helps an entrepreneur to resist excessive borrowing.

Conclusion:

In the today’s context, wherein the general economy is experiencing volatility due to global challenges and looming protectionism, the firms need to protect the financial flexibility by keeping enough headroom to borrow in times of dire need.

This flexibility is important as a defence against financial distress. If not, liquidity constraints can lead to altered operating and product-market strategies. If persist, creditors may resort to newly enacted Bankruptcy code (IBC 2016) and thereby precipitate the matter.

However, for most companies, the implicit costs of financial distress brought on by too much debt—lost opportunities, vulnerability to competition, suboptimal operating level, attrition of key employees and inaccessibility to debt —loom larger than the threat of bankruptcy.