What is the level of Sustainable Debt for my business?

SMEs should borrow loan amount just enough to meet the need of the business and it should be guided by the cash flow projected. It is the core of the sustainability.

Recently Reserve Bank of India came out with guidelines on S4A (Scheme for Sustainable Structuring of Stressed Assets). The scheme involves identifying an appropriate level of debt that can be sustained by the firm in distress and carving out the balance which unsustainable, as equity capital.  Though S4A is not applicable to SMEs, we would like to dwell upon the subject of sustainable debt level as excessive borrowing among the SMEs is becoming a serious problem in India and many of the long-standing businesses are nearing collapse or collapsed under the unsustainable debt load. Among large corporate also, we have seen the failure of many highly successful entities due to unsustainable debt despite having best professionals to advise and having survived for decades.

The obvious question is what is the sustainable level of Debt:

It is borrowing required amount of debt which can be serviced without any difficulties. In other words firm should generate enough surplus so that the debt can be serviced.

We intend to analyse the unsustainable borrowing by SMEs and its impact on their long-term solvency.

Examples of failure of the companies due to unsustainable debt:

First is a case of growing business. He is an entrepreneur who has built his business from scratch and became successful over 30 years. He had been toying with the idea of expanding the business by adding a new line with latest technologies. One day a banker approached him with a proposal to fund if he has any plan to expand or set up a new project. He agreed for taking the finance for the new project. Excited at the business proposition, everything was fast tracked. The borrower was amazed and also proud of his new identity because bankers approached him for business. It was totally opposite experience than thirty years back when he was struggling to raise a small loan.

As implementation progressed, many challenges cropped up and the project got delayed. Bank restructured the loan and sanctioned additional loan to complete the project. It was not enough. In order to support the new line, funds from existing business were also diverted and slowly its financial position started deteriorating. In the end, both the companies slipped into distress. Eventually, both the businesses came under legal action.

Another case is a matured business:

The promoter himself is very successful in his business and accumulated lot of properties. He went on diversification into unrelated areas without proper analysis. He funded those projects by diverting short-term loans raised from banks in the existing business.

As I mentioned, it was a matured business with stable sales and no growth. Since the business was not growing, there is no incremental cash flow. Neither any of the new ventures have. Arrears in the bank loans started accumulating. Although bank extended help through restructuring, it is of no help as cash generated is not enough to service the debt. That led to a severe liquidity crisis and forced the bank to initiate a recovery action.

What are common between them?

In both the cases, every cardinal principle of new project planning such as proper research on business potential, key success factors, identifying key risks etc are ignored.  There was no conscious strategy to arrive and firm up the right sustainable mix of debt and equity upfront. No attempt was made to ring fence existing core business from new ventures. Also, no proper attention was given to identify right candidates for different roles etc.

The debt level reached an unsustainable level and restructuring of the loan was of no help. New business was not in a position to earn enough to service the debt and significant amount of debt needed to be waived which is not possible under the present legal framework.

What are the differences between them?

First one is the case of flawed business strategy wherein the assumptions made before starting the project proved wrong and not enough analysis was carried out before starting the execution. Further, the promoters have not kept enough contingency fund to support any adverse development that may delay the project.

In the second case, it was a case of excessive leverage on the assets owned. Normally the promoters & bankers overlook the finer details of the project when there is good collateral to fall back upon. It is common among many asset heavy SMEs.  Secondly, the large spread between the cost of debt and expected growth in the value of assets is a key temptation to motivate larger borrowing by many entrepreneurs. Though in short terms it looks justifiable, in the long run, assets price movement is uncertain whereas debt accumulates due to the consistent addition of interest. Because the value of the assets goes up or down depends on local as well as macroeconomic factors.

Impact on the personal life due to unsustainable debt load:

Personal life and the family are the most affected by the pain in the business. The family had to suffer untold misery and loss of face in the public life. Many key employees had to leave. Had there been a proper financial planning and careful execution, things would have been better.

Normally in such circumstances, distressed entrepreneurs will become vulnerable to manipulation by deceitful advisors. Many were defrauded in the name of raising easier debt.

The final question is what is the yardstick to decide on sustainable debt? Is it based on the value of assets or cash flow from the business?

There is always temptation to leverage the property to raise the loan as it is hassle free and many banks & NBFCs are too wailing to consider the proposal. The time required to process the loan is very short. This naturally prompts many SMEs to go for a mortgage loan.

We suggest that in the long term interest of entrepreneur, it is not desirable to borrow loan based on the value of property. It is to be decided based on the cash flow. The entrepreneur should ensure that those assumptions that gone into building cash flow model remain realistic and conservative. The investment decision and size of loan should be derived thereafter. This will ensure long-term solvency of your company.

For those who are already into distress due to unsustainable debt, we advise that they may seek remedy under new Bankruptcy code which is going to be operationalised shortly.


The transition is always a serious challenge for SMEs. Expanding business is one of the many transition challenges. While opportunity tempts, risk discourages. To succeed in this, an entrepreneur should exercise control on the whole transaction starting with planning stage. One simple thumb rule- however attractive a new proposal is; if it cannot stand the test of scientific enquiry, it should not be pursued. Remember you are the one who suffers the agonising pain if your business fails tomorrow.

To supplement the above we suggest you visit the following links in www.smeadvsiors.in

  1. Transition- Managing Change in the journey of entrepreneurship for SMEs
  2. Risk Management Tool Kit for SMEs
  3. Financial planning
  4. Few considerations to keep in mind when your business has financing needs
  5. 10 Questions to Answer Before applying for Bank Loan
  6. Symptoms of Distress