Healthy business makes all the difference between equity and debt

Healthy cash flow ensures that the business can cover its expenses and invest in growth. Dividend history can give a fair idea regarding a company’s cash flow

“‘Debt’ Ho Ya ‘Equity’, Laabh Kaa Srot Ek Hi Nishchit Hai;

Udyog Lagaataar Ghaate Me Hai, Dono Nivesh Asurakshit Hai”

Translation: ‘Be it ‘Debt’ or ‘Equity’, the source of return is definite and same;

If the enterprise is in continuous loss, both investments are lame.’

Let’s imagine a village with a well that provides water to all locals. Depending on various factors, a varying amount of water is pulled out daily and distributed equally amongst the villagers, who have contributed to digging the well. By this arrangement, each contributor on average gets 15-20 litres of water every day. However, the fact is that there is no uniformity in the daily output of water. Many times, it does not produce at all, while on a few occasions it produces little water that is insufficient to meet the needs of the villagers.

There were situations when contributors had to pour water into the well.

And then some smart people entered the village and started buying contributors’ rights of getting an equal share of water from the willing villagers. They guaranteed specific litres of water (let us say around seven litres) per day irrespective of the quantum of water the well produces. That apart, as a further facility, these smart guys offered door delivery free of cost.

Quite naturally, many villagers, finding the arrangement comforting and resourceful, opted for the facility. In the bargain, they started getting seven litres of water every day without having to take the painstaking effort to go the well. In fact, they were doubly delighted to get seven litres even on the days when the well did not produce any water.

Things were very smooth till a day dawned when water did not reach the doorsteps of the recipients. On inquiry, they came to know that the well had gone dry for a few days and their other brethren had not gotten water since the day the well did not produce water. They comforted themselves that they were lucky enough to get water till that day.

Now, let’s try to understand ‘equity’ and ‘debt’ from the above story.

Consider the well as the enterprise and the water as the profit. The contributors who agreed to share the produce of the well equally are the equity investors (let’s call them ‘owners’) and the others who sold their rights for a fixed quantity of water were debt investors (let’s call them ‘lenders’). It is evident that the source of returns (litres of water) for the ‘owner’ as well as for the ‘lender’ is the water produced from the well. The day the well becomes dry, the source itself disappears. So, there is no question of any return on the investment of either of the investors.

To understand the concept, let’s simplify it further. In the village example referred above, suppose the well was functional for 100 days before going dry, and the owner received 1500 litres of water during its lifetime at the rate of 15 litres per day. The lender received 700 litres during its lifetime and maybe another 70 litres for ten days since the well went dry. It’s primarily the legality of the contract that continues to earn returns for the lender even though the enterprise earns no profit or runs into losses. But the legality of contract can earn the assured amount till the enterprise is earning profit or it has resources, saved out of the previous profit, to meet the obligations.

If we look at the totality, the owner got 1500 litres and the lender got 770 litres over the life span of the well. The extra 730 litres received by the owner are the rewards of braving the uncertainty and withstanding volatility. This is the cost paid by the lender for the assurance and certainty.

The example may be an oversimplification of the concept. But the crux remains that the health of the business makes all the difference. This is also an important corollary from the example that the owner will always get more than the lender in case an enterprise is up and running. Hence, the equity investment must outperform the debt investment. This has been proven empirically times and again.

Buying shares or bonds: Focus on buying or lending to the company. Of course, there are many factors like risk appetite, time horizon and asset allocation, among others, which should be considered before deciding to invest in equity or bonds, but from the investors’ point of view, the utmost importance should be given to identifying the company. Most of the time the price of entry or exit, in the case of equity and yield in the case of bond, has been given more attention. This has led to investment blunders by the investor.

Some statistics to watch out for: Though a detailed analysis of the factors is beyond the scope of this small write-up, an investor must still look at these data before they buy any capital market instrument. In case someone is lacking technical know-how, it’s better to leave this to professionals. For such an investor, the suggestible investment vehicle is a mutual fund.

Revenue growth: Like a well needs a continuous water supply, a business needs steady revenue growth. This shows the company is expanding and reaching more customers.

Profitability: It is not just about revenue but how efficiently it is converted into profit. Strong margins indicate a sustainable business model.

Cash flow: Healthy cash flow ensures that the business can cover its expenses and invest in growth, much like a steady water flow is vital for the village. Dividend history can give a fair idea regarding a company’s cash flow.

Debt levels: While debt can fuel growth, they can also deplete resources. It is crucial to assess a company’s debt relative to its income and assets.

Management quality: Strong management is like a good well-keeper, ensuring everything runs smoothly and the business remains resilient.

Happy informed investing!!!

(The writer is Executive Vice-president, SBI Funds Management Ltd; Translation and text by Harkaran Singh, Vice-president, Private Wealth, Uncomplicated, AnandRathi)