The Debt Trap

Companies are formed to generate employment and to achieve a common objective. Funds are required to start the Companies. Broadly, there are two source of funding in any company which is Equity and Debt. 

Equity is the amount invested by the owners of the company. It has no obligation once shares are issued. If business grow and performs well, value of equity increases and vice versa.

 

However this is not happen in the case of Debt, Debt has a fixed cost which need to be paid by the company for instance if company takes loan from the bank then it has to pay a fixed interest on the outstanding loan amount.

Below is the table wise difference between Equity and Debt-

Equity	Debt
Equity is owned	Debt is borrowed
Equity can be in the form of Share and Stocks	Debt can be in the form of Loans, Debenture, bonds, etc
Dividend is paid on the Equity	Interest is paid on the Debt
It has no fixed cost	It has a fixed cost

A company have option to get funding from either source but there should be a balance between both the source of funding. If a listed company has only equity then it has increased number of owners and chances of losing promoters control is increased. Though there are several benefits of being a Zero debt company and we will discuss this in detail in upcoming feeds. 

If a company has only debts then it is incurring huge Cost of Capital. It is definitely a bad figure in the balance sheet of the company. Investors and stakeholders generally avoid  dealing with such kind of company. 

What is Optimum Level ?

Optimum level could not be fixed based on formulas, tricks, tips rather it requires an in depth analysis of the company, its size, operation level, Liquidity, Margins and  Profitability. Optimum level of Equity and Debt is vary from industry to industry and it cannot be ascertained theoretically. Hence, there should be adequate debt but not in excess. Once company has done with the expansion and reaches stability, Debt level should comes down. A decreasing debt level attracts the investors and stakeholders.

We hear more nowadays about Corporate Crisis, Bankruptcy and defaults, like Kingfisher, DHFL, RCOM, etc are the perfect example of companies having excess debt at wrong time.

Let us understand the Collapse of DHFL-

Debt Trap-

DHFL was working fine till last year, its share was trading on the exchange somewhere around Rs. 250 a year ago but today it went to the liquidation. The main reason for the collapse of DHFL is they had excess debt and they lend the money for the longer duration then the duration for which they acquire funds. They took more and more debt to repay their previous debt and significantly they fall in the Trap of Debt. DHFL had huge cost of capital and they could not manage to repay their loans timely which leads to the liquidation proceedings for the company. 

It's Liquidation proceeding will be done by the RBI itself, ordered by Supreme Court recently.

Bottomline-

Debt is not bad source of funding but having excess debt at wrong time is the baddest situation for the company. With this, we can say, there shall be a balance between the Equity and Debt. Moreover, Debt level shall comes down over the period of time.

Happy Learning !!!