Today, we take a turn and leave investing in the meantime. Let’s go to debts or borrowing. At any rate, it looks like the heightened volatility in the financial markets since the last week of May is tapering off this July. Stocks, bonds, and the dollar-peso exchange rates are off their highs and lows. Stocks are back prancing to the beat of the country’s sound economic fundamentals though this time, a little less excitedly. Bonds and currencies? Oh well, it’s complicated. So let’s go to the opposite side of the balance sheet and have a little discussion on debts.
Should we borrow or stay debt-free? Is debt good or bad? We are almost sure to hear passionate opinion in defense of and in condemnation of debts. We think though that borrowing is not a moral question of good and evil, or of right and wrong. Because it is neither good nor bad in itself, it is just is. Properly handled and used, debts could be the best thing that could happen to fast break our economic goals. It could also be the path to destruction if not managed well.
We often hear the word ‘leverage’ to describe the situation of having debts – and for good reasons. Just like a lever that increases our power and force and allows us to lift or move objects that are beyond our natural strength to move, debt allows us to achieve more than otherwise we would without it. The extent of that power boost could be very huge. And it is true for businesses as well as for individuals like you and me.
Let’s say you have P30,000.00 savings in excess of your expenses every month. If you have the equity required by lenders as your participation, you could go to a bank and borrow P3.5 million to buy a house, at 6% interest, re-pricing every year for 15 years. Or buy a car worth P1.350 million payable in 5 years. It’s like magic. Your P30,000.00 is multiplied many times.
In business, financial leverage is normally expressed as the ratio of debts over equity capital. The higher this ratio, the more power it packs. Say, if your return on assets is 5% and you are leveraged 2x, you will have return on your equity capital of 10%. Push the leverage 4x, and with better efficiencies, your ROE can be boosted to 20%. Most of the rich and big businesses, if not all of them, got to their wealth partly due to the power of leverage, in varying degrees, of course.
If your business has good predictability of earnings and you have a good track record of paying debts and dealing fairly with people, most banks will be willing to lend you and support your business. With that debt capital, you can have a much bigger business.
If we are presently renting, we could buy our dream house now instead of waiting many more years. In the process, we save rent and ‘forced’ to allocate a portion of our income to pay the shortfall between rent and the monthly amortization. In a way, it is like having forced savings. If we consider the possible property appreciation, we really are better off.
If we are a sole proprietor, running a small company that can sell P1.0 million because our equity capital could only buy enough raw materials and equipment, we could multiply our sales and profits many times if we can secure debt capital for the needed additional working capital.
If we have credit cards, we can take advantage of interest-free installment to buy some big-ticket appliances that otherwise we could only buy next year after accumulating savings. Or we can bridge the money we are expecting to receive in six months from now by getting a personal loan.
A prolific mother of folly and of crime
Many of us can relate to this observation by Benjamin Disraeli, the British statesman. Desperate situation could lead to desperate acts. As debts have the power for good, it has an equally devastating power to destroy. It is tempting to borrow with our eyes on the price that it could bring, until we miscalculate and something goes wrong. A drop in sales occasioned by changing taste or economic conditions, stiffer competition, inability to pass on increased costs, rise in interest rates, and many other adverse things could happen. We can lose our jobs and our businesses can close shop. And we find ourselves in a disaster. We have seen so called sophisticated finance and business people fall from grace due to unmitigated debts. Warren Buffet called derivatives, which can really pack a lot of leverage, as the financial weapon of mass destruction for good reasons.
Too much force can lead to ruin. Most, if not all financial crises, were a result of too much leverage. Just like what is happening in the US and Europe now and the Philippines after the 1997 crisis. If we borrow too much and bought a new house such that most of our income goes to debt service, how is the quality of our life? What happens if the interests on our debts suddenly increase or we lose our livelihood? As the Portuguese proverb goes, an empty purse and a new house make a man wise, but too late. Debts could be addicting. It could lead us to postpone making hard decisions until it is too late.
Going into debt, calls for discernment and an objective assessment of our capabilities and conditions. By and large though, we think it brings more good than harm. The thing is to handle it well and be disciplined.
Tony Moncupa, Jr. is the President and CEO of East West Banking Corp. Please e-mail your questions, comments, suggestions to email@example.com.