Chris Emoghene has thirteen years banking experience across public sector,…
One of my granddad’s many sobriquets is “efeghenesa”, which is loosely translated as “rich despite debts”. When called, his response would be “it makes me richer than you”.
What then is debt?
Debt can be defined as an amount of money owed by a person, business, or government. The party giving the money out is the lender while the party taking the money is the borrower. There has been a lot of questions around debts from the borrower’s perspective. Some are scared of interests to their bone marrow while others perpetually live with/in debt. There is yet another group that generally demonizes debts while still others carefully seek out debts to execute deals and projects. Over time, the question has been asked, is debt good or bad? Especially now that traditional financial institutions and Fintech companies literally chase people with both personal and business loans.
Debt is neither good nor bad in itself. However, it can be described as a two-edged sword. When you master its art, like most of the rich
and mighty, it becomes a useful tool that can make great wealth and fortune for you. I have seen businesses grow and blossom on the back of loans. On the other hand, if you are not wise, you can become a slave to your lender through the instrumentality of debt by working hard to pay interest upon interest, loss of peace of mind, and dignity. Barring force majeure cases, the quality or impact (good or bad) of the loan depends on its: purpose/uses, adequacy, terms & conditions, type/nature, and timing.
Let’s look at these factors and their impacts on loan quality one after the other.
The purpose for which a loan is obtained is a critical factor that will determine whether it will be a good or bad loan. Taking out a loan to
finance businesses and projects capable of generating enough cash flow to self-liquidate the loan is something positive and should be encouraged. However, borrowing heavily for consumption and frivolities, in order to “keep up with the joneses” is a no-no. For instance, if you borrow to do a ‘society wedding’, chances are that it would put pressure on the new family’s finances which can lead to defaults in settling loan obligations and in turn lead to cracks in the young family. Personal loans should only be taken in cases of emergencies or exigencies.
There have been several debates among experts as to whether debt or equity is preferable in financing a business. The tables below will
attempt to explain why a good mix of debt (with favorable terms) and equity is desirable for a business.
There are two companies in the tables- company A and company B. The assumption here is that both companies are similar in nature
and operations. They have the same annual sales values, the same cost of goods sold (COGS), the same general expenses, and the same current and fixed assets. The only difference is how the companies were funded. Company A has 100% equity, ie
fully funded by the owners while company B has 60% owners’ equity and 40% debt.
Now, on the surface, it appears company A is doing better in terms of profitability. But when you look at it critically and analytically,
profit after tax (PAT)/equity for A is 0.25 while that of B is 0.33. Meaning, owners of company A get only 25k for every N1 invested while owners of company B get 33k for every N1.
One of the advantages here is that interests paid on loans are deducted from the company’s earnings before taxes are calculated. Even if you consider net profit or profit before tax against owners’ equity, while company A is returning 35% on owners’ equity, company B is rendering 48%.
Type of loan: This is another factor that would determine, to a large extent, if a particular loan will be good or bad. For example, if you take a bank overdraft to finance fixed assets, you will certainly run into trouble; making an overdraft that is not bad in itself looks bad. In other words, the type of loan you access must be suitable for the purpose of the loan, to avoid negative impacts. Do not borrow short-term to finance long-term projects.
Loan adequacy: If you must borrow, whether for personal or business purpose, don’t take more than is needed at that time neither should you accept an amount that is below what you actually need to adequately complete the project/transaction.
If you over-borrow, the business or your salary won’t be able to conveniently repay. Also, if what you borrowed is not enough for the project, you will get stocked and won’t be able to repay the loan as and when due. Therefore, over/under borrowing for a project/transaction can lead to bad debt.
Terms and conditions: What should ordinarily be a good loan can turn out to be a bad one as a result of the terms and conditions under which the loan was granted. Items like interest rate, tenor, repayment amount & frequency, fees, covenants, etc should be carefully examined in light of projected revenue and cash flow from the transaction (in case of a business loan) and income for the period (in case of personal loan) before committing to the loan. This will help to reduce the incidences of bad debts.
Imagine you are borrowing against your monthly salary, of say N500k, and the loan is structured such that you pay monthly interest of N50k and quarterly principal repayment of 50% of your salary. God help you if quarterly repayment (N250k), school fees (say N80k), and house rent (say N360k), not forgetting the normal monthly interest of N50k, all falling due in the same month without the extra income. This underscores the importance of negotiating favorable terms and conditions to avoid bad debts.
Timing: In the words of Innocent Mwatsikesimbe, “The wait is as much journey as the motion because timing is pivotal.” That almost sums it up. Do not borrow because the lender is offering you. There must be a reason or an underlying transaction for the loan.
Generally speaking, and looking at it from the borrower’s perspective, below are some of the attributes of good and bad debts.
Good debts (for individuals & organizations)
- It should increase your assets
- It should improve your cash flow
- It should lead to the improved bottom line
- It should increase your net worth
- It should lead to effectiveness, saving you time
- Can lead to anxiety
- Can lead to depression
- Losses in business
- Depletion of net worth
Words of caution: In times like these, COVID-19 and global economic slowdown, we should be vigilant when considering borrowing, whether for personal or business purposes. Expense control is highly recommended. Investments, especially in an uncharted area, should also be carefully analyzed before taking action.
*SGA = Sales, General, and Administrative Expenses.
Chris Emoghene can be reached via email@example.com or @emochris12