Understanding debt and equity with the help of mangoes

Many of us have heard the terms, equity and debt. But do you really know what they mean? This article will explain their meaning in 10 minutes.

Once you understand this, you will be much better placed to understand various equity and debt investment products that are available including equity mutual funds, debt mutual funds, deposits, debentures and direct stock investments.

Let us start a business

We are going to start a mango pulp processing company. We will buy mangoes, run them through a machine process using the right equipment and sell mango pulp.

Mango


I know inflation is high and this is not the right cost, but for simplicity sake, assume that we create a company and invest Rs. 10,000/-. Next, we take a term loan of Rs. 5,000/- at an interest of 10% per annum is taken from the bank. The bank loan has terms that require us to repay Rs. 5,000/- at the end of 5 years.  From Rs. 15,000/- of total capital raised, we spend cash for buying land and machinery to the extent of Rs. 9,000/- and start production. The balance amount of Rs. 6,000/- is used for purchasing raw materials, paying salary costs and overheads among other running expenses.

Assumptions

Variable costs (explained ahead) are 70% of sales.

Tax rate – 30% on profit before tax

Fixed operating cost – Rs. 1,500/- (explained ahead)

Profit and loss statement for a year – Base Case

Assume we have sales of Rs. 10,000/- in the 1st year by selling mango pulp, which is the output of the factory.

In any company, costs are divided into two types

  1. Fixed
  2. Variable

Variable costs

Suppose we need 6 mangoes to make mango pulp weighing 1 kg. To make mango pulp weighing 2 kg, we will need 12 mangoes. The cost of mangoes (raw material) is variable. The more the sales, the higher is the cost and vice versa.

Fixed costs

Salaries on the other hand behave differently. Typically no company hires and fires staff based on the output they produce, if they have machinery to do the core manufacturing. Salaries behave more like a fixed cost. Or, consider marketing. Even if you had a bad year typically you would not like to cut back on marketing because you would want to maintain your presence and reputation in the market.

We are taking fixed operating cost as Rs. 1,500/-

Interest cost

Similarly the interest cost would be fixed. The bank expects to receive its 10% interest on Rs. 5,000/- amounting to Rs. 500/- irrespective of amount of mangoes processed.

At the end of the first year, this is the profit and loss statement you would see as owner of the company.

All figures in Indian Rupee (INR)

Sales 10,000
Less: Expenditure on purchase of mangoes, electricity, water, packing cost etc. (variable costs) 7,000
Less: Expenditure on salaries, marketing cost (fixed costs) 1,500
Operating profit 1,500
Interest 500
Profit before tax 1,000
Less: Tax 300
Profit after tax 700

 Scenario 2 – A good year – Sales increase

In a good year, suppose that instead of Rs. 10,000 the sales rise by 30% to Rs. 13,000/-. The variable costs would rise by 30% to Rs. 9,100/-.

Fixed costs would not increase. With 30% increase in sales, profit after tax rises by 90%.

Sales 13,000
Less: Expenditure on purchase of mangoes, electricity, water, packing cost etc. (variable costs) 9,100
Less: Expenditure on salaries, marketing cost (fixed costs) 1,500
Operating profit 2,400
Interest 500
Profit before tax 1,900
Less: Tax 570
Profit after tax 1,330

 

Scenario 3 – A bad year – Sales decrease

Consider that it is a bad year and sales dip by 30%.

Now, you can fill up the table yourself. Variable costs come down by 30% as compared to base case and fixed costs stay the same.

You would see a picture like this at the end of the year. With 30% decrease in sales, profit after tax decreases by 90% from Rs. 700/- to Rs. 70/-

Sales 7,000
Less: Expenditure on purchase of mangoes, electricity, water, packing cost etc. (variable costs) 4,900
Less: Expenditure on salaries, marketing cost (fixed costs) 1,500
Operating profit 600
Interest 500
Profit before tax 100
Less: Tax 30
Profit after tax 70

 

Return on debt

Debt raised from the bank was Rs. 5,000/-. Interest of Rs. 500/- received every year by the debt-holder (in this case the bank) is their return on debt. The bank also expects to receive the principal back at the end of the 5 year period.

We will have to set aside enough reserves to be able to repay the principal amount after 5 years.

Return on equity

After all the operating expenses, we are left with operating profit.

Interest is first paid to the debt-holder. Tax is paid to the government. What remains after paying tax, is called profit after tax.

Investment of Rs. 10,000/- constitutes the equity investment we made in the company. The profit after tax is the return on the investment that we have made. 

The profit after tax can be reinvested in the business. Alternatively, if we do not want to expand the business we may take dividends out of this amount and collect them in our personal account (which is separate from the company account)

 Important observations

  • We have to honour obligations to debt-holders irrespective of how good or bad the the business scenario is.
  • In bad years, the equity holders have to make do with relatively less profits. In good years, they capture the upside of the business and make handsome profits.

Secured debt, unsecured debt and equity

Can debt-holders make a loss?

If there is tremendous competition and the business suffers so much that we are unable to make timely interest payments. The bank can seize the assets against which they have given the loan in the case of secured debt. e.g. plant and machinery

Usually, assets like plant and machinery cannot be sold in the market at full value. There is a loss on sale as compared to purchase price of asset. Finished goods (in this case, mango pulp) are also assets and they can be seized and sold to recover money. Here, the bank can recover greater amount of money at prices closer to market rate.

So, a secured debt-holder can make a loss on the debt they have given to a company if the debt is greater than the asset value that is backing the debt.

An unsecured debt-holder can make a loss if there is not enough value remaining in the assets once the secured debt-holders are done extracting their share.

Can equity holders make a loss?

In terms of right to seize assets, equity holders come last in line to extract value out of a company that is bankrupt.

Equity can reach zero value too in case of bankruptcy.

What is the upside for equity and debt?

  • Debt has inherently stable returns with a relatively fixed upside.
  • A debt-holder cannot expect to get more than the regular interest and the principal by the end of the loan period.
  • An equity holder captures all the upside of the business after all debt obligations have been met.

Debt and equity investments

By now, you will have understood the nature of debt and equity with respect to funding in a company.

Now, flip the picture and look at it as if you had invested money in this mango pulp processing company and replay the three scenarios as a debt holder and a equity holder.

Once you understand this, it will be relatively easy for you to appreciate the nature of debt and equity investments from a retail investor perspective.

Debt investment options in India

Examples include savings bank deposit, fixed deposits in banks and companies, non-convertible debentures (NCD), PPF, company bonds and infrastructure bonds.

Government securities and PPF are also a form of debt. Capital Orbit covered government debt in an earlier article.

Bank savings and fixed deposits are a form of debt. You as a customer of the bank are lending money to the bank. The bank puts this to use to make loans to others. In the mango pulp example, the asset in the company was the factory itself. Here the asset is the loan that the bank makes.

When you hear of cooperative bank failures with depositors unable to recover money that is an example of a debt investment gone bad.

Equity investment options in India

Examples include direct investments into specific stocks in the equity market and equity mutual funds including ELSS mutual funds (equity linked savings scheme), index funds, diversified equity funds and sector focused equity funds.

Free download

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