Last Updated on May 30, 2024 by Harshit Singh
During a recent conversation, I was taken aback by a startling account. The individual in question operated a yarn manufacturing facility and encountered significant difficulties when a major client declared bankruptcy. This event resulted in a substantial receivable turning into bad debt, compounded by subsequent bankruptcies of several smaller clients. Consequently, he found himself unable to cover his interest expenses and resorted to borrowing additional funds to meet these obligations. Following this choice, he encountered significant challenges in the subsequent months, ultimately leading to the closure of his operations.
Now, one might ponder what went wrong in such a scenario. The critical error made in the aforementioned case was meeting interest obligations through further borrowing. In situations like these, the preferable approach would be to settle debts by liquidating assets rather than compounding the debt burden. While interest represented a one-time obligation, the introduction of additional borrowings to the balance sheet led to the entrapment in a debt trap.
Numerous businesses face such challenges, and as an investor, it’s crucial to identify whether a business is entangled in such a situation early on. In today’s blog, we’ll delve into how businesses often fall into a debt trap.
Table of Contents
Leverage – A Friend or a Foe
When businesses want to grow at any cost the promoters try to bring in more and more funds and fuel the growth with debt. If this growth is a profitable growth then its well and fine but sadly a lot of promoters feel that by giving discounts and offers, they will grow and profitability will come to place today or tomorrow. In this way profitability might come tomorrow but there is no guarantee that you will see that tomorrow.
Case in reference – I remember going to this retail chain with my father on Wednesdays (For their Maha Bachat offers on Wednesdays). Now, folks younger than me won’t be able to connect. The entire downfall of this retail chain happened due to the mentality of the Growth at any cost model where the promoter took heavy leverage for bringing growth.
Misallocation – Playing a losers game
Ineffective financial planning, budgeting, or forecasting often results in the misallocation of capital within businesses. This misallocation leads to the accumulation of mounting debt, which often funds unsustainable business endeavors.
Case in reference – A leading air cooler company encountered bankruptcy after expanding into various appliance lines beyond coolers in an attempt to mitigate the seasonal nature of their primary business. However, this diversification strategy which was funded by debt backfired as the appliance ventures proved disastrous due to a lack of expertise, ultimately diverting attention away from their core cooler business and contributing to their downfall.
Debt – A fair weather friend
When a business operates with heavy fixed cost it looks great in an upcycle or a booming cycle but when the business faces a down cycle then the P&L goes for a toss and the business can’t meet its fixed cost obligations and it becomes tough to service debt in such a scenario.
Case in reference – We know that the King of good times planned to offer luxury airlines services at competitive pricing however they struggled to manage their fixed costs. They had funded the acquisition of aircrafts and infrastructure by debt. Despite initially attracting passengers with its premium services, Kingfisher Airlines faced intense competition, rising fuel prices, and economic downturns. As the losses mounted the airline had to file bankruptcy.
Robbing Peter to Pay Paul – Solved a problem and created another
When you start relying on short term debt for long term investment it solves the problems temporarily and in a lot of cases you end up creating new problems. This is a very common problem for a lot of businesses.
Case in reference – An U.S.-based financial services firm gathered substantial short-term debt to invest in long-term assets such as the real estate market and mortgage-backed securities. However, when the housing bubble burst and the subprime crisis emerged, the value of these assets plummeted. Since the company depended on short-term capital to finance its investments, it was unable to roll over its short-term debt. Consequently, the firm was forced to declare bankruptcy.
Crossing the bridge when you come to it – Plan things in advance
When businesses neglect to anticipate potential disruptions such as technological shifts or natural disasters, they risk encountering Murphy’s Law, which suggests that “Anything that can go wrong will go wrong while Mr. Murphy is out of town”. Such unforeseen events have the potential to significantly disrupt business models and operations.
Case in reference – A wind energy company had invested in expansion of its manufacturing facility and acquiring new wind energy projects. The things didn’t go as the company wished and the global financial crisis broke which led to economic slowdown and this was coupled with multiple regulatory changes in key markets which worsened the demand scenario and due to lack of contingency planning the company struggled to service debt.
Uncle Sam sneezes and the everyone catches cold – The regulatory challenges
Businesses encounter numerous challenges related to regulatory oversight and interference in their operations. These issues often result in significant litigation expenses and penalties, potentially necessitating additional borrowing to cover these costs.
Case in reference – A diversified conglomerate which was involved in consumer electronics, home appliances, oil and gas exploration, telecommunications. The license of telecom were canceled by the supreme court under the 2G spectrum scam and also in the similar time frame there were regulatory changes in the oil and gas sector which resulted in delay of project approvals due to regulatory changes in these two main sectors the company finally had to file bankruptcy.
Living on the edge – Cashflow Crisis
In numerous cases, companies encounter challenges with inadequately managed cash flows. Delays in receivables collection coupled with an inability to extend payables often necessitate external borrowing to fund working capital needs. This ineffective cash flow management can lead companies into significant debt traps.
Case in reference – A prominent textile company encountered problems like delayed receivables which impacted the cashflows negatively at the same time the company couldn’t manage its inventory well which led to more funds getting stuck in working capital so to pay the payables the company resorted to debt and eventually they filed bankruptcy and eventually was acquired by a conglomerate and a restructuring company.
Debt isn’t bad for businesses. A lot of businesses and promoters have created immense value by using leverage as a tool and they have created immense value for themselves and investors.
In conclusion, the factors outlined above represent only a subset of the multiple reasons that can plunge companies into a debt trap, potentially leading to the cessation of operations. As investors, it’s important to exercise vigilance and thorough due diligence to avoid involvement with businesses susceptible to such risks. Being mindful of the diverse array of factors that can contribute to financial instability underscores the importance of prudent investment decisions and ongoing assessment of a company’s financial health.
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