Let's break the myth that 'Loans are always bad!'

Say we have two businesses, one is software and another one is heavy machinery. Let us create scenarios. We know that the software industry needs fewer value assets(computers) to create revenue but the heavy machinery industry needs higher value assets(imported machines, earthmovers etc) to create revenue. This is called 'Return on Assets(ROA).



So ROA for Software is much higher than Heavy machinery. For example, to get 1 rupee from assets annually, I need 2 rupees of assets in Software and 10 rupees of assets in the Heavy industry.


ROA = Output/Input
ROA for software is Rs.1/Rs.2 = 50% annually
ROA for heavy machinery is Rs.1/Rs.10 = 10% annually

Clearly, the software industry is the winner here. But let us do permutations and combinations here.


Scenario-1:


I put money 1 lakh in software.

Here the return annually = 50% of 1 lakh = Rs.50000

I put money 1 lakh in heavy machinery.

Here the return annually = 10% of 1 lakh = Rs.10000

Clearly, the software business is the winner.


Scenario-2:


You can invest 1 lakh at the maximum. So if you need to invest more, you are likely to raise a loan.

More asset value = More loan because loans can be recovered by selling the assets.

Which one has more asset value? Clearly Heavy machinery. Also, we don't need more investments in Software as Rs.1 lakh is more than sufficient.


But say we got a loan of Rs.9 lakhs at 5% interest annually. So the investment amount is Rs.9 lakhs(Loan) + Rs.1 lakh(own).



ROA for this will be 10% of 10 lakhs = Rs.1 lakh

This 1 lakh is without deducting interest for the loan. So the interest amount is would be 5% of 9 lakhs = Rs.45000

Net earnings is Rs.1 lakh - Rs.45500 = Rs.55000.

Now we got Rs.55000.We know that Return ratio = output/input.


Here is the interesting part our overall asset value is 10 lakhs but the contribution from our own money is just Rs.1 lakh


Return on 'X' = Rs.55000/Rs.1 lakh = 55%.I am sure this scenario would surprise you because with the same amount of investment in the same business I get more return by just raising a loan. This return is called 'Return on Equity(ROE). Equity means only the owner contribution to assets.


This whole concept of using the loan or other source of funds for increasing the return is called 'Leveraging'

Almost all capital heavy industries or businesses use this leverage. Some examples are automobile, telecom, oil&gas, mining etc.

Note: Leveraging is two-edged sword and it also depends on the cost of borrowing(interest rate). That's why countries with lesser interest rates have more capital heavy industries. India has abnormally high-interest rates and hence fewer industries and manufacturing compared to its peers.

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Disclaimer: This article is me speaking to me through this blog! Short Intro: If you want to innovate in a particular field, you need to understand how things work in the first place. Innovation is a