B. Venkatesh

For most of us, borrowing is taboo. Yet, successful money managers and businessmen have always thought it wise to borrow. What differentiates them from us?

The answer lies in what you do with the borrowed money. Most people do not put borrowed money to effective use. Often, such money is spent on "non-income generating" assets, such as cars and consumer durables. If an asset does not generate income, it is that much more difficult to repay the debt.

Successful people use borrowed money to invest in real-estate, buy stocks or build businesses. Such leveraging is commonly termed as using "other people's money" (OPM).

Now, profitably leveraging to build a business or buy assets is not easy. If you borrow money at, say, eight per cent and do not generate returns more than the interest rate, you lose. Leveraging is a double-edged sword.

Suppose you buy shares worth Rs 5 lakh with 50 per cent borrowed money. Assuming 15 per cent returns, you would have a cash inflow of Rs 75,000. If you pay Rs 25,000 (10 per cent on the borrowed Rs 2.5 lakh) as interest, you keep Rs 50,000 — a return of 20 per cent. Had you invested only your money of Rs 2.5 lakh, you would have generated only 15 per cent, which is Rs 37,500.

But what if you generate only five per cent on total investment of Rs 5 lakh? Your cash inflow would be Rs 25,000 — just enough to pay your interest. Returns below five per cent will lead to losses.

The point is: Successful people borrow money to buy income-generating assets and that too, only if they expect positive cash flows. Do you?

(The author is based in Ontario, Canada)

© Copyright 2000 - 2009 The Hindu Business Line