Explain the importance of identifying the “primary” source of repayment. Clearly

Question

Explain the importance of identifying the “primary” source of repayment. Clearly, the primary source of repayment is always “cash.” The analysis question is really one of identifying the source of the cash used to repay the loan. Explain the advantages and disadvantages of the following sources of cash as the primary source of repayment on a loan:

Selling an asset

Increasing a liability Generating more sales

Decreasing expenses Issuing stock (equity)

Reducing cash dividends

Under what circumstances would you be comfortable with the mentioned sources being the “primary” source of repayment?

Explanation / Answer

Whether it is personal finance or business finance, the primary source of cash for loan repayment is very important.

Loan is a liability which should be extinguished by repayment. The repayment should not be by creating another liability which will ultimately create a debt trap.

Generally, the primary source of repayment for personal loan should be from earning and for business , it should be from the cash flow of the business.

Primary source of cash for repayment will depend upon the purpose for which the loan is taken.

For example, if the loan is taken for working capital, the primary source of repayment should be selling the merchandise.

If the loan is taken for purchase of assets for the business, the primary source of cash should come from the income generated by the asset. It should not be from disposal of assets which will lead to loss.

If it is a bridge loan before public issue, the repayment should be from the money received from the public issue.

If someone buys a house for giving on rent, the primary source of cash for repayment should be the rental income.

Selling an asset:

If temporary assets (current assets) like inventory or short term investments are acquired by borrowing, primary source of cash for repayment will be selling these assets

Increasing a liability:

In case of capital refinancing or restructuring, the repayment can be made by increasing liabilities

Generating more sales:

If the loan is taken for business expansion, the primary source of cash for repayment will be by generating more sales

Decreasing expenses:

If the loan is taken for business expansion, but the company is not able to generate more sales for repayment, the alternative would be to decrease expenses to repay the loan

Issuing stocks:

For financial restructuring, the company can issue stock and pay off long term debts with the objective of reducing leverage and risk.

Reducing cash dividend:

This should not be preferred method of repayment. In case the company is not able to generate enough cash from business for loan repayment and has no other option, it can think of repayment of loan by reduction of dividend payment. This will affect the market price of the stock.

Out of all above methods, increasing liabilities and reducing dividends are least preferred methods.

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