This 2 answers were best of the lot-
By piyush jajodia (CMA Inter Dec 2020):
Now, I want to bring some factors behind the reason why RELIANCE BECOME NET DEBT FREE even if there is importance of trading on equity ?
1. Dhirubhai Ambani promised its shareholder that RIL will be debt free by 31 march 2021, he fulfilled the promise of it by doing so before the time stated which will keep increase the value of the company by gaining the trust of shareholders as well as of stakeholders and thereby outsiders who now die for investing in such a company.
2. Not only did the stake sale helped company become net debt free, it will also provide RIL with foreign capital and strategic partnerships as it looks to become an end-to-end digital services provider in sectors such as telecom, data, content, entertainment, e-commerce, education, and more
3. Increased the share market price of the company.Gain 13 percent increase in share price after global announcement of net debt free
4. RIL has a "AAA" long term debt rating from CRISIL, CARE and ICRA. So it can borrow at historically low rates from the Indian debt market. No other AAA rated company is paying down debt in the current low interest rate environment. When a company's Weighted average cost of capital is calculated equity is more costly than debt. So essentially RIL is using a higher cost capital to pay down lower cost capital. It implies they find paying interest on debt very difficult which further means very low cash flow from operations.
5. More new investors will attract towards the Company,increase the trading market of the Company with high inflows of money.
And the second one was the best one by Dhruv Agarwal (CA Inter Nov 2020):
Trading on Equity is a financial process that involves taking more debt to boost the return of the shareholders. Trading on Equity occurs when a company takes new debt, in the form of bonds, preference shares, or loans etc. The company uses those funds to acquire assets to earn a return greater than the interest cost of new debt. (ROI > Cost of debt). The borrowed funds have an interest expense that is tax deductible. So, the borrowing company has to pay lower tax. So, basically, the new debt results in a reduction of the total cost for the borrower. The difference between the ROI and Cost of debt (post tax) is the additional return to equity. Thus, a well-established company having a good ROI can use Trading on Equity to improve its EPS. To illustrate numerically, Let us consider two companies: Company A & Company B Company A is a debt free Company having only Equity shareholders of ₹100crores. Company B has Equity shareholders worth ₹70 crores and a long-term debt of ₹30 crores at an interest rate of 10%. The Return on investment of both the companies is 15%. The computation of Earnings per share of both the companies is shown below
| Particulars | Company A | Company B |
| Equity Capital (₹10 share) | ₹100 crores | ₹70 crores |
| Debt | Nil | ₹30 crores |
| ROI | 15% | 15% |
| Earning Before Interest & Tax (15%) | 15 crores | 15 crores |
| Less: Interest | Nil | 3 crores |
| Earning Before Tax | 15 crores | 12 crores |
| Less: Tax (30%) | 4.5 crores | 3.5 crores |
| Earnings After tax | 10.5 crores | 8.4 crores |
| No of Equity Shares | 10 crores | 7 crores |
| Earnings Per Share | ₹1.05 | ₹1.2 |
This shows how debt can be used to boost EPS.
Trading on equity has its own risks. It may result in further losses if the company is not able to pay off its interest expenses. It may happen if the company’s Return on Investment falls below its cost of debt. Such borrowings may lead to a high-risk situation for a business, which is depending on the borrowed amount to finance its operations. If there is a rise in the interest rates, it can cause losses because the financial burden of the interest would increase for the company. So, while trading on equity can give increased returns, there is also a real risk of bankruptcy which must be taken into account.
WHAT ABOUT RELIANCE
As on March 2020, Reliance had a net debt of Rs 1.61 trillion and the company managed to turn itself net debt-free after raising Rs 1.68 trillion via a 24.7 per cent stake sale in Jio Platforms and its rights issue. So, Reliance isn’t actually debt free. Reliance is now “Net-Debt Free”.
What is Net Debt???
Net debt is a financial indicator that measures a company’s ability to pay all its debts if they were due today. It means, net debt compares a company’s total debt with its liquid funds. So Net debt is the amount of loans that would remain unpaid if a company has paid off its loans using all the liquid funds available. It is used to determine if a company can repay its liabilities if they were all due today. Net debt = Outside Liabilities – Cash & Cash Equivalents Example: Company X has a bank loan of ₹100,000 , ₹50,000 in debentures and a bank overdraft of ₹20,000. Current assets of the Company include ₹1,25,000 in cash, ₹10,000 in Treasury bills, and ₹15,000 in marketable securities. The total debt of the company is ₹1,70,000 ; whereas its Cash & Cash Equivalents stands at ₹1,50,000. Therefore, Net Debt of the company is ₹1,70,000 - ₹1,50,000 =₹20,000 If the company had an additional ₹20,000 in cash, it would have been Net Debt Free So, Reliance isn’t actually debt free. It still has debt in its capital structure but it has set aside such amount of cash which is enough to pay off its liabilities to become Net Debt Free.
Possible reasons why the company did this:
1. The company can still reap the benefits of Trading on Equity and use the Interest Tax Shield to boost its EPS and at the same time call itself Net Debt Free.
2. Having such a large cash reserve reduces the market risk of the company and boosts the investors’ confidence in the company.
3. Financial Performance
| Year | Non Current Borrowings (in Crores) | Debt to Equity Ratio | Interest Coverage Ratio | Return on Net Worth (%) | Return on Capital Employed(%) |
| 2011 | 62686 | 0.35 | 11.84 | 13.88 | 13.15 |
| 2012 | 60156 | 0.36 | 10.66 | 12.29 | 12.82 |
| 2013 | 55205 | 0.30 | 9.66 | 11.73 | 12.55 |
| 2014 | 74926 | 0.43 | 9.68 | 11.15 | 10.97 |
| 2015 | 90308 | 0.41 | 13.45 | 10.51 | 10.42 |
| 2016 | 92514 | 0.38 | 15.55 | 11.41 | 11.47 |
| 2017 | 105607 | 0.35 | 15.98 | 10.89 | 11.16 |
| 2018 | 112231 | 0.31 | 10.82 | 10.68 | 12.24 |
| 2019 | 168402 | 0.39 | 5.86 | 8.67 | 10.15 |
| 2020 | 234145 | 0.54 | 4.68 | 7.27 | 8.65 |
The above table shows Non-current Borrowings- Basically the long-term debt owed by the company
Debt Equity Ratio - is the ratio of the company’s debt to its Shareholders fund
Return on Capital Employed- It tells the percentage of profit a company earns on its total capital employed (Equity+ debt)
Interest Coverage Ratio – It is used to determine how easily a company can pay interest on its outstanding debt. It indicates the number of ‘times interest earned’. An interest coverage ratio of 2 indicates that the company can pay twice the interest incurred on its debt from its earnings.
Return on Equity- It is the return earned by the Equity shareholders of the company An analysis into the past 10-year data of Reliance Industries shows us that the borrowings of the company have increased consistently whereas the Return on investment has fallen from 13% to 8.6%. As discussed earlier if the ROI falls below the Cost of Debt, it can adversely affect the EPS. Increased borrowings lead to increased cost of borrowings (interest). The Interest coverage Ratio has also fallen from 11.8 times to mere 4.68 times. Maybe this is the reason why the company wanted to be debt free-- Declining Earnings (Return on Capital employed) and rising Cost of Debt. This has also led to fall in Return on Equity from around 14% to 7%- Shareholders won’t be happy about that.
4. Credit Rating – It is a rating assigned by rating agencies like CRISIL, ICRA, S&P, Moody’s etc. The ratings given by these agencies are taken into account while taking decisions by investors and lenders. A company can't just keep borrowing more debt without affecting its credit rating. If RIL would have continued adding loans to its books to finance growth then that would adversely impact a lot of financial ratios at which rating agencies have a look at while assigning a rating to a company. Lower coverage ratio leads to a lower credit rating score which will make RIL offer more interest on bonds to raise debt. This extra interest may outweigh the interest tax shield benefits that debt provides. Therefore to maintain a good rating, maybe the company decided to become Net-Debt free.
5. Psychological Effect- Becoming ‘Net-Debt free’ has brought RIL in the news. That means free publicity to the company which can improve the share markets confidence on the company. After all, the market is driven by sentiments. Another reason maybe that after seeing Mr. Anil Ambani submerged in debt and bankrupt, Mr. Mukesh Ambani didn’t want the sword of debt hanging over him.
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