Debt Trap

A debt trap is a situation in which a borrower is led into a cycle of re-borrowing, or rolling
over, their loan payments because they are unable to afford the scheduled payments on the
principal of a loan. These traps are usually caused by high-interest rates and short terms.

How does a Debt Trap work?

Any time a person borrows money from a professional lender - whether it’s a loan or a line
of credit - here are two basic elements to the loan agreement. First, there is the loan
principal: the amount of money that the person has borrowed. Second, there is the interest:
the amount of money that the lender charges on the principal. Paying back borrowed money
means paying back both the principal and the interest. Paying back the principal is
especially important because it’s the only way that a borrower makes progress towards
paying off the loan in full. Many installment loans come with amortizing structures, which
means that the loan is designed to be paid off in a series of regular, fixed payments; each
payment applies toward both the principal and the interest.

A debt trap occurs when a borrower is unable to make payments on the loan principal;
instead, they can only afford to make payments on the interest. Making payments on the
interest does not lead to a reduction in the principal, the borrower never gets any closer to
paying off the loan itself.

Jain Irrigation systems Ltd

Jain Irrigation Systems, often known as Jain Irrigation, JISL, or simply Jains, is a
multinational organisation based in Jalgaon, India. It develops, manufactures, supports and
sells diversified products, including drip and sprinkler irrigation systems and its
components.

Debt trap of Jain Irrigation systems Ltd

Jain Irrigation Systems Ltd. is increasingly losing its value in the last one year as it is the
world’s second-largest micro irrigation equipment maker with mounting debt and weak
cash flows. The company’s debt has more than doubled to Rs 5,112 crore in the past eight
years. That’s because the company continued to borrow to fund expansion as well as meet
its working capital requirements.
Working capital and interest payments have been eating into the company’s operating cash
flows, leaving negligible amounts for repaying debt. The company is in a debt trap as
leverage continues to rise. The company attributes the increase in its debt to short-term
debt.
The company used most of its loans to expand capacity, modernise operations and on
maintenance. It added nearly 3.2 lakh metric tons capacity over eight years in three key
verticals - micro irrigation system, plastic and tissue culture.
Higher finance cost wasn’t the only reason for depleting cash flow. Stretched receivables,
or payments from clients, too, impacted Jain Irrigation’s operating cash flow. The
company’s micro irrigation system has a long cash cycle - that begins with payment of raw
materials and ends with receipt of cash on goods sold. It took 9 to 12 months after delivery
of products to receive the government’s incentives, according to the company’s 2018
annual report. That led to higher demand for cash infusion or working capital, the report
said.
Jain Irrigation reported negative free cash flow for seven straight years before it turned
positive in the year ended March 2018 as it repaid some high-cost loans and acquired two
distribution businesses in the U.S.
Company’s decision to expand proved to be “painful” for stakeholders as better part of
earnings is going toward meeting finance cost, leaving little room for value creation.
The management after the third quarter said they aim to reduce debt by Rs 600-700 crore
in the fourth quarter. Historically, it generates a lot of cash flows in the fourth quarter which
will be used to reduce the debt.
The current level of earnings is enough to service the debt and there’s a good chance to
increase earnings substantially. The company also intends to raise long-term debt in the
ongoing financial year to reduce the refinancing risk inherent in the short-term loans and
improve the debt coverage ratios.