While business owners are choosing the fund parking avenue for their business surplus fund they often overlook one of the most important metrics – post-tax returns.
In today’s KOFFi book we will try to understand how looking into post-tax returns metrics before selecting the fund parking avenue is so important and how it will help you to make informed decisions.
What Are Post-Tax Returns?
Post-tax returns are returns that refer to the returns you get on your capital after considering all the taxes that are needed to be paid on the capital gains/interest income earned from a financial investment instrument.
The formula to calculate the post-tax return is:
Post-tax returns = Nominal returns * (1- Effective tax rate)
But Why Is That Important?
In India, businesses have various fund parking options like Fixed Deposits, Arbitrage Funds, Money Market Funds, etc on which you can see very different tax implementations for each.
As post-tax returns are calculated after considering all tax implementations, it showcases to us what actual returns you will get in hand.
That’s why considering post-tax returns is important before making any financial decision because taxes can leave a major impact on actual returns.
By looking into post-tax returns, businesses can optimise their funds and can make more accurate financial planning decisions.
Let’s Try To Understand This In More Detail
Let’s assume you’re running a business with total revenue of less than 1 crore annually.
After closing a huge deal, your business has a surplus of idle money worth ₹10 lakhs, which you want to park for 1 year to get steady capital appreciation and safety, instead of keeping it in the zero-interest current account.
For that, you found that Fixed Deposits, Arbitrage Funds, and Money Market Funds are idle for short-term fund parking but now you’re confused about which option to choose, and which option is more beneficial for your business surplus.
For That Let’s Analyse The Post-Tax Returns Of Each Product:
Fixed Deposits
Fixed Deposits(FDs) are one of the traditional banking options where you deposit a sum of money into a bank for a fixed period and at a fixed interest rate.
Taxation on FD’s interest income
The interest income from the fixed deposits is fully taxable. The interest income should be added to your business’s total income and it will be taxed at the applicable tax slab (In your case it’s 30%).
Returns on FDs for 1 year
Generally, as per the industry average, you will get 6.5% interest p.a. which is your nominal return for 1 year ₹ 65,000/-.
Calculate post-tax returns on FDs
Post-tax returns(%) = Nominal return (%) * (1 – Effective rate)
Post-tax returns(%) = 6.5* (1-30%)
Post-tax returns = 4.5% p.a
So, actual returns on FDs for you are 4.5% p.a that is ₹ 45,000/-
Arbitrage Funds
Arbitrage funds are one of the types of hybrid funds that take advantage of price differences of the same assets in different markets primarily in cash and derivative markets.
Returns from Arbitrage funds
One of the most reputed mutual funds – TATA mutual fund provides around 8.3% returns for 1 year as per past performance.
So, for 1 year nominal returns on ₹ 10 lakhs from Arbitrage funds are ₹ 83,000/-
Taxation on Arbitrage Funds
The tax treatment for arbitrage funds is like equity funds due to it having to trade at least 65% of their assets in equity.
So, if you keep parked your fund for 1 year then capital gains above ₹ 1 lakh per year are tax-free and if your capital gains are below ₹ 1 lakh then you have paid 10% tax
In your case, capital gains are below ₹ 1 lakh that is ₹ 83,000/- on which you have to pay 10% tax.
Calculate post-tax returns on Arbitrage Funds
Post-tax returns(%) = Nominal return (%) * (1 – Effective rate)
Post-tax returns(%) = 8.3* (1-10%)
Post-tax returns = 7.4% p.a
So, actual returns from the TATA arbitrage fund of ₹ 10 lakhs for 1 year 7.4% p.a that is ₹ 74,000/-.
Money Market Funds
Money market funds are debt funds that invest in highly liquid, short-term instruments like bonds, T-bills, commercial paper, etc.
Returns on Money Market Funds
Taking the same previous mutual fund house – TATA mutual fund provides around 7.7% p.a returns for 1 year as per their past performance.
So, for 1 year nominal returns on ₹ 10 lakhs from money market funds are ₹ 77,000/-.
Taxation on Money Market Funds
If you parked your funds for less than 3 years in a money market fund, then the capital gains were taxed at your applicable tax rate.
But if you keep your funds untouched for more than 3 years in money market funds, the capital gains will be taxed at a flat 20% rate.
In your case, you are parking your funds for only 1 year which is below 3 years you have to pay taxes as per your applicable tax slab which is 30%.
Calculate post-tax returns on money market funds
Post-tax returns(%) = Nominal return (%) * (1 – Effective rate)
Post-tax returns(%) = 7.7* (1-30%)
Post-tax returns = 5.3% p.a
So, the actual returns of TATA money market fund on ₹ 10 lakhs for 1 year is 4.5% p.a that is ₹ 45,000/-.
Now you have the post-tax returns of each option for funds parking of ₹ 10 lakhs.
Let’s compare all of them to make a decision
Particular | Amount | Duration | Nominal Returns | Post-tax returns | Actual Returns |
Fixed Deposits | ₹ 10 lakh | 1 Year | 6.5% | 4.5% | ₹ 45,000/- |
Arbitrage Funds | ₹ 10 lakh | 1 Year | 8.3% | 7.4% | ₹ 74,000/- |
Money Market Funds | ₹ 10 lakh | 1 Year | 7.7% | 5.3% | ₹ 53,000/- |
From the above comparison, we can see fixed deposits have the lowest returns for 1 year (4.5%) while arbitrage funds have higher returns than the other two options for 1 year (7.4%) due to their tax efficiency it can provide higher post returns than the other two options.
So, by comparing post-tax returns you can now make a more accurate decision for your company financials to optimise your funds for better returns in zero-risk.
Final Thought:
While making any financial decision regarding funds parking you as a decision maker should consider post-tax returns as it showcases the actual returns you get in your hand. This will help you to make more accurate and informed financial decisions to optimise your business funds.
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