An oft-argued case for the Indian corporate sector re-starting the investments cycle is that it has de-leveraged its balance sheet substantially in recent years. But what seems to be happening now is that the corporate sector is raising leverage without increasing investments appreciably. Commercial banks have been cautious in financing long-term projects after the spate of scams. The threat of investigative agencies in the case of non-performing assets has added to the risk-averse attitude of bankers towards long term projects. But, apparently, banks are very well willing to lend for working capital requirements. Investments, therefore, continue to remain a non-starter.
But this cannot last forever. Corporates cannot rely on the free ride offered by high commodity prices, low leverage and low interest rates for long. Growth now faces new challenges. Basic balance sheet ratios derived from the published asset and liability statements of 3,135 listed non-finance companies as of September 2022 available in CMIE’s Prowess database provide some clues of the emerging business environment in 2023.
Net fixed assets as of September 2022 were 3.9% higher compared to a year ago. This, when adjusted for inflation, implies a shrinking of the assets base of these companies. Year-on-year growth in net fixed assets has been in low single digits in nominal terms since September 2020. Implicitly, the larger companies in India have effectively stopped increasing their productive base.
Through these two years, borrowings growth was also low, but it was higher than the rate at which assets were growing. In September 2021, borrowings were 12.1% higher than a year ago, and in September 2022, these were 11.8% higher. This much larger increase in borrowings than the increase in fixed assets is a potential red flag.
Companies have had to raise borrowings in recent years essentially to finance growing working capital needs in the face of high commodity prices. These needs are limited to some large industries such as those linked with crude petroleum, natural gas, metals and fertilisers.
In recent years, profits have also grown quite well and therefore shareholder funds with these companies have also grown very well—mostly in double digits during this period. This is reassuring. But, the resources made available by the increase in profits were inadequate to meet the increased working capital funds requirements of corporate India. As a result, borrowings went up and consequently, the debt-equity ratio of listed companies has inched up.
The debt-equity ratio was 0.63 times as of September 2022. This is the highest in eight years—since March 2014 when it was 0.64 times. The 10-year average gearing ratio works out to 0.57 times.
As borrowings by the corporate sector are rising, so is the cost of borrowing. The RBI has been raising policy rates to control inflation and the transmission of these rates has been good. As a result, the falling gradient of interest costs of the listed corporate sector seen so far has changed course. Average interest incidence of listed companies increased to 8.6% as of September 2022. It was 7.3% as of March 2022 and 7.2% as of September 2021. Before this, the interest incidence had declined steadily from 9.8 per cent as of March 2020. As RBI has continued to raise interest rates, it can be expected that the interest incidence of the corporate sector would continue to rise.
Rising borrowing needs and rising interest rates have come at a time when corporates are seeing a correction in their profit margins. The rising cost of funds is also a cause for shrinking margins. And, it would continue to be a cause for this shrinkage in the near future. Net profit margin had shot up to an all-time high of 9.5% in the quarter ended March 2021. The average margin has been around 5-5.5% in the past 10 years. Earlier, during the heydays 2007-10, margins were higher at over 7%. But, in the seven quarters—from the quarter that ended September 2020 through the quarter ended in March 2022—the average net profit margin was 8.5% with a range of 7.5-9.5%. This was an extraordinarily profitable period for listed companies.
This period seems to have ended with profit margins climbing down to 6% in the quarter ended June 2022 and then to 5.8% in the quarter ended September 2022.
Profit margins can be expected to decline further as commodity prices had corrected and interest rates are rising.
The free ride that the corporate sector saw in the past two-three years based on high commodity prices allowed the corporate sector to ignore expansion of its fixed assets base. But, it may find it imperative to expand fixed assets soon in the coming future. Asset utilisation has risen to its highest level in over 10 years. As of September 2022, net fixed assets utilisation (net sales-to-net fixed assets) has risen to 2.44. It was 2.23 as of March 2022 and the average since March 2010 was 1.95 with a range of 1.29 to 2.29.
The spiking of the net fixed asset utilisation ratio implies that it may not be possible to flog the same assets to generate topline growth. An expansion of the asset base is therefore imminent if the corporate sector needs to grow.
But, here is the catch. The need to fund the working capital cycle will continue for some more time and interest rates will continue to remain high. As a result, any further borrowing to fund the capex cycle will likely make the balance sheet of the corporates look a little stretched. Gearing ratios will go up and as interest rates continue to rise, interest incidence will rise and interest cover will drop. The uncertain global economic environment will not help.
It could be a Hobson’s choice—for the borrowing corporates and the lending banks. They may choose to stall or postpone growth or accept the gauntlet of higher leverage in an adverse external economic condition. 2023 is likely to be a discriminating business year for enterprises in India.
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