With interest rates creeping up, it is time for investors to be wary of companies burdened with debt and high working capital needs.
The immediate impact of rising inflation is clearly visible on interest rates, which have also been moving up. That in turn is also reflecting on economic and corporate growth. Such a situation will bring with it a number of challenges for companies as they seek to fund their day-to-day operations as well as manage future growth.
In a rising interest rates scenario, where easy money gets wiped out (thanks to equities turning unattractive), banks also turn stringent while lending to companies.
For now, the fact that the prime lending rates (PLR), at which companies typically borrow from banks, have shot up and currently hover at about 15-17 per cent as against the 12-13 per cent three years back is a matter of concern.
What this means is that the companies, which are heavily dependent on the borrowings (debt) for their future growth plans as well as companies that have heavily borrowed in the past, are very likely to feel the heat.
Little wonder that the rising interest cost has forced some companies to stall or go slow on their expansion plans, while those that have already raised the money through debt are seeing the impact on their respective gross margins and profitability.
Need to be cautious
It seems that tough times, especially for companies with high debt and high working capital requirement, are here to stay for some more time.
That, many of these companies could still manage their growth and profitability is a possibility, but as an investor, one needs to be cautious in the eventuality of the macro environment worsening from current levels.
In a scenario where demand for many industries is slowing and commodity (where companies have announced mega investment plans) cycles are perhaps closer to peak levels, inability to effectively manage the rising interest rates and the debt burden could impact financials and hence, shareholder returns.
To put in perspective, according to investment experts, for the quarter ended June 2008, sales of the BSE 500 companies grew at about 37 per cent; however the growth in EBIDTA (profit before interest, depreciation, tax and amortisation) and profit after tax was marginal at 19.5 per cent and 6 per cent, respectively. The slow growth in operating and net profits was led by the rising input prices and interest cost.
For the same period, the operating and net profit margins dropped to about 21.1 and 9.1 per cent as against 24.3 per cent and 11.8 per cent, respectively in the corresponding period last year. Interest expenses as a percentage of operating profits went up to 40.3 per cent as against the 34.6 per cent, a jump of 570 basis points.
Further, the rising interest rates and high leveraging by way of raising funds through debt will only eat into the profitability of companies if they are not able to generate sufficient cash.
“Typically, cyclical businesses may draw healthy profits during the upturn in business cycle thereby showing healthy interest coverage, however when the cycle turns it becomes difficult to manage cash flows. In any case, higher leveraging is a risky proposition especially when the company is operating in a cyclical business,” says, Chetan Parikh of Capitalideasonline.com.
Many companies require funds for their day-to-day business, which is popularly known as the working capital. Working capital is the current assets minus current liabilities of a company.
In simple terms, it is money invested in the form of credit to customers, unsold inventories, advances given and cash and bank balances on one hand, minus the credit received from suppliers and provisions made on the other hand.
Let’s say a company has debtors (receivables) of Rs 100 crore, inventory of Rs 100 crore and cash and bank deposits of Rs 50 crore, its current assets will stand at Rs 250 crore. Theoretically, this also indicates that for the current sales turnover, the company will require Rs 250 crore towards the current assets.
However, if part of this money is funded by the current liabilities (say in this case Rs 150 crore including creditors) then the net capital or working capital required is Rs 100 crore. So, as business grows, the requirement for the working capital also typically keeps on increasing, unless the company efficiently manages its working capital-either by lowering or not allowing its debtors and inventories to rise or by seeking higher credit from suppliers.
For practical purposes, one should use the working capital figure in conjunction to the company’s sales, as it offers a more accurate reading.
There are exceptions, too. There are companies, which very efficiently manage their working capital such that it becomes negative or is virtually zero. This happens when a company is able to keep its receivables and inventory levels low, or when its current liabilities are high enough to take care of the current assets.
In other words, the receivable and payables are effectively managed on a daily basis. Such a situation is mostly possible when companies have a dominant or large market share in their respective segments or where their sales cycle is short. Here, other reasons leading to a low or negative working capital could be that the creditors are paid later or the customers are asked to pay up in advance. Efficient management of inventory can also help.
|BORROW TO GROW?|
|Company||ROCE (%)||RONW (%)||
|Asahi India Glass||6.81||4.64||4.89||1.22||4.83||1067|
|DCM Shriram Cons||3.93||1.02||1.55||1.15||1.50||
|Moser Baer (I)||1.93||-4.91||1.45||0.45||1.07||
|Thomas Cook (I)||16.49||47.08||1.46||2.24||0.58||63|
To name a few, Hindustan Unilever, Hero Honda, Bharti Airtel, Varun Shipping, Colgate Palmolive are among companies with a negative working capital, which is also partly responsible for them enjoying high return on equity range of 30-150 per cent.
Achieving ‘zero’ or ‘negative’ working capital is a ‘dream come true’ for most companies. This is because most companies require a high amount of working capital or loans if they are to sustain growth rates in their businesses; the nature of the industry and the cyclicality of the business typically plays an important role here.
With every rupee increase in sales there is some amount of working capital required, which in many cases is as high as 60 per cent of the sales. For instance, for a company which is exporting its products, it will need to provide credit to its customers as well as invest in inventories to keep its production ticking.
Likewise, when demand is high in a sector, companies tend to expand existing facilities or invest in new capacities to gain from such opportunities. The expansion programmes typically get drawn up when interest rates are low.
Though a high working capital requirement or high debt level is not considered to be bad, it hurts a lot in a rising interest rate scenario, especially if the company is not able to generate enough cash, has a low interest coverage ratio, debt to equity is high, margins are low or sales volumes are not keeping pace.
To give an example, construction companies seem to require a high amount of working capital, which is why they are getting hit by the rising interest rates. These companies have to continuously invest to service their long gestation capital intensive projects (real estate, etc). In case of real estate companies, in the past, many companies have purchased land at higher prices through short-term debt. However, to execute the same now, they require working capital.
In a scenario, where lending has been tight and interest rates high, it becomes difficult for companies to manage their working capital. The worst part is that demand tends to slowdown, especially housing and commercial, and property prices start correcting, all of which could lead to higher inventories and worsening financials for companies living on the edge.
“As long as the real estate companies can hold their inventories, which is possible if the company is having strong cash flow, high working capital and debt would not be a problem, but if things go wrong, the company may end up selling its inventory (constructed space or raw land) to pay its debt and interest, which is not good for its shareholders,” says Parikh.
In some cases such as HDIL, Kolte Patil, Peninsula Land, Sobha Developers, Hindustan Construction and Orbit Corporation, the working capital requirement is in the range of 70-270 per cent of the sales turnover of the company. However, this is not a bad sign till the time companies generate enough cash and maintain their debt-equity and the interest coverage ratio.
|HIGH ON WORKING CAPITAL|
|H D I L||232.02||2.38||210.19||272.78||0.85||10.69||59.23||45.13||64.64|
|J B Chem & Pharm||13.34||57.58||59.96||70.68||0.43||3.73||8.09||10.69||11.69|
|Kolte Patil Dev||102.91||6.77||59.12||76.83||0.26||26.61||30.93||37.43||34.34|
|Ess Dee Aluminium||