The Hindu Business Line : In the interest of filling corporate coffers

MARKET interest rates determine the extent to which existing investment opportunity will be utilised. In recent years, there has been a significant decline in the nominal interest rate. The cost of capital has been kept down by the economic system and the Reserve Bank of India's initiatives to encourage investment, keeping in mind the requirements of the economy.

What is the impact of this reduction in interest rates on a corporate's fixed capital formation, dividend payment, retained profit and so on? A quick analysis with data from an RBI report titled `Finances of Public Limited Companies.'

The first parameter is the interest-output relationship. During the 1990s, interest as a percentage of output decreased from 5.7 per cent in 1988-89 to 4.9 per cent in 2003-04 except for three years from 1998-99 and 2001-02 when the gross output declined in absolute terms without a corresponding fall in interest payment.

Interest as a percentage of total outstanding borrowings will show the capital cost as comprising borrowings from banks, and other sources, debentures, bonds, and so on. From 1988-89 to 1990-91 corporates had to bear an interest of 17-20 per cent on borrowed funds, which, over the years, has fallen persistently to about 10 per cent in 2002-03.

The interest cost has been declining following the fall in interest rates. Interest cost has enormous implications on a company's profits. High interest cost cripples profitability. In 1988-89, corporates had to sell nearly 65 per cent of gross profits to pay interest. This ratio declined during the next few years and was down to 50 per cent in 1993-94 and then to 48 per cent by 2002-03.

According to available data, gross profit as a percentage of net assets, which ranged between 9 per cent and 10 per cent from 1988-89 to 1997-98, declined to about 7 per cent from 1998-99 to 2002-03, the period when interest rates dropped considerably.

The fall in profitability during 1992-93 to 2002-03 was partly due to the rise in the cost of production, whose share in the value of output rose from 88 per cent to 89.8 per cent during this period.

A decline in interest rates should augment the retained earnings of corporates. Retained profit, which provides internal funds to the corporates, increased from 19.6 per cent of total resources in 1988-89 to 32 per cent in 1998-99 before moving down to 28 per cent in 2002-03 but still substantially higher than that of 1992-93.

This is clear proof of the healthy effect of the downward movement of interest rates on retained earnings of the corporates and is also reflected in the rise in share of internal resources in total liabilities of the companies.

An interesting point is that the impact of the interest cost has been mellowing with the continuous drop of the debt-equity ratio from 126 per cent in 1989-90 to 65 per cent in 2002-03. Thus, it is advantageous for corporates to keep their borrowings under control and generate large reserves. Unfortunately, companies today do not follow rational policy with respect to their borrowings. Often they borrow heavily and fail to create the desired level of fixed capital formation.

The corporate investment strategy has been, by and large, to push up fixed capital formation as reflected in the rising share of net fixed assets in total net assets from 43.9 per cent in 1988-89 to 48.0 per cent in 2001-02 (see Table). The break-up of fixed assets shows that share of plant and machinery in investment in fixed assets increased from 71.4 per cent in 1988-89 to 74.5 per cent in 2002-03 while that of land and buildings showed a marked decline. However, the overall investment preference does not show financial prudence. Companies have borrowed heavily to increase fixed capital formation but directed such funds to financial assets.

In 2002-03, investment in financial assets accounted for 12 per cent of total resources and more than 30 per cent of their outstanding borrowings. Between 1992-93 and 1994-95, corporates invested more than 15 per cent of their outstanding resources in financial assets. Moreover, they lent a substantial amount as loans and advances to subsidiaries and sister concerns, probably due to their low credit rating.

On an average, investment in financial assets per company, which was just Rs 2.7 crore in 1993-94, gradually and continuously increased Rs 26.7 crore in 2002-03. Similarly, loans and advances to subsidiaries and others have shot up from Rs 1.34 crore to Rs 20 crore in the same period. Which means that a company has been investing heavily in financial assets. In 2002-03 this amount was Rs 47 crore.

Let us now examine investment in financial assets in terms of rate of returns, which will include interest and dividend.

Return on financial assets was around 5 per cent from 2000-01 onwards against 10-11 per cent cost of borrowed funds. Even between 1990-91 and 1998-99, profits of corporates ranged between 11 per cent and 16 per cent. The overall profitability has always been much higher than the return on the financial assets. If so, why should there be a diversion of funds?

And why do companies keep borrowing at high cost and then invest funds in financial assets which earn a lower rate of return? Two reasons could be to achieve good cash management and judicious handling of borrowings especially for events requiring large amounts of money.

Taking into account all this, there is no reason for a company with inadequate production capacity to invest Rs 40-50 crore in financial assets.

The question arises whether the RBI should prescribe a cap on financial investments by corporates. For instance, investment in financial assets should not exceed 1 per cent of net assets of a company and that should be only in government securities such as Treasury bills or approved securities.

Finally, the policy of low interest rates has resulted in fixed capital formation at a relatively higher rate than any other assets of a company but not to the full potential due to diversion of funds.

It is advisable now to keep the lending interest rates down without hurting savings in financial assets. The government should bring down inflation to the level at which real interest rates on almost all investments are positive at 2 per cent. Banks can also help by reducing their spread by improving the efficiency and reducing operating costs. Part of the gains from such efficiency should be given to depositors in terms of interest on deposits.

(The author is former Economic Advisor to SEBI.)

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