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Suresh Krishnamurthy

Increasing gross margins in every sector is easier said than done. With only the capital structure to tinker with, managers may have no choice but to increase the gearing levels and reduce interest costs. Loading the firm with more equity may only perpetuate their dismal record as destroyers of capital.

ANALYSIS of historical financial performance is never really useful. It is usually just history, and rarely a reliable guide to future performance. Analysis of past financial performance could, however, occasionally throw up useful hints, as in the case of the record of Indian firms in generating returns on funds invested. The record on this score is abysmal.

Notwithstanding an improvement in returns over the past couple of years, most Indian firms have not been successful in managing money, with financial leverage only pulling down returns. This is despite a substantial decline in interest costs over the past two years.

This facet of the Indian corporate sector is particularly relevant given that a number of companies are queuing up to raise capital from the public.

Lower return on equity: Finally, the return on equity is the parameter on which the performance of a manager will be judged. In the case of the S&P 500 firms, this return increased from an average of 11 per cent at the end of FY02 to 16 per cent at the end of FY04.

A number of firms in industries such as auto, steel, capital goods and hotels have managed to get more out of their assets contributing to an increase in returns. The sharp decline in interest cost, depreciation and lower incidence of taxes have also contributed.

Still, return on equity continues to be below that of return on assets. This prima facie indicates that the effect of leverage (that is, borrowing) has been negative. The return on assets that accrue to the equity shareholders has not exceeded the cost of borrowings.

Mathematics of returns: Mathematically, the return on equity would be better than return on assets only if the benefits of leverage offset the interest burden.

Higher leverage pushes up return on equity above that on assets. At the same time, interest costs pulls return on equity towards and below return on assets. Firms that manage to mitigate the effect of interest burden manage to add value to their shareholders.

Indian firms, however, have not been able to deal successfully with interest costs. Interest, depreciation and taxes account for roughly 56 per cent of operating income, while debt accounts for only about 40 per cent of total funds deployed. The unfortunate aspect is that this is the case even after the sharp decline in interest costs over the past three years.

The phenomenon of return on equity being lower than return on assets, is also not a statistical effect caused due to the terribly poor performance of a few firms.

Three hundred and fifty out of 464 companies drawn from the S&P 500 Index have lower return on equity than return on assets. Importantly, we have not considered the effect of time value of money. That could raise the number of companies destroying value to an even higher number.

Model companies: It is, however, not a total washout. A number of outstanding performers still dot the corporate landscape. These include Matrix Labs, Asahi India Glass, Jubilant Organosys, Bharat Forge and GE Shipping.

Prominent companies with a poor record, however, include MICO, Asian Paints, P&G Hygiene, Nalco, Infosys and Maruti Udyog.

The case of these otherwise well-run companies falling in the list of those with relatively lower return on equity suggests that managers may be reluctant to return cash. This, of course, is as bad as investing in operating assets that yield little.

Efficient capital structure: For a number of companies, however, the answer does not lie in their ability to tweak the assets more.

Companies that generated higher return on equity than the return on assets sported healthy margins. The gross sales margins of these 114 companies were higher than those of the sample average by about 5 percentage points.

Increasing gross margins in every sector is easier said than done. While industrial recovery and inorganic consolidation might help in this regard, competition constantly eats into margins.

That leaves managers only the capital structure to tinker with. Managers may have no option but to increase the gearing levels and at the same time reduce interest costs.

Innovative financial restructuring is the need of the hour. In contrast, loading the firm with more equity is only likely to perpetuate their dismal record as destroyers of capital.

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