With interest rates spiralling upward, stock market investors have been worrying about how Corporate India will cope with its debt burden. However, an analysis of latest Annual Reports (year ended March 2011 or December 2010) shows that Corporate India may be better off than expected.

Companies have made considerable progress in cutting back on leverage, debt:equity ratios are at their lowest levels in five years and four out of ten companies managed to pay down their debt in the last year. Here's a look at the key trends that helped India Inc improve its balance sheet.

Balancing act

A look at the latest annual reports of 204 companies of the BSE-500 (excluding banks and NBFCs) shows that India Inc substantially reduced its leverage by raising fresh equity and repaying debt. These companies saw their total debt increase by about 11.5 per cent over the year, while equity zoomed by as much as 20.3 per cent. They were largely helped by a bolstered equity base — the result of improved internal accruals and capital raising.

During the year, the outstanding equity capital of companies grew by 7.9 per cent, indicating they had raised more equity after the near lull seen in 2009-10. Companies such as MOIL, Coal India, Prestige Estates, VA Tech Wabag, SKS Microfinance and Lovable Lingerie, to name a few, are companies that expanded their equity base through IPOs last year. Companies such as Adani Enterprises, Tata Motors, IDFC, Mannapuram General Finance and Vardhaman Textiles raised funds through QIPs, Suzlon Energy, REI Agro and EIH raised funds through rights issues.

The sample of companies had reported an improvement in leverage even in the year before. However, they had reported much lower growth in total debt, of about 2.1 per cent, even as total equity had grown by over 21.9 per cent then. Incidentally, the lower growth in debt had come on a high base and was partly driven by the fact that Reliance Industries had brought down its debt by over 15 per cent, year-on-year.

Reduced leverage

Despite reasonable growth in cumulative debt last year, companies brought down their overall gearing, driven by a stronger growth in equity. By March 2011, the debt-equity ratio for Corporate India was at 0.49, down from the 0.53 of 2009-10.

The current leverage is also the lowest in five years. While the presence of a good number of low debt companies in the list may have skewed the debt-equity ratio to some extent, the trend remains the same even if we exclude zero-debt companies. Excluding them, the cumulative leverage ratio goes up a bit to 0.52 in 2010-11, still an improvement from 0.56 recorded the year before for the same set of companies. This again is the lowest in five years.

On the whole, 108 companies (of the 204 companies) reduced their debt-equity ratio in the year-ending March-2011, compared with the year before. Of this lot, six out of ten companies managed to pay down their debt. Jubilant Foods, Whirlpool of India, Zee Entertainment, and Piramal Healthcare are cases in point. Interestingly, a good majority of them (88 companies) reduced their leverage to either below or in line with FY08 leverage levels (year before the economic crisis).

Companies such as Marico, Aurobindo Pharma, Havells India and Unitech are examples of companies that, despite an increase in debt, reduced their debt-equity ratio over the year.

Divergent trends

There nonetheless remained a wide divergence in leverage ratios between sectors. Auto and auto ancillaries, which enjoyed a good growth in demand throughout the year, managed to lower their debt-equity ratio over the year. Interestingly, stocks from the capital goods stable too managed to bring their leverage down to more manageable levels. Pharmaceutical and software companies too lowered their leverage, driven largely by an increase in equity resource.

The construction sector, on the other hand, saw an increase in its leverage. But for Punj Lloyd, which saw a marginal fall in its leverage ratio, rest of the stocks in the pack reported an increase in their debt-equity ratios. Companies from the cement and realty sectors in the sample, however, saw little change in their gearing.

Among the other sectors that witnessed an increase in leverage are consumer durables and power generation. In the latter, players such as Adani Power, JSW Energy and Tata Power saw their gearing go up considerably.

Borrowing profile

The massive jump in overall debt over the year was accompanied by visible changes in the borrowing profile of India Inc. While the year before saw companies turn to low-cost secured loans over unsecured borrowings, last year companies seem to have opted for a bit of both.

In 2010-11, secured borrowings grew by over 17.4 per cent (9.4 per cent the previous year), while unsecured borrowings increased by about 10.4 per cent (negative 5 per cent). However, not all the borrowed money may have found use in capital expansion this time around.

Some of it could have been routed to fund the working capital requirements also, as gross block plus capital work in progress growth was relatively low (13.7 per cent). Unsecured borrowing was seen predominantly in construction, consumer durables, FMCG, pharmaceuticals, power generation and realty companies.

Interest costs

Companies, however, did feel the heat from rising interest rates, with average cost of borrowings increasing to 7.4 per cent from 6.8 per cent over the year. A rise in unsecured borrowings too may have driven borrowings costs up.

A healthy growth in topline — rising input costs and interest rates notwithstanding — helped these companies improve their interest coverage ratio.

Companies in the sample registered a 21 per cent growth in operating profits over the year. This, in turn, cushioned them against the rising borrowings costs. Interest coverage for the companies in the sample improved marginally from 9.5 to 10.0 over the year.

What lies ahead on debt?

While Corporate India's near comfortable leverage ratio does provide some confidence in its ability to keep its finances in shape this year too, investing in it doesn't come without challenges.

For one, the twin demons of rising inflation and interest rates remain and, if anything, have only grown stronger. This means companies aren't going to find it easy to borrow.

High borrowing costs and longer working capital cycles can put most companies' balance sheets to test.

Cash-rich companies or ones with negligible debt on books or companies with lower leverage and comfortable interest coverage ratio will be better-placed to sail through such times.

Even MNC companies with a strong parent backing may weather these times without much difficulty.

That said, not all sectors can be measured with the same yardstick, given that there already are visible signs of a moderation in demand across select sectors.

Thanks to the rising interest rates, companies in the rate-sensitive sectors such as auto, auto components and consumer goods have started showing signs of tempering demand.

Companies in the engineering, capital goods and infrastructure space have seen a slowdown in order inflows, reflecting moderating capex.

Specific stocks and sectors that are either relatively shielded from these or have a strong competitive advantage over peers make better investment candidates here. Bottomline — use broad market corrections to accumulate such stocks and avoid over-leveraged companies.

While this may seem to significantly shrink the investment universe, the good news here is that the interest rates cycle in India is not expected to remain on an uptrend for long.

With developed economies not growing at expected rates, commodity prices may start to fall sooner or later. For that matter, crude oil has already given up six months of gains.

The relief on the input cost front would also lead to a cool-off in inflation over time, thus making room for a fall in interest rates.

There is, however, another side to this. If the much-talked about QE3 does go through in the US, global investors' monies could find their way into commodities.

This could push up commodity prices and, hence, inflation in emerging economies. The ghosts of the past could revisit us then.

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