The good, the bad and the risky

With the economy mired in a slowdown and the possibility of any decline in interest rates fading, the months ahead promise to be tough on companies which have taken on high levels of debt. The Reserve Bank of India’s recent measures to mop up excess liquidity from the system have had the effect of spiking the cost of short-term borrowings as well.

As short-term borrowing costs for companies have gone up by almost 2 per cent in just a month, they will now have to shell out more to finance their working capital requirements.

This may force companies facing a cash crunch to delay or even default on their immediate repayments to lenders and depositors. Signs of the cash crunch are already evident from instances such as Orbit Corporation delaying interest payments, Educomp Solutions delaying salaries to its staff and Coal India facing mounting dues from the power sector. This will surely have severe adverse implications for investors in their stocks. So, which sectors and companies are most vulnerable to the coming cash crunch?

We analysed recent numbers of the BSE 500 companies to find out.

High on debt

Before we get to individual instances, Corporate India has seen a steady fall in its debt servicing ability in the last three years.

With profits slowing down or even declining for many companies, the equity component in balance sheets has grown at a much slower pace than debt. While debt has increased by 23 per cent annually for BSE 500 companies, reserves grew by only 14 per cent since 2010. This has led to higher debt-equity ratio (ratio of long-term debt and shareholders’ funds). The average debt equity ratio increased to 1.8 times in 2012-13 from 1.3 times in 2011-12.

Particularly hit were sectors such as steel, construction, power generation, and infrastructure. Construction and infrastructure companies such as Hindustan Construction, GVK Power, JP Associates and IL&FS Transport, power generation companies Adani Power, JP Power, and Tata Power and some steel companies such as Electrosteel top the list of highly leveraged companies with a debt-equity ratio of over three times.

Yet, even after factoring in some monetary easing in recent times, the RBI has raised its policy rates by a total of 250 basis points between January 2010 and now. Hence, while the economic slowdown or hurdles to project completion slowed revenue growth for companies, interest costs have been heading up. In 2012-13, the sales growth of BSE 500 companies stood at 15 per cent, but interest costs shot up by 27 per cent. This hurt the ability of companies to service interest payments. In the BSE 500, 44 companies had a precarious interest cover (the number of times operating profits cover interest payments) of 1.5 times or less.

Of the companies with heavy debt burden, Adani Power, CPCL, Electrosteel, GVK Power, Kesoram Industries, Sri Renuka Sugar, and Tata Steel had less than 1 time interest cover in 2012-13, based on their consolidated numbers.

Slowing growth and pressure on earnings have been even more pronounced in the June ending quarter. The number of companies with an interest cover of less than 1.5 times bloated from 44 in March 2013 to 53 by June 2013. Some of the companies which saw their interest cover dip below one were Ranbaxy, Ashok Leyland, Shasun, Bombay Dyeing, BEML, and Balrampur Chini. While a dip in cover for a single quarter need not set the alarm bells ringing, investors may need to keep a close watch on these companies over the next few quarters.

These trends could see some companies stretch their finances to service debt while others actually delay payments to creditors. So, which sectors and companies would be most impacted by this liquidity crisis?

Who’s at risk?

Companies with higher reliance on short-term debt and those with long cash conversion cycles seem to be the key ones at risk.

An analysis of numbers for the BSE 500 companies showed that the cash conversion cycle (inventory + debtor – creditor days) for the entire universe increased from 40 days in 2011-12 to 56 days in 2012-13. In 2012-13, sectors such as realty, construction and infrastructure had long cash conversion cycles. So did capital goods, consumer durables, fertilisers, pharmaceuticals and textiles.

However, delving into the numbers shows that investors looking to avoid liquidity risks should take a company-specific view, rather than a sectoral one. A long working capital cycle will lead to actual credit problems only if accompanied by high leverage and low interest cover.

For instance, though realty is often seen as the immediate victim of a liquidity crisis, most realty players today appear to be on safe ground with relatively low debt and comfortable interest cover. In spaces such as capital goods, however, there are surprises. Take public sector major BEML, which is at risk not just from a long conversion cycle, but also from nearly 59 per cent of its total debt coming from short-term sources.

The defensive pharma space has Ranbaxy and Shasun featuring low interest cover in the latest June quarter, the former due to forex losses. Shasun funds nearly half of its total borrowings through short-term debt. In the case of Ranbaxy, close to 60 per cent of its total debt is short term. Most other players in the pharma space had a very healthy interest cover and thus seemed shielded from the liquidity crunch. Within textiles, Bombay Dyeing and Raymond had less than one time interest cover as of the June quarter. Both had a cash conversion cycle stretching on beyond 100 days, with nearly one-third of their total borrowings coming from short-term sources. Of the consumer durable players, Bajaj Electricals had a low interest cover of 1.1 times, mainly triggered by a sharp profit decline in June. Its performance in the coming quarters may bear watching. In the auto space, Ashok Leyland made losses attributable to the cyclical downturn in the commercial vehicle cycle during the June quarter, thus impacting its interest cover.

Though many of these stocks have been battered during the recent market correction, these metrics suggest that now is not the best time to bargain hunt. As economic recovery still remains elusive, investors should pick and choose cyclical companies with high interest cover, a short working capital cycle and strong cash generation.

> radhika.merwin@thehindu.co.in

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