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Corporate India: Not `capital'

Anup Menon

CORPORATE India has been going through a tough phase. With the downtrend in the economy persisting, earnings and profitability have been hit.

But companies also have to worry about their capital structure. With the equity market rocked by scandals and poor expectations slashing valuations, companies may have had to float their stock at prices discounted well below their true worth to compensate for the risk premium.

While many companies did not want to do this, the other options would be either not to invest or to go in for debt financing. Against this backdrop Business Line studied the entire sample of manufacturing companies for a four-year period to determine their debt profile.

Declining debt

A comparison of the debt-equity ratio over the last four years indicates that the proportion of debt in the capital structure is declining. For instance, the median debt-equity ratio declined from around 0.63 in 1998 to around 0.43 in 2001.

This means that either the companies have been reducing debt in their balance-sheets or the net worth has been rising. Between 1999 and 2001, net worth rose by around 6 per cent. At the same time, long-term borrowings dipped by around 9 per cent. This means that the fall in debt-equity ratio is largely due to declining debt. But does this sound contradictory? Perhaps not.

The decline of the equity market over the last few years is obvious. At the same time, raising fresh capital has also not been a priority for many companies.

For instance, in the same period of analysis, post-tax earnings have been on the rise. This means the companies have been using some of the excess cash to pay off debts. Two aspects have to be noted in this context:

First the declining interest rate milieu means that corporates were better off replacing their high-cost debt with lower-cost funds. For instance, the debt taken on in the balance-sheet somewhere in the mid-1990s would have been at an average cost of 14-16 per cent. In comparison, the current cost could well be 10-12 per cent. Therefore, it made sense from the cost saving-perspective for companies to replace costly with low cost debt. However, if that had been the case then there should not have been a decline in long-term debt.

Given that raising long-term debt would mean having good credit rating, many companies, especially those in the commodities business, would have had trouble. The state of the many industries has led to considerable downgrades in credit quality in the manufacturing sector. This means that raising long-term funds would have meant companies paying a higher rate of interest to compensate for the additional risk premium.

The other major aspect of debt repayment is probably the lack of investment opportunities for companies. Since the opening up of the economy in the early 1990s, expectations have been running high.

Companies felt that business prospects would move fast and they did not want to be caught on supply shortages. Therefore, in this period, many industries built up sizeable capacities way ahead of demand. However, the current slowdown means that much of these capacities are in excess. Hence, in the current situation there seems to be no scope for further investments. This would mean that companies may actually not look at raising capital for the long term, and, since they do not have the opportunities to invest their additional cash, they might as well reduce costs by paying off debts.

Implications for equity shareholders

The implications for equity shareholders are complex. Given that earnings are increasing, the repayment of debt means that more money moves into the hands of the equity shareholders.

Therefore, to that extent they can expect to receive a higher income — especially if the company declares dividends. But if the companies decide not to pay out dividends, then the investors' gains are purely linked to capital gains. Given that business conditions are not so good, expectations are likely to be weak which would again lead to lower valuations.

Hence, the question of whether the repayment of debt has actually helped equity valuations has to be answered in the negative for the past two years when this has mostly taken effect. Will this state of affairs change for the better remains to be seen.

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