Column: Between a rock and a hard place

Written by Ramraj Pai | Updated: Nov 22 2013, 10:06am hrs
The bright lights and festive cheer of Diwali had people hoping that some of the positivity would spill over into the economy and revive demand. But perhaps they were being a tad too optimistic. Slowing domestic demand is the biggest challenge faced by corporate India, and it seems it is here to stay. This problem is being compounded by stubborn inflation. Despite slowing demand, the CPI index breached 10% in October, diminishing hopes of a rate cut in the near future. Naturally, this isnt good for the industry, which was hoping for rates to soften at some point. Operating margins of rated firms are coming under pressure on account of their inability to pass on rising input costs to consumers. In addition, with the prospect of interest costs rising, India Incs credit quality looks set to remain under pressure. This is borne out by our study of 5,394 CRISIL-rated firms.

The study was based on data obtained from a sample of 5,394 CRISIL-rated firms, which is representative of CRISILs rating portfolio. The sample is well-diversified, as it has firms of varying sizes, from across rating categories and from 115 different industries. The operating income of the smallest firm in the sample is around R3 lakh, whereas that of the biggest one is around R1,36,557 crore.

In order to gauge the precise impact of the demand and interest rate scenario on different segments of India Inc, CRISIL segregated the firms by revenue into three bucketsup to R50 crore, between R50 and R250 crore, and R250-crore-plus. We then assessed the vulnerability of their interest coverage ratio (which indicates the sufficiency of operating profits to service interest costs) and profits after tax (PAT) in this fiscal by putting them through the twin sensitivities of an interest rate hike of 50 bps and a decline in operating profitability (OPBDIT) of 1%.

The 50 bps increase in interest cost is based on the increase in base rates by banks till date, as well as the CRISIL Centre of Economic Researchs rate expectations till the end of March 2014. Meanwhile, the slowdown in demandwhich remains a source of stress for a fourth of the firms assessed by CRISIL in its recently-launched State of the Nation reportwill result in pressure on the operating profitability of quite a large number of firms. While profitability pressures are likely to vary across different sectors, we have tried to gauge the impact of a uniform 1% decline in operating margins as part of our sensitivity analysis of the vulnerability of the rated firms credit profiles. Our analysis reveals that the double whammy posed by lower operating profitability and higher interest rates will have a significant impact on the interest coverage and PAT of the 5,394 firms (see tables 1 and 2).

Leverage, not size, the clear differentiator

An interesting insight arising from the data is that a firms revenue size has a lesser bearing on the impact on its coverage and profits than leverage. As table 1 shows, while the ability of smaller firms (less than R50 crore) to service their interest cost is likely to be affected, the impact is more pronounced on firms in the R50 to R250 crore and R250-crore-plus category. This also applies to profits after tax. More firms in the larger revenue brackets see declines in PAT, compared to the less than R50 crore bracket.

However, we have found a much clearer differentiator by segregating the data by indebtedness. The data reveals that a higher total outside liabilities to total net worth (TOL/TNW) ratiosignifying a more indebted firmattracts a higher adverse impact on interest cover and PAT.

In the overall universe of 5,394 firms, 23% of firms with a healthy TOL/TNW ratio of up to 2 times saw interest cover declining by over 20%. Also, 26% of the same subset saw PAT declining by over 50%.

However, as the TOL/TNW ratio increases to between 2 and 3.5 times and over 3.5 times, so does the proportion of firms getting impacted. In fact, among firms with a TOL/TNW ratio of over 3.5, over half (55%) will see interest cover reducing by 20%, and over two-thirds (71%) will see PAT reducing by 50%. This data seems to suggest that a firms indebtedness is the key differentiator when it comes to its ability to manage the impact of rate hikes and declining operating profitability margins (table 3).

Times have been tough for India Inc, and we believe that the rated firms find themselves between a rock and a hard place. Things will remain stressed for a while longer, particularly for firms that are leveraged to a higher degree. Factors such as high indebtedness, stretched liquidity and pressure on interest cover are impacting the real estate and infrastructure sectors adversely. Firms operating in infrastructure-dependent sectors like steel and power equipment have also been affected.

Of course, the ultimate recipe for growth is progressive policymaking that creates a favourable investment climate and regenerates demand in the long run. Quick fixes will clearly not be enough.

The author is president, CRISIL Ratings