Rising expenses: A long term trend

Updated: Oct 30 2005, 05:30am hrs
Profitability is determined by higher sales over costs. But there are times when costs exceed sales. Most of the time, costs escalate on the back of higher raw material expenses. There are other factors like interest rates, labour costs or, for that matter, exchange rates that can severely affect the bottomlines.

An analysis of 800 companies who have declared their second quarter results shows that expenses have grown at a faster rate than net sales. Overall net sales have moved up by 17.58% and total expenses have moved up by 18.78%. The operating margin has more or less remained constant at 33%.

Some of the companies that have seen their expenses soar belong to steel, power generation, shipping and finance. The steel industry is one of the most affected sectors where raw material costs have taken its toll. In general expenses have moved up by 12% compared to a 2.60% rise in income. Ispat, one of the bigger players in the industry, also saw its expenses rise by 14.60% vis--vis a 20% decline in sales.

Analysts feel that the overall outlook for the sector is negative on the back of poor second quarter results. This is evident from the fact that realisations for the sector have come down. Tata Steel saw its total income and net profit move up by 7% and 12.4% to touch Rs 4395 crore and Rs 1045 crore, respectively. On the other hand, the realisation per tonne for the company has come down to Rs 37258, a fall of 7.40%.The slackening Chinese demand is more cause for worry. According to a report, global steel production is expected to drop by 9.7% in the second half as some of the biggest producers of are cutting production as world demand is stagnating.

Interest costs

Interest rates have been benign in the past few years. But in the last one year or so, interest rates globally have started to move up and the same trend is expected here. In terms of interest costs, the interest cover for corporate India is healthy at 3.02.

There has been no substantial change in the way companies have tried to pay off their debt but rising interest costs may affect the profitability margins of the company. This is seen in companies involved in the business of oil exploration. ONGC saw its interest cost go up by 140%. Yet the interest cover of the company is still robust at 1455 times. For the previous year the same figure stood at Rs 2989 crore.Many companies have made expansion plans and have planned to increase capacities. A lot of them have also accessed the primary capital markets by way of IPOs for funding the expansion plans. As many as 25 companies came out with IPOs during April-September 2005.

A number of companies have financed their expansion plans either fully or partially by way of loans. As the interest rates start moving northwards, there will be pressure on corporates to maintain their margins. The impact is already been felt in the last quarter. The textile sector saw the total interest costs going up by 175%. But when it comes to cotton textiles, interest costs have gone down by 20%.

Says a fund manager with a leading mutual fund, "As far as the blue chip corporates are concerned, there is nothing to worry in terms of servicing the debt. Further, the appetite for debt is also very huge. The only thing that may deter the companies from borrowing is the cost of borrowed funds."

Commercial banks look for signals from the RBI for any changes in the interest rate regime. Analysts predict that interest rates in India will harden in the times to come. Correspondingly, the RBI has increased the repo and reverse repo rates by 25bps in the recent mid term review of monetary and credit policy. This effectively means that the interest rates on the loans taken by and the deposits made by public will go up. Says Romesh Sobti, executive vice president and country representative, ABN Amro Bank NV, "The policy rate hikes are bound to translate into a moderate rise in the borrowing and lending rates. The increase in general provisioning requirement for 'standard' loans from 0.25 to 0.40 per cent will strengthen the case for higher lending rates."

Dollar-rupee movement

Having talked about the interest rate scenario, let us focus now on another important parameter directly influenced by the interest rates in the country i.e. the Indian rupee. The year 2003 marked an important change in the domestic foreign exchange market, as this was the year when the rupee started appreciating against the US dollar. Since then, a lot of changes have happened in the global scenario. In the last one year, the US Fed has been consistently hiking the interest rates in a measured way i.e. 25bps. This means that the rupee should depreciate and the dollar should appreciate, but that is not the case with the Indian rupee because the forces of demand and supply have pushed the rupee up due to a booming economy.

In contrast to this, the last three months have seen a huge depreciation (around 3.6%) in the rupee for various reasons. While the exporters are having a merry time, its now time for importers to pull up their socks and take stock of the situation. Further, a lot of companies have gone in for foreign currency borrowings. These companies were having a good time when the rupee was appreciating, as they had to pay less for buying dollars. But now, with the rupee depreciating, these companies, who have not hedged their foreign currency risks, are now facing pressure to maintain margins.

Revenues per employee

Software companies who consider their employees as their greatest assets saw the per employee revenues fall by around 6%. Infosys and TCS, the two major software companies saw their revenues per employee fall to Rs 4.96 lakh and Rs 5.59 lakh, respectively.

Much of the reason was attributed to the fact that there has been a high attrition rate in the industry where companies have lost experienced people and had to replace them with fresh graduates and train them. Correspondingly, the retention costs have gone up in the industry. This, coupled with the increase in the employees, added to the fall in the per employee revenue.

During this quarter, Infosys saw its total employee strength go up by 40% over the last one year. For TCS, the same figure stood at 30.24%. On the other hand, Wipro saw its per employee revenue increase by 2.46% at Rs 5.47 lakh. It is interesting to note that profit per employee for the company fell to Rs 1.04 lakh, a decline of 6.12% over the last quarter.

Software companies are worried about the rising cost of employees as it is taking a toll on their profitability. Both Infosys and Wipro saw their operating profit margins fall. Infosys saw its OPM fall to 32.49% (previous year 33.14%) and for Wipro the same figure was at 21% (previous year 24%).

While the focus of the market is currently on the toplines and bottomlines, one must not forget that expenses also form an important aspect of profitability. It is better to be cautious than to experience a rude awakening.