Without stronger balance sheets, firms will perish in this harsh environment; board, group structure reforms will attract investors.
Going by the commentary from corporate chieftains, FY21 is probably going to be the worst year in decades. With its deteriorating debt profile, India Inc remains financially fragile and ill-equipped to take on a recession. Only well-capitalised businesses can hope to survive; over-leveraged players that are unable to generate cash flows will perish. Even getting back to the pre-Covid-19 growth levels isn’t enough because the existing supply of goods and services is way more than the demand.
That is clear from the decelerating growth in consumption demand in the last two years. Naturally, new project intentions are crawling; CMIE says they plummeted to about Rs 56,000 crore in the June quarter—a sixteen-year low. But, even in the June 2019 quarter—when there were no shutdowns—they were worth only `1.2 lakh crore, way below the long-term quarterly average.
But, it is not just the lack of demand that is holding back businesses from expanding, it is also the lack of financial wherewithal. Indeed, one should expect to see much more wealth destruction than wealth creation in the next couple of years. Brace for bankruptcies, thousands of them, mostly micro and small units. But also be prepared for some not-so-small companies to go belly-up. As one can see from the rising number of cases in the insolvency courts, the casualties were high even before the pandemic struck. Who would have thought a Jet Airways wouldn’t make it in the world’s fastest-growing aviation market!
The responsibility for the many corporate failures of the past 10-12 years lies, for the most part, with the managements or the promoters; they ran businesses that were over-leveraged and over-staffed, and indulged in over-priced and unviable acquisitions, and diversified into unsuitable areas. They failed to assess the competition, to anticipate the changes in consumer preferences and tastes and to keep pace with advancements in technology. They ventured into unfamiliar territory, aided and abetted by banks who over-lent, neglected to watch over the money and failed to recover it. If the loan losses of banks over the past decade are any indication, companies have ‘destroyed’ some Rs 20-25 lakh crore. If the business didn’t sink, its balance sheet remains bloated.
Indeed, most balance sheets are over-leveraged. Research from McKinsey published last year showed that companies hold 43 % of India’s long-term debt with an interest coverage ratio (earnings before interest and taxes over interest expense) of less than 1.5 times. This means much of the operating profits will be needed to pay the interest bill.
Operating profits last year for a sample of 1,691 companies (excluding banks and financials) were Rs 8.32 lakh crore—about the same levels as in FY17. Net profits in FY20, at Rs 2.64 lakh crore, were the lowest in at least the last five years; excluding TCS and Reliance Industries, the profits were only Rs 1.9 lakh crore.
S&P recently wrote that, despite several negative rating actions in the past three months, there could be a further downside for Indian companies; it added that about 35% of credit ratings on Indian corporates have either a negative outlook or are on credit watch with negative implications. In fact, if debt-free IT companies are excluded, the ratio deteriorates to one-in-two ratings. Having funded their expansions and acquisitions largely through debt, most companies today are financially fragile. The number of single ‘B’ ratings, for example, S&P said, increased to about 33% of total ratings at the end of 2019 from 13% in 2016.
Since it is going to be hard to generate revenues and profits this year, India Inc’s already anaemic debt profile can only worsen. McKinsey observed that many CEOs had indicated the crisis has knocked back their companies’ revenue levels to those seen three to five years ago. That doesn’t sound unlikely; at around `72 lakh crore in FY20, revenues, for the sample of 1,691 companies, were smaller than in FY19. These numbers could well shrink in FY21, given the prices of commodities are benign, and also because it will be harder to push through volumes at a time when consumer demand is weakening.
But, rather than wait, promoters need to raise capital fast. For too long, they have been sourcing their capital contribution from bank funds instead of their resources; one expects banks will be far more cautious and diligent now. Promoters must be willing to dilute their ownership, and while many will not get the price they want, they must realise the dangers of dithering. To attract investors, strategic or financial, they must reform and take the Governance in ESG a lot more seriously, strengthening the boards and cutting out complex group structures that allow them to transfer funds from one company to another.
Else, attracting serious investors won’t be easy. Also, the sooner they offload peripheral and unrelated businesses, and plough the cash back into the core companies, the better. There is no glory in running a dozen unviable businesses, and no shame in selling out. The way to a strong P/E multiple and a multi-lakh crore market capitalisation is through a lean, mean and clean business.