Aug 26, 2004|
Commodities: Shedding excess flab
Prudent financial management is key to the success of any business organisation. More so in the case of capital-intensive industries whose fund requirements for both, running the day-to-day operations as well as creating new assets are huge. Since, it is almost impossible to fund an entire project through equity, it becomes imperative for companies to resort to debt funding.
However, this very source of funding can prove to be a double edged sword. While in times of economic prosperity, (when demand is growing and capacity utilizations are at their peak) it can improve shareholders returns to a good extent; the damage may be even more severe during times of economic slowdown. Indian companies, especially from the commodity sectors of steel and cement have been guilty of carrying excessive debt on their books. However, in the recent past, these companies have been able to retire a substantial amount of debt and have thus become, leaner and stronger organizations. Let us try and find out what led to this phenomenon and the benefits that are likely to accrue from it going forward:
In case of steel industry, year 2000 and 2001 were one of the worst in terms of demand and realisations. The prices of steel were at all time lows and debt burdens were at all time highs. So, it was sort of a double whammy. But things have improved since then. Steel prices are near all time highs in recent times. On the other hand, the soft interest rate regime has helped companies restructure their debt. As can be seen in the graph above, the leverage (D/E ratio) for all the companies under consideration has come down in recent years. The major reason for this in case of steel industry is that the companies after achieving record profits in last year have reduced their high cost debt. Take for example steel major SAIL, it has reduced its debt by almost 50% in FY04. Government support also helped SAIL's case. The continued upturn in the cycle proved to be a boon for the steel industry and companies have improved their balance sheets in the last financial year. In case of cement companies, they focused on reducing high cost debt from their books, even though the growth in revenues and profits were not as high as that of their steel counterparts. It was more a case of prudent financial management helped by the soft rates.
These companies converted their high cost loans to low cost ones, improving their cash flows in the last three years. As can be seen from the graph below, the interest cost as a percentage of sales for the top commodity companies in India has come down in last five years. Average cost of debt for companies like Gujarat Ambuja has come down to from 12.6% in FY00 to 5.5% in FY04. Similarly, in case of ACC it has come down for 12% in FY00 to 7% in FY04. This has a huge impact on the net profit margins of the companies.
How does low debt on books help companies? Firstly, low debt equity ratio helps companies to improve their credit rating, which in turn helps them to access low cost debt. Secondly, it also gives companies financial freedom to raise debt when there is a need (such as capacity expansion). This enhances the shareholders value too, as the companies with lower leverage gets higher valuation and in case of any acquisition or merger these companies have higher bargaining power.
Lower debt leads to lower interest outflow, which in turn increases the cash flow to the shareholders. Higher cash flow for shareholders means higher returns in form of dividends or higher value of stock in the market, as commodity stocks are also valued on P/BV (price to book value) basis.
However, we have seen interest rates hardening since the beginning of the year and the interest rates are about 130 basis points higher than what they were in the beginning of the year. This increase, if continued, may not be good news for the companies in the commodity sector. While companies in the steel sector are planning to increase their capacity, higher debt cost can be a deterrent for these companies going forward. Investors must take a cautious view on the stocks from these sectors that have higher capex plans, as rising interest rates have a two-pronged effect on these companies. Rising interest rates will reduce demand for the product, as well as impact the bottomline of the companies due to higher interest outgo.
More Views on News
Jun 10, 2017
Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.
Aug 19, 2017
Ever heard of Lindy Effect? Find out how you can use it to pick timeless stocks.
Aug 18, 2017
Buying the index now will hardly help make money in stocks even in ten years.
Aug 18, 2017
Donald J Trump, a wrasslin' fan, took a 'Holy Sh*t!' blow on Tuesday.
Aug 17, 2017
PersonalFN simplifies the mutual fund account statement for you.
More Views on News
Aug 7, 2017
The data tells us quite a different story from the one the government is trying to project.
Aug 10, 2017
Don't miss these proxy bets on growing companies or in a few years you will be looking back with regret.
Aug 8, 2017
Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...
Aug 12, 2017
The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.
Aug 7, 2017
Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...
Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement. LEGAL DISCLAIMER:
Equitymaster Agora Research Private Limited (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA or Canada, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here
. The performance data quoted represents past performance and does not guarantee future results.SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.
Equitymaster Agora Research Private Limited. 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: firstname.lastname@example.org. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407