Cash flow-based analysis should throw up businesses better able to survive the transient effects of a working capital crunch, says Devangshu Datta.
Illustration: Uttam Ghosh/Rediff.com
Changes in the Goods and Services Tax (GST) over the past week might have eased the tax burden to some extent by moving many items down to the 18 per cent band, from 28 per cent.
But, the tax still lays heavy working capital burdens on businesses.
It needs to be paid upfront when invoices are generated, before revenues are actually realised.
The tax is then offset after matching the invoices. This is a long process. Indian businesses often have long credit cycles, which means more pressure.
This situation creates pressures up and down the chain: A cannot afford to pay B until A’s own payments come in and, in turn, B cannot pay C.
This will improve only if policymakers are sensible enough to make the requisite changes.
Otherwise, under-capitalised businesses - most small and medium-sized enterprises (SMEs) are - will struggle, even if larger businesses can bear the extra working capital costs.
The required policy changes are fairly major.
The government would have to alter the invoice requirements considerably.
Perhaps it needs to forgo payment of tax upfront on invoice generation and switch to a more practical regime of collections every quarter.
This could mean serious changes in the GST software and rebooting of the GST Network (GSTN).
Cynically speaking, policymakers are likely to be deeply reluctant to do this, until they are forced, either due to widespread protests or massive drops in tax collection.
So, this situation could lead to either transient (we hope) or more permanent pressures on the financing cost front.
It is likely to show up in corporate results of the second (Q2) and third quarter (Q3) for certain, and there would be an effect until some form of rectification occurs.
Under the circumstances, interest costs will rise and operating margins could be deceptive, since a company can show revenues it has not received.
Revenue is shown on accrual basis in the profit and loss (P&L) accounts.
In these special circumstances, there are unusual delays on actual receipt of revenues, while tax is paid early.
That could render accrual-based ratios, such as operating margins, and return on capital less transparent.
We might see a peculiar situation where supposedly highly profitable companies are struggling to meet working capital costs.
Other ratios could also deceive. For example, debt: equity ratios are usually calculated on the basis of long-term debts and liabilities and, hence, might not show the impact of higher working capital needs.
So, it is possible a corporate with decent debt:equity ratio would be struggling if its working capital costs suddenly spiked and revenue realisation slowed.
Return ratios such as return on capital employed (RoCE) have the numerator calculated on an accrual basis and, again, this could be deceptive.
Interest coverage ratios are also likely to give false comfort if free cash flows dip.
Instead of only looking at operating margins, debt: equity ratios, interest cover and return on capital, etc, there would have to be a sharper focus on cash flow.
Its analysis would show the degree of stress and help pinpoint corporates with serious problems.
For example, if there’s a major difference between cash flow from operations (CFO) and operating profits, RoCE will be higher than warranted.
Corporates with high sales on credit will be flagged by comparing their CFO to operating revenues.
Essentially, this means replacing the accrual-based numerator in various ratios by the equivalent in terms of cash flow.
Not an approach followed too often. Typically, it’s not mentioned in management discussion on balance sheets.
Also, not reported upfront by financial media. So, it does require some work to institute these filters and the results could present a very different picture from conventional balance sheets.
Is this worth doing, even if the GST Council does institute changes and the working capital crunch eases? The short answer is, yes.
Cash flow-based analysis should throw up businesses better able to survive the transient effects of a working capital crunch.
The same sample of companies will also show improved cash flow, as and when GST settles down.
Cash flow analysis is useful under most circumstances but it could be especially important under the current GST regime.