Indian companies are struggling to maintain their profitability as rising debt levels and slackening growth begin to take a toll.
The return on total capital – a key tool to measure how profitable a company has been on its invested capital – has been steadily deteriorating over five years. It is down from an average of 29 per cent in 2007-08 to 20.5 per cent in FY13 for a sample of 142 of the BSE 200 companies (excluding banks and financial entities).
Analysts say the return on capital employed (RoCE) is among the preferred tools to measure how efficiently a company uses its financial resources. This ratio deteriorates if a company takes on large debt or is not able to increase its profits commensurately.
Says Saurabh Mukherjea, chief executive, institutional equities, Ambit Capital: “RoCE is the most relevant, most critical matrix to measure the quality of a corporate franchise. We look at it extensively for all our corporate coverage.”
Indian companies were enjoying a higher return on capital till 2009 because the economic cycle was on an upswing. But the Lehman crisis in 2008 put a spanner in the growth wheels and return ratios began to deteriorate.
Mukherjea, however, says he’s not too perturbed about the slippage. He views it as a part of the economic cycle, which turns every three to five years. He’s more worried about many companies destroying return extensively by taking up aggressive expansions and doing unnecessary mergers and acquisitions.
Says Mukherjea: “More worrying is the self-destructive behaviour of Indian companies that do unnecessary M&As (mergers and acquisitions) or take up aggressive capital expenditure and destroy returns. It's got very little to do with government policies but more to do with companies themselves doing harm to their balance sheets.”
The economic situation notwithstanding, some companies have managed to increase their returns on capital considerably over the past five years. Among those with the highest increase are companies with little or no debt and where the profits have been rising. Castrol, for instance, has increased its RoCE to 104.3 per cent in five years. Titan Industries has seen an increase to 59.4 per cent.
Analysts see this ratio as critical to value creation. Says Bharat Shah, executive director, ASK Group: “Companies with higher RoCE and a decent profit growth create outstanding value.”
Indian companies that have consistently kept their returns on capital higher than 30 per cent have seen an increase in market values by around 89 per cent in the past five years. Companies with an average return on capital of 15-30 per cent have seen an increase of 38 per cent in market values.