The first step towards managing a problem is acknowledging it. As far as the problem of debt overhang in Corporate India is concerned, banks continue to ignore the elephant in the room if a recent report from State Bank of India’s Economic & Statistical Research Department is to be believed. The report surmises that the top 10 most indebted Indian corporate houses are “comfortably placed” () with debt levels 2 times their networth and nearly 2 times their market capitalisation. The companies analysed include the familiar when it comes to over-leveraged corporate groups: R-ADAG, Vedanta, Essar, Adani and Jaypee. The combined borrowings of the top 10 corporates has been pegged at ₹7,33,542 crores as per a recent Credit Suisse report that highlighted the debt mountain and the problems it poses.
As per SBI, it is inappropriate to use ‘interest cover’ and ‘debt servicing ratios’ of these companies to drive home the problem of corporate indebtedness . The SBI analysts count myriad other aspects, which would offset the concerns over debt serviceability: “However, [debt serviceability] in itself is misleading as what is more important at the end of day is the networth, cash in hand, yearly accretion to networth, investments, market value of assets and unbundling of value of some of their subsidiaries thus overall defining their repayment capacity,” the analysts say. Most of their contentions ring hollow, IMHO for the reasons here-under:
The SBI analysts go on to suggest that ‘overall debt to networth’ and ‘debt to market capitalisation’ of such companies may be a good alternative to analyse solvency and sustainability. Its estimates show that on aggregate basis such top ten companies ratios stands at 1.93 times and 1.88 times, respectively, which is well within respected level of two times.
The SBI analysts also criticise the emphasis on operating profits on the grounds that the global slowdown has affected some of best international companies as well. Again, they suggest “networth also needs to be factored during lean times,”. Pray tell, what is networth made up of other than accumulated operating profits, fundamentally? Besides, when debt levels are at 2x your networth (and growing!), how long can investors and lenders overlook poor operating performance?
Networth also consists of Capital Work-in-progress (the amount of money spent on ongoing projects), Goodwill (that arises from pricey acquisitions), and Intangible Assets (by definition intangible, i.e. can’t be seen, i.e. can’t be relied upon to bail you out). Best of times, these ‘assets’ are not stated at anywhere their realisable value, assuming they can be realised. In times of market stress, the concern amplifies – a host of companies like Vedanta and Tata Steel have taken massive write downs (₹ 26,500 crores) on their investments, which hit networth.
2. Cash in hand:
Often, leverage ratios are calculated on a ‘Net Debt’ basis, i.e. net of cash balances rather than on ‘Gross Debt’ basis. The Enterprise Value of a business is also calculated after netting off cash. On the face of it, this may seem reasonable. However, one should realise that we are talking about a ‘Going Concern’, not a business in liquidation that can use up all its cash to pay off liabilities at will. A running business needs a certain minimum level of cash to sustain operations, meet short term liabilities and in most cases, also comply with loan covenants. It is a fallacy to assume that all cash is available to use at will, least of all for debt repayment.
3. Yearly accretion to networth:
This would perhaps be the fairest of all contentions made by the SBI analysts since there is no arguing with the ability of (cash) earnings to buffer the balance sheet as well as pay down debt. However, the analysts seem to have failed to realise that the businesses they are speaking of have earnings prospects that have been bleak, to say the least, for several quarters now. Eg. Reliance Infra, Adani Power and JP Associates among others are not earning enough EBITDA to even cover annual interest commitments (leave aside principal repayments). This is pre-depreciation. After providing for depreciation (these are going concerns, presumably), they surely do not cover interest payments.
Barring ‘Current Investments’ – more in the nature of cash; very liquid and of short maturity (subject to my reservations on counting cash as a ‘free’ asset, as stated above) – any other investments, especially in subsidiaries, projects and group companies are inherently undependable for lowering leverage (see networth above). In most cases, illiquid investments are carried at cost or some notional assumption of fair value. Liquidation value in a stressed scenario and in case of distressed sale would be much lower.
5. Market value of assets:
Presumably this includes assets other than investments and cash as discussed above. So these would be Plant & Machinery, Land, Buildings and the like. Some valid questions that arise around these: How liquid are these kind of assets? Are they free of any encumbrances? Are these assets the subject of any loan covenants that bar their sale? How much lower is the true realisable value as against the book value in balance sheet? Does anyone even want them?!
Market capitalisation varies daily and is subject to significant volatility. Networth is subject to a lot of accounting shenanigans and may not accurately reflect the true worth of a business in the best of times. Besides, can the banker/lender take over the market cap or networth in lieu of dues? Doesn’t make any sense.
The only adage that holds true for all businesses, especially the over-leveraged kind is: accounting networth is inanity, revenue is vanity, margin is sanity, and cash is king. Time that bankers realised this, got their heads out of the sand and stopped believing ‘one shall not shed tears till one sees the coffin’.