Relevance: Mains: G.S paper II: Schemes and policies analysis
Most industries suffer from unduly high logistics cost as a big handicap on their return on equity since it dampens their net profit margins. Understandably this makes industries like textiles, leather, chemicals, etc, uncompetitive in export markets
Return on equity of companies in India’s Nifty 50 index has been declining quite starkly even though this rarely receives the attention it deserves. It has fallen monotonically to 12.8% from 17.5% in FY09. Indeed, it stood at 25.4% in FY06.
The significance of return on equity in a capitalistic system is difficult to overstate. As per modern finance theory, if the return on equity in a country is less than the cost of equity then economic growth turns out to be counterproductive. In such situations, faster is the growth in revenues and profits, higher is the value destruction. Eventually, this is expected to cause flight of capital from that country.
Now, companies that form a part of Nifty 50 index—these are the strongest companies in India—are a decent reflection of India’s economy. Accordingly, the assumption that trends in return on equity for India, in general, would not be too different from those in Nifty 50 companies, may not be too off the mark.
The deterioration in the return on equity seems even more remarkable since expected rate of return from investments in India has not changed much. Expected rate of return—the return an investor expects from his investment—increases with risk free rate, and market risk premium. India’s risk-free rate, which is defined as the rate of return that can be expected from investing in a riskless instrument, has actually increased slightly.
India’s ten-year government bond yield, one can count this as a good proxy for the country risk and the closest an instrument can come to being called risk free, increased from 7% in FY09 to 7.4% in FY19.
Improved systems, augmented balance sheet for the government with falling fiscal deficit, higher incomes, consistent growth, advancing socio-economic indicators, ease of doing business, etc, should have reduced sovereign risk for investments in India. However, factors like political risks, opaque policy-making process, sluggish legal system, corruption, poor land records, etc, may be the reasons for this resilience of risk-free rate. Similarly, market risk premium too does not seem to have changed much. Slippage in return on equity even as expected return has moved sideways has reduced India’s attractiveness as an investment destination by reducing margin of safety for investors.
The return on equity has three levers—it is lower when net profit margin, i.e., net profit as a percentage of revenues, asset turnover ratio, and financial leverage are lower, and vice versa. Return on equity, which is net profit as a percentage of equity capital deployed, falls if net profit growth is slower than growth in equity capital, i.e, if the net profit margin slips. Sluggish growth in India’s corporate earnings along with shrinking net profit margins in last six to seven years is the main reason for this sustained softening of return on equity.
Secondly, return on equity compression happens if the incremental equity capital is not being deployed efficiently which essentially means that asset turnover ratios, revenue generated for every rupee worth of asset, have declined. Financial leverage, the ratio of debt capital and equity capital, moves in cycles though currently it is on the higher side as compared to FY09, and, hence, hasn’t caused much damage to return on equity.
That return on equity has been softening over a decade suggests that this decline may have some structural elements. If not arrested and reversed quickly, it may hamper the country’s ability to attract investments. Even locally sourced capital may move towards more productive usage elsewhere if return ratios do not improve fast. It is in this context that the government’s recent move to slash the corporate tax to 22% from 30% seems like a much-needed one. In one shot, this has pulled up return on equity by 10%—from 12.8% in FY19 to about 14.1%.
However, return on equity of 14%, as can be expected after the corporate tax rate cut, still seems too low for a developing economy like India. Even for low-risk sectors like fast moving consumer goods, utilities and tech services the cost of equity is not too different from this figure incremental investment. This suggests investment, even in these well-placed companies, may not be much value accretive.
Indeed, return on equity must be reasonably higher than cost of equity for value creation to take place. Adverse return on equity-to-cost of equity differential often tempts corporates to try to push up their return on equity by using the third lever mentioned earlier, i.e., increasing financial leverage. Such an increase in debt capital obviously is a risky strategy as it causes sharp deterioration in balance sheets.
The key lies in the next set of big, focused reforms. First, land reforms are required to enhance the asset turnover ratio as well as net profit margins, thus, bolstering return for new projects. Such reforms should include improvement in systems of land records and titles, faster process of land acquisition, and moderation of land acquisition price. Second, labour reforms are needed urgently to improve productivity, and net profit margins.
Here, the government is progressing well. Out of the four exhaustive proposed labour codes, one has been made into a law, and the second has been introduced in the parliament. There is a need to look into the issue of training and skill development with an aim on productivity enhancement. Third—rapid upgrade of infrastructure is another basic, but urgent, requirement. Most industries suffer from unduly high logistics cost as a big handicap on their return on equity since it dampens their net profit margins.
Understandably this makes industries like textiles, leather, chemicals, etc, uncompetitive in export markets. This includes improvement in roads, railways, ports and their hinterland connectivity, digital infrastructure, urban infrastructure, and development of new urban agglomeration. Finally, a long overdue reform is one to overhaul the judicial system. The pace of dispute resolution needs to improve and the process needs to be simplified. These reforms may take between one year and three years to show some difference. The important point is to initiate the process—to ensure better returns on equity deployed, or else the progress to $5 trillion economy may be a listless one.