The immediate impact of rising inflation is clearly visible on interest rates, which have also been moving up. That in turn is also reflecting on economic and corporate growth. Such a situation will bring with it a number of challenges for companies as they seek to fund their day-to-day operations as well as manage future growth.

In a rising interest rates scenario, where easy money gets wiped out (thanks to equities turning unattractive), banks also turn stringent while lending to companies.

For now, the fact that the prime lending rates, at which companies typically borrow from banks, have shot up and currently hover at about 15-17 per cent as against the 12-13 per cent three years back is a matter of concern.

What this means is that the companies, which are heavily dependent on the borrowings for their future growth plans as well as companies that have heavily borrowed in the past, are very likely to feel the heat.

Little wonder that the rising interest cost has forced some companies to stall or go slow on their expansion plans, while those that have already raised the money through debt are seeing the impact on their respective gross margins and profitability.

Need to be cautious

It seems that tough times, especially for companies with high debt and high working capital requirement, are here to stay for some more time.

That, many of these companies could still manage their growth and profitability is a possibility, but as an investor, one needs to be cautious in the eventuality of the macro environment worsening from current levels.

In a scenario where demand for many industries is slowing and commodity (where companies have announced mega investment plans) cycles are perhaps closer to peak levels, inability to effectively manage the rising interest rates and the debt burden could impact financials and hence, shareholder returns.

To put in perspective, according to investment experts, for the quarter ended June 2008, sales of the BSE 500 companies grew at about 37 per cent; however the growth in EBIDTA (profit before interest, depreciation, tax and amortisation) and profit after tax was marginal at 19.5 per cent and 6 per cent, respectively. The slow growth in operating and net profits was led by the rising input prices and interest cost.

For the same period, the operating and net profit margins dropped to about 21.1 and 9.1 per cent as against 24.3 per cent and 11.8 per cent, respectively in the corresponding period last year. Interest expenses as a percentage of operating profits went up to 40.3 per cent as against the 34.6 per cent, a jump of 570 basis points.

Further, the rising interest rates and high leveraging by way of raising funds through debt will only eat into the profitability of companies if they are not able to generate sufficient cash.

"Typically, cyclical businesses may draw healthy profits during the upturn in business cycle thereby showing healthy interest coverage, however when the cycle turns it becomes difficult to manage cash flows. In any case, higher leveraging is a risky proposition especially when the company is operating in a cyclical business," says, Chetan Parikh of Capitalideasonline.com.

Day-to-day business

Many companies require funds for their day-to-day business, which is popularly known as the working capital. Working capital is the current assets minus current liabilities of a company.

In simple terms, it is money invested in the form of credit to customers, unsold inventories, advances given and cash and bank balances on one hand, minus the credit received from suppliers and provisions made on the other hand.

Let's say a company has debtors (receivables) of Rs 100 crore (Rs 1 billion), inventory of Rs 100 crore and cash and bank deposits of Rs 50 crore, its current assets will stand at Rs 250 crore (Rs 2.5 billion). Theoretically, this also indicates that for the current sales turnover, the company will require Rs 250 crore towards the current assets.

However, if part of this money is funded by the current liabilities (say in this case Rs 150 crore including creditors) then the net capital or working capital required is Rs 100 crore. So, as business grows, the requirement for the working capital also typically keeps on increasing, unless the company efficiently manages its working capital-either by lowering or not allowing its debtors and inventories to rise or by seeking higher credit from suppliers.

For practical purposes, one should use the working capital figure in conjunction to the company's sales, as it offers a more accurate reading.

There are exceptions, too. There are companies, which very efficiently manage their working capital such that it becomes negative or is virtually zero. This happens when a company is able to keep its receivables and inventory levels low, or when its current liabilities are high enough to take care of the current assets.

In other words, the receivable and payables are effectively managed on a daily basis. Such a situation is mostly possible when companies have a dominant or large market share in their respective segments or where their sales cycle is short.

Here, other reasons leading to a low or negative working capital could be that the creditors are paid later or the customers are asked to pay up in advance. Efficient management of inventory can also help.

To name a few, Hindustan Unilever, Hero Honda, Bharti Airtel [Get Quote], Varun Shipping, Colgate Palmolive are among companies with a negative working capital, which is also partly responsible for them enjoying high return on equity range of 30-150 per cent.

The culprits

Achieving 'zero' or 'negative' working capital is a 'dream come true' for most companies. This is because most companies require a high amount of working capital or loans if they are to sustain growth rates in their businesses; the nature of the industry and the cyclicality of the business typically plays an important role here.

With every rupee increase in sales there is some amount of working capital required, which in many cases is as high as 60 per cent of the sales. For instance, for a company which is exporting its products, it will need to provide credit to its customers as well as invest in inventories to keep its production ticking.

Likewise, when demand is high in a sector, companies tend to expand existing facilities or invest in new capacities to gain from such opportunities. The expansion programmes typically get drawn up when interest rates are low.

Though a high working capital requirement or high debt level is not considered to be bad, it hurts a lot in a rising interest rate scenario, especially if the company is not able to generate enough cash, has a low interest coverage ratio, debt to equity is high, margins are low or sales volumes are not keeping pace.

To give an example, construction companies seem to require a high amount of working capital, which is why they are getting hit by the rising interest rates. These companies have to continuously invest to service their long gestation capital intensive projects (real estate, etc).

In case of real estate companies, in the past, many companies have purchased land at higher prices through short-term debt. However, to execute the same now, they require working capital.

In a scenario, where lending has been tight and interest rates high, it becomes difficult for companies to manage their working capital. The worst part is that demand tends to slowdown, especially housing and commercial, and property prices start correcting, all of which could lead to higher inventories and worsening financials for companies living on the edge.

"As long as the real estate companies can hold their inventories, which is possible if the company is having strong cash flow, high working capital and debt would not be a problem, but if things go wrong, the company may end up selling its inventory (constructed space or raw land) to pay its debt and interest, which is not good for its shareholders," says Parikh.

In some cases such as HDIL, Kolte Patil, Peninsula Land [Get Quote], Sobha Developers [Get Quote], Hindustan Construction and Orbit Corporation [Get Quote], the working capital requirement is in the range of 70-270 per cent of the sales turnover of the company.

However, this is not a bad sign till the time companies generate enough cash and maintain their debt-equity and the interest coverage ratio.

In the case of HDIL and the Peninsula Land, core working capital (total of inventory and sundry debtor minus current liability) as a percentage of sales is almost 210 per cent and 121.4 per cent, respectively. However, for both the companies debt to equity is 0.85 and 0.29 respectively and interest coverage ratio is 10.6 and 7 times, which provides comfort.

A glimpse of the past

Beyond sectors, there are examples of individual companies which have seen their debt and working capital needs rise over time. But, it certainly helps if one is able to identify such trends in the early stages.

Among examples from the past are JB Chemicals, which has a working capital to sales ratio of almost 60 per cent. The reasons: while its average credit period to its customers is almost 209 days, it gets only 44 days of credit from its suppliers.

Also, the company as of March 2008 was sitting on a total debt of Rs 196.3 crore (Rs 1.96 billion), paying a interest of Rs 17.98 crore (Rs 179.8 million), which is almost 40 per cent of its net profit, its interest coverage was 3.73 times. The company has been gradually increasing the capital employed in the business, which has risen at a compound annual growth rate of 23 per cent.

However, the CAGR in sales has been a mere 15 per cent over the last five years. Profits have crawled from Rs 48.54 crore (Rs 484 million) in FY03 to just Rs 51 crore (Rs 510 million) in FY08, partly due to the drop in EBDITA margins to 14.8 per cent in FY08 as against the 24.45 per cent in FY03.

In case of DCM Shriram Consolidated [Get Quote], too, its sales have grown by 14.74 per cent annually between FY03 and FY08, while EBIDTA margins have slipped from 13.92 per cent to 8.18 per cent in FY08. On the other hand, its debt has gone up from Rs 543 crore (Rs 5.43 billion) to Rs 1,783 crore (Rs 17.83 billion) (CAGR of 26.8 per cent) during this period; debt-equity ratio was 1.55 for FY08.

Little wonder, the company's interest expenses has been rising; for FY08, interest expenses stood at Rs 87.61 crore (Rs 876 million), as against the adjusted net profit of Rs 3.47 crore. The impact is also visible on its RoCE, which has come down to 3.93 per cent in FY08 as against the 17.86 per cent in FY03.

Moser Baer [Get Quote], too, saw its debt-equity rise from 0.73 in FY02 (total debt of Rs 806.6 crore) to 1.07 in FY08 (total debt Rs 3,184 crore). During this period, even as sales grew three times, profitability has not kept pace, and in fact worsened.

The company, which reported a profit of Rs 215 crore (Rs 2.15 billion) in FY02, has reported a loss of Rs 78.91 crore in FY08. This is in part due to falling EBIDTA margins to 26.10 per cent in FY08 as against the 47.5 per cent in FY02.

This has led to a large part of the operating profits generated being used to pay interest. The company paid interest of Rs 37.55 crore (Rs 375 million) in FY02, which has gone to Rs 179.36 crore in FY08. Also, during the same time, interest coverage dropped from 6.86 times to 0.45 times.

The reasons for companies going through a trough could be many and will vary. There could also be some rough patches wherein the business environment has turned weak due to technological changes, better alternatives and the like.

Likewise, there could be times when plans don't materialise as expected. However, if companies are not able to overcome these, then its impact will sooner or later reflect on their financials; a drop in return on equity and capital employed ratios in the long run.

While all this is history, it does not suggest that any of these companies are not a good investment. But in such cases, investors can learn that going forward, "if the business is not keeping pace along with the funds invested, it would in the longer run result in destroying shareholder wealth," says Deven Choksey, CEO and managing director, K R Choksey Shares & Securities. And, then things could only worsen.

Time to wake up

While the attempt is to explain the potential impact of high debt or high working capital, there are various other factors that ultimately impact the fortunes of a company.

While the industry structure is one thing, the key for any company is to be able to generate enough profits so as to provide dividends to its shareholders as well as to reinvest in its business to sustain growth rates, even if it may require taking some amount of debt.

Failure to do so, will impact stock returns. The examples mentioned above only explain the past. The future however, will depend on the initiatives these companies take to emerge stronger.

But, for the time being, the two tables (on working capital and debt) reflect the current state of affairs of some companies, which investors need to make a note of.

These companies apart, investors should also look at their existing portfolios for corporates with high leverage and inadequate margins and cash flows.