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Every business leader wants to make her company's operations as environmentally sustainable as possible. But, what about a company's financial sustainability? After all, a company can go bust due to financial mismanagement or miscalculations by its management.
In the recent past, many leading companies have either closed operations or flirted with bankruptcy, owing to financial miscalculations by their management. The operating environment may worsen further for financially weak companies, in view of global economic uncertainty and market volatility. So it makes sense to invest in companies that are most likely to survive the economic downturn and thus have the first mover advantage once the economic environment turns favourable.
We have made the task easier for you. Starting this year, BS1000 companies will also be ranked on a financial sustainability index (FSI). Broadly, this index answers the question: How financially sustainable is a company's business? A company appearing higher on this index has greater staying power to withstand economic turmoil. While this is not the same as saying the company is more attractive to investors, a company with more sustainable finances is surely better placed to reward its shareholders than its financially suspect peers.
The choice of ratios is based on certain broad assumptions: One, the market knows the best and we should follow its cues; two, cash flows from operations are a better indicator of profitability than operating profit; three, too much debt is counterproductive in the longer term; lastly, we assume that chasing unbridled growth is futile, and may actually expose a company and its shareholders to unnecessary risks. Economic growth is a highly managed affair nowadays, with many government and public agencies involved, but beyond the control of anyone. This has resulted in a volatile and uncertain macro-economic environment. So, investors are better off looking for companies that are best placed to take advantage of emerging opportunities, rather than those that are likely to grow fastest. A consistently faster growth is an expensive proposition and cuts both ways.
The first priority for most companies in an economic slowdown is to weather the downturn without any damage and prepare their organisation for the opportunity that will open once the economic environment becomes favourable. And this what the BS Financial Sustainability Index shows. The index is based on six financial ratios that together capture a firm's historical earning power, their ability to generate internal accruals, debt servicing capability, health of the balance sheet, operational efficiency and relative market valuation. A company with the best record on these parameters can always be relied upon to grow faster and deliver superior returns to its shareholders.
The index is a weighted ranking of the BS1000 companies on the following parameters: equity to debt ratio (10 per cent weightage), sales to asset ratio (20 per cent), accumulated retained earnings as a percentage of a firm's total assets (20 per cent), net cash flows from operations to interest payments (20 per cent), cash flow from operations to a company's enterprise value (20 per cent) and market capitalisation to total assets (10 per cent). The first variable is a gearing ratio, and a higher value means that either the company is in a low-capital industry, or it relies on internal accruals (equity) to fund growth. A lower leverage ratio greatly reduces downside risks in the event of an economic slowdown and is a sign of financial conservatism. Traditionally, leverage is measured as debt divided by equity; but we have inverted it, as many companies in our list are zero-debt firms.
The ratio of sales to assets is an efficiency parameter and indicates a company's ability to generate revenue per unit of investment in assets. Though it varies from industry to industry and fluctuates over the business cycle - the ratio falls as companies invest in new projects, and rises as production is ramped up - a higher ratio is a sign that the company its milking its assets meaningfully.
Accumulated retained earnings as a proportion of total assets reveals a company's earnings record via-a-vis its funding requirements. A higher ratio means that the company is primarily dependent on internal accruals and retained profits to fund growth, and doesn't need to approach shareholders time and again for fresh capital. The latter leads to equity dilution and opens the company to the vagaries of market volatility. These companies usually have high return ratios and always command a premium valuation over their peers. We are talking about companies like NMDC, GSK Consumer, Hindustan Zinc, Honeywell Automation, ABB, Container Corporation, Bharat Electronics, GSK Pharma, Siemens, Bosch, Blue Dart, Hero Motocorp and Engineers India, among others. Over 90 per cent of the assets of these companies have been financed by internal accruals and their growth plans are not dependent on the whims and fancies of the stock market or interest rate cycles.
The ratio of net cash flows from operations (CFO) to interest payments (in the latest financial year) indicates a firm's debt servicing ability; the higher the ratio, the better it is. The fifth ratio, CFO to enterprise value, is a valuation multiple and a lower ratio means the company is attractively priced compared to the cash flows its business generates. This ratio generally favours cash-rich but low-priced stocks in sectors such as metals, mining, capital goods, chemicals and auto parts. We chose enterprise value instead of market cap to account for borrowings and free cash on the books of many firms.
The companies were then ranked on the market-capitalisation-to-assets ratio, to reflect the market value of a company's assets against its book value. A value greater than one means that the company's assets are more valuable than its book value, and this only happens when it has been consistently generating superior returns on capital employed (RoCE) and net worth (RoNW). Some of the companies topping the charts on this score include Colgate-Palmolive, Castrol, Hindustan Unilever, Nestle India, Titan Industries, Asian Paints, ITC, TCS, Bajaj Auto, Hawkins Cookers, Marico, Dabur India and Pidilite Industries, among others.
Finally, we ranked companies according to their consolidated revenues and average market capitalisation in the last three months. This was done to ensure that small companies don't crowd out bigger companies from the list. This was necessary because it is far easier for smaller companies operating in niche industries to generate superior financial ratios compared to large companies with many product lines operating at the national level.
This gave us a list of companies that not only have robust finances but are also fairly large in terms of revenue and market capitalisation. Does this index work in the real world? We tested it on the companies that comprise the BSE-200 index and our portfolio beat the Nifty-50 by a wide margin. We selected 162 non-financial sector companies from the index whose finances were available for FY09.
We then made a portfolio of the top 25 per cent companies in our universe.
This portfolio on average gave a 58 per cent cumulative return in the last three years, against a 6 per cent return provided by Nifty-50. If you had invested Rs 4 lakh split equally among 40 companies that were in the top quartile in our ranking, your money would have grown to nearly Rs 6.5 lakh by now. A similar investment in the Nifty-50 would have grown to around Rs 4.3 lakh.
This doesn't mean that all stocks on our portfolio did well. Some delivered negative returns, but their losses were more than made up by out-performers, and that's why it is always advisable to have a diversified portfolio.
Bajaj Auto had the highest FSI this year, followed by Hindustan Unilever, Hero Motocorp and Colgate Palmolive (See table). A quick survey of toppers suggests that the bigger companies are not always the healthiest, and that consumption-oriented companies have better finances than infrastructure and capital goods makers. This is not surprising. The stock market is in love with consumer goods stocks in these times of uncertainty and volatility.
