In national accounting, it is normal practice to adjust for inflation. However, the same convention is rarely followed in corporate accounting. Balance sheet and profit and loss (P&L) entries are usually reported without inflation adjustment.
In a fiscal like 2011-12, this hides the extent of slowdown. As this newspaper reported recently, the early bird results of 399 companies in Q2, 2011-12 (September quarter) shows that, while topline has grown 27 per cent, net profits are up just merely 5 per cent. Of that 399 sample, 56 companies reported losses, while 144 reported lower profits.
Part of the extra burden was interest costs, which were up 52 per cent. Raw material expenditure for manufacturers rose 38 per cent. Overall, the net profit margin dropped to 10 per cent (from an earlier 12 per cent).
Nominally, those aggregated results are disappointing. A net profit margin of 10 per cent is just marginally better than the current yield on government securities. If we discount for inflation, these results are abysmal. The wholesale price index averaged around 9 per cent point-to-point through the first half of the fiscal. Any form of inflation adjustment such as constant rupee accounting would reveal that aggregated net profits were really losses.
There's also strong evidence that many treasuries didn't hedge forex exposures sufficiently. There have been huge forex losses reported by many different businesses. This trend of forex losses happened in 2008 as well.
While forex losses or gains are technically extraordinary items, anybody aspiring to run a multinational companies must learn how to hedge unpredictable currency fluctuations. Thus far, India Inc. shows little signs of gaining expertise at this.
The ballooning interest costs also suggest a certain lack of foresight in companies that didn’t even have to cope with forex exposures. The RBI started hiking policy rates in February 2010. It is reasonable to expect that businesses would have adjusted to that policy trend by April 2011. Even more disturbing, this could mean that many apparently profitable businesses simply cannot handle rising cost of capital.
Given the global macro-economic situation, it would be optimistic to expect a turnaround in December quarter. The rate cycle will have to first top out and then reverse direction. That will have a lagged effect. The global situation will have to stabilise and that too, will have a lagged effect. The March quarter may be better than September quarter, but it's possible that December quarter will be worse.
Equity valuations continue to look frothy, despite 20 per cent drop in index values in calendar 2011. The chances of more earnings downgrades and steep price corrections in the next six months is high. A prudent investor could wait for that. At the least, anybody with equity exposures should be prepared to average down, if the market does breakdown.
The author is an equity and technical analyst
