The Covid-19 crisis and consequent lockdown across the country, for over 60 days now, have led to a severe decline in business demand and revenues and profits of both big corporates and those in the unorganised sector. Micro, small and medium enterprises (MSME), automobile & ancillaries, construction materials, travel & tourism, real estate, logistics and hospitality have all taken a beating.
The only sectors that have bucked the trend in market capitalisation are FMCG, which has declined by only 1.64 per cent, and pharmaceuticals, which has grown by 0.47 per cent. Vulnerable sectors such as realty, travel, hospitality, leather and textiles as well as MSMEs need to act now to be able to arrest the imminent decline in financial health.
The ongoing pandemic has thrown up multiple challenges to businesses on the four pillars of financial health, namely profitability, which is the ability to generate a surplus and earn reasonable returns on investment; long-term solvency reflected by positive net worth or owned assets being higher than external liabilities; technical solvency or the ability to meet current cash requirements; and continuity of operations ie the ability to sustain revenues.
Improving profitability
With profitability being a function of revenues, operating and financial costs and investments, the burden of improvement falls on augmenting revenues, minimising costs and carefully managing assets.
Augmenting revenues: In recent years, with the development of e-commerce platforms, the B2B2C model has become popular. E-commerce companies/websites, by expanding their consumer reach and establishing their brand, are in a position to sell to the end consumer as well as engage in the wholesale and distribution business. They become ideal partners to companies, be it restaurants or engineering goods manufacturers, who have the production capacity but not the consumer reach to augment revenues.
The social distancing norms may henceforward promote e-selling through B2B2C as opposed to personal selling, and could be particularly attractive for MSMEs.
Co-opetition is another workable solution, wherein competitors mutually agree to cooperate with each other by transparently sharing information and refraining from discount sales to liquidate inventory. Some textile companies have already formed a syndicate to prevent cut-throat pricing and ensure threshold sales and reasonable price realisation.
Minimising operational costs: When a firm’s sales are 60-80 per cent of break-even level, cost-cutting is the accepted operating turnaround strategy to trim the visible fat. There are opportunities to minimise the cost of raw-material inputs, evidenced by the commodity price index decline of about 10 per cent from 76.69 in October 2019 to 68.53 in March 2020. It is an opportune time for companies to move over to ‘strategic sourcing’ and enter into long-term agreements with fewer vendors, leading to a win-win situation for both suppliers and customers.
Companies should leverage on spends, information and relationships and adopt the ‘total cost of acquisition’ approach for long-term benefits. Further, companies should graduate to an ‘extended enterprise’ that entails e-integrating with suppliers and the trading community, to reduce transaction costs. For this, a peer-to-peer (P2P) networking approach ensures that the fixed operating costs of technology are shared by the participating companies.
Finally, this may be the right time to identify and focus on core competencies and outsource non-critical items/services. Outsourcing contracts should, however, be flexible and include portfolio contracts, wherein the buyer has the right to switch between the long-term, spot and options contract, depending on the market supply-demand dynamics.
Many companies have initiated pay cuts at the senior level to reduce their fixed costs and have stopped incentive payments to control variable costs. The steep decrease in crude oil prices to around $10 per barrel offers opportunities to companies who consume refined petroleum products such as furnace oil and diesel.
Reducing financial costs : Cash liquidation of excessive inventories and thereafter graduating to a ‘just-in-time’ (JIT) approach will be beneficial in the long term. Interest rates in India have declined by 0.25 per cent, which will marginally reduce the financial costs. Despite technological advances and pathbreaking legislation like GST, the cash economy is still rampant in India and a shift from the manual accounting systems to digital mode is warranted to minimise transaction costs.
Improving solvency
To ensure long-term solvency, balance-sheets should be made asset-light by outsourcing noncore/noncritical activities and availing soft loans under the Government of India’s ₹3-lakh-crore credit guarantee scheme, concurrently retiring expensive term loans.
Technical solvency can be achieved by liquidating inventories and realising receivables through factoring with banks.
Ensuring sustainability of operations
Operational sustainability can be achieved by closely monitoring the number of parameters that influence liquidity, profitability and stability of the business.
The key metrics for monitoring include net margin; inventory turnover; working capital cash cycle; and debt service coverage ratio (DSCR). These ratios reflect the ability to generate cash profits, the velocity of turning over inventory and sales, and the cash cushion available to meet debt obligations. Sectors that have a long operating cycle, like steel and aluminium, need to relook their value chain and supply parameters and, if need be, appoint supply-chain intermediaries.
Leveraged companies are vulnerable — for instance, hospitality, FMCG, ports, auto ancillaries and telecom companies that have a debt equity ratio greater than 1 and low DSCR ranging from 2-3, would — with declining revenues — suffer a liquidity crunch, rendering debt servicing difficult.
Operating leverage (OL), that captures the sensitivity of profit change with respect to revenues, is a control lever for CFOs. For instance, a company’s OL based on ₹100-lakh revenues, ₹40-lakh variable costs and ₹50-lakh fixed costs, is 6 — the contribution of ₹60 lakh divided by earnings before interest and tax (EBIT) of ₹10 lakh. A revenue increase by 20 per cent translates to higher EBIT of 120 per cent and vice versa.
Thus, a positive EBIT of ₹10 lakh soars to ₹22 lakh during normal times, and crash-lands to ₹2 lakh loss during a Covid-like scenario. Hence, it is vitally important for vulnerable companies to examine their cost structure and convert items of fixed costs to semi-variable costs.
This is where re-engineering techniques like zero base budgeting, that looks at revenues and expenses on a de novo basis; and value stream mapping, that identifies value-adding activities and eliminates non value-adding activities, thereby reducing fixed costs, are essential.
Conclusion
The pandemic has been labelled the 10th Black Swan economic event and is expected to result in major shifts in people’s socio-economic habits, which will adversely impact the fundamentals of businesses such as travel and tourism, necessitating drastic changes in their business models. Other businesses and industries that are reeling under the onslaught of the lockdown need to handle the shocks with sound financial acumen and the kind of defensive strategies discussed above to turn around from the crisis that has engulfed them and restore their financial health.
(Suresh Mony is Director, and Narayani Ramachandran is Associate Professor (Finance), at NMIMS, Bangalore.)