October 6: It is not unusual to see good Indian companies like Infosys or Crisil, engaged in the services sector, generating large quantities of free cash and being totally debt free.

But it is extremely unusual for a manufacturing company to be in the same league. Sundaram Clayton Ltd (SCL) of the TVS group is one such company with this distinction. It carries a debt equity ratio of 0.09:1 which makes it almost debt free.

In a difficult year the company managed to reduce debt to these levels, and at the same time, managed to grow its business by 20 per cent, improve operating margins to 15 per cent and push up its return on average networth to 18.5 per cent.

But this trend has been prevalent amongst all companies under the management of Venu Srinivasan. Even companies like TVS Suzuki, that set a scorching growth of 35 per cent last year along with an expansion of capacities, managed to generate large free cash flows and at the same time managed to remain relatively debt free.

This is also true for other group companies like TVS Electronics, Lakshmi Auto Components and Sundaram Fasteners.

A widely practiced convention with Indian companies is the diversion of funds into all kinds of activities; whether investing in unrelated businesses or simply shoring up cross-holdings in group companies directly or by extending soft loans to subsidiary investment companies to perform the same task, while being heavily indebted themselves.

SCL itself has a very strong investment portfolio that mainly comprises holdings in group companies, but this is done in a transparent manner through direct equity holdings and given the kind of companies invested in, it is quite a good thing.

These equity investments alone are worth around Rs 120 crore and provide substantial value to the stock.

All the TVS group companies enjoy good market valuations; better than the average market valuations and certainly better than those given to most Indian industrial groups.

Sundaram Clayton's valuation at 15 times its historical earnings is in line with the group's overall valuations, the exception being Sundaram Fasteners which rightfully is ahead of the rest, being valued at close to 20 times its historical earnings.

Cimmco Birla: risky capital structure

At the other end of the debt spectrum is a company like Cimmco Birla. By financing its assets with a debt equity ratio of 1.8:1 and with debts exceeding Rs 121 crore under normal circumstances, the company is exposed to a lot of financial risk.

To top that, last year was a bad and unfortunate one for the company which was caught unawares by natural disasters, sitting as it was on a huge pile of debt.

The company's operations is a good case of undiluted financial risk; a factor that severely dented profitability during the year, as the company obviously lacked the financial flexibility to fund its ever increasing inventories and receivables, except through more debt and that too expensive short-term funds.

Excess financial risk is unacceptable to a company like Cimmco Birla where its varied businesses operate at cumulative margins of just seven per cent and generate a return on average equity of below two per cent.

The extent and cost of the financial risk was obvious from both the dependence on short-term finance as well as the consequent cost.

The company's operations look more confused now than before. Being an engineering company, it should have been prepared for a lot of contingencies.

More so considering that one of its core businesses is project exports and equipment supplies to the cement industry; both being uncertain and competitive businesses.

Further, there seems to be limited scope for a reduction in debt given that the company feels the need to diversify further and put money into infrastructure projects, without really having the financial or physical resources.

As if that was not bad enough it looks ready to pump in more money into its BOPP division (that once belonged to Biax Ltd), an industry hit very badly by overcapacity and low operating margins. The company also seems determined to finance the expansion of its cotton spinning unit.

Needless to say, the stock is at a five-year low. But the company was well thought of in the past and some bold decisions taken recently, like hiving off the spinning division and also the BOPP business, will improve margins and perhaps sentiment for the stock.

But more importantly, it will clean up the balance sheet and offer some badly needed financial flexibility. This is crucial for its future growth, considering that its main business of engineering is dependent on the company's ability to raise structured finance.

The only other way out for the company will be to raise fresh equity which will prove to be more damaging to shareholders, for the company can barely service its current equity.

Copyright © 1997 Indian Express Newspapers (Bombay) Ltd.