Indian economy is on the back foot as compared to its global peers. Indian economy entered the pandemic period with an injured foot. One of the biggest impediments to India’s economic growth has been the muted level of investment activity in the last decade. Fixed capital formation (in lay man’s term capital expenditure or capex) grew at 8 per cent during the FY 2010 to FY 2020 as compared to more than 15 per cent in the immediate previous decade. While this is the status of the Indian economy, we try to understand what capex means for companies.
Capex, in any industry, exhibits the confidence of the entrepreneurs to generate profits from the business. Increased capex shows that the entrepreneur believes that the products/service in which he/she is getting into will have sufficient demand to achieve profitability. The COVID-19 pandemic has punctured many organisations' ability to execute capital-depended projects.
The path to recover from the crises and resetting the capital expenditure cycle remains a long one. Thus, companies should evaluate the impact of the pandemic on the demand of their product and services before getting into long bets of capex.
Deferring capex for a while will give time to the entrepreneurs to assess the situation in a better way and also will free up substantial cash reserves.
Factors to be considered before committing
The main objective of capex:
- To expand the business to different location, increasing product line
-Technological upgradation
-To replace existing machinery
-Increasing the capacity
Demand for the products and service (domestic or international) is the main factor in taking the decision of any of the above activities. Entrepreneurs should regularly take market leads to assess the demand for their products/ services.
Important things to evaluate before incurring capex
-Payback period
-Cost of finance and return on capital invested
-Liability tenure
-Availability of stressed assets
-Options of using an asset-light business model
It is important that companies' liability mirrors the payback period of the underlying asset. Many companies face the challenges of asset liability period mismatch and start showing signs of stress. In most of the cases the payback period is greater than the liability tenure that means you have to pay your entire liability (loan) before the cost of the asset is recovered.
Chinese companies have been able to do a better job at matching their liability profiles with their investments’ payback periods in comparison to Indian companies. This leads to choking up cash flows of Indian companies and the availability of working capital thus reducing the competitive advantage in the global market.
Companies looking for investing should evaluate the option of buying stressed assets at a cheaper cost and reviving the unit. This will reduce the cost of the company and also utilisation of idle capacity.
Tweaking the existing business model to an asset light model is also another way to save capital cost. Companies can take advantage of excess utilization in the economy and outsource the orders to other firms.
When should MSMS start considering investments
The government has by far taken measures to incentivise the supply side. In order to recover demand an aggressive government spending on infrastructures is the need of the hour to boost employment and revere the adverse impact of COVID-19. Companies will take a cue from government spending to start their investments. Recovery of the construction, real estate and manufacturing sector will give a green shot that demand will revive. Increased spending by governments (both by centre and states) will start the capex cycle; this will lead the big companies to start investing consequently generating employment and reviving demand for products and services. The resetting of the capex cycle will give opportunities to MSME to start investing.
In conclusion, the entrepreneur should keep an eye on Government and big corporate spending to start their investment cycle. The impact of slowdown will be there for some time so entrepreneurs should give special attention on the payback period and their liability tenure.
(Input by CA Abhay Nair)
Dr Menon is a business coach and a Professor at SP Jain school of Global Management
