Mumbai: The recovery may be on, but smaller Indian firms listed on the country’s exchanges are not out of the woods as yet.

The aggregate net profit of 2,028 firms, with net sales between Rs1 crore and Rs500 crore, has declined by 1.64% in the quarter ended 30 September. In comparison, companies with sales of at least Rs1,000 crore and more saw a net profit growth of 13.65% in the quarter over the corresponding period last year.

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Mid-sized firms with sales of between Rs500 crore and Rs1,000 crore recorded a net profit growth of 28.5%.

Three key ingredients were responsible for the poor showing of small firms: interest expenses, raw material costs, and the so-called other income or income from their non-core activities.

While the larger companies saw a significant drop in interest costs, they also saw a jump in other income comprising sale of assets and treasury income. Mid-sized companies that had net sales between Rs500 crore and Rs1,000 crore saw a significant, 13.7% drop in raw material costs.

Small firms neither had the advantage of other income nor could they significantly cut their raw materials cost. Their other income actually dropped 15% year-on-year (y-o-y).

A Mint study covered earnings of 2,607 companies for the September quarter. Oil firms and financial firms are not included in this study.

Oil and gas firms’ earnings depend on volatile international crude prices and a subsidy sharing mechanism by the Union government. Banks and financial institutions have a different earnings model as non-interest income is a part of their regular earnings, but for manufacturing and service sector firms, income generated from peripheral activities is excluded from profit calculations.

Sales of 2,028 small firms fell 2.15% and their other income fell 15%. Their raw material costs too declined by 5%, but interest costs rose 1.3%

For mid-sized firms, the fall in raw material cost was much sharper. And the fall in other income for these firms was also much less, 2.7%, but their cost of interest too rose, by 4.8%.

For 81 large firms with sales exceeding Rs1,000 crore, the cost of raw material dropped 1.8%, but the drop in interest cost was much sharper, 11.3%.

Gaurav Dua, head of research at brokerage Sharekhan Ltd, said: “An important reason for the net profit growth is the margin expansion. This margin expansion has primarily happened because of the low raw material cost. These companies have been able to use (up) the high-cost material (because of higher sales and have moved to low-cost raw material). Smaller firms will have to exhaust the high-cost raw material (to bring the cost down)."

Interest costs

Another analyst attributed much of the phenomenon to interest costs.

Sandip Sabharwal, CEO of portfolio management service of another domestic brokerage Prabhudas Lilladher Pvt. Ltd, said, “I don’t think there is a big difference between the small and big companies in terms of using raw materials. But changes in interest costs usually hits the smaller firms with a lag. So, they will benefit with a lag."

In the aftermath of the collapse of US investment bank Lehman Brothers Holdings Inc. in September 2008, credit became scarce and interest costs rose.

In a similar study by Mint last year, the interest costs of firms with a market capitalization of at least Rs1,000 crore went up by 110% y-o-y in the September quarter, while it increased by 38% for firms with a market cap below Rs500 crore. But interest cost as a percentage of operating profit was 14% for firms with a market cap of at least Rs1,000 crore, while it was 38% for those with a market cap below Rs500 crore. Clearly, rising interest costs hurt smaller firms the hardest.

This year’s analysis, which is based on sales, shows that the interest costs of large firms have fallen sharply, while they have remained the same or declined only marginally for smaller firms. “Last year, most of the companies faced a squeeze on high interest cost. The larger companies have been able to negotiate better rates with banks," said Dua of Sharekhan.

Interest rate reductions by the Reserve Bank of India and government’s fiscal stimulus packages have helped revive demand and propel the Indian economy.

Profit at firms that are part of the 30-stock Sensex, India’s bellwether equity index, grew by 10.96% on average in the three months ended September, the best in five quarters.

According to Sabharwal, the overall growth momentum is beginning to return. “When this happens, it is the larger companies that benefit first as it takes time for this momentum to percolate down."


Fund managers say there could be potential investment opportunities in small stocks though they are still struggling. Nitin Bajaj, fund manager at FIL Fund Management Pvt. Ltd, the Indian arm of Fidelity International that manages assets worth Rs8,660 crore, said: “I would love to buy loss-making companies because they present the best value. But one needs to be careful or you could lose your shirt."

According to him, it is not easy to find undervalued stocks in the present market, but there are still many scrips with valuation anomalies among the smaller stocks; such anomalies are less prevalent in large-cap stocks.

“Pickup in the economy and growth in corporate earnings will be much more than what people expect," said Sabharwal of Prabhudas Lilladher.

Graphics by Ahmed Raza Khan / Mint