Despite High Profit Margins, What Stops Manufacturing Firms' Capex Cycle?

The key to generating jobs in India is getting the manufacturing story right. Despite several policy pushes over the last decade, the government has failed to crack it. Tax breaks, low interest rates and production linked incentives have not yielded the results that one expected.  

In recent months, robust index of industrial production and purchasing managers' index numbers have given hope of brighter days ahead. But manufacturing sector’s value addition in the country’s GDP continues to lag. According to World Bank data, the number was at 13 per cent till 2022, declining by 3 per cent since 2016.   

The magnitude of the challenge is not lost upon the policymakers. Speaking at an event last year, Finance Minister Nirmala Sitharaman had lamented the lack of appetite of industry players to invest in the country. “I have been hearing the industry does not think it is conducive to invest...Alright, bring the rate down, the tax rate was brought down... Give production-linked incentives. We have given PLIs. I want to hear from India Inc, what is stopping you [from investing]?” the FM had said. While the government pushes the private sector to invest, it has been doing the heavy lifting when it comes to capital expenditure and project completions.  

Also Read | Modi Government Delivers More To Compensate For Private Sector's Abysmal Project Completion Rate 
 
Outlook Business looked at the financial data of manufacturing companies for the last 10 years to assess the health and the future prospects of the industry. 

Lagging Investment In Expansion  

Over the last few years, the growth in net fixed assets of manufacturing firms has been subdued as seen in the graph. Net fixed assets refer to land, buildings, plants, machinery, etc. The growth in net fixed assets would suggest that firms are adding more capacity to cater to increase in production and other operating activities. However, as seen in the graph, the growth trajectory of net fixed assets of around 10,000 manufacturing firms has been subdued. After the high of 2014-15, it has steadily declined with a rise in 2019-20. Initial data for 2022-23 of around 500 companies indicates that the growth still remained subdued in the last financial year. This suggests that the firms haven’t invested significantly in expanding their production capacity.  

Suman Chowdhury, chief economist and head of research at Acuite Ratings, says that one of the key reasons behind it has been inconsistent growth of Indian economy in the last few years which led to low confidence in firms to expand capacity. “Even before the pandemic started, the pace of growth had slowed down. The pandemic shock as well dealt a blow to the economy. The focus has been on recovering from the dip seen in growth.” 

Indian economy grew at a meagre 3.7 per cent in 2019-20, a year before the pandemic, suggesting the structural problem in India's growth story.  

Due to uncertain outlook regarding demand in the Indian economy, Aniket Dani, director of research at CRISIL Market Intelligence and Analytics, says that the appetite to add capacity has been low in the last few years. Experts point to the bank credit offtake number seen in the last few years to showcase industry’s low demand to expand capacity. While the services sector has seen a strong growth in credit offtake, the same has not been the case for the industry sector. Industry includes manufacturing apart from other categories like power, construction and mining.  

Looking at the sectoral deployment of credit in 2023, the growth to industry sector has been sluggish. Dani says it is not the case that banks are not willing to give credit to these firms but the demand for credit from these players hasn’t been there. “The reluctance to expand capacity boils down to one main reason of the firms not being sure about existing demand in the markets.” 

Another factor that has weighed on these firms’ calculation to invest in capacity expansion is the high cost of commodities which affected the expenses of these firms.  

The largest spike in operating expenses was seen in the cost of raw materials, power and fuel for these firms. Wholesale Price Index inflation rose sharply between 2020 and 2022. According to data, WPI inflation grew by 12.01 per cent year-on-year in June 2021 and 15.18 per cent in June 2022, which led to an increase in prices of commodities. However, analysts say that the spike in prices of commodities has cooled down and the expenses of firms on raw material will come down in future. The WPI inflation declined 4.18 per cent as compared to previous year in June 2023.  
 
Are Brighter Days Ahead? 

With expectations of commodities prices going down and consistent economic growth in the coming years, some analysts strike an optimistic note on manufacturing capacity addition. Chowdhury says, “Rising capacity utilisation by firms may lead to increase in growth of net fixed assets in the coming quarters.” 

According to available RBI data, capacity utilisation has been steadily rising after falling below 50 per cent at the height of the pandemic. At the end of 2022, capacity utilisation reached 74.3 per cent, which indicates that firms are increasing the use of existing production lines to meet demand. 

It is expected that the capacity addition will pick up pace as the utilisation improves further, Chowdhury claims.  

Analysts also point to improving profit margins of manufacturing firms which will help in investing in fixed assets in the coming days. Soumyajit Niyogi, Director at India Ratings & Research, says that recent financial numbers of these firms give signs of hope. “Cash flow has surely improved, which will help in capital expenditure in the coming months. Despite headwinds, the firms were able to post good numbers,” he adds.  
 

A look at the data for profit margin of manufacturing firms shows that the numbers are at an all-time high. After posting subdued growth in profit margins in the last decade, the past few years have seen the firms increasing their margins substantially. This, the experts believe, will help in expansion of capacity in the coming years as they are better placed in terms of funding.  

However, Niyogi strikes a cautious note talking about the overall industry in the short-term. “While improving balance sheets place the firms in a better position, one of the most important factors is how demand will evolve. Recently, the exports numbers have been volatile given the uncertainty in many global markets. This can surely weigh on the plans of manufacturing firms.” 

 

According to CMIE’s exports as percentage of sales data for manufacturing firms, there has been a sharp decline in the number over the last few years. The weak demand, experts point, weighs heavily on the decision to invest in growing fixed assets.  

As the IIP continues to move in positive direction and the Indian economy posts growth, there are hopes that the manufacturing sector will pick up and invest heavily in expanding capacity. However, whether optimism translates into investment in India’s growth story remains to be seen, with several factors like global and domestic demand playing a big role.