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Essar Steel: Defaulting on Debt Repayment

ESSAR Group: Essar Group presently is a conglomerate of companies and was established in the year 1956 by Mr. Nand Kishore Ruia, Essar has been engaged in various industries including power, telecom, shipping, oil and iron and steel. ESSAR Steel and How defaulting of FRNs Started : Essar steel was introduced by the group in 1976 and was the first private sector company that was permitted by the government to set up a 2 million tonne steel plant in 1989. During this period management realized that acquiring long term funds for steel industry was difficult in India and hence opted for FRNs (floating rate notes) in 1994. FLOATING RATE NOTES(FRN) : FRN is a medium to long term bearer note, carrying low rate of interests, which can be liberally traded. Interest on FRNs is paid periodically. However, the interest rates moves in tandem with the level of floating indices such as LIBOR in London, MIBOR in Mumbai, and SIBOR in Singapore. The FRN holders receive interest income equal to the total of the standard rate with a certain spread. These FRNs are listed on a stock exchange, which provides the note holders with a liquidity option. Companies prefer FRNs as they can get debt funds with low rate of interest throughout the loan period and from the investors side it met the needs of those investors who wanted to liquidate their investment before the maturity of the issue. Essar was the first Indian company to default FRNs, loan defaulting could have hampered Indias image in the international debt market. Essar defaulted the FRN investment due to the following reasons: LIQUIDITY CRUNCH: Liquidity crunch means when the company does not have enough cash to pay their liabilities on time. In this case, the company took a loan so that it could invest it later. The company estimated that it would have a certain amount of cash at a specified time in the future so that it could repay the loan, but the estimate was wrong. Why?

As the project got delayed which was particularly the reason they faced liquidity crunch. Moreover in 1998 steel industry faced severe downturn and steel prices fell all across the globe resulting in losses to many steel companies. All international loans were cancelled which included the loan which was to be provided to ESSAR steel as a consequence of nuclear tests conducted by India. ANALYSIS OF THE FINANCIAL STATEMENTS: CURRENT RATIO: 1999 2.67 2000 2.01 2001 1.76

As we can see that the companys current ratio is constantly decreasing and in 2001 it is even below the ideal of 2:1 clearly implies the non liquidity of the firm. INTEREST COVERAGE RATIO: 1999 0.15 2000 0.017 2001 0.47

Higher the interest coverage ratio higher is the ability of the firm to pay its debts. But here it is even less than .5 in all the three cases suggesting the non ability of the firm to repay its debt. ASSET COVERAGE RATIO: 1999 1.58 2000 1.52 2001 1.45

Here the total debt of the firm is just covered by 1.5 times of the net assets which is too less for any firm. DEBT-EQUITY RATIO: 1999 2000 2001

3.04

4.46

6.93

Since it is a capital intensive firm the ideal debt-equity ratio is around 3:1 but in this case it is much higher than that also signifying the higher risk for the lenders. RETURN ON EQUITY: 1999 -28.6% 2000 -50.67% 2001 -46.52%

The return on equity of the firm is negative in last three years indicating huge amount of losses incurred by the company and mismanagement of funds and poor planning and execution of the work. PROPRIETARY RATIO: 1999 0.21 2000 0.15 2001 0.10

It indicates the total shareholders fund by total assets of the company. Since it is very low it implies that the firm is highly financed by loan and other borrowings and lower the proprietary ratio greater the risk for the lenders RETURN ON CAPITAL EMPLOYED: 1999 -4.8% 2000 0.65% 2001 40.5%

The return on capital employed of the firm is 40.5% in 2001 but its return on equity is -46.5% indicates that the company has high interest and depreciation obligations which in turn results in losses for the company LARGE DEBTS LOW PROFIT

During the year 1997, though the sales had increased by 200% yet the net cash that was added was only Rs 715 million due to increase in debt servicing charges by an estimated 55.4%.In the same year Essars outstanding debts included Rs. 16 billion long term borrowings which included an average maturity of 3.5 yrs and average cost of 18% .Essar foreign currency borrowing was amounting to Rs 17.86 billion for an average maturity of 2.3yrs and average cost of 8%. Then it was decided that due to high interest rates (17%) in the domestic market they will be replacing the domestic loans with foreign currency borrowings .In the year 1997, Essar raised US $335 million by external commercial borrowings (ECBs) to pay off some high cost debts. In the year 1998 Essar signed as export Securitization deal of US $335 million with Union Bank of Switzerland & Nations Bank. The debts of the company for the year 1998 can be broadly classified into: Secured debt which amounted to Rs 19 billion (domestic FIs) Unsecured foreign debt US $262 million Unsecured debt US $ 250 million (FRNs)

BUSINESS DIVERSIFICATION AND MISMANAGEMENT OF FUNDS The Essar group launched various projects simultaneously in their drive to diversify their business .They raised funds from various sources .But these funds were being diverted to their group companies .As a result they were revising the scope of their projects again & again, due to which their project got delayed. The more they were delaying the projects, the more were the cost overruns. This resulted in a severe financial crunch. Without thinking about business diversification, had they directed their funds to their planned projects they would be able to meet the deadline of the project. This mismanagement also resulted in downgrading the position of the company. DUMPING BY FOREIGN VENDORS The CIS (Common wealth of Independent States) had started dumping their surplus low grade HRC debts in India .As anti dumping laws werent stringent enough in India during that period, steel companies like ESSAR took a severe beating. Also, 45% of Essar exports were directed to South East Asia which was facing an economy slump in 1995-96 due to Asian currency crisis. As a result exports also suffered to a great extent. HIGH PRODUCTION COSTS:

Total cost was above market price due to Interest depreciation and Investment in the plant. The debts that Essar steel was creating would have generated benefits had it been placed at a price scale of U.S$432 per tonne while market price was US$300(for Nippon Steel) & U.S$313 per(for US Steel) tonne which made Essar steel carry huge losses. Also the high productivity cost was the cause of high interest rates to be paid to FRN investors and moreover the project got delayed by 3 years which forced the company to incur high costs and by the time production started, Steel industry was already going into slump. It was the toughest period for the whole steel industry in the country. REFUSAL OF FUNDS: IDBI rejected Essars offer to provide a fresh loan of 7.5% to repay its debts. Refusal of guarantee by Financial institutions. Agreed to finance the debts. after getting pressurized by the Indian government on strict conditions which was never got materialized.

CONCLUSION AND SUGGESTIONS: From the case we can conclude that Essars loss was due to wrong selection of financial instruments, poor management and delay in project implementation. Also as project got delayed, the company had a few options: o They could have also gone for a mixed option; instead they went in only for borrowed capital. (They could have also gone for equity capital). o As suggested by IDBI also they should have gone for long term funding for a period of 12-15 years which is ideal for steel industry.
o

Proper planning and management functions should be implemented i.e. deadlines must not be breached. This shows lack of risk management. Management was short sighted which needs to be improved as it leads to lack of future planning.