Debt Default Risk High as Corporate India's Interest Coverage Ratio Slumps

The Indian Stock markets have gone up over 40% in the last two months. But not everything is fine with the fundamentals of Corporate India. In this article I would primairly discuss how the interest coverage ratio (combined statistics) for all companies in India has slumped in the last few quarters and what could be its implication on banks in India and the corporates. Related to banks I would also discuss how a sharp decline in interest coverage would impact credit growth.

I would first like to present a data chart below showing important statistics such as sales growth, gross profit growth, net profit growth, interest coverage ratio and several other important financial parameters for over 2000 companies in India. Right click on the data chart to open in a new window for enlarged image with greater clarity.

Data Source: RBI

Key Observations:

• The stock markets have surged over 40% as said earlier in a matter of 2 months. From a fundamental perspective the profit after tax for 2486 companies has fallen by 53.4% during the third quarter of 2008-09. This is a confirmation of the fact that in a global enviornment where Central Bankers are printing money at a rapid pace the stock markets are just a function of liquidity in the system. So the Sensex might go to 15k or 20k, but fundamentals will remain weak for a long time.

• The interest coverage ratio for about 2342 companies in India during the first quarter of 2007-08 was 8.5. The interest coverage ratio for 2486 companies as on the third quarter of 2008-09 stands at 2.9. This is a big slump from the highs. Moreover, with the next few quarters also expected to be weak for India Inc. this ratio is expected to go down even more. So the lower the ratio the higher is the risk of default on debt by Corporate India.

Implication of falling Interest Coverage Ratio:

• The global banking sector has become increasingly risk averse after a near collapse of the global financial system. While governments around the world have been trying to ease liquidity, banks have been tightening their lending standards. The declining credit growth, even after slashing of interest rates by Central Banks globally is a proof of the same. A falling interest coverage ratio would typically lead to increased risk for the lender. So in my opinion the Indian banks, especially the private sector banks would not be very eager to lend to corporates. Thus, the credit growth in India, which has already slowed significantly, is expected to decline further.

Data Source: RBI

The data above clearly shows that private banks and foreign banks are the ones where credit growth had dipped significantly. In my opinion this should not improve so soon going by the earnings trend for corporate India.

• As banks are increasingly unwilling to lend, small companies as well as over leveraged companies would be in a difficult position. With profits falling and operating cash flow turning negative, companies would need loans to fund their working capital. Inability to get loans would lead to closure of business units (especially small ones).

• Banks might tighten their lending standards now but as interest coverage for India Inc. falls, there will be greater defaults on principal and interest payments in the near future. Thus, the possibility of NPA's for Indian banks rising significantly in the near future cannot be ruled out.
  

Several Indian companies overleveraged themselves during the boom period for costly acquisitions and also for over ambitious expansion plans. The negative effects of such ill timed acquisitions and plans is going to hit many big as well as small companies in India in the near future.

The stock markets might be moving up, but the fundamentals of several companies is getting weaker with the passage of every quarter.

In my opinion, the global economy will surely not recover so soon. There can be sparks of optimism in certain economic data due to the effect of the stimulus package. But once that dies down the world should realise that the economic recovery is not going to come so soon after five years of super boom globally.

I also believe that we will witness more asset sales, debt restructuring and other such drastic steps by corporates in order to save themselves from this sharp global business downturn.

From an investors perspective it is important to buy companies with strong balance sheets. At least for the next 1-2 years.