The Corporate Stress Facet of India’s Twin Balance Sheet Problem

15 May 2017

India’s economic growth remains resilient, with official projections of FY17 Gross Value Added (GVA) growth at 6.9 per cent, and RBI forecasting an uptick in FY18 growth to 7.4 per cent. The pressing issue now is to sustainably accelerate India’s growth up to 8 per cent and above. The only way to do so is to reinforce consumption growth (which has been growing at a steady 5 – 6 per cent) with renewed investment. And a dominant reason that investment growth has been languishing is due to what the 2016-17 Economic Survey labels as the “Festering Twin Balance Sheet Problem” – “over-leveraged companies and bad-loan-encumbered banks”.

Understanding the nature of stress, and thereby remedying both the demand and supply impediments of credit off-take, will be key to reviving investment. While India has a significant external commercial debt (about US$181 billion), the bulk of the debt is owed to Indian banks (although incrementally, a significant part of this debt for the best credit rated companies has been raised through corporate bonds). Ergo, to materially address the “bad-loan” problem of banks (and consequently revive risk appetite for renewed project investment and supply of credit), deleveraging of cor- porate balance sheets is a necessary condition. This article looks at one of the causes for a drop in demand for credit: the rapid rise in corporate debt over the past five years to get a sense of the underlying stress.

A measure of the sustainability (and extent of excess) leverage is the total Debt to Equity (D/E) ratio. The total D/E ratio of 76 (non-financial) companies in the NSE 100 Index rose from 0.8 in FY12 to 1.0 in FY15. The encouraging part is that there is already an improvement visible in 2016, which is likely to have accelerated in FY17.

However, the stress of “excess” leverage can only be meaningfully understood in relation to cash flows to service the accumulated debt. An indicative metric of corporate health is the “Interest Cover Ratio” (IC Ra- tio). Whatever the debt level, if a company has the cash flow strength to pay interest and principal, it remains creditworthy. The IC ratio is essentially the Earnings Before Interest and Tax (EBIT) of a company to its in- terest liability (with EBIT measured as x times interest).

The stress in IC Ratio is also evident while comparing the current situation (the past five years ending FY16) with the five high growth years, i.e. from 2004 till 2008. The left panel in Chart 1 below shows that rising growth and corporate profitability during the period FY2004 to FY08 had positively impacted the corporate IC which has gone up from 8x in FY04 to over 13x in FY07, before dipping sharply to 9x in FY08 (precursor to the financial crisis). In the four years after that, it would be difficult to make an assessment of trend in corporate IC, as the situation was most likely distorted by various stimulus measures. Picking up the thread again in FY12 (the right panel), IC was already much lower (6x in FY2012) and has stead- ily deteriorated thereafter to half of that level by FY16.

Chart 2 (left panel) show the distribution of this stress across companies. Of a sample of 792 companies report- ing results in FY16, 101 companies had negative equity, which barring exceptions, have cceased to be the go- ing concern. Another 170 companies had IC less than 1 in FY16, and consequently were likely to be very stressed in meeting interest payment obligations. The rest 520 companies were better, with 353 of these having strong cash flows with IC greater than 2.

Note that the distribution of companies with the above IC classifications had improved a bit in FY16, after a steady deterioration since FY11, but the change was at the extremities. The number of companies with strong cash flows (IC > 2) increased from 312 in FY15 to 353 in FY16, but the movement in the other buckets actually deteriorated. The number of companies in the IC > 1 bucket (i.e., those with tolerable cash flows) went down, with most of these companies improving their performance and moving to the IC > 2 bucket and some even moving up 2 slots (i.e., improving) from the IC < 1 stressed bucket as well to IC > 2. At the other end, how- ever, there was a deterioration with about 20 of the stressed companies transitioning to the negative equity group.

At the same time, the right panel of Chart 2 shows that the better cash flow companies have also increased their debt holdings in FY16, which is a positive develop- ment. On the flip side, the debt holdings of the stressed group (IC < 1) had also risen, and this is contrary to the reduction in the number of companies in this group, as noted before. One hypothesis for this apparent para- dox – of rising debt in stressed companies – might be additional funds to maintain debt servicing ability.

This corporate debt servicing difficulty is reflected in stressed assets of banks, with a steep rise in Gross Non Performing Assets (GNPA) in the third quarter of FY16. Of course, it is difficult to disentangle this sharp rise of the effects of cash flow deterioration from the improv- ing recognition of NPAs post RBI’s Asset Quality Review (AQR), but both would have contributed.

Reiterating the point made earlier, addressing both ledgers of the Twin Balance Sheet problem is critical for reviving private sector capex spends. A combination of asset sell-offs by leveraged firms, improving cash flows of minerals based companies and RBI and Government steps to speed up resolution of stressed assets is gradually beginning to show results. A normal monsoon will help to sustainably boost consumption demand and gradually narrow the excess capacity overhang, at which point investments in capacity will begin to accelerate.


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