The corporate sector saw a sustained fall in the cost of borrowing during the period 1996-97 through 2005-06. The average cost of borrowing was 11.7% in 1996-97. This dropped to 6.7% in 2005-06. This fall in the cost of borrowing had a direct impact upon profits. Interest cost ate away 20-30% of the operating profits during the 1990s. In 1998-99, it took away 29% of the operating profits. But then, the fall in the cost of borrowings eased the interest pressure on profits substantially. Net interest costs accounted for only 1% of operating profits in 2007-08.
The cost of borrowings started increasing in 2006-07. It reached a recent peak of 8.2% in 2008-09 and then it fell back a bit to 7.4%.
Interest costs have risen in recent times for a variety of reasons. First, it was the natural outcome of an acceleration in investments and growth since 2004-05. Second, the financial crisis in 2008 led to a sudden spike in the cost of funds. And third, high inflation has kept policy rates high. The average cost of funds of the corporate sector during the four years since 2008-09 (i.e., 2008-09 through 2011-12) was 7.7%. This is about 10% higher than the 7% it was in the preceding four years. But it is much lower than the average rate seen in any preceding year.
Besides, in spite of the 10% increase in interest incidence, the interest cover has remained comfortable. As of 2011-12, it was 2.8. Till 2001-02, profits covered less than twice the interest payment obligations of the corporate sector.
However, a source of worry is the rate at which interest rates have been growing. In 2011-12, interest costs were up by 28% after having grown by 15% in the preceding year. Interest costs now eat away nearly 12% of operating profits.
A bigger worry is the impact of these rising interest rates on the smaller companies. Usually, the bottom 30% (by size) of the companies are unable to cover their interest payment obligations with sufficient profits. In difficult years, this proportion rises to 40%. For example, in 2008-09, profits of the bottom 40% of the companies could not meet their interest obligations. This was the case even in the difficult years between 1997-98 through 2003-04. In 2002-03, half the companies did not have the profits to service their interest payment obligations.
In 2011-12, the fourth decile barely managed to remain profitable to cover its interest obligations. The interest cover was just 0.07. It is very likely that this would have moved into the red. First, the margin is so thin that any increase in the sample size could easily move it into the red in 2011-12 itself. Second, interest rates have risen significantly in 2012-13.
The bottom 40% of the companies are in a mess. On an aggregate basis, their net worth has been eroded and so has their ability to service their borrowings. So, possibly, the bottom 40% of the companies are largely irredeemable from their current morass. Including these companies skews the results. It is perhaps therefore more important to look at the impact of the rising interest rates on the top and middle deciles. These are companies that can be considered viable financially. This is what we examine in the following paragraphs, drawing from the accompanying chart.
On an aggregate basis, one does not see a significant difference between the interest incidence of large and small groups of companies. There could be a difference when we see a full spectrum of companies. But, a decile-wise break of companies by size does not indicate that size makes a difference to the cost of borrowing. In the top-6 deciles by size, interest costs varied within the narrow band of 6.52% and 8.43% in 2011-12. Interest cost was the highest in the third decile and lowest in the sixth.
The third decile companies are also the most geared (debt:equity of 1.34). But this is not too high to be a source of worry.
Interest cover drops from 3 for the top decile companies to 1.8 for the second decile. Then it drops to 1.6 for the next four deciles. Operating profit margins for these top 6 deciles are reasonably strongvarying from 6.8% to 12.3%.
Most importantly, the fifth and sixth deciles do not look vulnerable to the expected increase in interest rates. While profitability will be impacted, the companies, on an aggregate basis, do not face any grave danger because their financials are reasonably robust.
Interest rate changes play a small role in impacting the profitability of companies. Changes in prices of raw materials and energy play a much bigger role in determining profits and even the viability of companies.
The author is managing director and CEO, Centre for Monitoring Indian Economy