The financial world has its eyes glued to corporate defaults, a subject that’s been making headlines. Corporate defaults are important to be noted and attended to since they impact the financial world and economy at large as the capital is locked for productive use. like dominoes falling – one company’s struggle can affect others.

But what triggers these corporate defaults? It can be a nuanced interplay of

• A decline in economic activity
• A rise in interest rates
• A fall in asset prices

Even the Reserve Bank of India (RBI) is keeping a watchful eye on this stress, issuing policies and guidelines to Banks and Non-Banking Financial Companies (NBFCs) to ensure they keep their banking exposures to corporates in check.

Reports reveal that banks have written off a staggering Rs. 14.56 lakh crore in bad loans over the past nine financial years, with a whopping Rs. 7.40 lakh crore attributed to large industries and services.

Here, we present a snapshot on how corporations can ensure their long-term success and aim for better economic returns based on study various corporate defaults in past and also, insights on how corporations better manage their capital and resources by avoiding debt traps.

But first, understand the basics of NPA.

The NPA (Non Performing Asset) Puzzle

When a corporation defaults on loan payments for more than 90 days, it becomes a Non-Performing Asset (NPA) on the lender’s books, as per RBI guidelines. Banks and NBFCs closely monitor their NPA ratio because it directly impacts their profit and reflects the quality of their lending book. A lower NPA ratio indicates a healthier lending portfolio for the lender.

The Why Behind Corporate Defaults

Corporate defaults driven by several factors. The defaults can be attributed to a mix of factors, some within the control of the corporations themselves (systemic factors), and others driven by external forces (non-systemic factors). The following factors would enable to gain a better understanding.

Systemic Factors: Within Corporate Control

Systemic factors are those that corporations can manage and influence. These factors include:

1.Business Discipline: This is all about corporations being pioneer in their ventures. It means not diving headfirst into unrelated businesses without the expertise or industry knowledge needed. While diversification can be a good strategy to reduce risk, venturing into unfamiliar territory without the necessary know-how can lead to financial trouble.

For instance, if an Engineering, Procurement, and Construction (EPC) company, specialized in building infrastructure like roads and bridges, suddenly jumps into real estate without the right expertise, it can result in losses and financial strain. This new business may burden the company with debt and strain its cash flow, ultimately leading to default. Thus, maintaining strict business discipline is crucial.

2.Financial Discipline: This involves using funds prudently. Money should be invested in ways that create value and long-term economic profit. It’s important for corporations to manage their financial obligations rigorously.

For example, working capital loans should be used exclusively for short-term operational needs, not for capital investments. Mismanaging these funds and using them for purposes they weren’t intended for can lead to potential default risks. Additionally, corporations should avoid refinancing existing loans at higher costs, as this can strain cash flows and potentially lead to a debt trap. Unfortunately, we’ve seen this trend in corporations with a history of high-ticket defaults.

3. Management Focus: Effective management within a corporation is vital. Different functions and divisions within the organization should work together harmoniously.

For example, the treasury function is responsible for fundraising and managing risk related to capital resources. If the corporation borrows in foreign currency, the treasury should ideally hedge against currency exchange rate risks. It’s important for the management not to expect the treasury to generate profits from occasional gains due to currency exchange rate fluctuations.

Similarly, other functions and divisions within a corporation should stick to their designated roles and responsibilities. A support function should not be burdened with revenue generation; it should focus on supporting the core functions.

Non-Systemic Factors: Beyond Corporate Control

Non-systemic factors, on the other hand, are external forces that corporations cannot control. These are like wildcards in the corporate world. These factors include:

1.Macroeconomic Forces: These are large-scale economic factors, like inflation, industry-wide slowdowns, and unforeseen external shocks such as the COVID-19 pandemic. Corporations must have robust business continuity plans in place to navigate these unpredictable events. Periodic assessments of the macroeconomic environment, including how it impacts their industry segment and business, are crucial for early adaptation.

2. Supply-Demand Dynamics: Constant monitoring of supply-demand dynamics is essential for adapting to changing business needs. In today’s world, industries are increasingly integrating technology into their operations for cost optimization and improved efficiency. Corporations should embrace the latest technology if it promises incremental business and profit.

If we try to understand precisely, these factors are:

• Natural Calamities: Sometimes, acts of God like earthquakes, floods, or hurricanes. Corporations should have plans in place to keep running their businesses when these things happen.
• Assessing the Big Picture: Corporations need to keep an eye on the big picture. They should regularly check how the overall economy is affecting their industry and their business. This helps them be prepared for any surprises.
• Supply and Demand: It’s like a seesaw. Corporations must watch how much stuff they have to offer and how much people want to buy. If they don’t match up, it can be a problem.
• Embracing Technology: Technology has been an enabler for achieving efficiency in prodicution or processes for Corporations. Corporations need to use the latest tech relevant to their line of business to make things work better and faster, not at the cost of unproductivity in terms of non – achievement desired output.

• Impact on Obligations: When these unforeseen things happen, they can make it hard for corporations to meet their financial obligations (like paying back loans or bills).

In a nutshell, non-systemic factors are the curveballs that corporations can’t predict or control. To survive and thrive, they need to be ready for whatever Mother Nature or the economy throws at them and use technology wisely to stay competitive.

5 Tips to help corporations steer clear of the potential debt trap

Here are essential five tips to stay away from the potential debt trap

1. Strategic Borrowing: Be mindful of the purpose behind your borrowing. Ensure that working capital loans are used exclusively for short-term operational needs, while term loans are reserved for long-term investments. Mixing these up can lead to financial strain and increase the risk of default.
2. Debt Refinancing Caution: Before refinancing existing loans, carefully assess the terms and conditions of the new loan. Avoid refinancing with a loan that has higher interest rates or less favourable terms, as it can strain your cash flows and potentially push your company into a debt trap.
3. Financial Planning: Create a robust financial plan that outlines your company’s income, expenses, and debt obligations. Regularly review and update this plan to ensure that your financial resources are allocated efficiently and that you have a clear picture of your financial health.
4. Diversification: Don’t rely too heavily on a single source of financing. Explore multiple funding options, such as equity, debt, or alternative financing methods, to reduce your dependency on a single lender or type of loan.
5. Risk Management: Implement effective risk management strategies, including hedging against currency exchange rate fluctuations or interest rate changes if your company deals with foreign currency or variable interest rate loans. This can help protect your cash flows from unexpected shocks.

This is an quick insight on how Corporations can reduce their vulnerability to debt traps and ensure a healthier financial future.

To Conclude “Borrow Prudently and Manage effectively”

Corporate default is an avoidable event. In order to stay afloat, it is important that corporate is better equipped for management of systemic factors and non-systemic factors for their respective business. Defaults might be a temporary event, but they can also be valuable lessons in financial discipline and resilience, guiding your business toward a brighter and more prosperous tomorrow.

Vesh