India has a big debt problem.
A third of the country's 500 largest listed non-financial companies failed to earn enough to make interest payments in the financial year that ended March 2015, according to a new report from local ratings agency India Ratings and Research.
The report, published last week, said in fiscal 2015, 178 out of the largest listed 500 corporate borrowers had an interest coverage ratio below 1. India calculates its fiscal year from April to March; fiscal 2015 ended Mar. 31, 2015, while FY17 began Apr. 1, 2016.
Interest coverage measures a firm's ability to make interest payment on its debt through earnings - the lower the ratio, the less likely the firm is able to make interest payment. India Ratings considers a company stressed if it has an interest coverage ratio below 1.
The 178 companies accounted for 8.1 trillion rupees ($27.1 billion) of the total amount borrowed by the 500 companies, which amounted to 31.3 trillion rupees, the local unit of Fitch Ratings said.
Sectors that experienced declining interest coverage ratio included construction and infrastructure, metals and mining and power. Varun Awtani, an analyst at India Ratings and one of the authors of the report, said factors such as low commodity prices and regulatory delays affected indebted companies in these sectors.
"There has been a sequential decline in the credit quality of the largest borrowers since FY12," Awtani told CNBC. "The number of companies falling into that bracket [below an interest coverage ratio of 1] has increased since then."
The rating agency added that data for FY16, which ended Mar. 31, 2016, is not yet available as Indian companies will report earnings in the coming months.
Reuters previously reported that the real-estate-to-road conglomerate Jaypee Group, which built India's Formula One racing track, had debts of around 670 billion rupees as of February.
In another report, Reuters said the now-defunct Kingfisher Airlines owed about $1.4 billion to its creditors as of last November, after ceasing operations in 2012. Kingfisher Airlines' owner, billionaire tycoon Vijay Mallya, has proposed to repay $603 million - less than half of what the airline owes to creditors, Reuters reported last week.
"Overall, around one third of the corporate sector's borrowing from banks is currently stressed," Awtani said.
For example, in the construction and infrastructure sector, companies were already highly leveraged and have been affected by issues such as project delays and cost escalations, he said. Companies in sectors such as iron and steel have been affected by the sharp fall in commodity prices.
Awtani explained some of these companies stayed afloat with the help of additional borrowings but now "the funding tap has dried up."
Public sector banks are likely to be more hesitant to lend money to these borrowers because chances of a turnaround for companies with high levels of debt seem unlikely, at least in the near term, according to Awtani.
He added banks also need additional capital infusion of around 1.2 trillion rupees in order to move towards compliance of the Basel III banking regulatory framework.
In its FY17 union budget, the Indian government announced 250 billion rupees will be allocated toward the recapitalization of public sector banks. At the same time, the Reserve Bank of India (RBI) launched an asset quality review for banks to take necessary steps to clean up their balance sheets by March 2017.
India's central bank governor, Raghuram Rajan in February warned banks to brace for "deep surgery" ahead, such as "restructuring or writing down loans." He added, "Banks must review their procedures to ensure they can make good credit decisions."
Awtani added provisioning requirements of public sector undertaking banks have increased with the surge in non-performing assets (NPA) and that there still exists stressed loans in the system which will probably be recognized as NPAs over the coming few quarters.
Indian companies' overall outlook remain weak, according to India Ratings. It said improvement in earnings will remain a challenge over the next two to three years and deleveraging, the process of reducing a company's debt, will be slow. External risks could create more volatility and derail the fragile recovery.
The ratings agency further predicted firms are unlikely to take up new investments in FY17 on weaker credit conditions than in FY16.
The estimated growth in earnings before interest, taxes, depreciation and amortization (EBITDA) for the top 500 corporate borrowers will be around 7 to 9 percent in FY17, according to India Ratings. For FY16, the agency estimated the number to be at "mid-single digit."
Factors that will have an impact on credit quality of companies include domestic consumption trends, exports, commodity price risks, sensitivity to changes in interest rates, working capital risk, capital expenditure and sensitivity to foreign exchange volatility.
Lower interest rates, the report noted, could provide some cushion for debt servicing to vulnerable firms with an interest cover between 1 and 1.75 - comprising around 15 percent of the total debt of top 500 listed borrowers in fiscal 2015. This is on the assumption that lenders will pass on the lower rates onto borrowers, the report said.
The RBI is set to announce its monetary policy decision later Tuesday, with the market forecasting a 25 basis points cut in policy rates.
Goldman Sachs said in a note last week that factors including weaker economic activity, lower-than-expected headline inflation, continued tightness in liquidity conditions and subdued global activity and dovish central banks around the world could push the RBI to ease its policy.