Mumbai: Earnings growth of Indian companies in the September quarter was the worst in several years as higher raw material costs and a spike in interest expenses eroded profit margins. The decline in profitability was sharper in the broader market.

A Mint analysis of 303 firms in the BSE-500 index that have declared their earnings so far and for which past data is available, shows 34 firms made losses in the quarter, the second highest count in five years. Forty BSE-500 firms made losses in the December 2008 quarter, when a financial crash hurled the global economy into a recession.

Analysts who have been reducing earnings estimates this year said sharper downgrades are likely.

Rising costs have crimped margins, though revenue growth has been robust. But volume growth, which was muted in the September quarter, may decelerate in the next two quarters, hitting revenue and profit, analysts and fund managers said.

The aggregate profit of the BSE-500 stocks under review fell 39% over the year-ago period, the biggest drop in at least five years. Net profit margin dipped to a 12-quarter low of 7.4%. Sales momentum continued with 20% growth, although this was slower than the average sales growth of 25% in the previous six months.

“A large part of the sales growth came from price increases, and there are indications that volume growth is slowing," said Vetri Subramaniam, head of equities, Religare Asset Management Co. Ltd, which manages assets worth Rs11,042 crore. “As the economy slows in the next few months, volume growth could slow down further."

Bigger firms fared better. Profits of 35 firms on the Nifty that have declared their earnings so far and for which past data is available saw a marginal decline of 0.4%, the second instance in five quarters when year-on-year profit growth was negative. Net profit for this set of firms fell 0.7% in the March quarter. Sales in the latest quarter grew 22%, in line with the average of the previous six months.

Graphic by Yogesh Kumar/Mint

Manufacturing firms saw a bigger hit in margins as successive hikes in the policy rate by the Reserve Bank of India (RBI) pushed up interest costs, and elevated commodity prices increased expenses on raw materials.

Earnings of 19 manufacturing firms in the Nifty index—excluding oil and gas firms, which have volatile earnings owing to selling fuel below cost—fell 16% in the past quarter, the worst fall in 22 quarters. The net profit margin for this set of firms has been falling since the March quarter, but the latest quarter’s 3.2-percentage points fall was the sharpest.

The 10.8% net profit margin for this set of firms was the worst in 25 quarters, as interest expenses rose 34% compared with the year-ago period and raw material costs as a proportion of net sales rose to their highest level in at least five years.

The trend in the broader market was similar. Profits of 222 manufacturing firms in the BSE-500 index (excluding oil and gas companies) fell 41% as raw material costs as a proportion of net sales rose to a 20-quarter high of 38.7% and interest costs as a proportion of net sales rose to a 11-quarter high of 3.1%. Profit margins hit a five-year low of 8.7%.

Although interest costs are a small fraction of total costs, in an environment of declining margins, these costs have a big impact on profitability, said Sandeep Singal, co-head, institutional equities, Emkay Global Financial Services Ltd.

The declining margins of manufacturing firms and falling factory output numbers add up to a bleak picture. The Index of Industrial Production fell to 1.9% in September partly on account of monetary tightening and partly owing to heightened macroeconomic uncertainty that has slowed investments.

An outlook downgrade by ratings agency Moody’s notwithstanding, banks and financial services companies reported earnings largely in line with expectations and compensated to an extent the poor show by manufacturing companies.

A slowing economy that may hurt the revenue growth of companies and rising inflation that may prompt more hikes in policy rates pose the biggest risks to earnings, analysts said.

While the pressure has been on margins so far, it is likely to shift to the top line in the coming quarters, Aditya Narain, head of research at the Indian arm of Citigroup Global Markets Inc., wrote in a 4 November note.

With inflation remaining high and volume growth falling, companies will find it increasingly difficult to pass on cost pressures, said Singal. “I do not see the inflation numbers falling off in a jiffy, and even if policy rates do not rise much from current levels, there is little chance of cuts in policy rates till March."

The lack of any fiscal response to inflation is likely to keep it sticky, Singal added.

The latest headline inflation number was 9.7%. RBI raised its policy rate by one-fourth of a percentage point to 8.5% on 25 October to fight persistently high inflation.

The worsening macroeconomic environment has led analysts to cut earnings estimates and has brought the Sensex, India’s bellwether equity index, down 16.5% since the start of the year.

Foreign inflows in equity markets slowed to a modest $651 million (around Rs3,275 crore) this year after record inflows of $29 billion in 2010. The consensus estimate for earnings per share of Sensex companies in fiscal 2012 has fallen 6.5% since the start of the fiscal year to Rs1,170 a share, according to Bloomberg data, but many analysts say sharper downgrades are likely in the months ahead.