Journal of Advance Management Research, ISSN: Vol.05 Issue-03, (August 2017), Impact Factor: 4.598

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1 LEVERAGE ANALYSIS AND ITS IMPACT ON PROFITABILITY OF SELECT STEEL COMPANIES OF INDIA TRADED IN BOMBAY STOCK EXCHANGE (BSE) Dr.J.Michael Sammanasu PhD Associate Professor St. Joseph s Institute of Management (JIM) Tiruchirappalli 2, Tamilnadu, India. Dr.A.Pappurajan PhD Associate Professor St. Joseph s Institute of Management (JIM) St.Joseph s College (Autonomous) Tiruchirappalli 2, Tamilnadu, India. Abstract The major objective of this paper is to analyze and understand the impact of leverage on the profitability of the firm. This paper investigates the relationship between the leverage (financial leverage, operating leverage and combined leverage) and the earning per share. And it aims to describe how the earning capacity of the firms is influenced by the fixed operating costs and the fixed financial charges. In this study, select steel companies are taken for analysis and hypothesis are examined with the help of one way ANOVA and t-test. The results suggest that the leverage and profitability are related and the leverage is having impact on the profitability of the firm. Keywords Leverage, Profitability, Market capitalization, Earning per share, Steel companies, Bombay stock exchange. INTRODUCTION All financial decision has financial implications. Single decision may financially affect different departments of the organization on the financial matters, implementing the decisions and review of the implementation as well. It is the process of managing financial function. The foremost objective of financial management is to increase the shareholders wealth. The achievement of this objective is based on three major decisions they are financing decision or capital structure decision, the investment decision or capital expenditure decision and the dividend decision. The investment id- jamrpublication@gmail.com Page 83

2 decision relates to the selection of assets in which funds will be invested by a firm. The dividend decision is related to the distribution of surpluses. The dividend decision will be made, based on the success of both investment and financial decision. Among the three decisions the financing or the capital structure decision which is having a impact over the profitability of the firm is a very important decision as it influence the debt-equity mix(i.e., the proportion between the borrowed funds and the shareholders funds) of the company, which ultimately affects the shareholders return and risk. For instance, if the borrowed funds are more than the shareholders fund, there will be increase in shareholders earnings as well as in shareholders risk. The risk of shareholders increases because the borrowed funds carry a fixed interest, which has to be paid whether the company earns profits or not. Thus, the earnings and the risk of the shareholders increase when there is a high proportion of borrowed funds as compared to owned funds in the capital structure of a company. On the other hand, if the proportion of the shareholders funds is more than the proportion of the borrowed funds in the capital structure of the company, the earnings as well the risk of the shareholders will be less. Thus, the debt-equity mix in the capital structure of a company has a significant effect on the shareholders earnings and risk. The use of operating leverage helps the management to determine the profits at various levels of output and sales and plan for the proper operating level, having regard to market risks. The use of financial leverage helps them, management to determine the proper and safe debt-equity mix in the capital structure, having regard to financial risks. That means, a company should make use of both the operating leverage and the financial leverage (i.e., should combine both the leverage), and should try to have a proper combination of both the leverages. A proper combination of both the leverages contributes to the growth of the company, while an improper combination of both the leverage restricts the growth of the company. Need for the study Generally, investors would like to invest in a company which is more profitable, and earnings per share serves as an indicator of profitability of the company hence this study will help the investor to take better investment decision. Therefore, there is a need to find out the relationship between leverage and the earning per share in companies. Objectives of the study General objectives The general objective of this study is to find out the leverage of select steel companies traded in Bombay Stock Exchange. Specific objectives: 1. To understand and analyze the leverage effects of the select steel companies traded in BSE, 2. To find out the leverages namely a) operating leverage b) financial leverage c) composite leverage, 3. To study the impact of leverage on Earning per share (EPS), id- jamrpublication@gmail.com Page 84

3 4. To make suggestion to the investors to take appropriate investment decisions. Hypothesis 1. There is no significant relationship between Degree of financial leverage and Earning per share. 2. There is no significant relationship between Degree of operating leverage and Earning per share. 3. There is no significant relationship between Degree of combined leverage and Earning per share. Research methodology The present study adopts an analytical and descriptive research design. The data of the select companies has been collected from the annual report and the balance sheet published by the companies in money control.com, a finite a sample size of three companies listed on the Bombay stock exchange has been selected for the purpose of the study. They are TATA steel, JSW steel limited, and Steel authority of India Sample design The technique of convenient sampling is being adopted for the study. The selection of the companies is made on the basis of market capitalization. Sample size Three public limited companies are chosen as sample size for the study on account of having the highest market capitalization. Data collection: This study is based on secondary data collected from various websites like, money control.com, steel.nic.in. Tools used for analysis Tools used for the analysis are Mean, Standard Deviation, Correlation and test of significance and Analysis of Variance (ANOVA). Limitations of the study The project is confined to the annual report of the companies. Due to the shortage of time, only secondary data analysis is done. Some of the external factors like inflation, GDP, supply and demand, interest rate affecting the leverage are not taken into account. id- jamrpublication@gmail.com Page 85

4 Leverage analysis tools 1. Operating leverage 2. Financial leverage 3. Combined leverage 4. Mean 5. Standard deviation 6. Analysis of variance (Anova) 7. Correlation analysis and test of significance. Review of Literature Govindasamy, P andchandrakumarmangalam, S (2010) 1, in their study they found out that there is a significant relationship between DFL and EPS, DCL and EPS, and DOL and EPS. Thus, fixed operating expenses and the financing mix decisions of the firms are significantly influencing the earning capacity of the firm. And they also found out that the leverage effect is positive when the earning of the firms is higher than the fixed financial charges. Mukesh C Ajmera(2012) 2,in his study he describe that there is a significant relationship between DFL and EPS, DCL and EPS, and DOL and EPS. The earning capacity of the firm is significantly influenced by the fixed operating expenses and the financing mix decisions of the firm. And he also found out that the leverage effect is positive when the earnings of the firm are higher than the fixed financial charges. Taiwo Asalu andolayinka Akinlo (2012) 3, this study shows that the leverage was negatively related to profitability. The study discovers that the use of debt by the firms decreases the profitability so they suggested that the firm should need to reduce the debt ratio to boost the profitability. Khan Huma(2012) 4,in this study he determines that there is a positive relationship between working capital and profitability, profitability on working capital and liquidity, and working capital on profitability and liquidity. Thus, the result indicates that all are interrelated and based on each other because the firms have to maintain liquidity position, working capital and also profitability. Wessels andtitman (1988) 5,observed that highly profitable firms have lower levels of leverage then less profitable firms do because they first use their earnings before seeking outside capital. Moreover, stock prices reflect how the firm performs. Ali Liaqat (2011) 6,the study based on the fixed estimation shows that all the five explanatory variables: firm size, growth, non-debt tax shields, profitability, and asset tangibility have strong significant influence on the firm s leverage. id- jamrpublication@gmail.com Page 86

5 Amsaveni, R (2009) 7,in her study she found out that there is a significant relationship between DFL and EPS, DOL and EPS. In case of financial leverage she found out that the value of DFL is maximum and that shows better return as well as more risk. And in case of operating leverage she discover that the value DOL is higher that indicate the tendency of operating profit to vary disproportionately with sales. RafiqueMahira(2011) 8,in this study he discovers that the capital structure and profitability are negatively correlated as debt to equity ratio increases, a firms profitability decreases. And he found out capital structure and degrees of financial leverage are positively correlated. Hence as the debt increases, so does the financial burden on the firm s assets. And also he discovers that profitability and financial leverage are negatively correlated. Thus one increases, the other one decreases, so the profitability is in negative relation with both capital structure and degree of financial leverage. HovryMartin(2007) 9, in this study he discover foreign holdings have a significant relationship with the leverage. Whereas, somewhat unexpectedly institutional ownership, through legal personal holding companies, state ownership and private holding are not found to have a significant relationship with the capital structure choice of firms. The result also suggest that some firm specific factors that are relevant for explaining firms leverage such as profitability, growth opportunity, size and tax shield. Yasi Bin Tariq and Syed Tahir Hijazi (2006) 10,in their study they found out there is a inverse relationship between size and growth and they also discover that the firm size is negatively correlated with leverage thus, suggesting that the bigger the firm size the less debt they will use. Muhammad Rafiq, Asif Iqbal, Mohammad Atiq(2008) 11,in this study they discover that there is a relationship between profitability and leverage and also growth which was measured as the annual percentage change in total assets, is positively correlated with leverage. Therefore they suggested that internally generated funds may not be sufficient for growing firms and debt financing may be the only option for their growth. Tariq Naeem Awan, Majed Rashid, Mohammed Zia-Ur-Rehman(2011) 12,in this study they found the effect of size, profitability, tangibility and growth(all are independent variable) on the leverage( dependent variable). They discovered that the size and profitability have the negative relationship and tangibility and growth have the positive relationship with the leverage. And they conclude that the profitability and leverage are negatively related and tangibility and leverage are positively related. Degree of Operating Leverage (D.O.L). Analysis and Interpretation of data Operating leverage is a measure of business risk. Operating leverage is defined as the firm s ability to use fixed operating cost to magnify the effect of changes in sales on its earnings before interest and taxes (EBIT) id- jamrpublication@gmail.com Page 87

6 Formula Contribution D.O.L = EBIT Table - 1 Degree of operating leverage YEAR TATA STEEL SAIL JSW TOTAL MEAN S.D The above table shows that the mean DOL of JSW was high as 1.17 and which is followed by TATA steel with mean DOL of The standard deviation value of SAIL was lower with 0.16 and it is followed by TATA steel with the standard deviation of 0.18 respectively. Standard deviation of JSW was comparatively high indicates that it has high variation in its fixed cost expenditure. ANOVA Hypothesis testing: Ho: The DOL position of the steel companies does not differ significantly. Ha: The DOL position of the steel companies differs significantly Table - 2 F test for degree of operating leverage Sum of squares df Mean square F ratio F critical Between Sample within Sample Total The above table shows that since the critical value at 5% significant level is 3.35, which is greater than F, calculated 3.21, the null hypothesis is accepted. Hence, it is concluded that the DOL position of TATA steel, SAIL, and JSW does not differ significantly. Degree of Financial Leverage (DFL) id- jamrpublication@gmail.com Page 88

7 Degree of financial leverage measure the impact of changes in EBIT on EBT. It can be calculated as follows. Formula EBIT D.F.L = EBT Table - 3 Degree of Financial Leverage YEAR TATA STEEL SAIL JSW TOTAL AVERAGE S.D The above table shows that the DFL shows a fluctuating trend and the calculated mean value of SAIL was higher as The standard deviation values of JSW was maximum when compare to other companies which is due to the inability of the firm to make profit during the year The standard deviation of TATA steel is comparatively low which indicates that the company less risky in terms the financial risk. ANOVA Hypothesis testing Ho: The DFL position of the steel companies does not differ significantly. Ha: The DFL position of the steel companies differs significantly. Table - 4 F test for degree of operating leverage Sum of squares df Mean square F ratio F critical Between Sample within Sample Total id- jamrpublication@gmail.com Page 89

8 The above table shows since the critical value at 5% significant level is 3.35, which is greater than F, calculated 0.749, the null hypothesis is accepted. Hence, it is concluded that the DFL position of TATA steel, SAIL, and JSW does not differ significantly. Degree of Combined Leverage (DCL) Composite leverage is a combination of operating leverage and financial leverage. Operating leverage affects the firm s operating profit which is the result of production. The degree of operating leverage shows the effect of changes in sales on EBIT. Formula: D.C.L = D.O.L x D.F.L = Contribution/EBIT X EBIT/EBT = Contribution/EBT Table 5 Degree of Combined Leverage (DCL) YEAR TATA STEEL SAIL JSW TOTAL AVERAGE S.D The above table indicates that the mean DCL of TATA steel, SAIL, JSW were 1.27, 1.17 and 1.17 respectively. The standard deviation shows that that TATA steel, SAIL, JSW has lesser risk as it is indicated the standard deviation value of 0.25, 0.61, and 0.97 respectively. ANOVA Hypothesis testing: Ho: The DCL position of the steel companies does not differ significantly. Ha: The DCL position of the steel companies differs significantly. id- jamrpublication@gmail.com Page 90

9 Table No: 6 F test for degree of combine leverage Sum of squares df Mean square F ratio F critical Between Sample within Sample Total The above table shows that since the critical value at 5% significant level is 3.35, which is greater than F, calculated 0.699, the null hypothesis is accepted. Hence, it is concluded that the DCL position of TATA steel, SAIL, and JSW does not differ significantly. Table 7 Earnings per share YEAR TATA STEEL SAIL JSW TOTAL AVERAGE S.D The above table indicates that the EPS of TATA steel is higher than that of JSW and SAIL. On an average TATA steel has generated the EPS of Rs.60.43, which is highest among all, followed by JSW (57.97), SAIL (11.66). The analysis reveals that TATA steel is the most efficient company in terms of generating earning per share. Standard deviation value of JSW is higher(37.44) which indicates a higher variation in earning per share during the study period which other companies have low standard deviation values TATA steel (13.85) and SAIL (5.86) respectively. ANOVA Hypothesis testing Ho: The EPS position of the steel companies does not differ significantly. Ha: The EPS position of the steel companies differs significantly. Table - 8 F test for Earning per Share Sum of squares df Mean square F ratio F critical Between Sample within Sample Total id- jamrpublication@gmail.com Page 91

10 The above table shows since the critical value at 5% significant level is 3.35, which is lesser than F, calculated 13.91, the null hypothesis is rejected. Hence, it is concluded that the EPS position of TATA steel, SAIL, and JSW. Test of correlation analysis Correlation is a statistical measurement of the relationship between two variables. Positive correlation ranges from +1 to -1. A zero correlation indicates that there is no relationship between the variables. A correlation of -1 indicates a perfect negative correlation, meaning that as one variable goes up, the other goes down. A correlation of +1 indicates a perfect correlation, meaning that both variables move in the same direction together. Formula of t-test is Table value of (n-1) i.e. 10 degree of freedom at 5% level of significance is for two tailed test Operating leverage and EPS Hypothesis 1 (HO): There is no significant relationship between operating leverage and EPS Correlation and T-test for operating leverage Table No: 9 Companies Correlation Result T-test (value) Hypothesis result TATA STEEL Negative Rejected SAIL Negative Rejected JSW Positive Rejected The above table shows that the correlation between the operating leverage and EPS is negative for TATA steel and SAIL. It is positive for JSW. As per the t-test result all companies have strong correlation between DOL and EPS. Hence the hypothesis is rejected there exist a strong relationship between DOL and EPS. Financial leverage and EPS Hypothesis 2(HO): there is no significant relationship between financial leverage and EPS Correlation and t-test for financial leverage Table No: 10 Companies Correlation Result T-test (value) Hypothesis result TATA STEEL Negative Rejected SAIL Negative Rejected JSW Negative Rejected id- jamrpublication@gmail.com Page 92

11 The above table shows that the correlation between the operating leverage and EPS is negative for all the companies. As per the t-test result all companies have strong correlation between DOL and EPS. Hence the hypothesis is rejected there exist a strong relationship between DOL and EPS. Combine leverage and EPS Hypothesis 2(HO): there is no significant relationship between combine leverage and EPS Correlation and t-test for combine leverage. Table No: 11 Companies Correlation Result T-test (value) Hypothesis result TATA STEEL Negative Rejected SAIL Negative Rejected JSW Positive Rejected The above table shows that the correlation between the combine leverage and EPS is negative for TATA Steel and SAIL. It is positive for JSW. As per the t-test result all companies have strong correlation between DOL and EPS. Hence the hypothesis is rejected there exist a strong relationship between DOL and EPS. Findings of the study Operating leverage 1. Mean and standard deviation of degree of operating leverages of JSW highest among the other companies and they are exposed with more risk of paying operating expenses. 2. One way ANOVA is adopted to find out the variability of data among the sample companies and it is found that the degree of operating leverages position of TATA Steel, SAIL, and JSW does not differ significantly. 3. Correlation test is used to measure association between degree of operating leverages and EPS where as strongly correlation found in all companies during the study period. Financial leverage 1. Standard deviation of Degree of financial leverages of JSW is highest among the sample companies. It reveals that JSW is exposed with more risk of paying interest but at the same time return of the owners can be maximized. JSW during the year 2003 did not have sufficient profit even to meet the interest expenses. 2. One way ANOVA is adopted to find out the variability of data among the sample companies and it is found that the Degree of financial leverages position of TATA Steel, JSW, SAIL does not differ significantly. 3. Correlation t-test is used to measure association between Degree of financial leverages and Earning per share where the correlation found in all companies during the study period is strong. id- jamrpublication@gmail.com Page 93

12 Combine leverage 1. The mean value of degree of combined leverages of TATA Steel is higher as it was 1.27 it was exposed with high risk of paying fixed operating expenses and financial risk. 2. One way ANOVA is adopted to find out the variability of data among the sample companies and it is found that the degree of combined leverages position of TATA Steel, SAIL and JSW does not differ significantly. 3. Correlation t- test is used to measure association between degree of combined leverages and Earning per share as strongly correlations found in all companies during the study period. Earnings per share 1. It is found that the mean value of earnings per share of TATA Steel and JSW are higher as they are Rs and Rs respectively. It is an indication of higher EPS of the company. Standard deviation of earnings per share of JSW and TATA Steel are higher that there is a high variation in its earnings per share during the study period. 2. One way ANOVA is adopted to find out the variability of data among the sample companies and it is found out that the earning per share position of TATA Steel, SAIL and JSW differ significantly. Suggestions The following suggestions are recommended based on the outcome of the study to improve the efficiency of the firms as well for the investors to make an effective investment decisions in the years to come. Operating leverage In case of JSW it was found that exposed with the risk of high operating risk so I order to reduce the risk it is suggested to employ greater amount of variable cost and smaller amount of fixed cost because low operating leverage will give cushion to the management by providing high margin of safety against fluctuations in sales. Since there is negative correlation between the degree of operative degree of operating leverages and earnings per share EPS for TATA Steel and SAIL the firm is suggested to use low operating leverage in order to increase the EPS of the firms. Financial leverage In case of degree of financial leverages the JSW is exposed with high risk so proper planning of capital structure is needed. So JSW in order to reduce the risk it is suggested to increase the equity capital and reduce the long term borrowing in capital structure of the firm. Since there is negative correlation between degree of financial leverages and earnings per share for all the firms. In order to increase EPS the firm should employ low financial leverage. id- jamrpublication@gmail.com Page 94

13 Combine leverage In case of degree of combined leverages it is suggested that proper balance between the operating and financial leverage of the selected firms. Since it was found negative correlation so it is suggested to reduce the degree of combined leverage in order to increase the earnings per share of the selected firms. Conclusion From this study it is found that there is a significant relationship between Degree of financial leverages and Earning per share, degree of combined leverages and earnings per share and degree of operative leverages and earnings per share. Thus, fixed operating expenses and the financial mix decisions of the firm are significantly influencing the earning capacity of the firm. The leverage effect is positive when the earnings of the firm are higher than the fixed financial charges to be paid for the lenders. The leverage is an important factor which is having impact on the profitability of the firm and wealth of the shareholders can be maximized when the firm is able to employ more debt. References Books 1. Khan, M.Y and Jain, P.K (2011), Financial Management (1st edition), Tatamcgraw hill education private limited, New Delhi. 2. Murthy, A (2010), Financial Management (1st edition), MarghamPublication, Chennai. 3. Raman, B.S (2011), Financial Management (1st edition), United Publishers,Mangalore. 4. Julsian, P.C (2009), Financial Management (1st edition), S.Chand &Company Ltd, New Delhi. 5. Pandey, I.M (2009), Financial Management (10th edition), Vikas Publishinghouse Pvt Ltd, New Delhi. 6. Ramachandran, R and Srinivasan, R (2007), Financial Management,(13 th edition), Sriram Publications, Trichy. Journals 1) Govindasamy, P and Chandrakumarmangalam, S (2010), Leverage- An analysis and its impact on profitability with reference to selected cement companies in india, European journal of economics, finance and administrative sciences, 27,pp54-66, 2) Mukesh C Ajmera(2012), leverage analysis and its impact on share price and earning of the selected steel companies of India, international journal of research in commerce & management,3:7,pp ) Taiwo Asalu and Olayinka Akinlo (2012), profitability and leverage: evidence from nigrian firms, Global journal of business research, 6:1, pp id- jamrpublication@gmail.com Page 95

14 4) 4) Khan Huma (2012), analysis of liquidity, profitability and working capital management-an empirical stud of BSE listed companies, international journal of research in commerce& management,3:11,pp ) Wessels and Titman (1988), the determinants of capital structure choice, journals of finance, 43, pp ) Ali Liaqat (2011), The determination of leverage of the listed- textile companies in India, European journal of business and management, 3:12,pp ) Amsaveni, R (2009), impact of leverage on profitability of primary aluminum industry in India, Indian journals of finance. 8) Rafique Mahira (2011), effect of profitability & financial leverage on the capital structure: A case of Pakistan s automobile industry, social science research network, vol.1 (4), pp ) Hovry Martin (2007), leverage and the ownership structure of listed firms in china, social science research network 10) Yasi Bin Tariq and Syed Tahir Hijazi (2006), determination of capital structure: a case for the Pakistani cement industry, the lahore journal of economics,11:1,pp ) Muhammad Rafiq, Asif Iqbal, Mohammad Atiq(2008), determination of capital structure of cement industry in Pakistan, the lahore journal of economics,13:1,pp ) Tariq Naeem Awan, Prof.Majed Rashid, Mohammed Zia-Ur-Rehman(2011), analysis of the determination of capital structure in sugar and allied industry, international journal of business and social science,2:1. Websites 1. control.com id- jamrpublication@gmail.com Page 96