163 5.1 INTRODUCTION Liquidity and Profitability Analysis Chapter is divided into four parts comprising of part I dealing with Liquidity Analysis divided into short-term and long-term. Part II deals with Profitability Analysis elaborating on profitability with respect to the shareholders and with respect to investments. Part III throws light on various aspects on Risk and Profitability Analysis explaining in detail on the aspects of risk and profitability. Part IV deals with establishing correlation between Liquidity and Profitability. 5.2 PART I LIQUIDITY ANALYSIS The liquidity position of the company is critical to its survival. The liquidity of a firm should neither be excessive nor be very low since too much of liquidity will result in accumulation of current assets which do not yield income to the firm. The concept what constitutes the liquidity of a firm has been viewed differently by different people with reference to a business firm. Liquidity is measured by the availability of cash whether direct or indirect and involving conversion of some assets into each to meet ordinary or extraordinary demands upon it. 1 Liquidity refers to cash and cash availability, and it is from current operations and previous accumulations that cash is available to take care of the claims of both the short-term and long-term 1. R.B. Westerfield, Liquidity in the Encyclopedia of Social Science, New York, 1993, p.491.
164 suppliers of capital. In each of these contexts, liquidity refers to the ability of a firm to provide cash to meet the claims, the supplier of capital have on the firm. 2 Liquidity ratios measure the company s ability to meet its current obligations ability to pay its obligations as and when they become due. They show whether the company can pay its short term obligations out of short term resources or not. Liquidity ratios establish a relationship between cash and other current assets to current obligations. A company should ensure that it does not suffer from lack of liquidity or on the other hand it is not highly liquid. A low liquidity may result in the failure of meeting company s short term liabilities which may carry a bad name to the company, loss of creditors confidence and unnecessary law suits. A very high degree of liquidity is also bad because the funds are unnecessarily tied up in current assets which earn nothing. A striking balance is necessary. Liquidity of the select cement companies has been analysed by liquidity ratio classifying into two. i. Short term liquidity solvency ii. Long term liquidity solvency 2. S.H. Archar, and D. Ambrosio, Business Finance Theory and Management, 2 nd Edition 1972, p.445.
165 i. Short-term Liquidity The short term creditors of the company are interested in short term solvency of the company. The liquidity ratios measure the ability of a company to meet its short-term obligations and reflect the short-term financial strength / solvency of the company. The important short term solvency ratios are: a. Current ratio b. Inventory Turnover ratio c. Debtors turnover ratio a. Current Ratio The liquidity ratios are: Current ratio Quick ratio The current ratio measures the short-term solvency of the company. In a sound business, a current ratio of 2:1 is considered to be ideal one. If the current ratio is lower than 2:1, the short term solvency of the firm is considered doubtful and it show that the company is not in a position to meet its current liabilities in time as and when they are due to mature. A high current ratio is considered to be an indication that of the firm is more liquid and can meet its short term liabilities on maturity. The higher the current ratio, the greater margin of safety to the creditors. However, from management perspective,
166 higher current ratio is an indication of poor planning since an excessive amount of funds are invested in current assets that lie idle. Quick ratio establishes the relationship between liquid assets to current liabilities. Liquid assets includes cash and those assets that can be converted into cash within a period of one year. Generally, quick ratio of 1:1 is ideal and a low one, will be an index of bad liquidity position. The mean values and C.V. of liquidity over the successive years for the sample companies are given in Table 5.1. TABLE 5.1 Liquidity Analysis of Sample Companies Cement Company Mean S.D. C.V. (in Percentage) Madras Cements 2.043 0.259 12.68 India Cements 3.703 1.311 35.40 Chettinad Cements 2.011 0.354 17.60 Dalmia Cements 3.025 0.278 9.19 Tamil Nadu Cements 2.074 0.412 19.86 Source: Computed Data. It is observed from Table 5.1 that on the average of 10 years, India Cements is placed in a good liquidity position (3.703) with a low liquidity of Chettinad Cements (2.011). The C.V. is high with India Cements (35.40%) and is low with Dalmia Cements with 9.19 per cent.
167 It can be further observed that a company is said to be financially sound if it is in a position to carry on the activities in a smooth manner, meeting its vendor obligations, either long, medium-term or short term, without any difficulty. It indicates the availability of current assets in rupees for every one rupee of current liabilities. 3 It is a well laid principle in finance that short term funds should take care of short term requirements and long term inflow to match the long term requirements. These ratios, are hence called short term solvency ratios. Liquidity is an important index of the financial strength of any company or organisation. The liquidity values of different companies are taken for observation and studied for a period of 10 years. It is proposed to investigate whether the liquidity values of the companies put together on the average is the same for different years. It is also proposed to test the validity of null hypotheses. H01: The average of the liquidity value of the selected cement companies do not differ significantly over the years. H02: The average liquidity values do not differ significantly between the companies for the period of 10 years. 3. I.M. Pandey, Financial Management, Vikas Publishing House Private Limited, New Delhi, 1995.
168 Using ANOVA two way classification procedure, the following results are obtained and it is presented in Table 5.2. Source of Variation TABLE 5.2 ANOVA for Liquidity Analysis SS Df MS F P-value F-cirt Rows 4.6177 9 0.512974 1.247777 0.298205 2.152607 Columns 23.2467 4 5.811675 14.13653 0.0049 2.633534 Errors 1.79998 36 0.411111 Total 42.66345 49 From Table 5.2, the following conclusions are drawn i. The F value corresponding to the years (rows) is F = 1.2477 with a corresponding p = 0.2982. Hence, H01 is accepted. This implies that there is no significant difference between the averages of the liquidity of the companies over 10 years. ii. The F value corresponding to the companies (columns) is F = 14.1365 with p = 0.0049 which is significant. Hence, H02 is rejected. This implies that on the average, liquidity values of the different cement companies differ significantly. b. Inventory Turnover Ratio This ratio indicates the number of times inventory is replaced during the year. It measures the relationship between sales and closing inventory level. The ratio is computed as follows: ` Net Sales Inventory Turnover Ratio = ------------------------- Closing Inventory
169 In general, a high inventory turnover ratio is better than the low ratio. A high ratio implies good inventory management where the old inventories are pushed out in the market and what is remaining in stock is fresh. So, even for items of less shelf storage, high inventory turnover ratio is preferred. Yet a very high ratio calls for a careful analysis. Thus, a company should have neither too high nor too low inventory turnover. To avoid both stock out costs associated with a high ratio and the costs of carrying excessive inventory with a low ratio, what is suggested is a reasonable level of this ratio 4 The mean values and C.V. of inventory turnover ratio over the successive years for the sampled companies are given in Table 5.3. TABLE 5.3 Inventory Turnover Analysis of Sample Companies Cement Company Mean S.D. C.V. (In Percentage) Madras Cements 23.62 6.83 28.94 India Cements 13.18 2.50 18.99 Chettinad Cements 19.02 8.48 44.59 Dalmia Cements 4.98 1.37 27.43 Tamil Nadu Cements 13.23 3.53 26.66 Source: Computed Data. 4. M.Y. Khan and P.K. Jain, Financial Management, Tata McGraw-Hill Publishing Company Limited, New Delhi, 2000. It is evident from Table 5.3 that on considering the average of 10 years, Madras Cements is placed in a good inventory turnover position (23.62) with a
170 low inventory turnover of Dalmia Cements (4.98). The C.V. is high (44.59%) with Chettinad Cements and is low (18.99%) with India Cements. Appears that Dalmia Cements is preferred to Madras Cements based on the Inventory Turnover Ratio. Inventory is an important index of the financial strength of any company or organization. The inventory turnover values of different companies are taken for observation and studied for a period of 10 years. It is proposed to investigate whether the inventory turnover values of the companies put together on the average is the same for different years. It is also proposed to test the validity of null hypotheses. H01: The average of the inventory turnover value of the selected cement companies do not differ significantly over the years. H02: The average inventory turnover values for the period of 10 years do not differ significantly between the companies. Using ANOVA two way classification procedure, the following results are obtained and it is presented in Table 5.4.
171 Source of Variation TABLE 5.4 ANOVA for Inventory Turnover Ratio SS Df MS F P-value F-cirt Rows 547.8065 9 60.86739 2.594498 0.020308 2.152607 Columns 1971.274 4 492.8184 21.00659 5.25E-09 2.633532 Errors 844.5666 36 23.46018 Total 3363.647 49 From Table 5.4, the following conclusions are drawn i. The F value corresponding to the years (rows) is F = 2.5945 with a corresponding p = 0.0203. Hence, H01 is rejected. This implies that there is significant difference between the averages of the inventory turnover of the companies over 10 years. i. The F value corresponding to the companies (columns) is F = 21.0066 with p = 0.0000 which is significant. Hence, H02 is rejected. It is concluded that on the average, inventory turnover values of the different cement companies differ significantly. c. Debtors Turnover Ratio A company sells goods for cash and credit. Credit is used as a marketing tool by a number of companies. When the company extends credits to its customers, book debts (debtors or receivables) are created in the
172 company s accounts. Book debts are expected to be converted into cash over a short period and, therefore, are included in current assets. The liquidity position of the company depends on the quality of debtors to a great extent. Hence, the liquidity position of a concern to pay its short-term obligations in time depends upon the quality of its trade debtors. Debtors turnover ratio indicates the velocity of debt collection of the company. In simple words, it indicates, the number of times average debtors are turned over during a year. 5 The formula to calculate debtors turnover ratio is Total Sales Debtors Turnover Ratio = ------------------- Average Debtors Generally, the higher the value of debtors turnover, the more efficient is the management of debtors. Similarly, low debtors turnover implies inefficient management of debtors. But, a precaution is needed while interpreting a very high debtors turnover ratio because a very high may imply a firm s inability due to lack of resources to sell on credit, thereby losing sales and profits. Thus, a firm should have neither a very low nor a very high receivables turnover ratio: it should maintain at a reasonable level. The mean values and C.V. of debtors turnover ratio over the successive years for the sampled companies are given in Table 5.5. 5. I.M. Pandey, Op.cit.
173 TABLE 5.5 Debtors Turnover Analysis of Sample Companies Cement Company Mean S.D. C.V. (In Percentage) Madras Cements 21.90 13.27 60.59 India Cements 11.81 5.28 44.67 Chettinad Cements 25.31 8.16 32.25 Dalmia Cements 14.53 2.32 16.27 Tamil Nadu Cements 4.05 1.58 38.97 Source: Computed Data. It is observed from Table 5.5 that on considering the average of 10 years, Chettinad Cements is placed in a good debtors turnover position (25.31) with a low debtors turnover of TANCEM (4.05). The C.V. is high with Madras Cements with 60.59 per cent and is low with Dalmia Cements with 16.27 per cent. Debtor is an important index of the financial strength of any company or organization. The debtors turnover values of different companies are taken for observation and studied for a period of 10 years. It is proposed to investigate whether the debtors turnover values of the companies put together on the average is the same for different years. `It is proposed to test the validity of null hypotheses. H01: The average of the debtors turnover value of the selected cement companies do not differ significantly over the years. H02: The average debtors turnover values do not differ significantly between the companies over the years.
174 Using ANOVA two way classification procedure, the following results are obtained and is presented in Table 5.6. Source of Variation TABLE 5.6 ANOVA for Debtors Turnover Ratio SS Df MS F P-value F-cirt Rows 1355.615 9 150.6239 3.795864 0.001913 2.152607 Columns 2834.509 4 708.6272 17.85808 3.68E-08 2.633532 Errors 1428.518 36 39.68105 Total 5618.641 49 From Table 5.6, the following conclusions are drawn i. The F value corresponding to the years (rows) is F = 3.7959 with a corresponding P = 0.0019. Hence, H01 is rejected. This implies that there is a significant difference between the averages of the debtors turnover of the companies over the successive years. ii. The F value corresponding to the companies (columns) is F = 17.8581 with P = 0.0000 which is significant. Hence, H02 is rejected. It is concluded that on the average, debtors turnover values of the different cement companies differ significantly. ii. Long-term Liquidity Ratio Ratio analysis is equally useful for assessing the long term financial viability of a firm. This aspect of the financial position of a borrower is of concern to the long term creditors, security analysts and the present and
175 potential owners of a business. The long term solvency of a company can be examined by using leverage or capital structure ratios. The leverage or capital structure ratios may be defined as financial ratios which throw light on the long term solvency of the company as reflected in its ability to assure the long term creditors with regard to i. Periodic payment of interest during the period of the loan ii. Re-payment of principal on maturity or in predetermined installments at due dates. The following ratios serve the purpose of determining the long term solvency of the companies. (a) Debt-Equity Ratio (b) Interest Coverage Ratio (a) Debt Equity Ratio The relationship between borrowed funds and owner s capital is a popular measure of the long term financial solvency of a company. This relationship is shown by the debt-equity ratio. This ratio reflects the relative claims of creditors and shareholders against the assets of the company. Alternatively, this ratio indicates the relative proportions of debt and equity in financing the assets of the company. 6 6. M.Y. Khan and P.K. Jain, Op.cit.
176 Long-term Debt Debt Equity Ratio = ----------------------- Shareholders Funds Long-term debt includes all debts/liabilities to outsiders. Shareholders funds consist of equity capital, capital reserve and revenue reserves. A high ratio shows the higher claims of creditors over assets of the company than those of owners. A very high ratio shows an unfavourable position as it feels difficulty in raising funds due to thin equity. Heavy indebtedness may result in undue pressures from creditors and clouds independent business judgement and saps management energies. A highly indebted company has a greater charge on its profits and profitability. A low debt equity ratio is considered favourable from management point of view. It means greater claim of shareholders over the assets of the company than those of creditors. It provides greater margin of safety to creditors. In boom period, however, it is disadvantageous to shareholders as they get lesser dividend because of the no trading on equity. The mean values and C.V. of debt-equity over the successive years for the sampled companies are presented in Table 5.7.
177 TABLE 5.7 Debt Equity Analysis of Cement Companies Cement Company Mean S.D. C.V. (In Percentage) Madras Cements 1.801 0.596 33.09 India Cements 1.851 0.725 39.17 Chettinad Cements 2.068 0.613 29.64 Dalmia Cements 1.015 0.214 21.08 Tamil Nadu Cements 2.705 2.068 76.45 Source: Computed Data. It is observed from Table 5.7 that on considering the average of 10 years, Dalmia Cements is placed in a good debt equity position (1.015) signifying a greater claim of shareholders over the assets of the company and with a greater average (2.705) of TANCEM (2.705) intimating that creditors have better stake in the company. The C.V. is low with Dalmia Cements (21.08 %) and is high with TANCEM Cements with 76.45 per cent. This further analysis is undertaken to measure the soundness of the long term financial policies of the companies. This ratio gives confidence to the owners about their stake with that of the outside lenders. The ratio measures the proportion of shareholders stake in the company. In short, this conveys that how much dependent is the company on outsiders funds. This provides a margin of safety to the creditors. At the same time, excessive liabilities tend to cause insolvency of the company.
178 In order to examine whether debt and equity differ significantly on the average over the years of observation namely 1995-96 to 2004-05. Also it is proposed to examine the debt and equity values on the average differ between the different companies, for the 10 years put together. The null hypothesis to be tested are: H01: There is no significant difference between the averages of the debt-equity ratio values between the years. H02: There is no significant difference between the averages of the debt-equity values of the different companies. The results of the two way classified in ANOVA are given in the following Table 5.8. Source of Variation TABLE 5.8 ANOVA for Debt-Equity Ratio SS Df MS F P-value F-cirt Rows 16.62916 9 1.847684 1.980058 0.071077 2.152607 Columns 14.70956 4 3.677390 3.940849 0.009391 2.633534 Errors 33.59328 36 0.933147 Total 64.93200 49 From Table 5.8, it is observed that the F statistic value corresponding to the years (rows) is F = 1.98005 with a corresponding p = 0.071. Hence, H01 is accepted. Thus, the average values of debt-equity do not differ between the years for the companies taken together.
179 The F value corresponding to the companies (columns) is F = 3.9408 with p = 0.0094 which is significant. H02 is rejected. It is concluded that on the average debt-equity values of the different cement companies differ significantly. (b) Interest Coverage Ratio This ratio is very important from the lenders point of view. It indicates whether the business would earn sufficient profits to pay periodically the interest charges. It is calculated as follows: Earning before Interest and Tax (EBIT) Interest Coverage Ratio = -------------------------------------------------- Interest Charges Interest cover is employed to indicate times interest charges that have been earned and how much safety margin is available to the shareholders. It measures debt servicing capacity of the company in so far as fixed interest on long term loan is concerned. This ratio suggests that how many times the interest charges are covered by the EBIT. A high ratio is a sign of low burden of debt servicing and lower utilisation of borrowing capacity. From the point of view of creditors, the larger the coverage, the greater is the ability of the company to handle fixed charge liabilities and the more assured the payment of interest to the creditors. In contrast, a low ratio signifies the danger signal that the firm is highly dependent on borrowings and its earnings cannot meet obligations fully. The standard for this ratio for an industrial undertaking is six to seven times. The higher the number, the more secured is the lender. This is
180 a periodical return to the lender. However, this does not cover the return of the principal amount in time. The mean values and C.V. of interest cover over the successive years for the sample companies are presented in Table 5.9. TABLE 5.9 Interest Coverage Analysis of Sample Companies Cement Company Mean S.D. C.V. (In Percentage) Madras Cements 1.382 1.360 98.41 India Cements 0.306 1.025 334.96 Chettinad Cements 0.710 0.926 130.42 Dalmia Cements 1.291 0.608 47.09 Tamil Nadu Cements - 0.148 1.385 935.81 Source: Computed Data. It is observed from Table 5.9 that the average of interest cover over 10 years is more in case of Madras Cements (1.382) indicating that the creditors are well covered. Similarly it is less in India Cements (0.306), sending signals that the company is more dependent on borrowings. It is worse in the case of TANCEM (-0.148) that the company is fully dependent on outside borrowings and meeting its finance charge obligation may not be met in full by the company.
181 To examine whether there is a significant difference between average values of the companies put together over the 10 year period, it is proposed to test the null hypothesis. H01: The averages of the interest cover for all the companies do not differ significantly over the years Similarly it is proposed to examine whether the interest cover on the average differs significantly between the companies. Hence, the null hypothesis to be tested is: H02: The interest cover on the average do not differ between the different companies. ANOVA for two way classified data has been carried out and the results are presented in Table 5.10: Source of Variation TABLE 5.10 ANOVA for Interest Coverage SS Df MS F P-value F-cirt Rows 135.6565 9 15.07294 1.803474 0.10162 2.152607 Columns 12.33827 4 3.084567 0.369068 0.829063 2.633534 Errors 300.8781 36 8.357725 Total 448.8728 49 It is observed from Table 5.10 that F statistic corresponding to the years (rows) is F = 1.8034 with a corresponding p = 0.1016. Hence, the null hypothesis H01 is accepted. Thus the interest cover on the average do not differ significantly between the successive years for all the companies put together.
182 In a similar way, it is observed that the F statistic corresponding to companies (columns) is F = 0.3690 with a corresponding p = 0.829. Hence, H02 is accepted thereby implying that the interest cover do not differ significantly between the companies on the average. The overall result of Liquidity Analysis is presented in Table 5.11. TABLE 5.11 Liquidity Analysis Result Short-term Solvency Long-term Solvency Current Ratio Inventory Turnover Ratio Debtors Turnover Debt-Equity Interest Cover India Cements MadrasCements Chettinad Cements Dalmia Cements Madras Cements It is clear from Table 5.11 that the analysis of short term and long term solvency it is evident that on the front of Short term solvency current ratio, India Cements is placed in a good liquidity position. In Inventory Turnover Ratio, Madras Cements tops the list and under Debtors Turnover Ratio, Chettinad Cements is placed in a good liquidity position. In the case of long term solvency Debt-Equity, Dalmia Cements stood first, Interest cover Ratio, Madras Cements finds a good position.
183 5.3 PROFITABILITY ANALYSIS Profitability implies profit making ability of a business enterprise. Profitability may be defined as the ability of a given investment to earn a return from its use. 7 Profitability is a relationship of the earning with the total resources of the company. Stanev remarked, profitability is an overall reflection of the strength and weakness of an enterprise. 8 Therefore, profitability is the main indicator of the efficiency and effectiveness of a business enterprise in achieving its goal in earning profit. Profitability as a relative measure enables the management to make prompt changes in the financial and production policies in the light of the past performance. Many important mono serial decisions pertaining to such issues as further expansion of plant, adoption of modern technology, raising of additional funds, payment of bonus and higher dividend are linked with this relative measure. 9 The primary objective of a business undertaking is to earn profits. Profit earning is considered essential for survival of the business. In the words of Lord Keynes Profit is the engine that drives the business enterprise. 10 A business needs profits not only for its existence but also for expansion and 7. Howard and Upton, Introduction to Business Finance, New York: McGraw Hill, 1961. 8. Stanev, Chartered Accountant, May 1975. 9. A. Slavin, Et Basic Accounting for management and Financial Control, New York: Holt, Rinshart and Winston Inc. 10. R.K.. Sharma. And K. Shashi Gupta., Management Accounting Principles and Practice, Kalyani Publishers, New Delhi, 2000.
184 diversification. Profit is, thus, a useful tool to measure the overall efficiency of the business. The operating efficiency of a company and its ability to ensure adequate returns to its shareholders depends ultimately on the profits earned by it. The profitability of a company can be measured by its profitability ratios. Profitability ratios can be determined on the basis of either sales or investment. Let us try to measure the select cement companies using both the methods. 1. Profitability Ratio Relating to Sales It is one of the key determinants in ascertaining the efficiency of a company under which it is performing. An increase compared to previous years indicate that the affairs have improved in the operational front provided the gross profit ratio is constant over the years. This is an effective check on profitability. From the investors perspective, the parameters on the cost of capital, industry return, market conditions are to be attached while valuing a company based on this measure. Even though there are no norms for this ratio, consistent increase over the years will speak on the financial stability of a company. This ratio measures the relationship between net profit and sales of the company. The net profit indicates the management s ability to earn sufficient profits on sales not only to cover all revenue and operating expenses of the business, the cost of borrowed funds and the cost of merchandising or servicing, but also to have sufficient margin to pay reasonable compensation to shareholders on their contribution to the company.
185 A high ratio ensures adequate return to shareholders as well to enable a company to withstand adverse economic condition. A low margin has an opposite implication. The mean values and C.V. of comparative net profit and sales over the successive years for the sampled companies are given in Table 5.12. Year/ Company TABLE 5.12 Net Profit Ratio Analysis of Cement Companies Madras Cements India Cements Chettinad Cements Dalmia Cements (Values in Percentage) TANCEM Industry Average 31.03.1996 0.24 0.10 0.14 0.20 0.04 0.15 31.03.1997 0.19 0.10 0.12 0.14 0.08 0.13 31.03.1998 0.08 0.07 0.06 0.10 0.04 0.07 31.03.1999 0.09 0.06 0.06 0.07-0.06 0.04 31.03.2000 0.09 0.03 0.04 0.06-0.15 0.01 31.03.2001 0.10 0.04 0.04 0.09-0.15 0.02 31.03.2002 0.06-0.01-0.02 0.08-0.04 0.02 31.03.2003 0.04-0.30-0.09 0.06-0.01-0.06 31.03.2004 0.08-0.11 0.07 0.07-0.05 0.01 31.03.2005 0.09-0.04 0.11 0.07-0.04 0.04 Mean 0.11-0.01 0.05 0.09-0.03 0.04 S.D. 0.06 0.12 0.07 0.04 0.07 0.06 C.V. 55.91-1957.32 124.32 43.00-213.81 132.73 Source: Computed Data.
186 It is observed from Table 5.12 that the average over a period of 10 years, Madras Cements (0.11) is ensuring adequate return to the shareholders with a C.V. of 55.91 per cent. TANCEM s average over 10 years is negatively carved with -0.03 with a greater negative C.V. of 213.81 per cent implying that the company does not promise return to its shareholders and may not with stand adverse economic conditions but for Government s support. We are interested in further probing the facts statistically. We chose to apply F test for the sample data. The data regarding this aspect have been obtained from the select cement companies of the sample group for the period 1995-96 to 2004-05. H 01 : The Net Profit ratio for the companies on the average do not differ significantly over the years. H 02 : The Net Profit ratio on the average over the years do not differ between the different cement companies H 11 : The Net Profit ratio on the average differ between the different years for the companies H 12 : The Net Profit ratio on the average differ significantly for the different companies In order to examine the validity of the null hypothesis H 01 and H 02, the analysis of variance of two way classification has been used. The results are given in Table 5.13.
187 TABLE 5.13 ANOVA for Net Profit Ratio Analysis Source of Variation SS Df MS F P-value F-cirt Rows 0.115 9 0.012778 6.404901 0.0021 2.152607 Columns 0.12958 4 0.032395 16.2381 0.00027 2.633534 Errors 0.07182 36 0.001995 Total 0.3164 49 From Table 5.13, it is seen that the F value computed for the rows (years) is F = 6.405 with a corresponding p = 0.0021. Hence, H 01 is getting rejected which implies that the net profit on the average differ significantly between the years for each company. Similarly, F value computed for the columns (companies) is F = 16.238 with a corresponding p = 0.00027. Hence in this case also the null hypothesis H 02 is getting rejected which implies that there is a significant difference between the average net profit of the companies for each year. 2. Profitability Ratio Relating to Investment ratios. Profitability relating to investment is analysed into the following two a. Return on Capital Employed (ROCE) b. Return on Net Worth (RNW)
188 a. Return on Capital Employed This is otherwise called Return on Investment (ROI) or Return on Capital Employed (ROCE). The profits are related to the total capital employed in the firm. Capital employed refers to long term funds supplied by the creditors and owners of the company. The higher the ratio, the more efficient is use of capital employed. Overall Profitability Ratio is also called as Return on Investments (ROI) or Return on Capital Employed (ROCE). This indicates a certain percentage of return over the capital employed in the business. This is the yield on capital and is to be measured periodically. The profit being the net result of the operation, the return on capital expresses all efficiencies and inefficiencies of a business collectively and is a dependable measure in judging the overall efficiency of a company. Profitability shows the financial performance of the companies. The mean values and C.V. of Return on Capital Employed over the successive years for the sampled companies are presented in Table 5.14.
189 TABLE 5.14 Analysis of Return on Capital Employed Cement Company Mean S.D. C.V. (In Percentage) Madras Cements 10.45 5.56 53.21 India Cements 3.91 5.98 152.94 Chettinad Cements 6.29 6.53 103.82 Dalmia Cements 5.72 4.15 72.55 Tamil Nadu Cements - 1.92 13.78 717.71 Source: Computed Data. It is observed from Table 5.14 that the value of Return on Capital Employed is the highest in the case of Madras Cements. Also the C.V. is the smallest in that case. It shows that the Return on Capital Employed is the highest on the average and at the same time it is rather relatively stable also. Next is Chettinad Cements. But the variation is rather higher in this case. In the case of Dalmia Cements, the average is higher and at the same time the fluctuations are less. But in the case of TANCEM, the ROCE is negative on the average. Also the C.V. is the highest showing more of fluctuations. On the basis of the data collected regarding ROCE for the different companies over the different years, it is proposed to test the following hypothesis to test the following hypothesis by using the analysis of variance two way classification procedure. The null hypothesis to be tested are:
190 Table 5.15. H 01 : There is no significant difference between the values of return on capital employed on the average between the different years for the companies. H 02 : The values of return on capital employed on the average do not differ between different cement companies. The alternative hypothesis are: H 11 : The mean values of the return on capital employed by the companies differ significantly between the successive years. H 12 : The mean values of the return on capital employed by the companies differ significantly between the companies. The results obtained by the analysis of data are given in the ANOVA TABLE 5.15 ANOVA for Return on Capital Employed Source of Variation SS Df MS F P-value F-cirt Rows 1268.59 9 140.9544 2.684756 0.016914 2.152607 Columns 811.8737 4 202.9684 3.865935 0.010308 2.633534 Errors 1890.064 36 52.50176 Total 3970.527 49 From Table 5.15, it is clear that the F value calculated corresponding to the rows (years) is F = 2.685 with a corresponding significance value p = 0.0169. Hence, the null hypothesis H 01 is getting rejected. Similarly, the F value calculated corresponding to the columns (companies) is F = 3.866 with a corresponding p = 0.010. Hence, the null hypothesis H 02 is getting rejected.
191 This concludes that there is a significant difference between the average values of the return on capital employed by different companies. b. Return on Net Worth This ratio is one of the most important ratios used for measuring the overall efficiency of a firm. As the primary objective of business is to maximise its earnings, this ratio indicates the extent to which this primary objective of business is being achieved. This ratio is of great importance to the present and prospective shareholders as well as the management of the company. 11 As this ratio reveals how well the resources of a firm are being used, higher the ratio, better the results. The return on shareholders investment should be compared with the return on other similar firms in the same industry. The inter-firm comparison of this ratio determines whether the investments in the firm are attractive or not as the investors would like to invest only where the return is higher. Similarly, trend ratios can also be calculated for a number of years to get an idea of the prosperity, growth or deterioration in the company s profitability and efficiency. Return on Net Worth = Net Profit after interest and tax / Shareholders funds * 100 Shareholders funds includes equity share capital, preference share capital, free reserves such as share premium, revenue reserve, capital reserve, retained earnings and surplus. 11. R.K. Sharma. And K. Shashi Gupta, Op.cit.
192 The result of Return on Networth Analysis is presented in Table 5.16. Year TABLE 5.16 Return on Networth Analysis of Sample Companies (Values in Percentage) Madras Cements India Cements Chettinad Cements Dalmia Cements TANCEM Industry Average 1995-96 42.86 18.89 28.80 38.53 23.81 30.58 1996-97 26.90 16.88 37.69 21.14 16.00 23.72 1997-98 13.02 11.96 22.16 10.89 12.90 14.19 1998-99 13.99 12.25-27.77 8.75 9.20 3.29 1999-2000 13.76 5.69-136.19 5.51 8.99 (20.45) 2000-01 17.67 5.97-137.65 4.15 11.09 (19.75) 2001-02 15.81-0.13-38.13-4.79 7.57 (3.93) 2002-03 9.54-31.70-6.60-18.93 5.78 (8.38) 2003-04 18.82-7.27-23.12 16.54 7.49 2.49 2004-05 18.61-3.68-18.12 26.65 8.58 6.41 Mean 19.10 2.89 (29.89) 10.85 11.14 2.82 S.D. 9.06 14.11 58.68 15.37 5.07 20.46 C.V. 47.45 488.85-196.30 141.76 45.50 726.64 Source: Computed Data. It is observed from Table 5.16 that the mean ratio of industry average was 2.82 per cent during the study period and ranged between 30.58 per cent in 1995-96 to 20.45 per cent in 1999-2000. The mean ratio of Madras Cements was 19.10 per cent which is the highest among the companies under study and the return on net worth of this company was satisfactory level during the study
193 period. The mean ratio of TANCEM was 29.89 per cent, which is the lowest among the companies under the study period and the return on net worth of this company was very poor from 1998-99 till the end of the study period. The mean ratio of return on net worth of the India Cements, Chettinad Cements and Dalmia Cements were 2.89 per cent, 10.85 per cent and 11.14 per cent respectively. The ratio of return on net worth of India Cements, Chettinad Cements registered a negative trend during the years 2001-02 to 2002-03 respectively. It signals that the resources of the firms are not properly used for these particular years. This ratio is proposed to be employed here to give an idea whether the Return on Net Worth of all companies are consistent and is over the periods also. With the view to examine whether the return on net worth on the average differ significantly between the successive years for the different companies put together and also between the companies for the years put together and also between the companies for the years put together it is proposed to use the analysis of variance two way classification procedure. The null hypothesis to be tested are as follows: H 01 : The average of the return on net worth for the different companies do not differ significantly between the successive years. H 02 : The average of the return on net worth over the years do not differ significantly between the different companies.
194 The alternative hypotheses are: Table 5.17. H 11 : The average of the return on net worth for the different companies differ significantly between the successive years. H 12 : The average of the return on net worth over the years differ significantly between the different companies. The results obtained by the analysis of data are given in the ANOVA TABLE 5.17 ANOVA for Return on Networth Source of Variation SS Df MS F P-value F-cirt Rows 12859.614 9 1428.846 1.904613 0.08284 2.152607 Columns 14687.792 4 3671.948 4.894607 0.00296 2.633532 Errors 27007.302 36 750.2028 Total 54554.707 49 It is observed from Table 5.17 that the F value computed corresponding to the rows (years) is F = 1.905 with a corresponding p = 0.0828. Hence, the null hypothesis H01 is accepted. Hence, the return on net worth on the average for the companies is the same over the successive years. Similarly, the F value computed to the columns is F = 4.895 with a corresponding p = 0.00296. The null hypothesis H 02 is rejected thereby implying that the return on net worth on the average differ between the companies.
195 Hence, it is concluded that the return on net worth on the average differs between companies. The various analysis done in this section on Profitability Analysis are presented in Table 5.18. Profitability Relating to Sales TABLE 5.18 Profitability Analysis Result Profitability Relating to Investments Return on Capital Employed Return on Networth Madras Cements Madras Cements Madras Cements From the analysis presented in Table 5.18 on profitability based on sales and relating to investments, it is summarised that comparing the parameters on profit, Madras Cements is placed in the best position, of the select cement companies. 5.4 RISK AND PROFITABILITY A firm s policy for managing working capital should be designed to achieve three goals, viz., adequate liquidity, minimization of risk and maximization of profitability. A firm should maintain adequate level of working capital to meet the current obligations and maintain uninterrupted business operation. It should ensure that it does not suffer from lack of liquidity. The failure of the firm to meet its obligation due to lack of sufficient liquidity is highly risky as it will result in bad credit image, loss of creditors
196 confidence, high-cost emergency borrowing, unnecessary legal battles or even closure of the firm. At the same time, if the level of working capital is more, holding cost of current asset would be more, again would badly affect the profitability. A well monitored minimum level of working capital at a calculated risk is always good for better profitability. In connection with trade-off between liquidity, risk and profitability, a firm can adopt three types of working capital policies Conservative policy this will result in high current ratio Aggressive policy will result in low current ratio with different degrees of financial flexibility Moderate policy a trade-off between the above two policies investment in current assets is neither too high nor too low. In order to analyse the trade-off between risk and profitability, the risk analysis of working capital management has been done to assess the extent of current assets maintained by the select cement companies, adequate enough to meet the current obligations and also to support the given level of operation. Enterprises are said to follow aggressive approach when the current assets are funded only by short-term sources and a conservative approach when current assets are financed by both short-term and long-term sources. The risk faced by a firm can be measured with the following formula:
197 Where, (Ej + Lj) - Aj Rk = ------------------ Cj Rk = Risk Factor Ej = Equity + Retained Earnings Lj = Long-term Loans Aj = Fixed Assets Cj = Current Assets The above measure indicates the extent of current assets financed by long-term assets financed by long-term funds after fixed assets are financed in full. Based on the above, the following inferences can be drawn. Value Rk = 0 Or Rk < 0 Rk = 1 Or Rk, close to 1 Inference Aggressive policy & Profitability high Conservative approach & Profitability low In our study, we are interested in assessing the trade-off between profitability and risk for the select cement companies during the period under review separately. Madras Cements The Risk and Profitability Analysis of Madras Cements is presented in Table 5.19.
198 TABLE 5.19 Risk and Profitability Analysis Madras Cements Year Rk ROCE (in Percentage) D 2 1995-96 0.531 27.27 81 1996-97 0.625 15.76 49 1997-98 0.694 14.62 16 1998-99 0.714 15.33 9 1999-2000 0.810 12.26 16 2000-01 0.725 11.62 9 2001-02 0.720 10.73 4 2002-03 0.724 8.41 36 2003-04 0.696 10.17 1 2004-05 0.741 8.66 49 D 2 = 270 Source: Computed Data. It is observed from Table 5.19 that Madras Cements has adopted a modest aggressive approach during the period under study. Even though the profitability is high, it is running a risk of meeting its current obligations or achieving the desired level of turnover. The formula for calculating Correlation Co-efficient (r) = 1 (6Σ D 2 / (n 3 n)) Test static t = r / ( 1 r 2 ) * (n 2)
199 The correlation coefficient (r) for ranked data of risk and profitability is calculated as (-) 0.636 indicates that there is a negative association between the two variables, namely, risk and profitability. It is a common fact that risk and profitability are positively correlated, but in Madras Cements, it is found that the correlation coefficient r is negative, means that risk and profitability are negatively correlated. To test the significance of the correlation coefficient, t is carried out and the null hypothesis is: H o : The correlation between risk and profitability is not significant H 1 : The correlation coefficient is significant The table value of t at 5 per cent level of significance for 8 degrees of freedom is 2.31, where as the calculated /t/ value is 2.33. Since the calculated value of t is more than the table value, null hypothesis is rejected accepting alternate hypothesis, and it is concluded that the correlation between risk and profitability is significant. India Cements The Risk and Profitability Analysis of India Cements is presented in Table 5.20.
200 TABLE 5.20 Risk and Profitability Analysis India Cements Year Rk ROCE (in Percentage) 1995-96 0.704 16.85 64 1996-97 0.699 13.39 64 1997-98 0.798 10.05 16 1998-99 0.757 11.94 16 1999-2000 0.806 9.38 1 2000-01 0.799 9.51 1 2001-02 0.822 7.84 9 2002-03 0.860-2.20 49 2003-04 1.130 0.68 64 2004-05 1.042 2.29 36 D 2 Source: Computed Data. D 2 = 320 It is observed from Table 5.20 that India Cements has adopted a modest aggressive approach during the period of first eight years and has adopted conservative approach for the last two years under study. Even though the profitability is high in the first eight years, it is running a risk of meeting its current obligations or achieving the desired level of turnover. In addition, in the last two years, since the company has adopted conservative approach, there is a reduction in profitability and has slipped into loss. The correlation coefficient (r) for ranked data of risk and profitability is calculated as -0.939 indicates that there is a negative association between
201 the two variables, namely risk and profitability. It is an accepted rule that risk and profitability are positively correlated, but in India Cements, it is found that the correlation coefficient r is negative, means that risk and profitability are negatively correlated. The null and alternative hypothesis are - H o : The correlation between risk and profitability is not significant H 1 : The correlation coefficient is significant The table value of t at 5 per cent level of significance for 8 degrees of freedom is 2.31, where as the calculated /t/ value is 7.72. Since the calculated value of t is more than the table value, null hypothesis is rejected accepting alternate hypothesis and it is concluded that the correlation coefficient between risk and profitability is significant. TANCEM 5.21. The Risk and Profitability Analysis of TANCEM is presented in Table
202 TABLE 5.21 Risk and Profitability Analysis TANCEM Year Rk ROCE (in Percentage) D 2 1995-96 0.316 22.903 64 1996-97 0.336 28.218 64 1997-98 0.546 16.255 25 1998-99 0.596 1.514 1 1999-2000 0.597-9.006 16 2000-01 0.927-4.652 25 2001-02 0.996 10.351 1 2002-03 0.803 6.001 0 2003-04 1.023-0.210 25 2004-05 1.045-0.212 49 Source: Computed Data. D 2 = 270 It is observed from Table 5.21 that TANCEM has adopted a modest aggressive approach during the period of first five years and has adopted conservative approach for the last five years under study. Even though the profitability is high in the first five years, it is running a risk of meeting its current obligations or achieving the desired level of turnover. In addition, in the last five years, since the company has adopted conservative approach, there is a reduction in profitability and has slipped into loss.
203 The correlation coefficient (r) for ranked data of risk and profitability is calculated as -0.636 indicates that there is a negative association between the two variables, namely, risk and profitability. It is an accepted rule that risk and profitability are positively correlated, but in TANCEM, it is found that the correlation coefficient r is negative, means that risk and profitability are negatively correlated. The null and alternative hypothesis are - H o : The correlation between risk and profitability is not significant H 1 : The correlation coefficient is significant The table value of t at 5 per cent level of significance for 8 degrees of freedom is 2.31, where as the calculated /t/ value is 4.834. Since the calculated value of t is more than the table value, null hypothesis is rejected accepting alternate hypothesis and it is concluded that the correlation coefficient between risk and profitability is significant. Chettinad Cements Table 5.22. The Risk and Profitability Analysis of Chettinad Cements is presented in
204 TABLE 5.22 Risk and Profitability Analysis Chettinad Cements Year Rk ROCE (in Percentage) D 2 1995-96 0.487 22.726 1 1996-97 0.427 17.885 1 1997-98 0.310 13.831 9 1998-99 0.328 12.898 1 1999-2000 0.386 11.228 9 2000-01 0.499 7.297 49 2001-02 0.060 5.437 1 2002-03 0.052 4.658 1 2003-04 -0.001 11.547 16 2004-05 0.177 11.902 4 Source: Computed Data. D 2 = 92 It is observed from Table 5.22 that Chettinad Cements has adopted a modest conservative approach during the period of first eight years, the last year and has adopted a vibrant aggressive approach for the last two years under study. The situation had been highly risky during the second part of the study period, the risk factor being negative except the last year. The correlation coefficient (r) for ranked data of risk and profitability is calculated as 0.442 indicates that there is a positive association between the two variables, namely., risk and profitability, it is found that the correlation
205 coefficient r is positive, means that risk and profitability are positively correlated. The null and alternative hypothesis are - H o : The correlation between risk and profitability is not significant H 1 : The correlation coefficient is significant The table value of t at 5 per cent level of significance for 8 degrees of freedom is 2.31, where as the calculated /t/ value is 1.395. Since the calculated value of t is less than the table value, null hypothesis is accepted and alternate hypothesis is rejected and it is concluded that the high degree of conservative policy adopted by the Chettinad Cements has not made a positive impact on its profitability. Dalmia Cements The Risk and Profitability Analysis of Dalmia Cements is presented in Table 5.23.
206 TABLE 5.23 Risk and Profitability Analysis Dalmia Cements Year Rk ROCE (in Percentage) D 2 1995-96 0.691 23.79 64 1996-97 0.737 15.86 36 1997-98 0.876 13.36 4 1998-99 0.915 11.60 4 1999-2000 0.872 10.94 0 2000-01 0.881 13.11 0 2001-02 0.744 9.73 0 2002-03 1.047 7.90 64 2003-04 0.976 8.55 36 2004-05 0.661 6.36 0 Source: Computed Data. D 2 = 208 It is observed from Table 5.23 that Dalmia Cements has adopted a modest conservative approach during the period of first seven years, in the eighth year it has adopted a vibrant aggressive approach and in the last two years it is a modest conservative approach under study. The situation had been highly risky during the second part of the study period, the risk factor being negative except the last year.