Prof. Bhavini Patel
Assistant Prof. MBA Dept
Govindrao Wanjari college of Engg and tech. Nagpur
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Prof. Sunil Ikharkar
Assistant Prof. MBA Dept
Govindrao Wanjari College of Engg and Tech Nagpur
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Capital structure is defined as the composition of debt and equity. When companies earn profit, return on debt is treated as expenses and return on equity is the distribution of profit after tax. The paper focuses on making an attempt to ascertain the impact of capital structure on the profitability of a firm and whether there is an impact of IFRS while preparing the financial statement of automobile industry.
The first part the paper reflects brief history of IFRS and the later part shows the impactof IFRS based firm’s capital structure statements on financial performance and shareholders’ wealth: with reference to automobile companies in India
In order to achieve the objectives of the study, the researchers have employed the analysis of various ratios.
Keywords: Capital structure, IFRS, Profitability, Return on equity, Return on assets, financial performance.
The financing decision of a firm relates to the composition of relative proportion of various sources of finance. Business is a continuous process and to run it smoothly, one requires sufficient amount of funds. Finance plays a very important role in a company’s working. It is considered as the lifeblood of business organization. The basic objective of any business is to maximize its wealth and profit, and hence to support the same selection of proper sources of finance is very important. The sources of finance are usually comprised of a combination of debt and equity. Thus an optimal mix of various such financing sources constitutes the “capital structure” of a business. Further, the decision related to the capital structure is critical for a firm because of its relation with financial performance.
Capital structure is the strategy employed by a firm to finance its assets, growth and operations. Capital structure is the composite of total equity and total debt of firms. Firms can issue a number of securities to finance its assets however; appropriate combination of debt and equity (Optimal Capital Structure) is critical for a firm as it reduce the firm’s cost of capital and maximize their market worth and stock price. Firms can even attain competitive advantage, if it has perfect capital structure.
Several macro environmental and firm-specific factors influence the decisions of firm’s capital structure. The country within which the particular firm operates also influences their capital structure as well as their “financial performance”. Capital structure is the combination of a firm’s long-term debt, specific short-term debt, common equity, preferred equity and retained earnings which are used to finance its overall operations and growth. Capital structure is a very important financial decision as it is directly related to the risk and return of a firm. Any immature capital structure decision can result in high cost of capital; thereby lowering firm’s value while effective capital structure decision can do the opposite.
Automobile sector in India:
The automobile sector in India has come a long way. This sector has reported high growth rate from 26 percent to a worst negative growth in some segments during past years. Indian auto sector is one of the most vibrant industry. The automobile industry is one of India’s major sectors; accounting for 22% of the country’s manufacturing GDP. The Indian auto industry, comprising passenger cars, two-wheelers, three-wheelers and commercial vehicles, is the seventh-largest in the world with an annual production of 17.5 million vehicles, of which 2.3million are exported .Indian Auto market has the potential to dominate the Global auto industry, provided, a conducive environment is created for potential innovators to come up with new pilot projects. Automotive industry is the key driver of any growing economy. Due to its India’s Automobile Background deep forward and backward connections with almost every segment of the economy, the industry has a strong and positive multiplier effect and thus propels progress of a nation. The automotive industry comprises of the automobile and the auto component sectors. It includes passenger cars; light, medium and heavy commercial vehicles; multi-utility vehicles such as jeeps, scooters, motor-cycles, three wheelers, tractors, etc; and auto components like engine parts, drive and transmission parts, suspension and braking parts, electrical, body and chassis parts; etc. The Indian automotive industry has made rapid strides since de-licensing and opening up of the sector in 1991. It has witnessed the entry of several new manufacturers with the state of art technology, thus replacing the monopoly of few manufacturers. The norms for foreign investment and import of technology have also been liberalized over the years for manufacture of vehicles. At present, 100% foreign direct investment (FDI) is permissible under the automatic route in this sector, including passenger car segment.
Inidan automobile industry is the stands second in the list of top ten countries in the world in the area of two wheelers. It is the third in the section of small cars and fifth in the list in the section of commercial vehicles.
Further, talking about IFRS, IFRS stands for “International Financial Reporting Standards” and includes International Accounting Standards (IASs) until they are replaced by any IFRS and interpretations originated by the IFRIC or its predecessor, the former Standing Interpretations Committee (SIC). IFRSs are developed and approved by IASB (International Accounting Standard Board).
These are standards for reporting financial results and are applicable to general purpose financial statements and other financial reporting of all profit- oriented entities. Profit-oriented entities includes those engaged in commercial, industrial, financial and similar activities, whether organized in corporate or in other forms also includes mutual insurance companies, other mutual co-operative entities, etc.
Upon its inception the IASB adopted the body of International Accounting Standards (IASs) issued by its predecessor and as such IFRS includes IAS until they are replaced by any IFRS.
IFRS in India
At its 269 meeting the Council of ICAI has decided that public interest entities such as listed companies, banks, insurance companies and large-sized organizations to converge with IFRS for accounting period commencing on or after 1 April, 2011.
In India, financial statements are basically prepared as per Indian Accounting Standards (AS) where all the assets including financial instruments are measured as per historic or the book value. In the year 2010, when ICAI announced their opinion regarding the adaptation of IFRS and officially said to disclose the next financial statement as per IFRS, some Indian companies voluntarily adopted it and presented their financial statement as per IFRS.
Few of the Indian companies which have adopted IFRS for the purpose of accounting are :
- Infosys Ltd.
- Wipro Ltd
- Dr. Reddys Lab. Ltd.
- Bharti Airtel Ltd.
- Sterlite Industires Ltd.
- Tata Motors Ltd.
- Seimens ltd.
- Tata consultancy Ltd.
Impact of adopting IFRS:
- It would benefit the economy by increasing growth of international business.
- It would encourage international investing and thereby lead to more foreign capital inflows into the country.
- Investors want the information that is more relevant, reliable, timely and comparable across the jurisdictions. IFRS would enhance the comparability between financial statements of various companies across the globe.
- Better understanding of financial statements would benefit investors who wish to invest outside their own country.
- The industry would be able to raise capital from foreign markets at lower cost if it can create confidence in the minds of foreign investors that their financial statements comply with globally accepted accounting standards.
- It would provide professional opportunities to serve international clients.
- It would increase their mobility to work in different parts of the world either in industry or practice.
- It would reduce different accounting requirements prevailing in various countries there by enabling enterprises to reduce cost of compliances.
Shareholders’ wealth and financial performance:
The financial performance of the companies shall be analyzed by using the following variables:
The variables consist of:-
- Return on Equity (ROE),
- Return on Asset (ROA) and
- Earnings Per Share (EPS).
Return on Assets Return on Assets (ROA) measures the profitability of the firms and calculated as Return on assets=operating income/total assets
Return on Equity (ROE) is used to calculate a firm’s profitability by revealing how much profit a firm generates with money invested by shareholders and its formula is given below.
Return on equity=net profit attributed to shareholders/total shareholders’ equity
Earnings per share (EPS) measure shareholders profitability by revealing how much profit a share generate with money shareholders have invested and calculated by this formula.
Earnings per share=net earnings/number of shares
Dividend per share (DPS) is the amount of dividends that the shareholders receive on a per-share basis. It is calculated using the total dividends paid out to shareholders over one fiscal year and the number of shares outstanding. DPS can be calculated using the formula (total dividends paid out over a period – any special dividends)/(shares outstanding).
Total Debt equity Ratio indicates how much debt a company is using to finance its assets relative to the amount of value represented in shareholders’ equity.
Debt – Equity Ratio = Total Liabilities / Shareholders’ Equity
Net profit margin is the ratio of net profits to sales for a company or business segment – typically expressed as a percentage – that shows how much of each rupee earned by the company is translated into profits.
Net profit margin= net profit/sales
Modigliani and Miller (M & M) (1958) wrote a paper on the irrelevance of capital structure that inspired researchers to debate on this subject. This debate is still continuing. However, with the passage of time, new dimensions have been added to the question of relevance or irrelevance of capital structure. M&M declared that in a world of frictionless capital markets, there would be no optimal financial structure (Schwartz & Aronson, 1979). This theory later became known as the “Theory of Irrelevance’. In M & M’s over simplified world, no capital structure mix is better than another. M & M’s Proposition-II attempted to answer the question of why there was an increased rate of return when the debt ratio was increased. It stated that the increased expected rate of return generated by debt financing is exactly offset by the risk incurred, regardless of the financing mix chosen.
Velnampy & Niresh (2012) revealed that profitability of the firm’s is dependent upon the capital structure decisions of the firm having the different debt and equity combination that can well suited to increase the profitability of the firm. The important part of the firm’s financial strategy is to prosperous choice and use of its capital. The relationship between firm’s capital structure and the firm’s profitability is very significant as the profitability of the firm can be directly affected by the capital structure decisions of the firms. Decision about firms Capital structure is very important element in the firms overall strategy.
Saleem (2013) revealed that by maintaining the balance between benefits of debt and cost of debt associated with that benefit that will results in optimal capital structure according to trade off theory. For the purpose of reducing agency cost and gain tax shield firms chose to finance its operations through debt financing. The benefit from debt financing is that the firms can gain tax benefit and reducing the agency cost by not giving the ownership right to the equity holders if they go for the equity financing rather than debt financing.
The outcome of an investigation in India by (Goyal, 2013) discloses the positive association between short term debt and profitability while negative link was discovered between profitability and long term debt.
In the empirical study of (Patel & Bhatt, 2013) the negative association between profitability and debts were unveiled while the linkage was positive in between equity and profitability. Measures of financial performance such as ROE and ROA had negatively affected by their capital structure to a large extent (Mwangi et al. 2014).
Rameltula &Elsana Ejupi (2010) conducted a research on relationship between capital structure and profitability at Macedonia. They found a negative relationship with return and debt.
The data collected for the purpose of the study is secondary data and the analysis is made for the two years i.e 2013-14 and 2014-15. the information required for the purpose of the study is collected through the audited annual reports of the company. The company selected for the purpose of the study is Tata Motors ltd. The method used for the purpose of analysis is ratio analysis method
Objectives of the study:
- To analyze the impact of IFRS based firm’s capital structure statements on financial performance and shareholders’ wealth: with reference to automobile companies in India
- To study the impact of capital structure on firms’ financial performance.
- To study the returns offered by the companies to its shareholders.
- To study profitability and Long Term Solvency ratios.
H1: capital structure has a significant impact on net profit.
H2: Capital structure has a significant impact on financial performance.
RETURN ON EQUITY (ROE):
Return on equity measures how efficiently a firm can use the money from shareholders to generate profits and grow the company. Unlike other return on investment ratios, ROE is a profitability ratio from the investor’s point of view—not the company. In other words, this ratio calculates how much money is made based on the investors’ investment in the company, not the company’s investment in assets or something else. That being said, investors want to see a high return on equity ratio because this indicates that the company is using its investors’ funds effectively. Higher ratios are almost always better than lower ratios, but have to be compared to other companies’ ratios in the industry. Since every industry has different levels of investors and income, ROE can’t be used to compare companies outside of their industries very effectively.
The ROE of 2013-14 is 2.52 where as it is -5.61 in 2015-15, which means that the returns which were given to the shareholders in 2013-14 were more than that of 2014-15. it simply implies that if an investor is investing one rupee in the company, he shall fetch a return of 2.52 rupees on every rupee invested by him. Hence it can be said that the performance of the company in 2013-14 was much better than that in 2014-15 as it gave positive returns to the shareholders of the company.
RETURN ON ASSETS (ROA):
The return on assets ratio, often called the return on total assets, is a profitability ratio that measures the net income produced by total assets during a period by comparing net income to the average total assets. In other words, the return on assets ratio or ROA measures how efficiently a company can manage its assets to produce profits during a period.
Since company assets’ sole purpose is to generate revenues and produce profits, this ratio helps both management and investors see how well the company can convert its investments in assets into profits.
It can also be inferred that ROA is a return on investment for the company since capital assets are often the biggest investment for most companies. In this case, the company invests money into capital assets and the return is measured in profits. A higher ratio is more favorable to investors because it shows that the company is more effectively managing its assets to produce greater amounts of net income. A positive ROA ratio usually indicates an upward profit trend as well. ROA is most useful for comparing companies in the same industry as different industries use assets differently.
From the collected data, and the figures so obtained it can be said that every rupee that an investor invested in assets during the year 2013-14 produced rupees 59.51 of net income. Depending on the economy, this can be a healthy return rate no matter what the investment is. further, in the year 2014-15 the ROA was 46.10, which means that every rupee invested in the company generates rupees 46.10 of the net income. This is comparatively less than that of the previous year.Which in turn says that the company’s performance in the previous year was better than that of the current year.
EARNINGS PER SHARE (EPS):
Earnings per share, also called net income per share, is a market prospect ratio that measures the amount of net income earned per share of stock outstanding. In other words, this is the amount of money each share of stock would receive if all of the profits were distributed to the outstanding shares at the end of the year.
Earning per share is also a calculation that shows how profitable a company is on a shareholder basis. A higher earnings per share is always better than a lower ratio because this means the company is more profitable and the company has more profits to distribute to its shareholders.
From the comparative analysis of the company’s EPS in the said period, it is seen that the company offered earnings of Rs. 43.51 per share to its share holders in the year 2014-15 where as it offered earnings of Rs. 43.44 per share, which simply means that the company performed fairly well in the year 2013-14 as compared to 2014-15.
DIVEDEND PER SHARE (DPS):
The dividend payout ratio measures the percentage of net income that is distributed to shareholders in the form of dividends during the year. In other words, this ratio shows the portion of profits the company decides to keep to fund operations and the portion of profits that is given to its shareholders.
Investors are particularly interested in the dividend payout ratio because they want to know if companies are paying out a reasonable portion of net income to investors. Since investors want to see a steady stream of sustainable dividends from a company, the dividend payout ratio analysis is important. A consistent trend in this ratio is usually more important than a high or low ratio.
Since it is for companies to declare dividends and increase their ratio for one year, a single high ratio does not mean that much. Investors are mainly concerned with sustainable trends. Generally, more mature and stable companies tend to have a higher ratio than newer start up companies.
It can be seen that the company is paying Rs. 2 per share as dividend to its shareholders in the year 2013-14 where as it has not paid any dividend in the 2014-15.
NET PROFIT MARGIN (NPM):
The profit margin ratio, also called the return on sales ratio or gross profit ratio, is a profitability ratio that measures the amount of net income earned with each dollar of sales generated by comparing the net income and net sales of a company. In other words, the profit margin ratio shows what percentage of sales are left over after all expenses are paid by the business.
Creditors and investors use this ratio to measure how effectively a company can convert sales into net income. Investors want to make sure profits are high enough to distribute dividends while creditors want to make sure the company has enough profits to pay back its loans. In other words, outside users want to know that the company is running efficiently. An extremely low profit margin formula would indicate the expenses are too high and the management needs to budget and cut expenses. The profit margin ratio directly measures what percentage of sales is made up of net income. In other words, it measures how much profits are produced at a certain level of sales.
This ratio also indirectly measures how well a company manages its expenses relative to its net sales. That is why companies strive to achieve higher ratios. They can do this by either generating more revenues why keeping expenses constant or keep revenues constant and lower expenses.
In this case, it is seen that the company offers a NPM of 0.97 in the year 2013-14 which is positive in nature where as it offers a NPM of -13.05 in the year 2014-15 which is negative in nature. This means that the company performed comparatively well in the year 2013-14 as compared to the performance in 2014-15. This further implies that the company had a steep increase in the expenses as compared to that of the sales, due to which the net profit fetched crossed the line of positivity in the year 2014-15.
DEBT TO EQUITY RATIO (D/E ratio):
The debt to equity ratio is a financial, liquidity ratio that compares a company’s total debt to total equity. The debt to equity ratio shows the percentage of company financing that comes from creditors and investors. A higher debt to equity ratio indicates that more creditor financing (bank loans) is used than investor financing (shareholders).A debt to equity ratio of 1 would mean that investors and creditors have an equal stake in the business assets. A lower debt to equity ratio usually implies a more financially stable business. Companies with a higher debt to equity ratio are considered more risky to creditors and investors than companies with a lower ratio. Unlike equity financing, debt must be repaid to the lender. Since debt financing also requires debt servicing or regular interest payments, debt can be a far more expensive form of financing than equity financing. Companies leveraging large amounts of debt might not be able to make the payments. Creditors view a higher debt to equity ratio as risky because it shows that the investors haven’t funded the operations as much as creditors have. In other words, investors don’t have as much skin in the game as the creditors do. This could mean that investors don’t want to fund the business operations because the company isn’t performing well. Lack of performance might also be the reason why the company is seeking out extra debt financing.
From table 1, it is seen that the company had a D/E ratio of 0.76 in the year 2013-14. The ratio went up to 1.35 in the year 2014-15 which means that the company raised more of its fund from debt in the later year. There were comparatively less borrowings in the year 2013-14 as compared to that of 2014-15.
1. It can be concluded that the prosperity of Tata Motors Ltd., is wealthy for the said period, but it was found to be in a gradual decrease in the profit offered to the share holders of the company.
2. The debt borrowing increased in the said period which created a cascading effect on the profit and dividend received by the shareholders in the said period. These changes in the profits might have occurred due to High taxation, High cost of borrowed funds, High depreciation cost, High expenses etc. which can be modified by implementing proper financial management concepts.
3. This study results reveal significantly negative relation between capital structure and financial performance.
4. These findings imply that an increase in debt position is associated with a decrease in profitability; thus, the higher the debt, the lower the profitability of the firm.
Finally it can be concluded there is positive relationship between capital structure and financial performance. And also capital structure has a significant impact on financial performance of the firm. So every firm should make good capital structure decision to earn profit and carry on their business successfully.
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