Impact of Financial Leverage on Profitability of Fast Moving Consumer Goods Companies Listed on BSE

Jasminder Kaur¹, Dr Harsh Vineet Kaur²

¹Assistant Professor, Institute of Management Studies, Bhaddal, Ropar

²Assistant Professor, School of Commerce and Management, Sri Guru Granth Sahib World University,

Fatehgarh Sahib

*Corresponding Author E-mail:

ABSTRACT:

The paper focuses to investigate the effect of leverage on profitability of companies in FMCG Sector in India. For the purpose of the study of the relationship between leverage(independent variable) is defined in terms of Financial Leverage and Profitability (dependent variable) is defined in terms of earning per share, return on net worth (return on equity), and net profit margin. The data base is fast moving consumer goods companies listed on S&P BSE FMCG Index. The research techniques include Karl Pearson Correlation and T-Test. The data of five year period from F.Y 2009-10 to 2013-14 is taken for the purpose of the study. It is expected that financial leverage exerts its influence over profitability margin and investment. The results indicate that three among seven companies under study have witnessed negative correlation between EPS and degree of financial leverage, while four companies have faced decline in return on net worth as aftermath of leverage adopted by them. It is apparent that presence of debt has not brought any positive change in net profit margins which could be due to the fact that higher interest payments cause decline in net profits.

KEY WORDS: Capital structure, financial leverage and profitability ratios.

INTRODUCTION:

Financial leverage is associated with financing decisions and activities of a company. In other words it is concerned with capital structure decisions. Generally company encounters with two sources of finance. One is that source which bears fixed financial charges and the other that does not carry any fixed charge. The former source is comprised of debentures, bonds and preference shares. In case of long term debt company is required to pay interest charges irrespective of the level of profits it has earned and thus these expenses are termed as charge against the profit. On the contrary dividend on preference shares may or may not be paid as payment is contingent on the profit levels of company albeit these shares carry fixed rate of dividend likewise the debentures carry fixed rate of interest.

Presence of fixed financial charges implies trading on equity or financial leverage. Financial leverage signifies the impact of modulations in earnings before interest and tax on earning per share or earning available for equity shareholders. Main motive of company behind employing financial leverage is to augment the return to ordinary shareholders. Financial leverage is said to be favorable when the return on asset financed through the debt raised is exceeding the cost of such debt and vice versa. It’s because this difference belongs to shareholders which is their income. Existence of long term debt in capital structure gives rise to financial risk. EPS, ROE and net profit margin are few ingredients of profitability which bear the impact of trading on equity. EPS and ROE which could be called return on net worth are two of the several other measures of profitability in terms of investment and net profit margin measures profitability in terms of sales. In case company earns inadequate net profits, it means that it fails to get satisfactory returns on shareholder’s funds.

LITERATURE REVIEW:

Modigliani and Miller (1958) analyzed that change in leverage has no impact on value of firm and wealth of shareholders. When they assumed that corporate taxes exist then due to the fact that interest is tax deductible expense, value of firm does change with presence of financial leverage and thus value of levered firm exceeds the value of unlevered firm contrary to the circumstances when assumption of absence of corporate taxes is taken.

Net income approach evolved by Durand (1959), when a firm uses leverage then the cost of capital declines and shareholder’s wealth increases. Therefore optimal capital structure does exist when cost of capital is lowest and the value of firm is highest. Unlikely net income approach, another approach by Durand which is net operating income approach says that benefit derived from the decline in cost of debt is offset by the increase in expectations of ordinary shareholders regarding return on their investments due to high financial risk perceived by them which is signified by increase in cost of equity. Therefore there is no effect of financial leverage on value of firm which is further reflected in constant EPS.

Handoo and Sharma (2014), in their study of 870 listed Indian firms on determinants of capital structure which includes both private and government companies for 10 year period from year 2001-2010 concluded that debt, both long term and short term and total debt bears robust link with profitability of companies measured by operating profit rate of return. The paper concluded that return on the total assets is affected by debt on the liability side of balance sheet.

Mishra (2011) carried an analysis of determinants of capital structure of 48 manufacturing PSUs in India. It was investigated that profitability measured by return on assets is negatively related to leverage. The researcher found that the cost of debt was more than return on assets and fixed interest payments further magnifies such negative impact.

Dhankar and Boora (1996), in their study of 26 widely held Indian private sector companies belonging to 15 different industrial sector of ten year period deduced that relation and association between profitability and financial leverage differs in nature depending on industry to industry. But in general and at macro level debt usage causes reduction in cost of debt and increase in value of firm which further implies that shareholders are earning adequate returns on their investment.

Babu and Chalam (2014), established a fact from their research study on factors influencing capital structure decisions of Indian computer software industry that there is positive relation between profitability and financial leverage which further satisfies the inferences of the trade off theory and the pecking order theory.

Mahmoudi (2014) analyzed the effect of leverage on profitability of 28 cement firms listed on Tehran stock exchange. It was concluded that there is significant and negative relation between leverage and profitability. The probable reasons behind such results could be insufficient interest coverage ratio, fluctuation in sales and regular dividend policy.

Yoon and Jang (2005) also contributed to the empirical study of relationship between return on equity and financial leverage. They reported in their study on restaurant firms that leverage has no impact on firm’s profitability but firms with larger assets have high profitability. Also firms with high leverage were proved to be less risky however financial risk increases with corresponding increase in debt level.

Poddar and Mittal (2014), argued that it’s the size of the firm too which influences the capital structure decisions and large sized companies aggressively employ debt. Also, profitability plays vital role in capital structure decisions. As per their study firms with slow growth rate but highly profitable prefer less debt and firms with low profitability in identical industry prefer high debt content in capital structure.

Gweyi and Karanja (2014) emphasized in their research that financial leverage affects the financial performance of deposit taking and credit cooperative societies in Kenya. As per this empirical study there is a perfect positive correlation between degree of financial leverage and return on equity and profit after tax. This proves that there is direct relationship between EPS and DFL.

Singapurwoko and Wahid (2011) analyzed non financial companies listed in Indonesia Stock Exchange. The results show that financial leverage significantly impacts firm’s profitability. This study, therefore contradicts the fact that firms with high profitability prefer internal funding i.e. they use retained earnings to finance their growth.

Panigrahi (2010) gave his views on changing trends in deciding capital structure of Indian Corporate sector. He compared capital structure of Indian companies prior and post liberalization and found that small sized companies employ more debt than large sized companies. Manufacturing companies rely more on debt than service sector does. Highly profitable firms go for retained earnings and low profitable firms raise and depend much on long term borrowings to survive. But most of the Indian firms prefer to retain large chunk of profits so as to use them as internal funds for financing its diversification instead of raising loans, debentures for the same purpose.

Alkhatib (2012) studied 121 companies in both industrial and service sector listed on Jordan Stock Exchange. The author studied factors like current ratio and ratio of fixed asset to total asset to determine the leverage in industrial sector and factors like growth in terms of increase in total assets, current ratio and ratio of fixed assets to total assets affects leverage in service sector.

Barakat (2014) studied the impact of financial leverage on share value of 46 Saudi Industrial Companies. The analysis showed that there is inverse relation between leverage and stock price. This probably means that cost of debt is increased due to excessive leverage and thus value of firm reduces. These findings are consistent with the traditional theory that excessive debt will negatively impact the value of firm.

Rehman (2013) found a positive relationship between debt equity ratio and return on assets while negative relation between debt equity ratio and EPS, net profit margin and ROE (return on equity). According to finance experts when EBIT level of companies is low and further interest charges are to be paid which are kind of charge against profit that are to be met inspite of low earnings and thus increases the risk of insolvency, then debt existence will cause decline in return on net worth and earnings per share.

Pahuja and Sahu (2012) analyzed that there is very low negative correlation between leverage and profitability. He concluded that it is at par of zero correlation. The study showed that profitability does not affect capital structure of the company. He also examined that growth opportunities do play very eminent role as if firm is having such opportunities in hand then it won’t distribute profits but will decide to retain them and thus rely less on debt (leverage). With the breakthrough of this magnitude leverage and growth of firm are negatively correlated.

Singh and Luthra (2013) conducted study on impact of financial leverage on capital structure of telecommunication companies. They came up with the result that in the end leverage influences profitability and EPS of firms. They also suggested that companies with high financial risk must not further rely on debt but should keep their debt equity ratio balanced.

OBJECTIVES:

The present paper focuses on the following objectives:

· To study the Degree of Financial Leverage, Return on Equity, Earning Per Share and Net Profit Margin

· To study the association between capital structure decision as defined by Degree of Financial Leverage and profitability factors like Return on Equity, Earning Per Share and Net Profit Margin

Data Source:

This study is based on the analysis of seven fast moving consumer goods companies listed on BSE FMCG and are the constituents of andP BSE FMCG index. The data relating to various financial parameters have been taken from the annual reports of five years i.e from F.Y2009-10 to F.Y2013-14.

Research Techniques:

For the purpose of analysis Degree of Financial Leverage, Return on Equity, Earning Per Share and Net Profit Margin have been calculated using the below mentioned formulas

Degree of Financial Leverage (DFL)	(Tulsian, 2012)
Return on Equity (ROE)	Net profit after interest, tax and preference dividend	×100
	Equity share holder sfund
Earning Per Share (EPS)
Net Profit Margin	* 100

Degree of freedom = n-2 = 5-2 =3

Level of significance is set at 5% which means that there is just 5 % chance that null hypothesis in spite of being true could be rejected and type I error can be made.

Table value of t at 3 degree of freedom and at 5% significant level is 3.182.

T will be calculated as under for the test of significance:

T = r

Where r is correlation coefficient

The following hypothesis were developed

Karl Pearson Coefficient of correlation is used to find correlation between degree of financial leverage and various profitability parameters of companies. T test has been used to study the level of significance.

FINDINGS:

Table1 shows that in case of Jubilent Foodworks DFL was 1 for year 2011-12 and 2013-14, DFL was 1 in year 2012-13, 2013-14 in case of Colgate Palmolive, ITC respectively. 1 as Degree of leverage indicates that there is no debt in the capital structure of company for the particular year. DFL exists when debt finds place in capital structure of company.

Table 1: DFL

Years	ITC	Colgate Palmolive	Britannia	Jubilent Foodworks	Emami	Hindustan Unilever	Nestle India
2009-10	1.015	1.0155	1.0719	1.188777	1.52941	1.002487	1.001501
2010-11	1.011	1.0168	1.2072	1.003679	1.09365	1.000082	1.000928
2011-12	1.01	1.0026	1.1508	1	1.052	1.000357	1.006453
2012-13	1.008	1	1.1136	1.000304	1.02221	1.005073	1.017132
2013-14	1	1	1.01	1	1.00861	1.007165	1.021758

Table No. 2: Return on equity (%)

Years	ITC	Colgate Palmolive	Britannia	Jubilent Foodworks	Emami	Hindustan Unilever	Nestle India
2009-10	28.98	129.78	29.4	28.36	26.64	85.25	112.69
2010-11	31.36	104.82	32.19	37.56	33.3	86.7	95.7
2011-12	32.88	102.54	35.9	35.26	36.86	76.61	75.47
2012-13	33.28	101.46	36.74	30.97	28.51	141.98	59.38
2013-14	33.45	90	43.33	22.33	42.88	118.01	47.16

Table 1 shows that ITC has decreasing DFL over the past five years and in FY 2013-14 there was no debt in its capital structure and overall financial structure. In case of Colgate Palmolive higher DFL is witnessed in FY 2010-11 than from in preceding FY. Contrarily it declines in FY 2011-12 and reduced to 1 in succeeding years signifying zero additional debt employed. This means it relied on equity financing. Identical scenario is present in Britannia’s case. Its DFL increases at the first sight from FY 2009-10 to FY 2010-11. Thereafter it starts depleting. Randomness is found in the DFL pattern of Jubilent Foodworks. First its DFL reduces to 1.003679 in FY 2010-11 from 1.188777 of FY 2009-10 significantly. In the succeeding year it turned 1. Then in the subsequent year it increases to 1.000304 and it ended up with figure 1 in FY 2013-14 reflecting absence of debt. There is continuous decline in DFL from FY 2009-10 to FY 2013-14 in case of Emami which means it is depending lesser and lesser on debt as the time passes by. DFL of Hindustan Unilever declined from 1.002487 in FY 2009-10 to 1.000082 in FY 2010-11 which is a big drop. Then in succeeding years it went on rising signaling more debt proportion in capital structure of the company. Similar trend can be seen in Nestle India. In FY 2009-10 DFL stood at 1.001501 and in FY 2010-11 it fell to 1.000928. From FY 2011-12 onwards it had fast moving pace and is its rise.

Table 2 shows that with the fall in DFL, ITC has witnessed rise in return on equity. This could be due to the fact that burden of fixed financial charges decreases as debt content decline in the financial structure of the company, which further leads to more earnings available to equity shareholders. Emami too has declining DFL like ITC but trend of fluctuations in its return on equity differs a bit from that of ITC’s. Emami had declining return on equity in FY 2012-13 only in spite of fall in DFL in the same year. Existence of such situation pertains to the presence of lurking variables, the variables not forming part of the study yet exerting influence on the explained (dependent) variables like in the above case, these are- government policies, economic reforms and most importantly increase in the non-employment of debt risk. Colgate Palmolive experienced increase in its return on equity in FY 2010-11 and thereafter it faced reduction in the same though its DFL falls consecutively from FY 2009-10 onwards. Insufficient EBIT could be the reason for this which in turn could be the effect of low level of sales. Britannia seemed to be benefitted from the low debt presence in its capitalization which is evident from the rise in its return on equity over the last five years. Its low dependence on debt for additional fund raising activity indicates its preference for using internal equity (retained earnings). There is increase in return on equity from 28.36% in FY 2009-10 to 37.56% with decrease in DFL from 1.188777 to 1.003679 in the corresponding period in case of Jubilent Foodworks. The biggest abatement in return on equity was in period of FY 2013-14 as witnessed by Jubilent coupled with slight decrease in its DFL to 1. This means that debt is not the sole factor being impactful on its profitability but there could be certain other factors like loss of confidence of shareholders in company’s financial figures, poor creditworthiness and other qualitative factors. Return on equity rose in FY 2010-11 with the fall in DFL in the corresponding period of time. While random pattern of changes was observed in its ROE (return on equity) from FY 2010-11 onwards i.e. at first it declined, then rose and then declined again while direction of change showed uniform trend. Nestle India’s ROE went on decreasing in spite of increasing DFL from FY 2010-11 onwards. One more point to be note here is that there was fall in DFL in FY 2010-11 from FY 2009-10.

Table No. 3: Earning per share (Rs)

Years	ITC	Colgate Palmolive	Britannia	Jubilent Foodworks	Emami	Hindustan Unilever	Nestle India
2009-10	10.64	31.12	48.77	5.18	21.86	10.09	67.94
2010-11	6.45	29.6	12.16	11.16	15.03	10.68	84.91
2011-12	7.88	32.83	15.63	16.23	16.97	12.45	99.73
2012-13	9.39	36.53	19.57	20.7	14.65	17.56	110.76
2013-14	11.05	39.7	30.84	19.22	17.55	17.88	115.87

Table No. 4: Net Profit Margin (%)

Years	ITC	Colgate Palmolive	Britannia	Jubilent Foodworks	Emami	Hindustan Unilever	Nestle India
2009-10	21.3	20.7	3.38	6.93	16.09	12.29	112.68
2010-11	22.91	17.34	3.42	9.38	18.45	11.52	95.7
2011-12	23.97	16.3	3.71	10.32	17.83	12.01	75.47
2012-13	24.05	15.45	4.12	9.54	13.16	14.37	59.38
2013-14	25.57	14.87	5.83	7.25	22.53	13.5	47.16

It’s evident from table no. 3 that ITC has been witnessing positive change in its EPS with the fall in its DFL over the period of five years. Rise in EPS in response to decline in DFL of Colgate Palmolive strengthens the belief that use of retained earnings in financing the growth and diversification of firm will result in maximizing the wealth of shareholder by the way of augmenting their EPS. In case of Britannia there has been major fall in its EPS in FY 2010-11 which could be related to the largest increase in its DFL in FY 2010-11. This proves that for Britannia trading on equity does not seem to charm its profitability. Contrarily Jubilent Foodworks experienced big increase in its EPS in FY 2010-11 which was accompanied by eminent fall in its DFL in the corresponding period. That means bigger fall coupled with significant rise in EPS did wonders to the financial statements of Jubilent Foodworks. It can be seen in table no. 3 that EPS of Emami was highest in FY 2009-10 with the highest DFL observed during the same time period. Since then company has not achieved that level of EPS, perhaps due to low financial leverage in the succeeding FYs. Here the findings and results of Net Income approach by Durand have been proved rightly. There is largest increase in EPS of Hindustan Unilever in FY 2012-13 accompanied with highest rise in its DFL during the same period. Here trading on equity exerts positive influence on profitability in terms of investment of company. NI approach of capital structure rightly establishes the fact that increase in debt causes increase in wealth of firm. Nestle India too has positive impact of DFL on its EPS. Over the period of five years EPS of Nestle India goes on rising due to its increasing dependence on debt in financing its growth opportunities. As per Table No. 4 there is rising trend of net profit margin in ITC and Britannia. This implies that both companies have convincing net profit after taxes figure over the time period of five years that make these companies fruitful investment avenues. It’s because when a company has thick cushion of net profit after taxes its shareholders are the first one to gain. As it’s their residual share because all secured and unsecured creditors liability get discharged. Now whatever remains, it belongs to the owners. Colgate Palmolive and Nestle India have decreasing net profit margins. Colgate has higher DFL in FY 2010-11 than that in preceding year but its DFL decreased from FY 2011-12 onwards. This shows that decreasing net profit margin may or may not bear any relation with that of DFL which first increased and then decreased at the other time. Nestle India had lower DFL in FY 2010-11 but it increased in succeeding years. Here financial leverage instead of showing its tax advantage in the form of tax shield by magnifying earnings for equity shareholders has threatened the profitability of company. It may be because of higher hurdle rate than the return on assets earned. Net profit margin of Jubilent Foodworks rose for the first three years taken in study when at the same time its DFL was falling. The time it increased in fourth year its NPM (Net profit margin) declined and then did not recover. Emami’s NPM rose to its highest in FY 2013-14 while its DFL was consistently declining. NPM of Hindustan Unilever first declined in FY 2010-11 and then rose till FY 2012-13. It decreased all of a sudden in FY 2013-14. On the other end its DFL rose during the corresponding period.

RESULTS OF HYPOTHESIS:

Table No. 5: Pearson’s coefficient of correlation between DFL and EPS

Companies	r	t	T-test result
ITC	-0.32879	-0.60301	accepted
NESTLE INDIA	0.899216	3.559932	rejected
COLGATE PALMOLIVE	-0.8621	-2.94669	accepted
BRITANNIA	-0.7045	-1.71935	accepted
HINDUSTAN UNILEVER	0.859708	2.91523	accepted
EMAMI	0.867115	3.015184	accepted
JUBILANT FOODWORKS	-0.82826	-2.56019	accepted

After going through analysis table no. 5, it can be seen that few companies like ITC, Colgate Palmolive, Britannia and Jubilant Foodworks have shown inverse relationship between DFL and EPS while the rest of three have shown that they are being influenced positively by DFL.

Results of :

From table 5 it can be concluded that in case of Nestle India calculated t value is more than the table value. Therefore calculated t value lies in rejection region and thus it can be said that the correlation between DFL and EPS exists and is significant. Contrarily in case of rest of six companies it can be said that the correlation is insignificant for the reason of calculated t value being less than the table value. This implies that t value calculated lies in the acceptance region and the null hypothesis is accepted which further means that correlation coefficient is merely by chance and thus it’s insignificant.

Table No. 6: Pearson’s coefficient of correlation between DFL and ROE

Companies	r	t	T-test result
ITC	-0.80164	-2.32262	accepted
NESTLE INDIA	-0.94069	-4.80247	rejected
COLGATE PALMOLIVE	.707265	.353791	accepted
BRITANNIA	-0.53755	-1.10416	accepted
HINDUSTAN UNILEVER	0.804067	2.342463	accepted
EMAMI	-0.62744	-1.39567	accepted
JUBILANT FOODWORKS	-.22589	-1.778007	accepted

Results of

In table 6 it is found that DFL and ROE move in the same direction which brings positive correlation coefficient for Colgate Palmolive and Hindustan Unilever unlike in case of other five companies. Null hypothesis is rejected for company Nestle India which implies that this company faces decline in ROE with employment of more debt. On the other hand null hypothesis is accepted for the remaining six companies. In case of all six companies apart from Nestle India correlation coefficient is insignificant.

Table No. 7: Pearson’s Coefficient of correlation between DFL and NPM

Companies	r	t	T-test result
ITC	-0.95005	-5.2725	rejected
NESTLE INDIA	-0.94072	-4.80381	rejected
COLGATE PALMOLIVE	0.817251	2.456298	accepted
BRITANNIA	-0.74536	-1.93652	accepted
HINDUSTAN UNILEVER	0.858393	2.898249	accepted
EMAMI	-0.25651	-0.45967	accepted
JUBILANT FOODWORKS	-0.65048	-1.48338	accepted

Results of :

Calculated t value in case of ITC and Nestle India outpaced the table value which makes us to infer that the ‘r’ is significant and null hypothesis is rejected. In case remaining five companies calculated t value was less than the table value. Thus it lies in acceptance region. Therefore it’s concluded that null hypothesis is accepted for Colgate Palmolive, Britannia, Hindustan Unilever, Emami and Jubilent Foodworks and their respective ‘r’ is merely by chance that makes it insignificant.

Conclusion and Scope of further study:

The results of this study show that DFL does not necessarily bring positive results for companies in terms of profitability. Perhaps it’s due to the age and size factors of companies that play as extraneous variables in manipulating and speculating the results of well established theories by many experts like Durand. In case companies are not earning sufficient profits before interest and taxes yet paying fixed financial charges in form of interest on debentures, ordinary shareholders don’t get much in their hands as residual amount. Therefore earnings available for them will be a meager amount which by dividing with number of equity shares outstanding in the end of period gives lesser EPS. Further, if the earnings of company fall below the breakeven point then financial leverage magnifies the losses and results in negative EPS. Other than that higher DFL will also cause rise in agency cost and thus disturbs the optimal capital structure. Higher proportion of long term debt also offers less safety margin to creditors, it’s because company trades on the equity which if, in case falls less than debt employed long term creditors won’t get their claims fully satisfied due to lower profit margins.

Another reason is inadequate interest coverage ratio. Moreover several other factors like growth opportunities, government policies, tangibility of assets exert influence over stock prices of companies. In further study on this topic one may take up regression analysis technique to establish cause and effect relationship by taking all major determinants of capital structure because correlation only indicates the direction and degree of change in variable. It does not establish cause and effect relationship. Now here, fluctuations in ROE, NPM and EPS might be caused by other factors external to the organization. Thus the ‘r’ here in this study could by superfluous. DFL might not be the actual cause of changes in dependent variable taken in this study. Leverage turns out to be ineffective if the return on assets falls short of cost of capital. This will increase the losses as nothing will go to the shareholders in the form of earnings. When company earns more on assets financed from the debt raised than its cost or hurdle rate, its difference goes in the hands of equity shareholders. Here trading on equity will prove itself beneficial.

It’s observed in the study that net profit margin has shown many movements which bear no relation with DFL. This could be due to depreciation charged by company. Let’s explain this point. Normally companies charge higher depreciation which can be shown in profit and loss statements. As this is a non cash expenditure yet shown in P and L A/C will show lower net profit before tax. So that companies are obliged to pay smaller amount to income tax authorities. Due to this fact net profits after tax decline when companies charge large amount of depreciation over the years to come. Therefore one can consider this factor of ‘writing off depreciation’ in financial years can be taken as one of the independent variable influencing NPBT in computing net profit margins.

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Received on 09.08.2015 Modified on 25.08.2015

Accepted on 31.08.2015 © A&V Publication all right reserved

Asian J. Management; 6(4): Oct. -Dec., 2015 page 276-282

DOI: 10.5958/2321-5763.2015.00040.2