Profitability Analysis
Profit test is more than a conventional test of economic efficiency. It has a direct bearing on the company’s ability to function as a successful business firm. Further, the company’s ability to tap capital markets and/or other sources of finance (for its
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Profitability Analysis
Introduction The profit test is more than a conventional test of economic efficiency, that is, whether the resources are gainfully employed or not and whether the business enterprise is operating competitively or not. It has a direct bearing on the company’s ability to function as a successful business firm. Further, the company’s ability to tap capital markets and/or other sources of finance (for its growth and additional requirements) would depend on its commercial profitability. Given the significance of financial viability of business operations, the objective of this chapter is to assess the financial performance of the sample companies primarily in terms of profitability with a special focus on the pre- and post-recession period. Expectedly, financial management of resources in terms of profitability constitutes, by far, the most important element of operational efficiency and hence the significance to study this aspect. Further, to the best of the authors’ knowledge, an analysis of the impact (if any) of the recent recession on such a large sample has not been undertaken. Analysis that follows seeks to answer such basic questions with respect to the sample companies as the following: (a) Are their profits adequate? (b) What rates of return do they earn? and (c) Are their returns to equity owners satisfactory? It is in this context that profitability of the sample companies has been analysed in this chapter. Analysis is based on profit margins on sales as well as rates of return earned on total assets, capital employed and shareholders’ funds. To begin with, the basic components of profits, namely, gross profit and net profit are determined for the sample companies for the entire 11-year period of the study (sub-divided into four phases). Then three sets of rates of return (RoR) have been computed. These are (a) return on total assets (ROTA), (b) return on capital employed (ROCE) and (c) return on ordinary shareholders’ equity (ROSE). The first two rates of return highlight how efficiently financial resources are deployed by the sample companies; the RoR on the common shareholders’ equity indicates the return provided to their equity owners. P.K. Jain et al., Financial Management Practices: An Empirical Study of Indian Corporates, India Studies in Business and Economics, DOI 10.1007/978-81-322-0990-4_9, © Springer India 2013
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9 Profitability Analysis
The first two types of RoRs have been determined on the basis of operating profits, that is, earnings before interest and taxes. By precluding effect of financial structure and taxes, these rates focus directly on operational efficiency. The rationale of inclusion of interest is that the RoRs (related to total assets and capital employed) exclusively based on pre-tax profits would be an underestimate as the interest paid to lenders is excluded from the net profits (in numerator), whereas total capital employed as well as total assets (as a part of denominator) includes borrowed funds. Therefore, a better and reliable indicator
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