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CHAPTER VII ANALYSIS OF PROFITABILITY OF INDIAN HOTEL INDUSTRY
Chapter VII Analysis of Profitability of Indian Hotel Industry 7.1 Introduction 7.2 Meaning and Definition of Profitability 7.3 Analysis of Profitability 7.4 Return on Equity 7.5 DuPont Analysis 7.6 Conclusion
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CHAPTER VII PROFITABILITY OF INDIAN HOTEL INDUSTRY 7.1 Introduction Business is conducted primarily to earn profits. The amount of profit earned measures the efficiency of a business. The greater the volume of profit, the higher is the efficiency of the concern. The profit of a business may be measured and analyzed by studying the profitability of investments attained by the business.
7.2 Meaning and Definition of Profitability The word ‘profitability’ is composed of two words, namely; profit and ability. The term profit is the positive gain from an investment or business operation after subtracting for all expenses.1 The term ability indicates the power of a Firm to earn profits. The ability of an enterprise also denotes its earning power or operating performance. Also the business ability points towards the financial and operational abilities of the business. So, on this basis profitability may be defined as “the ability of a given instrument to earn a return from its use.”2 Weston and Brigham define profitability as “the net surplus of a large number of policies and decisions.”.3 Profit being an absolute figure fails to indicate the adequacy of income or changes in efficiency resulting from financial and operational performance of an enterprise. Much difficulty and confusion comes home while interpreting the absolute figures of profit in case of historical or inter-firm comparisons due to variation in the size of investment or volume of sales etc. Such problems are handled by relating figures of profit either with the volume of sales or with the level of investment.
1
“Profit: Definition”, available http://www.investorwords.com/3880/profit.html; accessed in July 29, 2011 2 Bion B. Howard and Miller Upton (1953), “Introduction to Business Finance”, McGraw Hill Book Company, New York, P.147 3 Weston. J. F, and Brigham. E. F (1975), “Essential of Managerial Finance”, McDonald & Evans Ltd., London, P.48
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A quantitative relationship is thereof established either in the form of ratios or percentages. Such ratios are names as profitability ratios. Thus, profitability may be regarded as a relative term measurable in terms of profit and its relation with other elements that can directly influence the profit. No doubt, profit and profitability are closely related and mutually interdependent, yet they are two different concepts. "The accounting concept of profit measures what have been accumulated, the analytical concept of profitability is concerned with future accumulation of wealth."4 Profit of an enterprise, reports about the financial and operational efficiency of the business. Whereas, profitability interprets the term profit in relation to other elements likely to affect these profits in order to help in decision-making. Profit is regarded as an absolute connotation as against profitability, which is regarded as a relative concept. Where profit is the residual income left after meeting all manufacturing, administrative expenses, profitability is the profit making ability of an enterprise. The profit figure indicates the amount of earning of a business during a special period. While, profitability denotes whether these profits are constant or improved or deteriorated, how and to what extent they can be improved. Profit in two separate business concerns may be identical, yet, at many times, it usually happens that their profitability varies when measured in terms of size of investment. It has been aptly remarked that the role played by profits and profitability in a business enterprises is identical to the function carried out by blood and pulse in the human body. Profitability is the ability to earn profit from all the activities of an enterprise. It indicates how well management of an enterprise generates earnings by using the resources at its disposal. In other words the ability to earn profit e.g. profitability, it is composed of two words profit and ability.
4
Mahesh. M. Barad (2009), “A Study on Liquidity Management of Indian Steel Industry,” Unpublished Doctoral Thesis, Saurashtra University, Rajkot, India, P.183
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The word profit represents the absolute figure of profit but an absolute figure alone does not give an exact idea of the adequacy or otherwise of increase or change in performance as shown in the financial statement of the enterprise. The word ‘ability’ reflects the power of an enterprise to earn profits, it is called earning performance. Earnings are an essential requirement to continue the business. So we can say that a healthy enterprise is that which has good profitability. According to Hermenson Edward and Salmonson, ‘profitability is the relationship of income to some balance sheet measure which indicates the relative ability to earn income on assets employed.
7.3 Analysis of Profitability The most effective tool of analysis of profitability is ratio analysis. Ratios revealing profitability are popularly called profitability ratios. Profitability ratios measure the degree of operating success of a company in an accounting period. The only reason why investors are interested in a company is that they think they will earn a reasonable return in the form of capital gain and dividends on their investment. Therefore, they are keen to learn about the ability of the company to earn revenues in excess of its expenses. They will not be interested in a Company that does not earn a sufficient margin on its sales. Failure to earn an adequate rate of profit over a period will also drain the Company’s cash and impair its liquidity.5 In the present study, the profitability is analyzed in detail from the point of view of the following considerations: 1. Profit Margin 2. Return on Investment
5
Narayanaswamy. R (2001), “Financial Accounting A Managerial Perspective”, Prentice Hall of India Private Limited, New Delhi, Pp.443-444
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7.3.1 Profit Margin “The profit margin is a measure of overall profitability. These measures also referred to as the net income percentage or the return on sales”.6 Profit margin is the return generated by the Company’s assets and represents the difference between revenues and total expenditure.”7 in a manufacturing concern the profit margin results from sale of its products. In fact, “it is the key figure in the income statement or profit and loss account.” The best way of calculating profit margin is to express them as a percentage of net sales, that is, sales minus sales returns, discount and rebates etc. Sales are the main activity of all concerns; manufacturing or merchandise. The aggregate of sales and other incomes becomes the total revenue but as against the net sales, total revenue fails to indicate the effective volume of business which does not reveal the true profit. A Company is expected to earn adequate profit on each rupee of sale; else it would fail to give reasonable returns to its shareholders and will not be in a position to cover fixed costs and fixed charges on debts. There are certain constraints that put restrictions on the efforts directed towards widening of profit margin. As the free economy featuring free competition, consumerisation and public interest places limit on profit margin. Likewise, inflation adds to difficulty in controlling cost accelerations. Yet, better organization, technical innovations, effective administration etc. are certain factors that provide answer to the problem of limiting the percentage of profit margin to a great extent. “Terms like income, earning or profit are used interchangeably. The more commonly used accounting forms of profit are gross profit or operating profit (known as earnings before interest and tax) and net profit”.8 Profit margins can be studies in detail under three heads; gross profit margin, net profit margin and operating profit margin. 6
Kuchhal. S. C (1982), “Indian Management Ratio Charts for Top Management”, Chairtungya Publishing House, Allahabad, P.64 7 Egra Soloman and John J. Pringle (1978), “An Introduction to Management”, Prentice Hall of India Pvt. Ltd., New Delhi, P.89 8 Chowdhary. S.B (1977), “Management Accountancy”, Kalyani Publishers, New Delhi, P.45
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7.3.1.1 Gross Profit Ratio Gross profit ratio is a measure of the gross profit earned on sales. The gross profit ratio considers the firm’s cost of goods sold, but does not include other costs. It is defined as follows.9
Gross Profit Ratio
(Sales - Cost of goods sold) Sales Table 7.1
Gross Profit Ratio of the Indian Hotel Industry from the year 1999-2000 to 2009-2010 Year 1999 – 2000 2000 – 2001 2001 – 2002 2002 – 2003 2003 – 2004 2004 – 2005 2005 – 2006 2006 – 2007 2007 – 2008 2008 – 2009 2009 – 2010 Average S.D Maximum Minimum
IHC 0.53 0.55 0.50 0.50 0.52 0.55 0.57 0.62 0.62 0.54 0.52 0.55 0.04 0.62 0.50
EIH 0.47 0.52 0.43 0.40 0.43 0.50 0.54 0.58 0.58 0.47 0.39 0.48 0.07 0.58 0.39
ITDC -0.20 -0.20 0.00 0.31 0.30 0.23 0.25 0.36 0.40 0.38 0.25 0.19 0.22 0.40 -0.20
HLV 0.57 0.56 0.43 0.41 0.56 0.61 0.65 0.65 0.62 0.56 0.51 0.56 0.08 0.65 0.41
Average 0.34 0.36 0.34 0.41 0.45 0.47 0.50 0.55 0.56 0.49 0.42 0.45 0.10 0.56 0.28
Source: Data compiled and computed from annual reports and accounts from the year 1999-2000 to 2009-2010
9
“Financial Ratios: Gross Profit Margin”, available at http://www.netmba.com/finance/financial//ratios_html; accessed in June 9, 2009
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Inference:
It is inferred from the Table 7.1 that the gross profit ratio of the Indian Hotels Company Limited was fluctuating in upward direction. The highest ratio was 0.62 both in the year 2006-2007 and 2007-2008 and the lowest ratio was 0.50 both in the year 2001-2002 and 2002-2003. The average gross profit ratio of above-said Company was 0.55. Normally, a higher ratio is considered as an index of higher profitability. The Indian Hotel Company Limited is keeping this ratio in and around the average ratio. It implies that the Indian Hotels Company Limited has a constant gross profit margin according to sales. It is observed from the Table 7.1 that the gross profit ratio of the East Indian Hotels Limited was showing fluctuated trend with an average of 0.48. The gross profit ratio was 0.47 in the year 1999-2000 which went down to 0.40 in the year 2002-2003. The ratio was 0.43 in the year 2003-2004 which went up to 0.58 in the year 2007-2008. The ratio was 0.47 in the year 2008-2009 and again it went down to 0.39 in the year 2009-2010. The average ratio was 0.48. The standard deviation was 0.07. The East Indian Hotels Limited is keeping this ratio in and around the average ratio. It implies that the East Indian Hotels Limited has a constant gross profit margin according to sales. It is evident from the Table 7.1 that the gross profit ratio of the India Tourism Development Corporation Limited was progressive and fluctuated from minus 0.20 in the year 1999-2000 to 0.40 in the year 2009-2010. The highest ratio was 0.40 in the year 2007-2008 and the lowest ratio was minus 0.20 both in the year 1999-2000 and 2000-2001. The standard deviation was 0.22. The average net profit ratio of above-said Company was 0.19. There is highest fluctuation in the ratio during the period of study. It indicates that the India Tourism development Corporation Limited has no constant gross profit margin according to sales.
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It is understood from the Table 7.1 that the gross profit ratio of Hotel Leela Venture Limited was fluctuated trend during the research period. The highest gross profit ratio found 0.65 both in the year 2005-2006 and 2006-2007 and the lowest net profit ratio found of 0.41 in the year 2002-2003 with average of 0.56. The standard deviation was 0.08. The Hotel Leela Venture Limited is keeping this ratio in and around the average ratio. It shows that the Hotel Leela Venture Limited has a constant gross profit margin according to sales. Above analysis explains that the Hotel Leela Venture Limited has the highest gross profit ratio followed by Indian Hotels Company Limited, East Indian Hotels Limited and the India Tourism Development Corporation Limited.
Figure 7.1
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172
Testing of Hypothesis - ANOVA Null Hypothesis: There is no significant difference in the gross profit ratio of
the selected hotel companies in Indian Hotel Industry during the period of study. Table 7.2 Analysis of Gross Profit Ratio - One way ANOVA Sum of Squares
df
Mean Square
Between Groups
.990
3
.330
Within Groups
.612
40
.015
1.601
43
Total
P Value
F
21.579 .000*
Source: Computed from table 7.1 *Note: Significant at 1 per cent level
Inference:
It is inferred from the Table 7.2 that there is significant difference in the gross profit ratios of the selected hotel companies during the study period at 1 per cent level of significance. Table 7.3 Analysis of Variance of Gross Profit Ratio by Duncan Method Name of the Company
N
Subset for alpha = 0.05 1
2
India Tourism Development Corporation Limited
11
East Indian Hotels Limited
11
.4827
Indian Hotels Company Limited
11
.5473
Hotel Leela Venture Limited
11
.5573
Source: Computed from table 7.1
.1891
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It is observed from the Table 7.3 that the results of ANOVA test are fully supported by Duncan method. There are two subsets where India Tourism Development Corporation Limited falls under the first subset and the other three hotel companies form the second subset. That is the mean value of gross profit ratio of India Tourism Development Corporation Limited is very low compared to other three hotel companies. This is because the employee cost and the other manufacturing expenses are in increasing trend compared to sales during the period of study. This situation may lead this hotel to incur loss in case of net profit. Hence, it is advised to reduce employee cost and other manufacturing expenses to increase their gross profit ratio. The highest mean value (0.56) is recorded in Hotel Leela Venture Limited.
7.3.1.2 Net Profit Ratio As pointed out by Hingorani, Ramanathan and Grewal, “Net profit margin indicates the net margin earned in a sale of Rs. 100.”10 Van Home states that net profit “tells us the relative efficiency of the Firm after taking into account all expenses and income taxes, but not extra-ordinary charges”11 Net profit is obtained after deducting amount of operating expenses, interest and taxes from the gross profit amount. Net profit after taxes is nothing but the sum of dividends (paid or provided for) plus the retained earnings. Net profit ratio is measured by dividing net profit after taxes by sales. Thus, Net Profit Ratio
Profit after tax Sales
Again no specific norm has been set for measurement of net profit ratio. If the ratio shows an increasing trend year after year, it may be concluded that business conditions are improving. Talking of an exception, a Company with a low profit margin can earn a high rate of return on investment. This can happen only if the Company has higher inventory turnover. Moreover, if net profit ratio is interpreted with gross profit ratio jointly, it adds meaning to the Firm's profitability. 10
Hingorani. N. L, Ramanathan. A. R and T.S.Grewal (1980), “Management Accounting”, S.Chand Ramanathan & T.S. & Sons, New Delhi, P.127 11 Van Home. J. C (1978), “Financial Management and Policy”, Prentice Hall of India Pvt. Ltd., P.726
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“A high net profit ratio would ensure adequate return to the owners as well as enable a Firm to withstand adverse economic conditions when the selling price is declining, cost of production is rising and demand for the product is falling.”12 The inadequate net profit would debar the Company from paying off its debts and giving a satisfactory return to its shareholders. “This ratio indicates a Firm's capacity to withstand adverse conditions which may arise because of various reasons such as; (i) falling prices, (ii) rising costs, and (iii) declining sales”.13 Table 7.4 Net Profit Ratio of the Indian Hotel Industry from the year 1999-2000 to 2009-2010 Year 1999 – 2000 2000 – 2001 2001 – 2002 2002 – 2003 2003 – 2004 2004 – 2005 2005 – 2006 2006 – 2007 2007 – 2008 2008 – 2009 2009 – 2010 Average S.D Maximum Minimum
IHC 0.19 0.17 0.14 0.07 0.09 0.12 0.17 0.21 0.21 0.14 0.10 0.15 0.05 0.21 0.07
EIH 0.17 0.20 0.09 0.04 0.06 0.06 0.25 0.21 0.20 0.19 0.07 0.14 0.08 0.25 0.04
ITDC -0.13 -0.16 -0.18 -0.03 0.00 0.05 0.13 0.09 0.10 0.07 -0.05 -0.01 0.11 0.13 -0.18
HLV 0.07 0.13 0.01 0.12 0.04 0.17 0.22 0.33 0.29 0.32 0.10 0.16 0.11 0.33 0.01
Average 0.08 0.09 0.02 0.05 0.05 0.10 0.19 0.21 0.20 0.18 0.06 0.11 0.09 0.23 -0.02
Source: Data compiled and computed from annual reports and accounts from the year 1999-2000 to 2009-2010
12
Khan. M. Y and Jain. P. K (1982), “Financial Management”, Tata McGraw Hill Publishing Co. Ltd., New Delhi, P.139 13 Pandey. I. M (1980), “Concept of Earning Power”, Accounting Journal, Rajasthan accounting journal, Vol V, April, P. 11
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Inference:
It is inferred from the Table 7.4 that the net profit ratio of the Indian Hotels Company Limited was fluctuating in downward and upward direction during the study period. The highest ratio was 0.21 both in the year 2006-2007 and 2007-2008 and the lowest ratio was 0.07 in the year 2002-2003. The average net profit ratio of above said company was 0.15 with the standard deviation of 0.05. Normally, a higher ratio is considered as an index of higher profitability. There is a high fluctuation in the net profit ratio during the period of study. Hence, the performance of the Indian Hotels Company Limited is not at satisfactory level. It is observed from the Table 7.4 that the net profit ratio of the East Indian Hotels Limited was showing fluctuated trend with an average of 0.14. The net profit ratio was 0.17 in the year 1999-2000 which went down to 0.04 in the year 2002-2003. The ratio was 0.06 both in the year 2003-2004 and 20042005 which went up to 0.21 in the year 2006-2007. The ratio was 0.20 in the year 2007-2008 and again it went down to 0.07 in the year 2009-2010. The standard deviation was 0.08. There is a high fluctuation in the net profit ratio during the period of study. Hence, the performance of the East Indian Hotels Limited is not at a satisfactory level. It is understood from the Table 7.4 that the net profit ratio of the India Tourism Development Corporation Limited was negative and fluctuated from minus 0.18 in the year 2001-2002 to 0.13 in the year 2005-2006. The highest ratio was 0.13 in the year 2005-2006 and the lowest ratio was minus 0.18 in the year 2001-2002. The standard deviation was 0.11. The average net profit ratio of above-said Company was minus 0.01. There is highest fluctuation in the ratio and the company incurred heavy loss in most of the years of study.
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It is clear from the Table 7.4 that the net profit ratio of Hotel Leela Venture Limited was fluctuated trend during the research period. The highest net profit ratio found 0.33 in the year 2006-2007 and the lowest net profit ratio found of 0.01 in the year 2001-2002 with an average of 0.16. The standard deviation was 0.11. There is a high fluctuation in the net profit ratio during the period of study. Hence, the performance of the Hotel Leela Venture Limited is not at satisfactory level. Above analysis explains that the net profit ratio of the selected hotel company is at lowest level. Particularly India Tourism Development Corporation Limited incurred loss in most of the years of study. Hence those Companies are advised to reduce their indirect expenses.
Figure 7.2
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178
Testing of Hypothesis - ANOVA Null Hypothesis: There is no significant difference in net profit ratio of the
selected hotel companies in Indian Hotel Industry during the period of study. Table 7.5 Analysis of Net Profit Ratio - One way ANOVA Sum of Squares
df
Mean Square
F
P Value
Between Groups
.214
3
.071
8.759
.000*
Within Groups
.327
40
.008
.541
43
Total
Source: Computed from table 7.4 *Note: Significant at 1 per cent level
Inference:
It is inferred from the Table 7.2 that there is significant difference in the net profit ratios of the selected hotel companies during the study period at 1 per cent level of significance. Table 7.6 Analysis of Variance of Net Profit Ratio by Duncan Method Subset for alpha = 0.05 Name of the Company
N
India Tourism Development Corporation Limited 11
1
2
-.0100
East Indian Hotels Limited
11
.1400
Indian Hotels Company Limited
11
.1464
Hotel Leela Venture Limited
11
.1636
Source: Computed from table 7.4
It is observed from the Table 7.6 that the results of ANOVA test are fully supported by Duncan method. There are two subsets where India Tourism Development Corporation Limited falls under the first subset and the other three hotel companies form the second subset. The mean value of net profit ratio of Hotel Leela Venture Limited is high compared to other three hotel companies.
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The mean value of India Tourism Development Corporation Limited is recorded in negative figure (-0.01). The overall mean value is not at satisfactory level. This is because; the selling and administrative expenses of the selected hotel companies are high during the period of study. These Companies are advised to reduce selling and administrative expenses. The interest rate is also high in Hotel Leela Venture Limited, East Indian Hotels Limited and Indian Hotels Company Limited. These three Companies are advised to reduce the debt capital to bring down the interest rate. There is no interest in India Tourism Development Corporation Limited, because, there is no debt capital. Apart from selling and administrative expenses, miscellaneous expenses are high in India Tourism Development Corporation Limited. That is the main reason for the loss. Hence, it is advised to control the miscellaneous expenses.
7.3.2 Return on Investment The most commonly used measure of profitability is the technique of relating the profit with the capital, popularly called the rate of return on capital invested. “This rate is the end-profit of a series of a quantitative variable representing different interconnected and interdependent factors of business operations.”14 The return on investment is calculated by multiplying the profit margin on sales with investment turnover. Profitability on the basis of return on investment can be analyzed and interpreted under following categories: (i). Return on Capital Employed. (ii). Return on Shareholders’ Equity/Net Worth.
14
Krishan. M. M (1975), “Corporation Finance-An Introduction to Principle and Practices”, Harper & Row, New York, P. 180
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7.3.2.1 Return on Capital Employed
The term investment refers to total assets or at times net assets. Net assets are the term used for the fixed assets in addition to current assets less current liabilities. The funds employed in net current assets are mostly known as capital employed though there is no consensus as regards to the definition of capital employed. In simplest possible words capital employed whether owned or borrowed is said to be the investment made in the business. Capital employed, in other words signifies net worth plus total debts. Where, Copetand, Dascher and Davision15 preferred the term 'Group Capital', R. Worwick Dobson16 suggested the term, ‘Return on Capital contributed’ for it. Return on capital employed indicates the efficiency and profitability of a Company’s capital investments. It should always be higher than the rate at which the Company borrows; otherwise any increase in borrowing will reduce share holders’ earnings. It is used in finance as a measure of the returns that a Company is realizing from its capital employed. The ratio can also be seen as representing the efficiency with which capital is being utilized to generate revenue. The ratio is calculated as follows,17 Return on Capital Employed Ratio
EBIT (Total Assets Current Liabilities)
Let us examine the various items used for computation of capital employed. These items are described below: -
7.3.2.1.1 Cash Cash, normally used for fulfilling business requirements is a component of capital employed. But cash in excess of normal business requirement is an 'idle asset' therefore; it should be excluded from computation of the capital employed. 15
Copeland Ronald. M, Dasher. E, Paul and Dairson L. Dale (1976), “Financial Accounting”, John Wiley & Sons, New York, P.431 16 Warwick Dobson. R (1960), “Editorial page”, Cost Accountant, Vol. 38, No.12, December, P.142 17 “Return on Capital employed”, available at http://www.answers.com/topic/capital-employed.html; accessed in February 17, 2010
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7.3.2.1.2 Debtor Debtors too are a part of capital employed in business but provision should be made in respected of bad and doubtful debts before including this term.
7.3.2.1.3 Stock Stock of raw material, work-in-progress and finished goods are also included at cost for obtaining amount of capital employed.
7.3.2.1.4 Investment Usually the investment made by a Company outside the business is excluded from this preview but if these external investments are made in the interest of the company they are included.
7.3.2.1.5 Fixed Assets Certain points are required to be considered before fixed assets are taken into account for evaluation of capital employed, which are:
7.3.2.1.5.1 Valuation of Fixed Assets There are three methods that can be used for valuing fixed assets, viz., gross value (original cost), net value (written down values) and replacement cost. Each of these methods has its own pros and cons. As a matter of fact, the net value methods are favoured more than gross value method. Further, due to the problem of rising prices replacement cost has become more preferable a method than gross value method. "Replacement cost can either be carried at on the market rates or with the help of index numbers of market prices.18’ 7.3.2.1.5.2
Idle Assets
Return on investment is a test of efficiency. So, idle assets are not included for the purpose of computing capital employed such non-operating assets do not contribute anything towards the earning of the company. But assets like, 'stand-by plant' as is required to maintain the level of production shall be included therein. 18
Singh. J, and Paul. P (1982), “Management Accounting”, Kitab Mahal, Allahabad, P.83
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7.3.2.1.5.3 Intangible Assets Intangible assets like goodwill, patents, trademark and franchise are to be written off as early as possible. Therefore, should be excluded unless have some resale value.
7.3.2.1.5.4 Fictitious Assets Fictitious assets like preliminary expenses and deferred revenue expenditure shall in no case be included for the purpose of calculating capital employed. Still the problem remains that the word investment implies different things to different persons. 'An analyst may include certain assets while the other may exclude them altogether in the computation of the amount of capital invested in the business.19 Table 7.7 Return on Capital Employed Ratio of the Indian Hotel Industry from the year 1999-2000 to 2009-2010 Year 1999 – 2000 2000 – 2001 2001 – 2002 2002 – 2003 2003 – 2004 2004 – 2005 2005 – 2006 2006 – 2007 2007 – 2008 2008 – 2009 2009 – 2010 Average S.D Maximum Minimum
IHC 0.12 0.11 0.05 0.06 0.04 0.08 0.14 0.20 0.22 0.11 0.06 0.11 0.06 0.22 0.04
EIH 0.09 0.10 0.05 0.04 0.05 0.10 0.17 0.20 0.23 0.12 0.07 0.11 0.06 0.23 0.04
ITDC -0.14 -0.27 -0.31 -0.02 -0.02 0.22 0.27 0.32 0.23 0.10 -0.04 0.03 0.22 0.32 -0.31
HLV 0.05 0.04 0.02 0.05 0.06 0.09 0.09 0.11 0.10 0.07 0.03 0.06 0.03 0.11 0.02
Average 0.03 -0.01 -0.05 0.03 0.03 0.12 0.17 0.21 0.20 0.10 0.03 0.08 0.09 0.22 -0.05
Source: Data compiled and computed from annual reports and accounts from the year 1999-2000 to 2009-2010
19
Ibid P. 84
183
Inference:
It is inferred from the Table 7.7 that the return on capital employed ratio of Indian Hotels Company Limited was fluctuating trend during the study period. The ratio was 0.12 in the year 1999-2000 and it declined to 0.04 in the year 2003-2004. In the year 2004-2005, the ratio was 0.08. It went up to 0.22 in the year 2007-2008 and it again declined to 0.06 in the year 2009-2010. The average ratio was 0.11 with the standard deviation of 0.06. The ratio was maximum in the year 2007-2008 (0.22) and minimum in the year 2003-2004 (0.04). During the period of study the ratio was ups and downs because there is a high fluctuation in earnings before interest and tax. Hence it indicates that the return on investment is not at a commendable growth rate. It is observed from the Table 7.7 that the return on capital employed ratio of East Indian Hotels Limited was fluctuating trend. The ratio was 0.09 in the year 1999-2000 and it declined to 0.04 in the year 2002-2003. In the year 2003-2004, the ratio was 0.05. It went up to 0.23 in the year 2007-2008 and it again declined to 0.07 in the year 2009-2010. The average ratio was 0.11 with the standard deviation of 0.06. The ratio was maximum in the year 2007-2008 (0.23) and minimum in the year 2002-2003 (0.04). During the period of study the ratio was ups and downs because there is a high fluctuation in earnings before interest and tax. Hence it indicates that the return on investment is not at a commendable growth rate. It reflects the operational inefficiency of the company. It is evident from the Table 7.7 that the return on capital employed ratio of the India Tourism Development Corporation Limited showed negative and fluctuating trend during the study period. The ratio was minus 0.14 in the year 1999-2000 and it again declined to minus 0.31. The ratio was minus 0.02 both in the year 2002-2003 and 2003-2004. The ratio was 0.22 in the year 20042005. It went up to 0.32 in the year 2006-2007 and again it went down to minus 0.04 in the year 2009-2010.
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The average ratio was 0.03 with the standard deviation of 0.22. The ratio was maximum at 0.32 in the year 2006-2007 and minimum at minus 0.31 in the year 2001-2002. During the period of study the ratio was at highest fluctuation. It shows that the operational inefficiency of the India Tourism development Corporation Limited. It is clear from the Table 7.7 that the return on capital employed ratio of Hotel Leela Venture Limited was fluctuated trend during the study period. The ratio was 0.05 in the year 1999-2000 and it went down to 0.02 in the year 20012002. In the year 2002-2003, the ratio was 0.05 and it went up to 0.11 in the year 2006-2007. It again went down to 0.03 in the year 2009-2010. The average ratio was 0.06 with the standard deviation of 0.03. The ratio was maximum in the year 2006-2007 (0.11) and minimum in the year 2001-2002 (0.02). The ratio was at highest fluctuation during the period of study. Hence it indicates that the return on investment is not at a commendable growth rate. Above analysis, shows that the return on capital employed ratio of Indian Hotels Company Limited was slightly better followed by East Indian Hotels Limited, India Tourism Development Corporation Limited and Hotel Leela Venture Limited. These companies are advised to utilize its capital efficiently to generate the enough sales
Figure 7.3
185
186
Testing of Hypothesis - ANOVA Null Hypothesis: There is no significant difference in the return on capital
employed ratio of the selected hotel companies in Indian Hotel Industry during the study period. Table 7.8 Analysis of Return on Capital Employed Ratio - One way ANOVA Sum of Squares
df
Mean Square
F
P Value
Between Groups
.048
3
.016
1.167
.334
Within Groups
.552
40
.014
.600
43
Total Source: Computed from table 7.7
Inference:
It is inferred from the Table 7.8 that the difference in return on capital employed ratios of selected hotel companies during the study period is not significant. Table 7.9 Analysis of Variance of Return on Capital Employed Ratio by Duncan Method Name of the Company
N
Subset for alpha = 0.05 1
India Tourism Development Corporation Limited
11
.0309
Hotel Leela Venture Limited
11
.0645
Indian Hotels Company Limited
11
.1082
East Indian Hotels Limited
11
.1109
Source: Computed from table 7.7
It is observed from the Table 7.9 that the results of ANOVA test are fully supported by Duncan method. There is one subset where all the four hotel companies fall under the same subset. That means the mean value of return on capital employed ratio of selected hotel companies is not at commendable growth rate during the period of study. These companies are advised to utilise the capital in an efficient manner to enhance the sales volume.
187
7.4 Return on Equity Ratio In the words of K. Jr. H. Clifton, “The return on equity relates net to stockholder’s equity.”20 One of the objectives of operating a company is to seek benefit of its shareholders. Shareholders are all the more interested in knowing the amount of return entitled to them by the company on the investment made by them. Return on shareholders’ equity calculates the profitability of owner’s investment. So, the formula derived is: Return on Equity
Net Profit after Interest and Taxes Net Worth
Total Shareholders’ Equity ratio is expressed in terms of percentage of net profit (after interest and taxes) earned on owner’s equity. Shareholder’s equity includes equity share capital, preference share capital, share premium, revenue and surplus less accumulated losses. Anthony and Reece are of the opinion that this ratio “reflects that how much the firm has earned on the funds invested by the shareholders.21 “This ratio is, thus, of great interest to the present as well as prospective shareholders and also of great concern to management.” As it significantly tells how efficiently the firm is using the resources of the owners, that is, the shareholders of the company.22 A high rate of return is desirable in this case too. As it would depict the efficiency of the management in handling owner‘s funds, business conditions and trading on equity. Contrary to this, a low rate of return simply implies misuse of shareholder's funds because of inefficient and ineffective production, sales, financial and general management. It also indicates unfavourable business conditions and over investment in the fixed assets.23 20
Kreps Jr. H. Clifton and Wacht F. Richard (1975), “Financial Administration”, Illinois: Dryden Press, Hinsdale, P.46 21 Anthonay. R. N and Reece. J. S (1975), “Management Accounting-Text & Cases”, Ilinosis, R.D. Irwin, P.346 22 Manmohan & S,N. Goyal (1979), “Principles of Management Accounting”, Sahitya Bhawan, Agra, P. 144 23 Weston. J. F and Brigham. E. F (1975), “Managerial Finance, Essential of Managerial Finance”, McDonald and Evans Ltd., London, P. 88
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Table 7.10 Return on Equity Ratio of the Indian Hotel Industry from the year 1999-2000 to 2009-2010 Year 1999 – 2000 2000 – 2001 2001 – 2002 2002 – 2003 2003 – 2004 2004 – 2005 2005 – 2006 2006 – 2007 2007 – 2008 2008 – 2009 2009 – 2010 Average S.D Maximum Minimum
IHC 0.12 0.11 0.09 0.05 0.07 0.09 0.11 0.18 0.19 0.08 0.07 0.11 0.04 0.19 0.05
EIH 0.07 0.08 0.03 0.02 0.03 0.04 0.18 0.17 0.17 0.12 0.04 0.09 0.06 0.18 0.02
ITDC -0.10 -0.16 -0.30 -0.06 0.01 0.12 0.25 0.22 0.14 0.08 0.05 0.02 0.17 0.25 -0.30
HLV 0.03 0.04 0.00 0.03 0.01 0.06 0.09 0.14 0.16 0.07 0.02 0.06 0.05 0.16 0.00
Average 0.03 0.02 -0.05 0.01 0.03 0.08 0.16 0.18 0.17 0.09 0.05 0.07 0.08 0.20 -0.06
Source: Data compiled and computed from annual reports and accounts from the year 1999-2000 to 2009-2010
Inference:
It is inferred from the Table 7.10 that the return on equity ratio of the Indian Hotels Company Limited was fluctuating trend. The ratio was 0.12 in the year 1999-2000 and it came down to 0.05 in the year 2002-2003. The ratio increased from 0.07 in the year 2003-2004 to 0.19 in the year 2007-2008 and again it went down to 0.07 in the year 2009-2010. The highest ratio was 0.19 in the year 2007-2008 and the lowest ratio was 0.05 in the year 2002-2003. The average return on equity ratio of the above said company was 0.11 with the standard deviation of 0.04. During the study period, there is a high fluctuation in the ratio because of fluctuations both in net worth and the profit after tax. Hence it reveals that the Indian Hotels Company Limited has failed to utilise the resources of the owners in an efficient manner.
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It is observed from the Table 7.10 that the return on equity ratio of the East Indian Hotels Limited was fluctuated trend. The return on equity ratio was 0.07 in the year 1999-2000 which went down to 0.02 in the year 2002-2003. The ratio was 0.03 in the year 2003-2004 which went up to 0.17 in the year 2007-2008. The ratio was 0.08 in the year 2008-2009 and again it went down to 0.04 in the year 2009-2010. The average ratio was 0.09 with the standard deviation of 0.06. During the period of study, the ratio was ranged both upward and downward trend, because there is a fluctuation in the profit after tax. It indicates that the East Indian Hotels Limited has failed to utilize the resources of the owners in an efficient manner. It is evident from the Table 7.10 that the return on equity ratio of the India Tourism Development Corporation Limited was fluctuated trend. The highest ratio was 0.25 in the year 2005-2006 and the lowest ratio was minus 0.30 in the year 2001-2002. The average net profit ratio of above said company was 0.02 with the standard deviation of 0.17. During the period of study, the India Tourism Development Corporation Limited has incurred heavy loss in the initial four years (from 1999-2000 to 2002-2003) and in the remaining years, (from 2003-2004 to 2008-2009) the ratio was at high fluctuations. It implies that the India Tourism Development Corporation Limited has failed to utilize the resources of the owners in an efficient manner. It is clear from the Table 7.10 that the return on equity ratio of Hotel Leela Venture Limited was fluctuated trend during the study period. The highest return on equity ratio found 0.16 in the year 2007-2008 and the lowest return on equity ratio found of 0.00 in the year 2001-2002 with average of 0.06 with the standard deviation of 0.05. During the period of study the ratio was very low and high fluctuations because of changes in the profit after tax. It implies that the Hotel Leela Venture Limited has failed to utilise the resources of the owners in an efficient manner. Above analysis explains that the selected hotels companies have failed to utilise the resources of the owners in an efficient manner.
Figure 7.4
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Testing of Hypothesis - ANOVA Null Hypothesis: There is no significant difference in return on equity ratio of
the selected hotel companies in Indian Hotel Industry during the study period. Table 7.11 Analysis of Return on Equity Ratio - One way ANOVA Sum of Squares
df
Mean Square
F
P Value
Between Groups
.043
3
.014
1.560
.214
Within Groups
.364
40
.009
.406
43
Total Source: Computed from table 7.10
Inference:
It is inferred from the Table 7.11 that the difference in return on equity ratios of the selected hotel companies during the study period is not significant. Table 7.12 Analysis of Variance of Return on Equity Ratio by Duncan Method Name of the Company
N
Subset for alpha = 0.05 1
India Tourism Development Corporation Limited 11
.0227
Hotel Leela Venture Limited
11
.0591
East Indian Hotels Limited
11
.0864
Indian Hotels Company Limited
11
.1055
Source: Computed from table 7.10
It is observed from the Table 7.12 that the results of ANOVA tests are fully supported by Duncan method. There is one subset where all the four hotel companies fall under the first subset. It indicates that there is no significant difference in return on equity while making an analysis. It means that the mean value of return on equity ratio of the selected hotel companies is very low. These Companies are advised to utilise the owners fund in an efficient manner to enhance the return on equity.
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7.5 DuPont Analysis The Du Pont Company of the US pioneered a system of financial analysis, which has received widespread recognition and acceptance. This system of analysis considers important interrelationships between different elements based on the information found in the financial statements. The Du Pont analysis can be depicted via the following chart: CHART 7.1
At the apex of the Du Pont chart is the Return on Total Assets (ROTA), defined as the product of the Net Profit Margin (NPM) and the Total Assets Turnover Ratio (TATR). As a formula this can be shown as follows: (Net profit/Total asset)= (Net profit/Net sales)*(Net sales/Total assets) (ROTA) (NPM) (TATR)
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Such decomposition helps in understanding how the return on total assets is influenced by the net profit margin and the total assets turnover ratio. The left side of the Du Pont chart shows details underlying the net profit margin ratio. A detailed examination of this side presents areas where cost reductions may be effected to improve the net profit margin. The right side of the chart highlights the determinants of total assets turnover ratio. If this study is supplemented by the study of other ratios such as inventory, debtors, fixed asset turnover ratios, a deeper insight into efficiencies and inefficiencies of asset utilisation can be sought. The basic Du Pont analysis can be extended to explore the determinants of the Return on Equity (ROE).24 Return on Equity (ROE) is a closely watched number among knowledgeable investors. It is a strong measure of how well the management of a Company creates value for its shareholders. The number can be misleading, however, as it is vulnerable to measures that increase its value while also making the stock more risky. Without a way of breaking down the components of ROE investors could be duped into believing a company is a good investment when it's not. Read on to learn how to use DuPont analysis to break apart ROE and get a much better understanding about where movements in ROE are coming from. The beauty of ROE is that it is an important measure that only requires two numbers to compute: net income and shareholders’ equity. ROE
24
Net Income Sharesholder' s Equity
“DuPont Analysis”, available at http://www.themanagementor.com/enlightenmentorareas/finance/cfa/DUPontAnalysis.htm; accessed in October 21, 2011
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If this number goes up, it is generally a great sign for the Company as it is showing that the rate of return on the shareholders’ equity is going up. The problem is that this number can also rise simply when the Company takes on more debt, thereby decreasing shareholder’ equity. This would increase the leverage of the Company, which could be a good thing, but it will also make the stock more risky.
7.5.1 Three-Step DuPont To avoid mistaken assumptions, a more in-depth knowledge of ROE is needed. In the 1920s, the DuPont Corporation created a method of analysis that fills this need by breaking down ROE into a more complex equation. DuPont analysis shows the causes of shifts in the number. There are two variants of DuPont analysis, the original three-step equation, and an extended five-step equation. The three-step equation breaks up ROE into three very important components: ROE = (Net profit margin)* (Asset Turnover) * (Equity multiplier) These components include: Operating efficiency - as measured by profit margin. Asset use efficiency - as measured by total asset turnover. Financial leverage - as measured by the equity multiplier The Three-Step DuPont Calculation Taking the ROE equation: ROE = net income / shareholder's equity and multiplying the equation by (sales / sales), we get: x
ROE = (net income / sales) * (sales / shareholder's equity) We now have ROE broken into two components, the first is
net profit margin, and the second is the equity turnover ratio. Now by multiplying in (assets / assets), we end up with the threestep DuPont identity:
195 x
ROE = (net income / sales) * (sales / assets) * (assets / shareholder's equity) This equation for ROE, breaks it into three widely used
and studied components: x
ROE = (Net profit margin)* (Asset Turnover) * (Equity multiplier)
We have ROE broken down into net profit margin (how much profit the Company gets out of its revenues), asset turnover (how effectively the company makes use of its assets), and equity multiplier (a measure of how much the company is leveraged). The usefulness should now be clearer. If a Company's ROE goes up due to an increase in the net profit margin or asset turnover, this is a very positive sign for the company. However, if the equity multiplier is the source of the rise, and the Company was already appropriately leveraged, this is simply making things more risky. If the Company is getting over leveraged, the stock might deserve more of a discount, despite the rise in ROE. The Company could be under-leveraged as well. In this case it could be positive, and show that the Company is managing itself better. Even if a Company's ROE has remained unchanged, examination in this way can be very helpful. Suppose a Company releases numbers and ROE is unchanged, Examination with DuPont analysis could show that both net profit margin and asset turnover decreased, two negative signs for the Company, and the only reason ROE stayed the same was a large increase in leverage. No matter what the initial situation of the company, this would be a bad sign.25
. “Decoding DuPont analysis”, available at http://www.investopedia.com/articles/fundamentalanalysis/08/dupont-analysis.asp#axzz1bPA1zG6s; accessed in October 21, 2011
25
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7.5.2 Importance of DuPont Analysis Any decision affecting the product prices, per unit costs, volume or efficiency has an impact on the profit margin or turnover ratios. Similarly any decision affecting the amount and ratio of debt or equity used will affect the financial structure and the overall cost of capital of a company. Therefore, these financial concepts are very important to evaluate as every business is competing for limited capital resources. Understanding the interrelationships among the various ratios such as turnover ratios, leverage, and profitability ratios helps Companies to put their money in areas where the risk adjusted return is the maximum.26 Table 7.13 Regression Model for ROE and DuPont Factors Model
R
1
.773a
.597
.587
R Square Change .597
2
.840b
.705
.691
.108
R Square
Adjusted R Square
F Change
Sig. F Change
62.217
.000
15.048
.000
DurbinWatson
.999
Source: Computed from net profit margin, total assets turnover and equity multiplier of selected hotel companies
Inference:
The Regression model is applied to find out the extent to which Profitability, Asset Turnover Ratio and Multiplier affect the ROE. The above table shows that, R square as 0.597 and 0.705 which is the degree of determination. This means that 59.70 per cent variance in ROE can be determined by Profitability and 70.50 per cent variance in ROE can be determined by Profitability and Total Assets Turnover Ratio, wherein the Assets Turnover Ratio alone comes to the difference among the values which is 11 per cent.
26
“DuPont Analysis”, available at http://www.themanagementor.com/enlightenmentorareas/finance/cfa/DUPontAnalysis.htm; accessed in October 21, 2011
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Table 7.14 Regression Coefficient for ROE and DuPont factors
(Constant)
Unstandardized Standardized Coefficients Coefficientss t B Std. Error Beta -.005 .013 -.395
Net Profit
.670
.085
(Constant)
-.054
.017
Net Profit
.794
.080
Total Asset Turnover
.054
.014
Model
1 2
.773
P Value
.695
7.888
.000
-3.163
.003
.917
9.903
.000
.359
3.879
.000
Source: Computed from net profit margin, total assets turnover and equity multiplier of selected hotel companies
Inference:
The above table 7.14 gives the regression coefficients for the independent variables profit margin, total asset turnover ratio and the equity multiplier. If profit margin is alone taken, the coefficient of the profit margin is 0.670. Thus the regression equation can be written as ROE = -0.005 + 0.760 Profit Margin. For model 2, the coefficient of the profit margin is 0.794, the coefficient of the total asset turnover is 0.054 and the coefficient of the equity multiplier is excluded from the variables. Thus, the regression equation can be written as ROE = -0.054 + 0.794 Profit Margin + 0.054 Total Asset Turnover.
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Figure 7.5 Histogram Profit Margin, Asset turnover, Equity Multiplier and ROE
Source: Drawn from net profit margin, total assets turnover and equity multiplier of selected hotel companies
Inference:
The Diagram 7.5 represents the frequencies of the regression standardized residuals. It shows there is a normal distribution. This means that the variability in ROE is mainly due to variance in independent variables. The above diagram represents the plots between observed cumulative probability and the expected cumulative probability of the regression standardized residual. It shows the high correlation between observed cumulative probability and the expected cumulative probability.
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Figure 7.6 Scatter Plot for ROE and Profitability, Asset Turnover, Multiplier
Source: Drawn from net profit margin, total assets turnover and equity multiplier of selected hotel companies
The residual values are not much scattered in the above diagram. That is, the residuals are close to the main line. Figure 7.7 Path Diagram for DuPont Variables .01
Net Profit
.00 .80
-.03
e1 1
.41 .05 .02
Total Assest Turnover
Return on Equity
-.01
-.25 .34
Multiblier Source: Drawn from net profit margin, total assets turnover and equity multiplier of selected hotel companies
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Inference:
The Path diagram shows relationship among DuPont variables and Return on Equity. The numbers in the arrow is the co-efficient for the relationship between the variables. The coefficient value indicates the extent of influence of DuPont variables on Return on Equity. The influence of Profit margin (Profit/Sales), Total Asset Turnover (Sales/Asset) on Return on Equity is positive relationship. The path diagram also shows relationship within DuPont variables. There is a negative relationship between Equity multiplier (Asset/Equity) and Return on Equity.
7.6 Conclusion Chapter titled “Profitability of Indian Hotel Industry” describes the conceptual framework of financial efficiency and profitability. Financial efficiency is the ability of a given investment to earn a return from its use. It‘s vital instrument to measure not only the business performance but also overall efficiency in its concerned. In the present study four types of measurement tools of financial efficiency were discussed, that is, gross profit ratio, net profit ratio, return on capital employed ratio and return on equity ratio. Generally, return on equity ratio is used widely and famous. The present study showed concept, importance and measurement tools for profitability performance for measure the efficiency of business organization. The DuPont analysis has used to explore the determinants of the Return On Equity. Return on equity (ROE) is a closely watched number among knowledgeable investors. It is a strong measure of how well the management of a Company creates value for its shareholders. If a Company's ROE goes up due to an increase in the net profit margin or asset turnover, this is a very positive sign for the Company. However, if the equity multiplier is the source of the rise, and the Company was already appropriately leveraged, this is simply making things more risky.
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In this DuPont analysis, the influence of Profit margin (Profit/Sales), Total asset turnover (Sales/Asset) on Return on Equity is positive relationship. There is a negative relationship between Equity multiplier (Asset/Equity) and Return on Equity, when analysing the overall performance. This is an highly appreciable one. Even though the overall performance is better, the net profit ratio of the selected hotel companies are not at commendable growth rate. Hence, these Companies are advised to increase their profit ratio by reducing the cost and Hotel Leela Venture Limited is advised to reduce the debt capital also to increase the profit of the organisation.