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A Refereed Monthly International Journal of Management

Capital Structure and Altman’s Z score of Indian Capital goods Industry-Empirical Analysis

AUTHORS

ABSTRACT

The present paper is to investigate the effect of capital structure on Altman’s Z score of Capital goods industry in India. This study is based on the secondary data, collected from annual reports of the BSE 200 listed companies and applied content analysis. Mean, Standard Deviation, Correlation coefficients and linear regression analysis have been used. Edward Altman’s Z score was calculated and applied as modern solvency variable with Debt equity, EPS and Book Value per share. This study found that the capital structure has no any impact on Altman Z score, but Z score is determined to the extent of 63.7% by debt equity at 1% levels and Earnings per share at 10% levels of selected Capital goods industry in India.

Keywords: Capital structure, Debt equity, current ratio, book value per share, Altman’s Z score and Capital goods industry.

Capital Structure and Altman’s Z score of Indian Capital goods Industry-Empirical Analysis

Introduction

Capital structure refers to the combination of long term funds required for an organization. Capital structure role is important because it affect the financial performance of the company. It is a mix of long term debts and owner’s equity. Capital structure the way a company finance itself by combining long term debt, short term debt and equity, is one of the most important themes in corporate finance(Jothi,2010). Financial structure refers to the composition of the entire liabilities of the firm, where as Capital structure is the permanent financing of the firm represented primarily by long term debts and shareholders’ funds but excluding all short term credit. Capital structure decision is used to examine, its impact factor on the value of firm. The use of debt in Capital structure leads toward finance cost. EBIT – EPS technique analysis is generally applied to determine an appropriate capital structure of the firm.

Capital Structure

“Capital structure encompasses a corporation’s publicly issued securities, private placements, bank debt, and trade debt, leasing contracts, tax liabilities, pension liabilities, deferred compensation to management and employees, performance guarantees, product warranties and other contingent liabilities. This list represents the major claims to a corporation’s assets. Increase or reduction in any of these claim represent a form of capital structure change.” There may be four fundamental patterns of capital structures. They are 1) Equity share capital only, including Reserves and Surplus. 2) Equity share capital and Preference share capital. 3) Equity, preference share capital and long term debts. 4) Equity share capital and long term debt. Long term debt includes debentures, Bonds and loans from financial institutions. It is an overall policy decision about the proportion of various sources of long term finance and it provides qualitative decision in nature. Corporate Governance has mainly focused three principles namely, Accountability, Transparency and equality of treatment for all stakeholders. Accountability is not only for the shareholders, creditors and employees but also applicable to the Board of directors. Transparency is important for good corporate governance. It should not be like Satyam, because the concern felt down by the improper maintenance of books accounts.

SEBI introduced clause 49 to ensure the disclosures of the listed companies. Corporate excellence includes higher contribution to investors and money lenders based on required capital structure of the organization. Corporate governance is the social, legal and economic process in which companies function and are held accountable. It is the system by which companies are run (Cadbury Committee Report). Corporate governance insists the manner to organize its functions guided by the board of directors for value addition to the stakeholders and to make impression about the possible growth of the concern.

Table 1: Capital Employed of Capital Goods Industry in India (in crores)

Solvency Health measurement

Leonard N Stern school of Business of New York university professor Edward I Altman published formulae to access the probability that a firm will go bankruptcy within two years. Edward Altman derived business ratios, weighted by coefficient with the help of multi-discriminant analysis. Z score = 1.2X₁ + 1.4 X₂ + 3.30 X₃ +0.60 X₄ +0.99X₅ where X₁ stands for Working Capital / Total Assets, X₂ stands for Retained Earnings / Total Assets, X₃ stands for EBIT / Total Assets, X₄ stands for Market capitalization / Total Liabilities and X₅ stands for Sales / Total Assets. Altman stated that when the score is below 1.80 means failure is certain, Between 1.80 to 2.99 means uncertain is predict and above 2.99 means solvency is too healthy.

Table -2: Edward Altman’s Z score of Capital goods Industry in India

Review of Literature

V N Parthiban (2011) explained three principles of Corporate Governance namely accountability, transparency and equality of treatment and its value addition to the stakeholders of the corporate sector and concluded that the directors are architects and guide in order to create goodwill and board members should act on a fully informed basis, in good faith with diligence and care. Akinmulegun Sunday Ojo (2012) have examined the effects of financial leverage measured by (Debt-Equity ratio) on Earnings per Share (EPS) and Net Assets per Share (NAPS). Author used panel data on effect of leverage on performance indicators of some corporate firms in Nigeria during 1993 and 2005 with employed econometric technique of Vector Auto Regression (VAR) on the variables and create that leverage shock on EPS indirectly affect the NAPS. Leverage so considerably affects Corporate Performance. Dr. D P Singh (2012) examined working capital management and profitability in the IT and Telecom industry in India by using Working capital ratio, Sales to Total Asset ratio, Cash conversion cycle and selected 11 companies in India and applied Karl Pearson’s coefficient correlation and Regression analysis based on pooled observations and concluded that working capital turnover ratio, Sales to Total Assets ratio and ROCE has positive significant relationship with profitability of both IT and Telecom Industry in India and also observed that Telecom industry is operating below average so far as working capital management concerned. Shailesh et al (2013) examined capital structure practices with its effect on profitability of top 5 pharmaceutical companies in India, listed on BSE for the period of 5 years and used operating profit margin ratio, ROCE, RONW and Debt to Equity ratio and tested through regression analysis and t test and concluded that firms profitability of pharmaceutical firms in India, is insignificant in bringing about any changes in their capital structure.. Dr. Shiv Prasad et al (2013) examined the financial health of ITDC, public sector undertaking in India and concluded that the financial health was in the too healthy zone during 2007, 2008 and 2009, which have come to gray area due to recession in tourism sector, global crisis and terrorist attack at Mumbai. Dr Jothi Jayakrishnan et al (2015) studied the relationship between fourteen capital structure determinants and its effects on capital structure of fifty chemical companies in India for the period of six years from 2000-2013 and concluded that profitability, uniqueness and manufacturing sources are the positive determinants, but tax and retained earnings are negative determinants of the capital structure of the selected chemical companies in India. Parul Khanna et al (2015) studied the capital structure and it returns through analyzing the CG practices of Nifty 50 companies with regard to Board of directors and its composition, shareholder grievances committee and handling of investor’s complaints and explained about clause 49 of the listing agreement and concluded that 82% of the companies are not having pendency with respect to investor’s complaint redresses. Tahir Akhtar et al (2016) investigated the effect of capital structure on firm performance of Karachi stock exchange listed companies under Textiles industry, using the agency cost hypothesis and reverse causality hypothesis and concluded that ownership structure and leverage had positive relationship. Agency cost hypothesis supported the positive effect of leverage on efficiency.

Statement of the Problem

This study was descriptive in nature and expands the knowledge in the area of impact of capital structure on Altman Z score is that considerable attention in the financial literature in India. The statement of problem is Capital Structure and Altman’s Z score of Indian Capital goods generation industry in India.

Objectives of the study

1. To calculate the Capital structure and Altman Z score of selected companies
2. To find the relationship between Capital Structure with Solvency variables of selected companies
3. To check whether solvency variables have any cause and effect relationship with Altman’s Z score of selected companies.
4. To check whether Capital structure has any cause and effect relationship with Altman’s Z score of selected companies.

Null Hypothesis

1. There is no significant relationship between capital structure and solvency variables of capital goods industry in India
2. There is no significant relationship between capital structure and Altman Z score of capital goods industry in India
3. That the solvency variables has no any cause and effect relationship with Altman’s Z score of selected companies
4. That the Capital structure has no any impact on Altman’s Z score of capital goods industry in India

Research Design

The study is based on the secondary data collected from annual reports of the BSE 200 Listed companies belong under this industry were 10 Companies. They were ABB Ltd, Bharat Electronics, BHEL, Crompton Greaves, Havells India, Larson and Toubro, Pipavav Defense, Siemens, Suzlon Energy and Thermax Ltd. Out of which ABB India Ltd, Siemens Ltd and Suzlon Energy Ltd (Loss) were not furnished required data for the study period in addition to applied content analysis Nazli et al., 2003, Tamoi et al., 2007, Md Abdur Rouf 2011. Secondary data was collected from the annual reports of selected companies and websites of moneycontrol.com, BSE.com etc for the period of Six years, which ended on 31^st March. The period of the study is 2009-10 to 2014-15. Capital employed was treated as Capital Structure of the selected companies which comprises equity share capital, preference share capital along with reserves and surplus and long term debts (Tahir Akhtar 2016). Altman’s Z score (Dr Shivprasad 2013) was computed by author based on the Edward Altman derived business ratios, weighted by coefficient with the help of multi-Discriminant analysis and used as modern solvency variable. Debt equity ratio (Sunday Ojo 2012, Shailesh 2013), Book Value and EPS were used as control variables. For the analysis Mean, Standard Deviation, Correlation coefficients and regression analysis have been used for its validity.

Analysis and Interpretations

Table 3: Descriptive Statistics of selected variables of Capital goods industry in India

Table 3 showed that the mean value of capital employed of the industry is 2.21. BHEL and Larson and Toubro ltd has got higher than the industry level but all other companies have showed lower than the industry level. It shows that the capital employed of the industry was not normally distributed. The mean value of Current ratio of the industry is 1.32. Bharat electronics ltd, BHEL and Cromption Greaves Ltd have showed higher the industry level which indicates that these companies applied proper working capital management. The mean value of Debt equity is 0.388, the Pipava defence Ltd have higher than the industry level and it shows that higher debts than the other companies in this industry. Mean value of Book value per share is 241.34, Bharat Electronics and Larson and Toubro Ltd had higher than the industry level, but other companies show lesser then the average level of the industry. Mean value of EPS is 41.20. Bharat electronics, BHEL and Larson and Toubro have higher than the industry level. Mean value of Altman z score is 5.65. It means the solvency level of the industry is very high, but Pipavav defence Ltd only shows bankruptcy level.

Table 4

Table 4 showed that the correlation coefficient between capital structure and EPS is significant at 5% level. Current ratio have significant relationship with Debt equity ratio, EPS and Altman Z score too. Debt equity ratio has significant relationship with EPS and Altman Z score. Hence author accepts the null hypothesis-1 and rejects the null hypothesis - 2 and concluded that capital structure has no any significant relationship with solvency variables and Altman Z score has significant relationship at 5% levels.

Table 5: ANOVA Table

Table -6 Regression Analysis Table

1. Predictors: (Constant), Capital Employed, Current Ratio, Debt equity, EPS, Book Value per share
2. Dependent Variable: Z Score

Findings and Conclusion

Table 5 ANOVA table shows that the significance value is 0.000, which means dependent variable Z score have significantly predicted. Table 6 showed that the effect of capital structure and other solvency variables on Altman Z score is given by the regression equation, Z score (Y) = a + b1 (Capital structure) + b2 (Current ratio) + b3(Debt equity) + b₄ (EPS) + b5 (Book value per share). Debt equity ratio only has significant impact on Z score at 1% level, being the f value is 9.287. R square is 0.637. So author reject the null hypothesis 3 and stated that Debt equity have the cause and effect relationship at 1% level and EPS at 10% levels, and author accept the null hypothesis-4 and concluded that the Capital structure has no any impact on Altman’s Z score of capital goods industry in India.

References

1. V.N. Parthiban, “The role of Directors and the Board in Corporate Governance”, Corporat Ethics, Measi Institute of Management, 2011.
2. Dr D P Singh, “Working Capital Management and Profitability in the IT and Telecom Industry in India’, Indian Journal of Finance, March 2012, pp 54 -61
3. Shfv Prasad and Dr.Veena Kumari (2013) “An empirical study on Financial Health of ITDC through Z score analysis”, Indian Journal of Accounting, Vol- XLIV (2), PP26-34
4. Shailesh N and Ransariya (2013), Relationship between Capital Structure and Profitability of Indian Pharmaceutical Industry”, Indian Journal of Accounting, Vil – XLIV 2, June 2013, pp 95-103
5. Financial Management principles and practices & Principles of Management .Accounting Dr S N Maheshwari,
6. Jothi Jayakrishnan and John Jacob, “Determinants of Capital Structure: Empirical evidence from Chemical industry in India”, Vels Journal of Management, Vol-1 Issue-1, June 2015
7. Parul Khanna and Gitika Nagrath, “Recent developments in Corporate Governance: An Indian context”, IJRESS, Vol-5, Issue 4, 2015 ISSN- 2249 7382

8. Tahit Akhtar, Ahmed Zahir, Mohamed Ali Tareg and Fazle Rabbi,’ Capital Structure and Firm Efficiency: A case of Pakistan”, Indian Journal of Finance, Feb 2016, pp50-63

Annexure -1:

1. Bharat Electronics

2. BHEL

3. Crompton Greaves

4. Havells India Limited

5. Larson and Toubro

6. Pipavav Defence

7. Thermax Limited