How IFRS Based
Financial Statement Define the Relationship between Capital Structure and Firm’s
Profitability: An Analysis based on Selected Indian Companies
Mr.
SURAJIT DAS*
Abstract
Capital structure is
defined as the composition of Debt and Equity. When Company earn profit, Return
on Debt treated as expenses before tax and return on Equity is the distribution
of profit after tax. The earlier study disclosed that there is a strong
relationship between capital structure and firm’s profitability when Indian
Companies prepared their financial statement as per Indian Accounting Standard.
But from 201011 financial year, some Indian Companies prepared there financial
statement as per IFRS according with Indian accounting standard. In this paper
through multiple regression analysis, try to find out whether the same relationship
exists or not when the Indian Companies prepare their financial statement as
per International Financial reporting Standard. In this study, data have been
extracted from the 201011, financial statement which were prepared as per
IFRS.
Keywords: Capital
Structure, Profitability, Indian Accounting Standard, IFRS
*Asst.Professor, Institute of Management Study,WBUT,Mb:8100035983,email:surajitdas.d@rediffmail.com.
Introduction
When a firm raised its
capital structure from different sources, mix of these sources generally called
Capital Structure. A Company balance Sheet shows the different proposition of
Debt, preferred and common stock which are jointly represent the capital structure
of that company. According to Bierman & Smidt Capital structure is nothing
but the relative proposition of various kinds of securities used by a company. A
common choice between Debts and Equity aims to maximize the wealth of stock
holder. So, it means that Capital structures have a direct effect on the firm’s
value and profitability. Modiglini and Mill (1963) define how the firm value
will increase by using debt capital into capital structure of a Company. Return
on Debt capital is an item which is consider as a pre tax factor at corporate
level. For identifying this corporate tax benefit against the relevant cost, so
many research have been done from the last few decades and the result is that,
researcher developed the tradeoff theory.
The main objective of
financial management is to create the Shareholder wealth or maximize the firm
value. Through minimizing the weighted average cost of capital, a firm can
achieve it. Empirically there are so many researches across the globe on the
relationship between Capital Structure and Firms profitability. Most of them
have found a strong relationship between capital structure and Company’s
profitability. But all the researches have been done when the respected country
followed the local accounting standard.
In India, Financial
statement basically prepared as per Indian Accounting standard where all the
Assets including financial instrument measured as per historic value or the
book value. Depreciation calculation, revenue recognition, borrowing cost calculation
has been done as per AS 9 and AS 16 respectively. In the year of 2010, when
ICAI announced their opinion regarding the adaptation of IFRS and officially
said to disclosed the next financial statement as per IFRS, some Indian
company voluntarily adopt it and presented their financial statement ,201011
as per IFRS.
In open economy, where
entire globe treated as a common village, need a common set of business
language which is easily understandable for all. On the basis of this concept
International Accounting Standard Board formulated the International Accounting
Standard. Most of the countries in the globe have already been adopt this
international standard. To keep all this things in mind ICAI have announced the
adaptation year for India.
In this paper I have
tried to find out whether the same relationship between Capital structure and
firm’s profitability exist or not when Indian Companies prepare their financial
statement as per International Accounting Standard.
Review of Literature
Ibiamke et.al (2014)
disclosed how financial ratios have been effect by IFRS adaptation in
Nigeria. They found that IFRS adaptation does not differ significantly but
through gray Comparability Index they show that IFRS negatively effect on
financial ratios. Khalid Ashraf Chisti et.al (2013) carried a research
on Impact of capital structure on profitably of Listed Companies ( Evidence
from India).They found that Debt to Equity ratio was negatively correlated with
profitably ratio and Debt to Assets ratio was positively correlated with
profitabily ratio. Rameltulla & Elsana Ejupi (2010) conducted a
research on the relationship between capital structure and profitability at
Macedonia. They found a negative relationship with return and Debt. Yhlas
Sarbetor (2013) carried a study to find out how IFRS impact on
financial ratio in U.K market. They revealed that IFRS does not make any
significant difference on financial ratio of U.K firms. Dr Mohanmod Fawzi
Shibita & Dr jaafer maroof (2012) concluded that there is a negative
relationship between Capital structure and Profitability.Irena Jindrichovska
& Dana Kubisckova (2014) found some positive result on financial
ratios by adopting IFRS on Czech Republic. Balios Dimitrios et.al (2013)
studies the impact of IFRS on ratio of listed and new listed Companies of
Athens Exchange. They found that there is no significant effect from the
adaptation and implementation of IFRS in Greace.Other way they found a strong
relationship between local GAAP and IFRS.Ying Wang & Michael Campbell
(2012) revealed that there was no change on financial figure by adopting
IFRS of Chinese Companies through Tobin’s Q Test. Balasundaram Nimalathesan
& valeriu Brabeta (2010) conducted a study at Sri Lanka on this
relationship. They found that Debt Equity ratio was positively correlated with
all the profitability ratios.Debt to assets ratio was strongly associated with
major profitability ratios. Susana Callao (2007) has done a research on
the effect of IFRS adaptation on the comparability and relevancy of financial
reporting in Spanish Firm. They stated that most of the ratios significantly
differ due to application of IFRS. Dr. Edward Lee et.al (2008) conducted
a study on the impact of IFRS on Cost of Equity Capital. They found some
limited and mixed result of this impact. Ahmet aca & Rafet Akta (2007)
imparted the impact of IFRS on financial ratio when the Turkish listed firms
adopt it first time. They found that IFRS adaptation did not have significant
effect on Turkish firm. Ishaya luka chechet & Abduljeetlee badmus
Olayiwola (2014) conducted a study at Nigeria on the relationship
between Capital Structure and Profitability. They conclude that Debt ratio was
negatively correlated with profitability ratio.
Objectives of the Study
The
review of literature disclosed that where a country changed her accounting
language from local standard to IFRS. The relationship between the financial
figures also changed. So, on the basis of this concept, the objectives of this
study are:
1. To
find out the relationship between capital structure and net profit
2. To
find out the relationship between capital structure and Operating profit
3. To
find out the relationship between capital structure and return on capital
employed
4. To
find out the relationship between capital structure and return on investment
Methodology and Hypothesis
Sample
selection: As per ICAI previous announcement, the first time
adaptation of IFRS and presentation of financial statement period was 201011.But
they failed to meet the target. Still it is not a mandatory criterion. At that time,
some Indian companies voluntarily adopt it. They are 1. Wipro Ltd. 2. Infosys
Ltd.3. Rolta India Ltd. 4. Noida toll Bridge ltd and 5.Great eastern
electronics Ltd. In this study, I have considered 201011 financial year for
analyzing this relationship.
Data
Source: To meet the objectives and testing the hypothesis,
data were collected from the secondary source, mainly the financial statements
which have published at Companies Annual Report.
Design
of Statistical Analysis: In this study capital structure and
Co’s profitability expressed as ratios. To find out the relationship, some
major capital structure’s ratios and some profitability ratios have been
considered. These are:
Capital
Structure Ratios
1

Debt to Equity

D/E

2

Debt to Assets

D/A

3

Capital gearing

CG

Profitability ratios
1

Net
Profit ratio

NPR

2

Operating
Profit ratio

OPR

3

Return
on capital Employed

ROCE

4

Return
on Investment

ROI

Multiple regression
Equations have been formulated to prove the objectives and two ways ANOVA is
considered to test the hypothesis.
The following Equations
are being formulated to measure the impact of Capital structure on
profitability. Where profitability ratios are dependent variable and capital
structures ratios are independent variables.
1. NPR = α
+β_{1}(D/E) + β_{2}( D/A) +β_{3} (CG)+
e (1)
2. OPR = α
+β_{1}(D/E) + β_{2}( D/A) +β_{3} (CG)+ e
(2)
3. ROCE = α
+β_{1}(D/E) + β_{2}( D/A) +β_{3} (CG)+ e
(3)
4. ROI = α
+β_{1}(D/E) + β_{2}( D/A) +β_{3} (CG)+ e
(4)
The
following hypothesis has been formulated to determine the relationship between capital
structure and firm’s profitability as per IFRS based financial statement.
Hypothesis
H_{1}: Capital
structure has an impact on net profit.
H_{2}: Capital
structure has an impact on Operating profit.
H_{3}: Capital
structure has an impact on Return on Capital Employed.
H_{4}: Capital
structure has an impact on return on Investment.
Analysis and Findings
Capital
Structure Ratios on Net Profit Ratio
REGRESSION STATISTICS


R
Square

0.992280533

Adjusted
R Square

0.969122133

Standard
Error

0.019269433

Observations

5

On
the above regression results, show that R Square value is 0.99 and the Adjusted R Square is 0.96.So we can conclude that 96% portion of
net profit ratio can define by the capital structure ratios and other 4% may be
some other factors.
ANOVA







df

SS

MS

F

Significance F*

Regression

3

0.047729

0.01591

2.84754

0.111723364

Residual

1

0.000371

0.000371



Total

4

0.048101




*5% Significant Level
On
the other hand ANOVA table show that the calculated F value is 2.84 which is
higher than the tabulated F value (0.111) at 5% level of significance. So here
we reject the null hypothesis and can conclude that there is a strong
relationship between Capital structure and net profit numbers , when Companies
prepare their financial statement as per IFRS.
Capital Structure Ratios on Operating Profit Ratio
Regression Statistics


R
Square

0.174366293

Adjusted
R Square

2.302534828

Standard
Error

0.562302294

Observations

5

On the above regression
results, show that R Square value is 0.174and the Adjusted R Square is 2.30.So we can conclude that capital
structure ratios does not carry any relationship or better to say carry a
negative relationship with operating profit ratio. May be the reason is that
operating profit calculate by the operating expenses and operating income,
there is no role of financial cost.
ANOVA







df

SS

MS

F

Significance F*

Regression

3

0.066775144

0.022258381

0.070396954

0.967311295

Residual

1

0.31618387

0.31618387



Total

4

0.382959014




*5%
Significant Level
On the other hand ANOVA
table show that the calculated F value is 0.0703 which is lower than the
tabulated F value (0.967) at 5% level of significance. So here we accept the
null hypothesis and can conclude that there is a no relationship between
Capital structure and Operating profit numbers which have prepared as per IFRS
base financial statement.
Capital Structure Ratios on
Return on Capital Employed
Regression Statistics


R
Square

0.843695435

Adjusted
R Square

0.674781741

Standard
Error

0.095077476

Observations

5

On
the above regression results, show that R Square value is 0.84 and the Adjusted R Square is 0.67.It depict that 67% portion of return
on capital employed can define by the capital
structure ratios and other 33% may be some other factors .So we can conclude
that there is a relationship between capital structure
ratios on return on capital employed.
ANOVA







df

SS

MS

F

Significance F*

Regression

3

0.048794

0.016265

1.799255269

0.48994051

Residual

1

0.00904

0.00904



Total

4

0.057834




*5%
Significant Level
On the other hand ANOVA
table show that the calculated F value is 1.799 which is higher than the
tabulated F value (0.489) at 5% level of significance. So here we reject the
null hypothesis and can conclude that there is a strong relationship between
Capital structure and return on capital employed, when Companies prepare their
financial statement as per IFRS.
Capital Structure Ratios on Return on Assets
Regression Statistics


R
Square

0.890476736

Adjusted
R Square

0.761906945

Standard
Error

0.067288756

Observations

5

On the above regression
results, show that R Square value is 0.89 and the Adjusted R Square is 0.761.It leads to the conclusion that 76%
portion of return on capital employed can define by the capital structure ratios and other 24% may be
some other factors .So we can conclude that there is a strong relationship
between
capital structure ratios on return on Assets.
ANOVA







df

SS

MS

F

Significance F*

Regression

3

0.036813

0.012271

2.71016

0.413546488

Residual

1

0.004528

0.004528



Total

4

0.041341




*5%
Significant Level
On
the other hand ANOVA table show that the calculated F value is 2.710 which is
higher than the tabulated F value (0.413) at 5% level of significance. So here
we reject the null hypothesis and can conclude that there is a strong
relationship between Capital structure and return on capital employed which
have got as per IFRS base financial statement.
Support from the Literatures
Moazam. Me et.al
(2011) conducted a study and disclosed that there is a significant
relationship between capital structure and profitability: case study on Tobacco
Industry in Pakistan. Khalid Ashraf Chisti et.al (2013)
carried a research in India on the Impact of capital structure on profitabily
of Listed Companies. They found that Debt to Equity ratio was negatively
correlated with profitabily ratio and Debt to Assets ratio was positively
correlated with profitably ratio.
Conclusion
These
findings led us to the conclusion that IFRS adoption does not have a
significant effect on the relationship between capital structure and firm
profitability. As per earlier study in India, when Companies prepared their
financial statement as per Indian Accounting standard, researcher found a
strong relationship between capital structure and firm profitability. The same
tradition is being carried when Indian firms adopt IFRS voluntarily.
References
Ahmet
Agca, Rafet Akta., 2007. First Time Application of IFRs and Its Impact on
Financial Ratios: A Study on Turkish Listed Firms, Problems and Perspectives
in Management / Volume 5, Issue 2.
Balasundaram
Nimalathasan,Valeriu Brabete., (2010). Capital Structure and Its Impact on
Profitability: A Study of Listed Manufacturing Companies in Sri Lanka. The
Young Economists Journal, Volume1.
Balios Dimitrios, Eriotis Nikolaos, Paraskevopoulos
Konstantinos , Vasiliou Dimitrios., May,
2013. The impact of IFRS on ratios of listed
and new listed companies of Athens Exchange, International
Journal of Business and Social Research (IJBSR), Volume 3, No.5capital
structure: an empiricalstudy. Managerial Finance; Emerald Group Publishing
Limited, Vol. 33 No. 5
Dr.
Khalid Ashraf Chisti,Dr. Khursheed Ali,Prof. Mouh‐I‐Din
Sangmi.,
2013. Impact Of Capital Structure On Profitability Of Listed Companies
(Evidence From India). The Usv Annals Of Economics And Public Administration
Dr. Mohammad Fawzi
Shubita ,
Dr. Jaafer Maroof alsawalhah., 2012. The Relationship between Capital
Structure and Profitability. International Journal of Business and Social
Science Vol. 3 No. 16 [Special Issue – August]
Ibiamke,
Nicholas Adzor, AtebohBriggs, Patricial B., March 2014. Financial
Ratios Effect of International Financial Reporting Standards (IFRS) Adoption in
Nigeria, International Journal of Business and Management Invention
ISSN (Online): 2319 – 8028, ISSN (Print): 2319 – 801X, PP.5059
Irena
Jindřichovská, Dana Kubíčková ., February 2014. Impact of
International Financial Reporting Standards (IFRS) Adoption on Key Financial
Ratios: The Case of the Czech Republic, Journal of Modern Accounting and
Auditing, ISSN: 15486583, ISSN: 15486583, Vol. 10, No. 2, 133146.
Ishaya
Luka Chechet,Abduljeleel Badmus Olayiwola.,2014. Capital Structure and
Profitability of Nigerian Quoted Firms: The Agency Cost.
American International Journal of Social Science Vol. 3 No. 1
Moazam Me, Muhammad;
Mahdi, Syed Ghulam; Shafiq, Malik Muhammad; Naseem, Mohammad Akram., June 2011.
The Impact Of Capital Structure On Profitability: A Case Study Tobacco
Industry Of Pakistan. Franklin Business & Law Journal, Issue 2, P129
Nikolaos
Eriotis,Dimitrios Vasiliou and Zoe VentouraNeokosmidi.2007. How firm
characteristics affect
Rametulla
Ferati, Elsana Ejupi.,2010. Capital Structure And
Profitability: The Macedonian Case. European Scientific
Journal .April Edition Vol. 8, No.7. Issn: 1857 – 7881 (Print) E  Issn
1857 7431
Susana
Callao, Jos´e I. Jarne, Jos´e A. La´ınez., 2007. Adoption of IFRS in
Spain: Effect on the comparability and relevance of financial reporting,
Journal of International Accounting, Auditing and Taxation, 16 (2007)
148–178
Yhlas Sovbetov.,
September 2013. THE Impacts of IFRS Adoption on Key Financial Ratios in U.K
Market Over FTSE 100 Firms Through 20032007 Years,
Unpublished
Ying Wang, Michael Campbell., Spring 2012. Effects of
IFRS implementation on China publicly listed companies: Evidence using Tobin’s
Q , Journal of Business Administration Online.