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WARSAW
Charity Shamboko
23817
Bachelor thesis
Written under the supervision of:
Dr. Pawel Mielcarz
Abstract
This paper investigates the relationship between financial ratios and profitability using basic econometric
models to see if there is any relationship ratios have on profit determination. Initially ten variables are used
but reduced to three to see this relationship. The models showed the relationship with either negative or
positive connection of the ratios to profitability.
Student statement
I hereby certify that this project and presentation for the purpose of a bachelors degree diploma
examination titled The Relationship Between Profitability And Financial Ratios submitted to the
Kozminski University, is all my own work and has not been earlier used as a basis for a procedure related
to conferring professional titles and higher education institution diplomas.
I also certify that the content of the project and presentation does not violate copyrights under the Act of 4
February 1994 on copyright and neighboring rights (Journal of Laws No. 24, item 83, as amended) or
legally protected personal interests.
I acknowledge that the content of the project and presentation will be subject to verification by a plagiarism
detection system.
/date/
/signature/
Supervisor statement
I confirm that these project and presentation have been prepared under my supervision and I declare that
they meet the requirements specified for the purpose of the degree awarding procedure.
/date/
/signature/
TABLE OF CONTENTS:
ABSTRACT.. 2
INTRODUCTION 5
CHAPTER 1
1. METHODOLOGY.. 6
CHAPTER 2
2. EMPIRICAL RESULTS. 9
2.1 INTERPRETING RESULTS 13
CONCLUSION.. 15
BIBLIOGRAPHY.. 16
LIST OF TABLES.. 16
APPENDICES. 17
Introduction
This paper takes into account various papers done on the subject of profitability and its relationship with
financial ratios. In particular is the paper by Renato Schwambach Vieira (2010) on profitability and
liquidity, Enekwe Chinedu Innocent et al (2013) on financial analysis as determinant of profitability and
Prof.(Dr). T. Velnampy & J. Aloy Niresh (2012) on the relationship between capital structure and
profitability.
This combination of ideas allows for a much broader consideration of financial ratios and their effect on
determining the profitability of a firm. For this research six American firms (Microsoft, Oracle, IBM, HP,
Intel Corp, Adobe) and four European firms (SAP AG, Dassault Systems S.A, Gemalto N.V, SAGE
Group) were used with observations from a period of 10 years and various ratios such asset utilisation
ratios, liquidity ratios and capital structure ratios were used. Therefore, 100 observations were made to
identify the effects of financial ratios on profitability. A linear regression model was computed using these
observations to define the relationship and relevance in determining profitability.
In financial analysis, which involves the selection, evaluation of financial data and other relevant
information in order to assist in financial decision making such as investment, financial ratios play a great
role in determining the efficiency of operations, and credit policies. The main financial ratios used in this
research are liquidity ratios; quick ratio, current ratio and cash ratio, financial leverage ratios (capital
structure component) have also been added and these ratios are total debt to total assets ratio, total equity
to total assets ratio and net debt to equity ratio and asset utilisation ratios, otherwise known as, activity
ratios; R&D to sales, sales to accounts receivable, sales to working capital and sales to total assets.
The financial ratios assessed in this paper all reflect parts of financial statements, this allows for a
comparison of aspects of different elements to ascertain the performance of the firm. For instance, a
comparison of debt and equity or knowing the return on equity enables and investor or management to
determine not only the financial performance but also the strategy behind these numbers. Ratios give
different indications which vary from industry to industry; therefore this paper focuses on one industry, the
software industry.
In essence all ratios have classifications based on their use and are constructed to show typically four
aspects of the financial and operational performance. There is the coverage ratio, which measures the
firms capability to pay back its dues or obligations. A return ratio in its case shows the expected pay back
from an investment or resources allocated into the firm before expected costs. To measure the return after
cost turnover ratio is used and to measure a component of a particular aspect in another, component
percentage is used. The above mentioned ratios used in this paper each have an aspect of these classified
financial and operating performance indicators of the firm.
1.1 Methodology
The data was collected for each firm over a ten year period for each ratio in question, making it a panel
data set. The data is secondary as it was collected from an internet database on well-known firms around
the world (InFinancials). The public information was made available for use from the ten year period for
the particular areas of data relevant to the research. All the financial information, financial statements, ratio
graphs and financial ratios, are sourced from there (InFinancials).
Data Analysis
The analysis involved was of quantitative nature in that ratio analysis, regression and panel data analysis
and correlation analysis were conducted. The data provided had all the ratios calculated for the period in
question. Econometric/statistical tools such as Excel and Gretl were used to analyse the given data.
Capital Structure
Operating Profit
EBIT- Earnings before Interest and Tax =
The financial ratios, publicly provided as shown above, used had some limitations so some were removed
to keep the data unbiased. The ratios used provide an insight for managers, accountants or lenders into the
financial health, position, performance and prospects of an institution1. Liquidity ratios assess whether a
company is able to meet its financial obligations, by the ease at which they are able to convert current
assets to cash. As for leverage ratios, they measure the comparative allocation of debt and equity in a firm
and also show the reliance on debt financing. 2 On the other hand, we have asset utilisation ratios which are
used as analysis tools to identify whether a company is wasting its assets or putting them to good use. 3
Richard Pike and Bill Neale, Corporate Finance and Investment, Decisions and Strategies, Prentice Hall, 2009, Sixth Edition,
(pg 45)
2
Micheal Dennis, Key Financial Ratios For The Credit Department,Business Credit, November/December 2006, (pg. 62)
3
http://www.forbes.com/sites/forbesfinancialglossary/2011/07/12/asset-utilization-ratio/
All these ratios mentioned have a purpose far from profit determination, which is done through its own
specific ratios such as return on equity and return on assets, gross profit margin etc. But they come from
the same financial statements and together they give a full detailed position of a firm.
Therefore, the main purpose of this paper is to establish whether there is a relationship between profit and
these ratios. Used as profit is EBIT, due to its pure nature in the income statement, in that it does not
include any external factors such as tax and interest that may make the data biased on the cross sectional
data. Therefore, operating profit proved to be a better profit standard.
However, EBIT has not been used in its standard form but seeing that most of these ratios have an aspect of
assets in them it is given as a ratio to total assets. Hence,
variable.
Model
Used in the analysis is the linear regression, in particular Ordinary Least Squares (OLS). This is used to
determine relationships between one dependent variable and two or more independent variables, multiple
regressions. In this case we have more than one independent variable with the regression equation being:
(4)
Considering the varied data from the software industry, we start with descriptive statistics which shows this
variation in our data:
Table.1
Descriptive statistics (Quantitative data):
Statistic
QRatio CRatio CtRatio TDt / TA TEq / TA NDt/Eq R&D/Sales Sales/acc rec Sales/workcap Sales/TA
EBIT
No. of observations
100
100
100
100
100
100
100
100
100
100
100
Minimum
0.255
0.078
0.456
0.000
0.123
-1.050
-0.286
3.300
-7.430
0.430
-11057000.000
Maximum
7.386
4.612
8.277
0.310
0.864
1.560
-0.024
18.700
214.030
1.220
28071000.000
1st Quartile
0.799
0.371
1.219
0.017
0.493
-0.468
-0.156
4.805
1.783
0.568
313068.750
Median
1.556
1.014
2.004
0.090
0.585
-0.235
-0.129
5.975
2.820
0.765
3221500.000
3rd Quartile
2.366
1.834
2.616
0.187
0.670
0.110
-0.064
8.860
5.908
0.900
11134000.000
Mean
1.716
1.203
2.105
0.106
0.565
-0.174
-0.126
7.069
7.730
0.762
6325607.020
Variance (n-1)
1.386
0.965
1.465
0.009
0.027
0.233
0.004
11.774
516.975
0.041 55125770966103.500
Standard deviation (n-1) 1.177
0.982
1.210
0.093
0.165
0.483
0.062
3.431
22.737
0.202
7424673.122
From this we can see that most of the independent variables have standard deviation below 2, which
indicates that they are not too far from the mean. However, Sales to receivables and Sales to working
capital have very high standard deviations, meaning the data points are widely dispersed away from the
mean. This gives an idea of what to expect from the regression analysis. (Also see Appendix.I for
Coefficient determination R2).
Initially all variables are included in the model just to see the results retrieved. We analyse the outcome by
checking the R-squared and p-values for each of the independent variables. R-squared will justify the
relationship, if there is any, between the dependent and independent variables. It will give us the
percentage explanatory relationship. Below is the regression with all variables included:
Table.2
Model 1: Pooled OLS, using 100 observations
Included 10 cross-sectional units
Time-series length = 10
Dependent variable: Ebit_TA
const
QRatio
CRatio
Coefficient
0.223943
0.273836
-0.129682
Std. Error
0.0858834
0.0577691
0.0355907
t-ratio
2.6075
4.7402
-3.6437
p-value
0.01069
<0.00001
0.00045
**
***
***
CtRatio
TDt_TA
TEq_TA
NDt_Eq
R_D_Sales
Sales_accrec
Sales_workcap
Sales_TA
-0.160178
0.040756
-0.155744
0.16692
-0.355196
0.0850404
-0.116385
0.0313407
-0.302387
0.140279
0.0186334
0.00333286
-0.000273868 0.000260701
-0.0236494
0.0509511
0.153423
0.276084
0.529892
10.03184
152.7171
-254.7774
0.530564
-3.9302
-0.9330
-4.1768
-3.7136
-2.1556
5.5908
-1.0505
-0.4642
0.00017
0.35332
0.00007
0.00036
0.03381
<0.00001
0.29633
0.64367
***
***
***
**
***
0.077020
0.055696
0.477071
4.48e-11
-283.4343
-271.8363
0.806577
The regression does not seem satisfactory. Various disturbances that may cause a biased result have not
been taken into account. For starters, there are too many independent variables. There is a need to keep the
independent variables at a maximum of five to avoid any further distortions.
We need to check the correlation of the variables at this point. Highly correlated independent variables in
multiple regressions can give biased results as it is hard to determine whether which particular variable
predicts changes in the dependent variable5. Therefore we must take note of any multicollinearity in the
dataset.
Teresa Bradley, Essential Statistics for Economics, Business and Management, 2007 (p.g 538)
10
Table.3
For all variables that have correlation >0.7 there is a chance of multicollinearity, therefore, some variables
will be removed from the dataset to leave room for an unbiased regression. These independent variables to
be removed will be from each set of ratios, this is an obvious decision but in order to make this choice we
will first run a OLS regression. Having in mind that R-squared is maybe inflated due to the many variables
involved we get the new OLS analysis results as:
Table.4
Model 2: Pooled OLS, using 100 observations
Included 10 cross-sectional units
Time-series length = 10
Dependent variable: Ebit_TA
const
CRatio
TEq_TA
Sales_workcap
Coefficient
0.148276
0.0362552
-0.0648759
-0.000237725
Std. Error
0.0274561
0.00918397
0.0545009
0.000324814
0.153423
0.486460
0.171671
6.631973
124.3947
-230.3686
0.664018
t-ratio
5.4005
3.9477
-1.1904
-0.7319
p-value
<0.00001
0.00015
0.23684
0.46602
***
***
0.077020
0.071185
0.145785
0.000405
-240.7893
-236.5719
0.565559
11
The model is now good enough as the overall p-value is less than 1% The r-squared is low but there is not
always a guarantee that the dependent variable stated by the percentage of the r-squared is explained by the
independent variables.
The above model used three variables that were picked using the correlation matrix to rule out the best
suited to check relations with the dependent variable. However, out of curiosity, another model is used to
see how R&D to Sales which is also another variable less correlated to the other variables (see Appendix I
and III), affects the dependent variable EBIT to Total assets.
Table.5
Model 1: Pooled OLS, using 100 observations
Included 10 cross-sectional units
Time-series length = 10
Dependent variable: Ebit_TA
const
QRatio
TEq_TA
R_D_Sales
Coefficient
0.121391
0.0200664
-0.117012
-0.505368
Std. Error
0.0246595
0.00746868
0.0538457
0.141226
0.153423
0.437200
0.255549
10.98470
129.7329
-241.0450
0.613103
t-ratio
4.9227
2.6867
-2.1731
-3.5784
p-value
<0.00001
0.00850
0.03223
0.00054
***
***
**
***
0.077020
0.067485
0.232285
2.89e-06
-251.4657
-247.2483
0.652374
Keeping in mind that correlation was observed between variables, a fixed effects model can be used to rule
out any unexplained heterogeneity explanatory variables 6. Taking into consideration the size of the sample
as well we will go back to these models using the financial statements to tie the results together, as this will
best explain the results.
C. Dougherty, Introduction To Econometrics, 3rd Edith, Oxford University Press, 2007 (pg 412)
12
Coefficient
0.148276
0.0362552
-0.0648759
-0.000237725
p-value
<0.00001
0.00015
0.23684
0.46602
***
***
These numbers, coefficients, represent the change the dependent variable experiences when there is a one
point change in the individual independent variables. This effect can either be negative or positive
depending on the sign on the independent variables sign. A negative sign means there is a negative change
in the dependent variable when there is an increase by one in the independent variable and the opposite
would be for the positive sign.
In this case, a one point change in CRatio, a one point change in Cash ratio would result in a 0.0362552
change increase in EBIT_Total assetsTEq_TA and Sales_workcap, are insignificant because their pvalues are too high.
However, Sales to working capital is not statistically significant in this model as its p-value is too high and
this also applies to Total equity to total assets. The most significant in the model is Cash ratio as it has a
lower p-value.
7
http://dss.princeton.edu/online_help/analysis/interpreting_regression.htm#coefficients
13
0.153423
0.486460
0.171671
6.631973
0.077020
0.071185
0.145785
0.000405
Second model;
The coefficients in Table.5, as explained in the previous model, tell us the changes we expect in the
dependent variable when there is a change by one in the independent variable holding everything else
constant. In this case the greatest change comes from R_D_Sales and TEq_TA with -0.505368 and 0.117012, respectively. This is interesting as it would result in a very large decrease in the dependent, by
approximately 50% and 11%.
const
QRatio
TEq_TA
R_D_Sales
Coefficient
0.121391
0.0200664
-0.117012
-0.505368
p-value
<0.00001
0.00850
0.03223
0.00054
***
***
**
***
The individual p-values for the independent variables are lower making them much more significant in the
model.
P-value and R-squared
The r-squared for the second model is slightly higher and the p-value lower suggesting a more significant
model in comparison to the first model. This entails a 25% explanation of the dependent variables by the
independent variables.
R-squared
F(3, 96)
0.255549
10.98470
Adjusted R-squared
P-value(F)
0.232285
2.89e-06
14
CONCLUSION
In conclusion, looking at the various inputs into the models, financial ratios such as such asset utilisation
ratios or leverage ratios are related to profitability even though they focus more on their designated aspects.
This can very well be explained in the financial statements. Profit is shown in the income statement as
EBIT and from there EBIT is influenced by changes such as an increase or decrease in R&D to sales which
in this case is an expense in the income statement.
For instance, the fact that an increase in R&D to sales has a negative impact on EBIT to Total Assets can
be explained using basic accounting. Depending on the classification of R&D, in this case being software
companies it is classified mostly as an expense in the income statement this in turn reduces profit, EBIT.
Therefore, using this asset utilisation ratio R&D to sales, it can be concluded that the higher the ratio the
lower the profit. But of course, knowledge of basic accounting would tell us the same.
In the case of sales to working capital, which is another asset utilisation ratio, it can be seen though that
there is not much influence. The relationship is not very clear as mostly involves the creation of profit and
not the amount of profit.
Total equity to total assets, however, showed a negative link to profit. An increase would be linked to a
decrease in profit. This is mostly due to the fact that assets in part have retained earnings, which are part of
profit. A decrease in retained earnings causes a decrease in assets in the ratio, total equity to total assets,
therefore increasing the output of the ratio.
The relationship these ratios have with profit would help determine were the weakest points are in profit
making for a firm. Assets, equity, cash, sales and R&D are all part of or a result of profit, therefore the link
is inevitable.
15
LIST OF TABLES
Table.1:
Descriptive Statistics
Table.2:
Table.3:
Correlation Matrix
Table.4:
Table.5:
16
APPENDICES
Appendix I.
Coefficients of determination (R):
Variables
QRatio
CRatio
CutRatio
TDt/TA
TEq / TA
NDt/Eq
R&D/Sales
Sales/acc rec
Sales/workcap
Sales/TA
Ebit/TA
QRatio
CRatio
CutRatio TDt/TA TEq / TA NDt/Eq R&D/Sales Sales/acc rec Sales/workcap Sales/TA Ebit/TA
1
0.918
0.955
0.252
0.329
0.440
0.304
0.004
0.042
0.014
0.149
0.918
1
0.859
0.222
0.361
0.460
0.357
0.006
0.053
0.054
0.156
0.955
0.859
1
0.261
0.292
0.359
0.206
0.003
0.039
0.000
0.112
0.252
0.222
0.261
1
0.604
0.647
0.118
0.006
0.027
0.026
0.058
0.329
0.361
0.292
0.604
1
0.541
0.318
0.000
0.046
0.100
0.024
0.440
0.460
0.359
0.647
0.541
1
0.319
0.054
0.062
0.007
0.192
0.304
0.357
0.206
0.118
0.318
0.319
1
0.009
0.049
0.206
0.188
0.004
0.006
0.003
0.006
0.000
0.054
0.009
1
0.001
0.008
0.003
0.042
0.053
0.039
0.027
0.046
0.062
0.049
0.001
1
0.004
0.022
0.014
0.054
0.000
0.026
0.100
0.007
0.206
0.008
0.004
1
0.000
0.149
0.156
0.112
0.058
0.024
0.192
0.188
0.003
0.022
0.000
1
in relation to ebit/total assets
Appendix II.
p-values:
Variables
QRatio
CRatio
CutRatio TDt/TA TEq / TA
QRatio
0
< 0.0001
< 0.0001 < 0.0001 < 0.0001
CRatio
< 0.0001
0
< 0.0001 < 0.0001 < 0.0001
CutRatio
< 0.0001
< 0.0001
0 < 0.0001 < 0.0001
TDt/TA
< 0.0001
< 0.0001
< 0.0001
0 < 0.0001
TEq / TA
< 0.0001
< 0.0001
< 0.0001 < 0.0001
0
NDt/Eq
< 0.0001
< 0.0001
< 0.0001 < 0.0001 < 0.0001
R&D/Sales
< 0.0001
< 0.0001
< 0.0001
0.000 < 0.0001
Sales/acc rec
0.517
0.426
0.572
0.439
0.881
Sales/workcap
0.041
0.022
0.048
0.101
0.033
Sales/TA
0.248
0.020
0.999
0.109
0.001
Ebit/TA
< 0.0001
< 0.0001
0.001
0.016
0.127
Values in bold are different from 0 with a significance level alpha=0.05
Appendix III.
Multicolinearity statistics:
Statistic QRatio CRatio CutRatio TDt/TA TEq / TA NDt/Eq R&D/SalesSales/acc recSales/workcap Sales/TA Ebit/TA
R
0.995
0.978
0.989
0.871
0.867
0.882
0.603
0.823
0.119
0.704
0.530
Tolerance
0.005
0.022
0.011
0.129
0.133
0.118
0.397
0.177
0.881
0.296
0.470
VIF
184.865 44.839 91.117
7.768
7.510
8.441
2.521
5.640
1.135
3.383
2.128
17
18
19