IMPACT OF CORPORATE GOVERNANCE ON FINANCIAL PERFORMANCE In this chapter, an attempt has been made to analyze the impact of corporate governance disclosure practices as per clause 49 of the listing agreement on financial performance of companies through regression analysis. A set of four firm performance measures have been selected, categorized into accounting based measures and market based measures to ascertain the relationship between corporate governance and firm performance. These measures are (i) Net Profit Margin on Sales, (ii) Return on Assets (ROA), (iii) Return on Equity (ROE) and (iv) Tobin’s Q. First three measures are termed as accounting based measures and the fourth one is known as a measure of market valuation. The variables used for measuring the financial performance have been explained in section 7.1.The explanation of control variables used in the present study has been given in section 7.2. Section 7.3 explains the regression model employed for measuring the impact of corporate governance on financial performance of the companies under study and sections 7.4 and 7.5 give the results and discussions. 7.1 Measures of Financial Performance As explained above, four financial performance measures have been selected for the present study namely net profit margin on sales, return on assets (ROA), return on equity (ROE) and Tobin’s Q. These are explained as given below: 7.1 (a) Net Profit Margin on Sales Net profit margin on sales ratio establishes the relationship between net profit and sales and indicates management’s efficiency in manufacturing, administering and selling the products (Pandey, 2000, p.132). Higher the net profit margin better will be the profitability position of the company. Rechner et al. (1991), Dalton et al. (1999), Brown and Caylor (2004) and Phani et al. (2005) have used net profit margin on sales as a measure of firm performance in their studies. Net profit margin on sales has been calculated by dividing the earnings before interest and taxes (net of non-recurring
30
Embed
Impact of Corporate Governance on Financial …shodhganga.inflibnet.ac.in/bitstream/10603/5121/13/13_chapter 7.pdfIMPACT OF CORPORATE GOVERNANCE ON FINANCIAL PERFORMANCE ... dividing
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
IMPACT OF CORPORATE GOVERNANCE ON
FINANCIAL PERFORMANCE
In this chapter, an attempt has been made to analyze the impact of corporate
governance disclosure practices as per clause 49 of the listing agreement on financial
performance of companies through regression analysis. A set of four firm performance
measures have been selected, categorized into accounting based measures and market
based measures to ascertain the relationship between corporate governance and firm
performance. These measures are (i) Net Profit Margin on Sales, (ii) Return on Assets
(ROA), (iii) Return on Equity (ROE) and (iv) Tobin’s Q. First three measures are termed
as accounting based measures and the fourth one is known as a measure of market
valuation. The variables used for measuring the financial performance have been
explained in section 7.1.The explanation of control variables used in the present study has
been given in section 7.2. Section 7.3 explains the regression model employed for
measuring the impact of corporate governance on financial performance of the companies
under study and sections 7.4 and 7.5 give the results and discussions.
7.1 Measures of Financial Performance
As explained above, four financial performance measures have been selected for
the present study namely net profit margin on sales, return on assets (ROA), return on
equity (ROE) and Tobin’s Q. These are explained as given below:
7.1 (a) Net Profit Margin on Sales
Net profit margin on sales ratio establishes the relationship between net profit and
sales and indicates management’s efficiency in manufacturing, administering and selling
the products (Pandey, 2000, p.132). Higher the net profit margin better will be the
profitability position of the company. Rechner et al. (1991), Dalton et al. (1999), Brown
and Caylor (2004) and Phani et al. (2005) have used net profit margin on sales as a
measure of firm performance in their studies. Net profit margin on sales has been
calculated by dividing the earnings before interest and taxes (net of non-recurring
Impact of Corporate Governance on Financial Performance
231
transactions)1 by the net sales. Net sales are the sales excluding indirect taxes and duties
such as excise duty and octroi duty. Sales are also net of internal transfers.
Net Profit Margin on Sales= EBIT
100 Net Sales
7.1 (b) Return on Assets (ROA)
ROA is used as an accounting based measure of firm performance. ROA is
commonly used and well understood measure of firm performance, particularly
appropriate for manufacturing firms (Kim, 2005). ROA measures the ability of the
management to earn a return on resources and the firms using their assets efficiently have
higher returns (Sharan, 2005, p.283). Various researchers namely Rechner et al. (1991),
Klein (1998), Core et al. (1999), Dalton et al. (1999), Jog and Dutta (2004) and Phani et
al. (2005) have used ROA as a firm performance measure in their studies. We have
calculated return on assets by dividing the earnings before interest and taxes (net of non-
recurring transactions) by the total assets. Taxes are not controllable by the management
and also one may not know the marginal corporate tax rate while analyzing the
publishing data (Pandey, 2000, p.136). So, in order to remove this anomaly, we have
considered EBIT instead of profit after tax (PAT).
ROA = EBIT
100 Total Assets
7.1 (c) Return on Equity (ROE)
Return on equity has been considered as another measure of firm performance. A
number of researchers have employed ROE as firm performance measure in their studies
(Rechner et al. 1991, Dalton et al, 1999, Rhoades et al., 2001, Brown and Caylor, 2004
and Jog and Dutta, 2004). ROE is an important indicator which tells us how the company
has used the resources of its owners. This ratio reflects the extent to which the objective
of wealth maximization of shareholders has been achieved. In the present study, we
1 As per Prowess Database of CMIE, net of non-recurring transactions includes profit or loss on sale
of fixed assets and investments, provision written back, prior period income or expenses,
insurance claims, etc. So, the above figure of EBIT is adjusted of NNRT.
Impact of Corporate Governance on Financial Performance
232
calculated ROE by dividing the profit after tax (net of non-recurring transactions)
adjusted with preference dividend by net worth minus preference share capital.
ROE= PAT – Preference Dividend
100 Net Worth-Preference Share Capital
7.1 (d) Tobin’s Q
Tobin’s Q as a measure of market valuation has been extensively used by the
researchers in their studies (Farrer and Ramsay, 1998, Chen, 2001, Mohanty, 2002, Weir
et al., 2003, Brown and Caylor, 2004, Jog and Dutta, 2004, Dwivedi and Jain, 2005 and
Khiari et al., 2005). Tobin’s Q ratio has been devised by James Tobin. This ratio is based
on the notion that combined market value of all the companies on the stock market
should be equal to their replacement costs (www.investopedia.com/terms/q/qratio). This
is the ratio of market value of equity and debt divided by the replacement costs of total
assets. Firms displaying Tobin’s Q greater than unity are considered to be using scarce
resources effectively, while those with Tobin’s Q less than unity are using resources
poorly (Chen, 2001).
Tobin’s Q as a measure of firm performance represents the value that investors
put on in firm’s shares above the total value of assets of the firm and thus represents
investor’s confidence which in turn is an indicator of the effectiveness of corporate
governance mechanisms of the firm (Dwivedi and Jain, 2005).
We calculated Tobin’s Q ratio as a market value of equity plus book value of debt
divided by book value of total assets. Since debt is not traded in the Indian stock market
and replacement cost of assets is not available in case of Indian companies, so we used
book value of debt and total assets. Hence, we computed it as follows:
Tobin’s Q = 365 Days Average Market Capitalization + Book Value of Debt
100 Book Value of Total Assets
Debt here includes both short term and long term liabilities. So far as market
capitalization is concerned, we have considered annual average market capitalization and
this figure has been extracted out from the Prowess Database.
Impact of Corporate Governance on Financial Performance
233
7.2 Control Variables
The study of existing literature reveals that there are certain other factors also
which may affect the performance of the firms. These factors are size of the firm, age,
risk, leverage, industry type, etc. Therefore, it is essential to control these variables while
analyzing the impact of corporate governance on financial performance. The details of
control variables are given as below:
7.2 (a) Age
Age is considered to be a significant factor affecting the firm performance. Due to
the effects of learning curve and survival bias, older firms are considered to be more
efficient than younger ones (Chen, 2001). Older firms have established themselves firmly
in the market and are able to reap the benefits of the economies of scale which the
younger ones or newcomers find it difficult to achieve. The researchers have controlled
the impact of age while analyzing the impact of corporate governance mechanisms on
firm performance (Chen, 2001, Mohanty, 2002, Jog and Dutta 2004, Kim 2005, Phani et
al. 2005, Sheu and Yang 2005 and Mayur and Saravanan, 2006).
7.2 (b) Size of the Firm
Numerous researchers have examined the relationship between size and
performance of the firms. In product market, size reflects entry barriers that might result
from economies of scale and in capital market, size reflects financial barrier of entry due
to the ability of large companies to finance investment projects from internal sources as
well from issue of new equity (Phani et al., 2005). There are mixed evidences available in
the existing literature on relationship between size and firm performance. Chen (2001),
Mohanty (2002), Weir et al. (2003), Mollah and Talukdar (2007) found out significant
negative relationship between size and firm performance. On the other hand, Jog and
Dutta (2004) and Kim (2005) found significant positive relationship between firm size
and performance. There are no. of ways available for measuring the size of the firm.
Chen (2001), Kim (2005), Wan and Ong (2005), Saravanan (2006) and Mollah and
Talukdar (2007) have measured the size in terms of log of assets. While on the other
hand, Fuerest and Kang (2000), Carson (2002), Mohanty (2002) and Jog and Dutta
(2004) have considered market capitalization as proxy of a firm size. A few researches
Impact of Corporate Governance on Financial Performance
234
have measured size in terms of sales also (Weir et al. 2003, Phani et al. 2005 and
Subramanian, 2006).
In the present research, log of net sales has been used as a proxy of firm size. As
there is curvilinear relationship between the size and firm performance, we have
employed log of net sales instead of simply taking net sales figures. It is expected that
firms with larger size outperform the smaller ones due to the certain advantages of
economies of sales. So, it is essential to control the impact of size on firm performance.
7.2 (c) Risk
Risk denotes some degree of hazard which can result on account of various
factors such as short term fluctuations in profits, change in consumer tastes, change in
technology, change in government policy, strategic moves of competitors, etc. Risk is
associated with the future events. Since future is always uncertain and can’t be predicted
with accuracy. So, entrepreneurs have to take future decisions by keeping in mind the risk
factor. Based on the concept of ‘higher the risk, higher will be the return’, various
researchers have tried to find out the relationship between risk and profitability of the
firm. In line with Mohanty (2002), Jog and Dutta (2004) and Mollah and Talukdar (2007)
beta has been incorporated as a measure of risk.
7.2 (d) Leverage
Leverage has also been employed by researchers in their studies on firm
performance (Daily and Dalton, 1994; Chen, 2001; Carson, 2002; Dwievedi and Jain,
2005; Khiari, et al. 2005; Kim, 2005 and Mayur and Saravanan, 2006). When the firm’s
cost of debt is lower than the firm’s rate of return on its assets, then shareholders’ returns
in form of EPS and return on equity increase and hence, leverage will have favourable
impact on profitability. However, shareholders’ returns will fall, when the firm obtains
the debt at higher cost than the rate of return on its assets. There are mixed evidences
available in the literature on the relationship between leverage and profitability. Chen
(2001) found out the negative relationship between leverage and profitability. On the
other hand, Kim (2005), Khiari et al. (2005) examined the positive association between
leverage and profitability. There are various measures of financial leverage employed by
the researchers. But in line with Chen, 2001, Khiari et al., 2005 and Kim 2005 debt-
Impact of Corporate Governance on Financial Performance
235
equity ratio has been employed as a measure of financial leverage. We have used the
following formula to compute debt-equity ratio of the firm.
Leverage = Long Term Debt
100 Shareholder’s Funds
7.2 (e) Industry Effects
Industry characteristics have vital concern in the analysis of firm performance.
Firms in new and expanding industries are expected to outperform those operating in old
and declining industries (Kumar, 1985, Singh, 1997 and Kaur, 2005). The firms in those
industries, where exist growth opportunities, concentrated competitors and stable markets
should have higher profits than industries that are in decline (Coles et al., 2001). It has been
persistently shown that firms in a particular industry earn comparatively above normal
profits by virtue of some favourable structural characteristics (Amato and Wilder, 1990).
Like Mohanty (2002), Dwivedi and Jain (2005) and Mollah and Talukdar (2007), we have
captured the industry effects by introducing 8 industries dummies in regression model.
Table: 7.1
Summary of Control Variables Used in Various Studies
S.No Variables
Studies
Size Age Risk Leverage Industry
Effects
1 Daily and Dalton (1994)
2 Klein (1998)
3 Fuerest and Kang (2000)
4 Chen (2001)
5 Carson (2002)
6 Mohanty (2002)
7 Weir et al. (2003)
8 Jog and Dutta (2004)
9 Dwivedi and Jain (2005)
10 Khiari et al. (2005)
11 Kim (2005)
12 Phani et al. (2005)
13 Sheu and Yang (2005)
14 Wan and Ong (2005)
15 Mayur and Saravanan (2006)
16 Subramanian (2006)
17 Mollah and Talukdar (2007)
Impact of Corporate Governance on Financial Performance
236
7.3 Regression Model
In order to find out the impact of corporate governance on financial performance
of the companies, ordinary least square (OLS) regression model with enter method has
been employed. SPSS 13.00 version has been used to compute the results of multiple
regression models. The following models have been used to analyze the impact of
corporate governance on various measures of financial performance:
Model I
Net Profit Margin on Sales = 0 + 1 (Corporate Governance) + 2 (Age) + 3