Analysis of determinant factors of a companys performance

Author: Nicolescu Elena Irina Coordinator Prof. Univ. Dr. Ion Stancu

Introduction In this paper I tried to introduce the concept of performance and the most important factors that influence the profitability of a company. Company`s performance is influenced both by micro factors, internal factors, specific to the company and by macro or external factors specific to the state or to the region. In what follows I will make a short presentation of the theoretical part together with the most important studies made in this field. Then using a database and a statistically well-founded methodology I will analyze the influence of these factors on company profitability. Theoretical framework A considerable number of studies addressing the performance issue from microeconomic to macroeconomic prove it has great importance for financial management. Performance measurement is important for every company operating on the market. Performance assessment of an enterprise is very important because it helps improve future work. An interesting study for analyzing the performance is one made by Hansen and Wernerfelt (1989) includes two models for the company`s profitability, one that used economic factors and one with organizational factors. The economic factors model has its basis on traditional economy highlighting the importance of external market factors in determining the success of the firm. The other model, the organizational one, is built on behavioral and sociological paradigm. The results confirm the importance and independence of the two factors in explaining the performance. They found that the organizational factors explain twice more the variation in profit rates than the economic ones. Taking into consideration that in this study we will limit in studying the effects regarding microeconomic factors upon the company`s performance the idea of studying the organizational factors in Romania can be one of the next research. Brush, Bromiley, and Hendrickx (1999) see that both the company and the industry where the company is included can influence profitability, only that the firm has a greater influence. In the end, they found a considerable effect of the microeconomic factors upon the company`s performance, an effect that seems to be greater than the industry`s effect. This effect of the industry we will search through EVA indicator, where we determined a capital cost different for each industry.

Other authors have analyzed the determinant factors of the performance by establishing if these factors measure market values or book values(Hirschey i Wichern, 1984). They found that there are differences between accounting indicators and market indicators of the return and suggest that the influence of the accounting indicators should be seen as a historical interpretation unlike the market indicators of the return that give a future vision. Moreover they see that there is a set of significant factors when it comes to measuring performance such as the intensity of research and development costs, TV advertising, leverage and industry cost. Indicators involved in the regression analysis of economic performances are numerous. Models used to study the impact caused by the allocation and use of capital in the company on company profitability have been proposed by many authors, even for the Romanian market (Dumbrava, 2010). Dumbrava found to be determinants of profitability turnover, leverage and market to book ratio. Recent literature analyzing the profitability of companies from different countries and sectors of the economy through indicators such as return on total assets (ROTA) (Deloof, 2003), financial return (Padachi, 2006), invested capital (ROIC), return on assets (ROA) (Narware, 2010). In these cases, factors considered in the analysis of profitability, independent variables are financial ratios expressing working capital. Return to the micro level was also studied, according to indicators such as turnover, working capital to total assets. Other performance evaluation studies looked at the earnings before interest and taxes (EBIT) and risks using a particular influence on financing structure (Akintoye, 2008) or economic value added (EVA), return on equity (ROE) and operating profit margin (OPM), (Ryan, 2008). Ciobanu (2006) performed an analysis of the determinants of companies listed on BSE performance. In our study we retained and some of those in this article. There are many works studying rates of return of the company and factors that may affect this. For this paper we considered a number of four indicators relevant to measure effectiveness and profitability of these companies: economic profitability (ROA), return on equity (ROE), economic value added (EVA), and return on enterprise sales (ROS). Given the approaches in the literature, I have found interesting views on the first three of them so I decided to talk at length about them in this chapter, following in chapter of methodology to deal with the other indicators and factors affecting them. Database

The database used in this study includes companies listed on BSE for the period 2009-2011. Number of companies was originally considered 40, and finally after successive eliminations, the database included only 27 companies. The first companies that were removed were those which reported losses for all years taken into account. Since we need to notice an impact on company performance was not relevant to take situations where the net profit was negative. We also eliminated companies for which equity was negative (Oltchim SA), because a negative equity and negative net income, get a positive financial return. Second, we eliminated companies for which we have not had sufficient information to conduct rigorous studies. All information was obtained from the following sources: web sites that provide information on companies listed on BSE, such as www.bvb.ro and www.ktdt.ro financial statements (profit and loss account and balance sheet) published on the company website. The indicators used in this study are primarily indicators that quantify performance such as company financial return (ROE), economic profitability (ROA), return of Exploration (EBIT / CA), and economic value added (EVA). Also to see the influence factors of these indicators we considered other indicators that will be presented in detail in the chapter on research methodology. In the following we present the averages of these indicators for years considered in the study from 2009 to 2011. Each indicator expresses the average indicators for each of the 27 companies studied. Table of indicators registered of each company is attached. Table 1. Mean performance companies

Year ROE ROA ROS (EBIT/CA)EVA (mii lei)

2009 4.09% 6.77% 12.88% -51469.67 2010 5.96% 7.56% 15.10% -18552.66 2011 6.82% 8.43% 16.16% 93136.34

Notice that in all three years, return on equity is positive and growing, but is lower than the economic profitability, which shows that the average cost of debt is high, even higher yield obtained by the shareholders. This is mainly due to financial crisis in Romania that took place between 2008-2009. One can notice a lower value of the indicators for 2009 compared with the other two years. Regarding the indicator EVA see that it is positive only in 2011 indicating a return to higher performance of companies operating on the capital market in Romania. All these things are highlighted in the chart below.

Research Methodology

1.Indicators used in the analysis In this chapter I will present the main modeling methods used to find the determinants of performance of companies in Romania. I will start by presenting the main rates characterizing the performance of particular companies such as economic profitability (ROA - Return of assets), return on equity (ROE) and economic value added (EVA). After presenting these indicators I have continued with regression equations where the variables were considered as dependent and as independent variables we considered that microeconomic indicators, both as book values and as market values. Economic profitability measures efficiency of resource allocation and its quality management. It is an indicator measuring the effectiveness of company assets. Brealey and Myers1 believe that managers measure the total performance of a company by dividing the total income to total assets. It is better to use net income plus interest, because this measure shows the return on all assets of the company, not just capital investment:

, where

is earning before interest and taxes AE0 economic asset of the company at the begining of the year

In view of other authors, Stancu2 (2007) emphasizes the use of total asset performance of an enterprise, the invested capital to get this performance. The economic profitability must allow shareholders and creditors pay, according to the risk by investing in the company or giving them loans. 1 Brealey, Richard A. Myers, Stewart C. Fundamentals of corporate finance, ediia a patra, McGraw-Hill, 20042 Stancu, I., Finane. Piee financiare i gestiunea portofoliului. Investiii directe i finanarea lor, Ediia a 4-a, Ed. Economic, Bucureti, 2007;

Return on equity (ROE) is one of the major indicators watched by investors and management. With this rate, investors can assess whether their investment is profitable or not. In analyzing the rates of overall efficiency, detach the idea of creating additional value for shareholders. (Stancu, 2007)

,where PN1 net profit of the company at the end of the year CPR0 equity of the company at the begining of the year

EVA is the most commonly used indicator to assess growth in value of an enterprise. Economic value added is defined by Stren Stewart & Co. as net operating profit of the company minus the opportunity cost of capital invested in fixed assets and assets of the enterprise. It is also an estimate of the company's economic profit or net profit since the company is greater than the minimum requirement of return that investors would require any investment with similar risk (Stancu, 2007). Brealey and Myres define EVA as a company's net profit after deduction of capital costs. The formula proposed for determining EVA is:

EVA=Capital costs* (ROA-k)

We calculated values for economic value added, keeping fixed capital cost of keeping all three years and the economic returns and capital invested will be variable. Given the low economic return in years to study and take a relatively high value of the cost of capital for most companies have obtained a negative EVA, which means that during the analyzed period companies reported losses in the capital invested. To check which are the factors that influence business performance we used studies in the literature worldwide (Narware, 2010) or those made for Romania (Dumbrava, 2010). In these studies were used indicators such as tangible assets, company size, liquidity and growth opportunities (market to book ratio or price-earning ratio), etc., and we have added others to capture the influence of other factors on company performance. We used, in turn, as the dependent variable indicators presented earlier in this chapter, namely financial return, economic return, return from the exploitation and economic value added. To check the impact of these factors considered independent variables on the profitability of the company we used multiple regression and the regression method we used OLS (Ordinary Least squares). First I checked if there is not multicolinearity between the explanatory variables otherwise the regression results were flawed. We removed from the original records where

recorded negative net income because PER indicator would have no relevance. I also removed where leverage recorded values over 300%, because they are not relevant to the study. First I checked the stationarity of data series, this is necessary because we talk about time series. Then, to test data multicolinearity I made the correlation matrix for the indicators taken into account. 2. Analysis of the determinants of financial profitability As I mentioned above, we will make a multiple regression as the dependent variable is financial return. The equation is: ROE = C(1) + C(2)*TANG + C(3)*LNCA + C(4)*LEVERAGE + C(5)*COVER + C(6)*DURATAACR + C(7)*PER, where ROE is return on equity Tang is the share of fixed assets in total assets Lnca is the logarithm of turnover expressed in nominal values Leverage is the ratio between current liabilities and equity Coverage is coverage of interest in operating profit DurataACR is the duration of current assets through the turnover PER is price earning ratio In this case after the first test we observed that both the duration current assets and PER are insignificantly different from 0, so we rebuilt regression only with the first four indicators: ROE = C(1) + C(2)*TANG + C(3)*LNCA + C(4)*LEVERAGE + C(5)*COVER

Given that liquidity was correlated both with the duration of current assets and interest coverage, we conducted another regression to test whether this indicator has influence on financial profitability. ROE = C(1) + C(2)*LIQUID, where liquid is generally liquidity determined as the ratio of liquidity assets and current liabilities or

short term.

Liquidity ratio appeared to be significantly different from 0 and so I did not include the results of this regression in the next chapter. Note that in this case free factor came to be significant and the coefficient of determination modest of 11%. 3. Analysis of the determinants of economic profitability (ROA)

As for financial return, we modeled the economic profitability of companies in conjunction with microeconomic indicators registered in the company. ROA = C(1) + C(2)*TANG + C(3)*LNCA + C(4)*LEVERAGE + C(5)*COVER + C(6)*DURATAACR + C(7)*PER In this case after the first test we observed that only the weight ratio of fixed assets in total assets resulted to be insignificant, and the leverage is significant at a level of 10%. In these conditions we recovered regression in this form: ROA = C(1) + C(2)*LNCA + C(3)*LEVERAGE + C(4)*COVER + C(5)*DURATAACR Given that liquidity was correlated both with the duration of current assets and interest coverage, we conducted another regression to test whether this economic indicator has influence on profitability.

ROA = C(1) + C(2)*LIQUID Liquidity ratio appeared to be significantly different from 0 unlike the situation in case of financial profitability; one possible explanation is that the economic return is an average return of all invested capital and not just equity. It should be noted that in this case free factor came to be significant and the coefficient of determination modest 10%. 4. Analysis of the determinants of commercial profitability (ROS - Return on sales) As the cases above, we modeled the commercial profitability of companies in conjunction with microeconomic indicators registered in the company. ROS = C(1) + C(2)*TANG + C(3)*LNCA + C(4)*LEVERAGE + C(5)*COVER + C(6)*DURATAACR + C(7)*PER Again after a first test I noticed that two of the coefficients are insignificantly different from 0, namely leverage ratio and PER. In these conditions we recovered regression in this form: ROS = C(1) + C(2)*TANG + C(3)*LNCA + C(4)*COVER + C(5)*DURATAACR Given that liquidity was correlated both with the duration of current assets and interest coverage, we conducted another regression to test whether this indicator has influence over commercial profitability. ROS = C(1) + C(2)*LIQUID

Liquidity ratio appeared to be insignificantly different from 0 and so did not include the results of this regression in the next chapter. Note that in this case free factor came to be significant and the coefficient of determination modest 11%. Because EVA indicator showed mainly negative values we did not considered necessary modeling because there would be some inconclusive results without a solid economic foundation. Results In this chapter we presented the results of my research on the determinants of enterprise performance. Specifically, we used regression equations proposed in the chapter on research methodology and data series we modeled statistically. Note that we considered linear dependencies between variables taken into account. We used EViews software to perform regression analysis. For each equation in hand, we checked all the factors to be significant; otherwise they were removed from the regression. In this way, we left only factors that were significant. Subsequently, all results were generated and discussed, and also conducted a statistical analysis of results (the model coefficients, the coefficient of determination R2, the adjusted coefficient of determination or F test for model validation). 1. Parameter estimation for financial profitability (ROE) As mentioned in the chapter on study methodology, in this case we performed a multiple regression with annual data of 27 companies for 2009-2011. The equation is: ROE = C(1) + C(2)*TANG + C(3)*LNCA + C(4)*LEVERAGE + C(5)*COVER The coefficient of determination of the model is 0.64, a value relatively high, suggesting that the model captures about 64% of the total variance. Adjusted coefficient of determination is close to 0.62. F test analysis comes to validate the proposed model. Probability in this case is close to 0 which validates the results. Economically speaking, financial return is positively influenced by turnover and interest coverage and negatively by leverage and fixed assets share in total assets. This last indicator showed that the negative influence is mainly because the period of analysis. Generally companies with a large number of property operating in industrial, manufacturing, a sector hard

hit by financial crisis. From another point of view these companies get a return on equity moderate, but fairly constant, compared with enterprises having as main activity the provision of services, where equity have a reduced rate resulting in higher profitability. This indicator is expressed as a percentage and with a fairly low coefficient of only -0.08, indicating that there will be a great influence on the final result. As I said in the chapter on methodology, variable liquidity, price-earning ratio and duration of current assets in turnover did not come out to determine significant financial return. Diversity of specific sectors and firms lead to different values in terms of assets and accounts payable. If we had used companies working in the same sector of activity is very likely that these indicators provide a visible influence on company profitability by return on equity. 2. Parameter estimation for economic profitability (ROA) As for financial return, we modeled the determinants of economic profitability of 27 companies with annual data for 2009-2011, the following equation: ROA = C(1) + C(2)*LNCA + C(3)*LEVERAGE + C(4)*COVER + C(5)*DURATAACR The coefficient of determination of the model is even higher than ROE model is 0.69, a value relatively high, suggesting that the model captures about 69% of the total variance. Adjusted coefficient of determination is close to 0.67. F test analysis comes to validate the proposed model. Probability in this case is close to 0 which validates the results presented above. Economically speaking, economic profitability is positively influenced by turnover, interest coverage and duration in current assets turnover and negative leverage. Unlike ROE and ROS like we will see, liquidity has an influence on ROA in statistical terms. Yet this statement must be pretty book because the model has a coefficient of autocorrelation of only 10%. Economically speaking is difficult to say that this variable can be considered important determinant of economic profitability. 3. Parameter estimation for commercial profitability (ROS) As for financial and economic profitability, we modeled the determinants of business profitability with annual data of 27 companies for 2009-2011, the following equation: ROS = C (1) C (2) * TANG C (3) * Inca C (4) * COVERAGE C (5) * DURATAACR The coefficient of determination of the model is relatively high of 0.58, a value relatively high, suggesting that the model captures approximately 58% of the total variance. Adjusted coefficient

of determination is close to 0.55. F test analysis comes to validate the proposed model. Probability in this case is close to 0 which validates the results. Economically speaking, commercial profitability is positively influenced by weight in total fixed asset turnover, interest coverage and duration of current assets in turnover. As with ROE, statistically, liquidity has not a significant influence on ROA. Diversity of specific sectors and firms lead to different values in terms of assets and accounts payable. Also another indicator that is not significant is leverage because the cost of debt does not affect the operating result or turnover and therefore variation of this indicator is not correlated with business profitability. 4. General features of factors influencing the profitability of companies and its prediction for the near future In this chapter we intend to achieve a synthesis of previous results and a general comment on the determinants of corporate performance. We must remember that we tried to quantify the performance of companies through four indicators: return on equity, economic and commercial and economic value added. We begin by explaining the state of economic value added. As the methodology presented in this chapter EVA is added value to investors by operating activity of the company. The database used was composed of a number of 27 companies listed on Bucharest Stock Exchange for the period 2009 to 2011. Because a relatively high expected return of 14.84% and relatively poor results for this period found in most companies, the indicator has given over 70% negative, which made it impossible to develop a model for EVA. If we follow the results obtained from modeling returns studied, we could say that investors can rely on the Romanian market accounting information contained in the indicators calculated, and their investment decision can have as a source of information the financial reports listed of the companies. The table from below shows which factors influence the profitability and the direction of this influence. If the factor is significant then we remember the influence it has on profitability (+) if a positive, (-) if negative. If one factor was insignificant, we noted in the table with (n). One can see that the PER does not affect liquidity and profitability in the period while turnover size or coverage of interest always have a positive influence. Table 2 Influences on performance determinants

ROE ROA ROS IMO/AT (-) (n) (+)

CA (+) (+) (+) Leverage (-) (-) (n) Liquidity (n) (n) (n) Durata ACR (n) (+) (+) EBIT/Dob (+) (+) (+) PER (n) (n) (n)

If we were to make a forecast for the near future, company performance seen in terms of indicators of its determinants, we could say that is expected to improve corporate profit. We used the published financial statements after the first quarter of 2012 and noticed the following: 1) share of the fixed assets turnover - in most cases is kept the same so the influence of this factor may be excluded from the forecast 2) Turnover increased from same period last year over 72% of cases, indicating an improvement in sales and will lead to an increase in profit and profitability. Given that, we found a positive relationship between this indicator and profitability we can say that only from this point of view, companies will gain in 2012 relative to 2011. 3) leverage is maintaining constant, companies are quite indebted from 2008-2009 4) The ACR in turnover improves, companies are beginning to collect receivables from customers and stocks are falling, so more money in cash and increasing profitability. This indicator has a positive impact on profitability 5) Coverage of debt is increasing and will positively influence all indicators to quantify a company's profitability. Conclusions The purpose of this study was to identify determinants of profitability of companies operating on the capital market in Romania. Finding accountant financial factors to estimate the full performance is an approach quite difficult. Profitability of a company is not explained only by microeconomic factors such as financial accounting results or performance of a particular industry. It should be considered macroeconomic factors such as inflation, unemployment, economic crises, the evolution of GDP, etc., but also qualitative factors such as innovation capacity of companies, knowledge manager's, etc.. To quantify the performance we considered four installments, of which only three could be modeled (ROE, ROA, ROS). For each we checked their influence on fixed assets, turnover, and price earning ratio, duration of current assets by turnover, leverage and liquidity. The results were significant for most of them, and regression models were validated with a coefficient of determination above 60%.

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