ANALYSIS OF THE PROFITABILITY RATIOS OF HCL1

COMPANY PROFILE: HCL

Company overview HCL Enterprise is a leading Global Technology and IT enterprise that comprises two companies listed in India - HCL Technologies & HCL Infosystems. The 3-decade-old enterprise, founded in 1976, is one of India's original IT garage startups. Its range of offerings spans Product Engineering, Custom & Package Applications, BPO, IT Infrastructure Services, IT Hardware, Systems Integration, and distribution of ICT products. The HCL team comprises approximately 45,000 professionals of diverse nationalities, who operate from 17 countries including 360 points of presence in India. HCL has global partnerships with several leading Fortune 1000 firms, including leading IT and Technology firms. HCL Technologies is one of India's leading global IT Services companies, providing software-led IT solutions, remote infrastructure management services and BPO. Having made a foray into the global IT landscape in 1999 after its IPO, HCL Technologies focuses on Transformational Outsourcing, working with clients in areas that impact and re-define the core of their business. The company leverages an extensive global offshore infrastructure and its global network of offices in 18 countries to deliver solutions across select verticals including Financial Services, Retail & Consumer, Life Sciences & Healthcare, Hi-Tech & Manufacturing, Telecom and Media & Entertainment (M&E). For the quarter ended 31st December 2007, HCL Technologies, along with its subsidiaries had last twelve months (LTM) revenue of US $ 1.65 billion (Rs. 6715 crores) and employed 47,954 professionals. Born in 1976, HCL has a 3 decade rich history of inventions and innovations. In 1978, HCL developed the first indigenous micro-computer at the same time as Apple and 3 years before IBM's PC. This micro-computer virtually gave birth to the Indian computer industry. The 80's saw HCL developing know-how in many other technologies. HCL's in-depth knowledge of Unix led to the development of a fine grained multi-processor Unix in 1988, three years ahead of Sun and HP. HCL's R&D was spun off as HCL Technologies in 1997 to mark their advent into the software services arena. During the last eight years, HCL has strengthened its processes and applied its know-how, developed over 30 years into multiple practices - semi-conductor,

Tarumoy Chaudhuri, Student pursuing B.B.A. L.L.B. (Hons.) at National Law University (Jodhpur).

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operating systems, automobile, avionics, bio-medical engineering, wireless, telecom technologies, and many more. Today, HCL sells more PCs in India than any other brand, runs Northern Ireland's largest BPO operation, and manages the network for Asia's largest stock exchange network apart from designing zero visibility landing systems to land the world's most popular airplane.

INTRODUCTION TO RATIO ANALYSIS

When it comes to investing, analyzing financial statement information (also known as quantitative analysis) is one of the most important elements in the fundamental analysis process. At the same time, the massive amount of numbers in a company's financial statements can be bewildering and intimidating to many investors. However, through financial ratio analysis, they will be able to work with these numbers in an organized fashion. Purposes and Considerations of Ratios and Ratio Analysis Ratios are highly important profit tools in financial analysis that help financial analysts implement plans that improve profitability, liquidity, financial structure, reordering, leverage, and interest coverage. Although ratios report mostly on past performances, they can be predictive too, and provide lead indications of potential problem areas. Ratio analysis is primarily used to compare a company's financial figures over a period of time, a method sometimes called trend analysis. Through trend analysis, you can identify trends, good and bad, and adjust your business practices accordingly. You can also see how your ratios stack up against other businesses, both in and out of your industry. There are several considerations one must be aware of when comparing ratios from one financial period to another or when comparing the financial ratios of two or more companies.
If one is making a comparative analysis of a company's financial statements over a

certain period of time, an appropriate allowance for any changes in accounting policies that occurred during the same time span should be made
When comparing one business with another in the same industry, any material

differences in accounting policies between your company and industry norms should be allowed.

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 When comparing ratios from various fiscal periods or companies, inquiry about the

types of accounting policies used should be done. Different accounting methods can result in a wide variety of reported figures.
Determine whether ratios were calculated before or after adjustments were made to

the balance sheet or income statement, such as non-recurring items and inventory or pro forma adjustments. In many cases, these adjustments can significantly affect the ratios.
Any departures from industry norms should be carefully examined.

When we use ratio analysis we can work out how profitable a business is, we can tell if it has enough money to pay its bills. Ratio analysis can also help us to check whether a business is doing better this year than it was last year; and it can tell us if our business is doing better or worse than other businesses doing and selling the same things. The key question in ratio analysis isn't only to get the right answer: for example, to be able to say that a business's profit is 10% of turnover. We can use ratio analysis to try to tell us whether the business 1. is profitable 2. has enough money to pay its bills 3. could be paying its employees higher wages 4. is paying its share of tax 5. is using its assets efficiently 6. has a gearing problem 7. is a candidate for being bought by another company or investor and more, once we have decided what we want to know then we can decide which ratios we need to solve the problem facing us. Any successful business owner is constantly evaluating the performance of his or her company, comparing it with the company's historical figures, with its industry competitors, and even with successful businesses from other industries. To complete a thorough examination of your company's effectiveness, however, you need to look at more than just easily attainable numbers like sales, profits, and total assets. You must be able to read between the lines of your financial statements and make the seemingly inconsequential numbers accessible and comprehensible.

This massive data overload could seem staggering. Luckily, there are many welltested ratios out there that make the task a bit less daunting. Comparative ratio analysis helps you identify and quantify your company's strengths and weaknesses, evaluate its financial position, and understand the risks you may be taking. As with any other form of analysis, comparative ratio techniques aren't definitive and their results shouldn't be viewed as gospel. Many off-the-balance-sheet factors can play a role in the success or failure of a company. But, when used in concert with various other business evaluation processes, comparative ratios are invaluable. Not everyone needs to use all of the ratios we can put in these categories so the table that we present at the start of each section is in two columns: basic and additional. The basic ratios are those that everyone should use in these categories whenever we are asked a question about them. We can use the additional ratios when we have to analyse a business in more detail. Use and Limitations of Financial Ratios Attention should be given to the following issues when using financial ratios:
A reference point is needed. To be meaningful, most ratios must be compared to

historical values of the same firm, the firm's forecasts, or ratios of similar firms.
Most ratios by themselves are not highly meaningful. They should be viewed as

indicators, with several of them combined to paint a picture of the firm's situation.
Year-end values may not be representative. Certain account balances that are used to

calculate ratios may increase or decrease at the end of the accounting period because of seasonal factors. Such changes may distort the value of the ratio. Average values should be used when they are available.
Ratios are subject to the limitations of accounting methods. Different accounting

choices may result in significantly different ratio values.

USERS OF ACCOUNTING INFORMATION

The list of categories of readers and users of accounts includes the following people and groups of people: Investors Lenders Managers of the organisation

 Employees Suppliers and other trade creditors Customers Governments and their agencies Public Financial analysts Environmental groups Researchers: both academic and professional

WHAT DO THE USERS OF ACCOUNTS NEED TO KNOW?

Investors

to help them determine whether they should buy shares in the business, hold on to the shares they already own or sell the shares they already own. They also want to assess the ability of the business to pay dividends.

Lenders Managers

to determine whether their loans and interest will be paid when due might need segmental and total information to see how they fit into the overall picture

Employees

information about the stability and profitability of their employers to assess the ability of the business to provide remuneration, retirement benefits and employment opportunities

Suppliers and other businesses supplying goods and materials to other businesses will read trade creditors their accounts to see that they don't have problems: after all, any supplier wants to know if his customers are going to pay their bills! Customers the continuance of a business, especially when they have a long term involvement with, or are dependent on, the business Governments and their agencies the allocation of resources and, therefore, the activities of business. To regulate the activities of business, determine taxation policies and as the basis for national income and similar statistics Local community Financial statements may assist the public by providing information

about the trends and recent developments in the prosperity of the business and the range of its activities as they affect their area Financial analysts they need to know, for example, the accounting concepts employed for inventories, depreciation, bad debts and so on Environmental groups many organisations now publish reports specifically aimed at informing us about how they are working to keep their environment clean. Researchers researchers' demands cover a very wide range of lines of enquiry ranging from detailed statistical analysis of the income statement and balance sheet data extending over many years to the qualitative analysis of the wording of the statements

WHICH RATIOS WILL EACH OF THESE GROUPS BE INTERESTED IN?

Interest Group Investors Lenders Managers Employees Ratios to watch Return on Capital Employed Gearing ratios Profitability ratios Return on Capital Employed

Suppliers and other trade creditors Liquidity Customers Governments and their agencies Local Community Financial analysts Environmental groups Researchers Profitability Profitability This could be a long and interesting list Possibly all ratios Expenditure on anti-pollution measures Depends on the nature of their study

Therefore from the above table it is clear that profitability ratios are generally required by owners, managers, customers, governments and their agencies. There can be still more interest groups who will be interested in these ratios.

PROFITABILITY RATIOS
Profitability ratios are a class of financial metrics that are used to assess a business's ability to generate earnings as compared to its expenses and other relevant costs incurred during a specific period of time. For most of these ratios, having a higher value relative to a competitor's ratio or the same ratio from a previous period is indicative that the company is doing well. Profitability ratios focus on how well a firm is performing. Profit margins measure performance with relation to sales. Rate of return ratios measure performance with relation to the size of the investment. The owners and management or the company itself are interested in the financial soundness of the firm apart from its creditors. The management of the firm is naturally eager to measure its operating efficiency. Similarly, the owners invest their funds in the expectation of reasonable returns. The operating efficiency of a firm and its ability to ensure adequate returns to its shareholders depends ultimately on the profits earned by it. In other words, the profitability ratios are designed to provide answers to questions such as (i) (ii) (iii) (iv) (v) (vi) Is the profit earned by the firm adequate? What rate of return does it represent? What is the rate of profit for various divisions and segments of the firm? What are the earnings per share? What was the amount paid in dividends? What is the rate of return to equity shareholders?

The profitability ratios can be sub-divided into two categories: A. In relation to sales which include gross profit ratio, net profit ratio and operating profit ratio B. In relation to investments which include return on assets, return on return on capital employed and return on shareholders equity Profit is the difference between turnover, or sales, and costs: that is, Profit = Sales costs A profit margin is one of the profit figures we just mentioned shown as a percentage of turnovers or sales. They always tell us how much profit, on average, our business has earned per Rupee of turnover or sales.

In the following pages, these ratios have been evaluated and analysed in detail.

A. Profitability Ratios Related to Sales These ratios are based on the premise that a firm should earn sufficient profit on each rupee of sales. If adequate profits are not earned on sales, there will be difficulty in meeting the operating expenses and no returns will be available to the owners. These ratios are of three types which are discussed below.

1. Gross profit Margin:

A company's cost of sales, or cost of goods sold, represents the expense related to labor, raw materials and manufacturing overhead involved in its production process. This expense is deducted from the company's net sales/revenue, which results in a company's first level of profit, or gross profit. The gross profit margin is used to analyze how efficiently a company is using its raw materials, labor and manufacturing-related fixed assets to generate profits. A higher margin percentage is a favorable profit indicator. It is also known as gross profit ratio. Profit margin measures the relationship between profit and sales. Gross profit ratio is calculated by dividing gross profit by sales. Thus, Gross Profit Margin = Gross Profit x 100 Sales Significance and uses of gross profit ratios Gross profit ratio reveals profit earning capacity of the business with reference to its sale. Increase in gross profit ratio will mean reduction in cost of production or direct expenses or sale at reasonably good price and decrease in the ratio will mean increased cost of production or sales at lesser price. The true efficiency or profitability of the business cannot be understood by gross profit because profitability may be lesser, whereas gross profit is more. So the gross profit ratio has to be calculated in order to have the correct view of the business. The gross profit ratio also acts as a guide to the management in determining its selling and distribution expenses. There is no ideal standard for gross profit but it should be sufficient to cover the selling expenses o the firm. The effective stock control system can be adopted on the basis of gross profit ratio. Higher gross profit ratio is always in the interest of the business.

Causes responsible for increase in gross profit ratio Gross profit ratio may increase due to the following reasons: 1. Increase in the sale proceeds without corresponding increase in the cost of production or purchase price of goods. 2. Under valuation of opening stock 3. Over valuation of closing stock 4. Decrease in the cost of production or purchase price without corresponding decrease in sale price. 5. Decrease in direct expenses that is, expenses on acquiring or manufacturing goods 6. Omission of the invoices regarding purchases

Causes for decline in gross profit ratio 1. Purchasing of goods at relatively higher price. If the goods are purchased at comparatively higher price the cost of goods will increase and reduce the margin of profit. 2. Shortage of goods. Loss of goods due to theft, pilferage and spoilage will reduce the quantity of goods to be sold and the sales will decrease. As the firm has paid for these goods but is nor able to sell, the gross profits will fall. 3. Increase in the manufacturing expenses. An increase in the manufacturing expenses such as carriage, freight, wages and power will increase the cost of production and reduce the margin of profit. 4. Sales at comparatively low rates. Sales at lower rates will reduce margin of profit. Efforts should be made to sell goods at competitive price. The decline in the gross profit ratio must receive due attention of the management. Possible reasons for its decline should be identified, thoroughly investigated and the remedial measures applied. HCL Infosystems ends its financial year in the month of June. Let us now look at the Gross profit margin / Ratio of HCL Infosystems for the last three years: June 2005 (Rs. in crores)

7787-7141 Gross Profit Margin = 7787 x 100

646 = 7787 = 8.3 % x 100

June 2006 (Rs. in crores)

11455-10588 Gross Profit Margin = 11455 x 100

867 = 11455 = 7.57 % x 100

June 2007 (Rs. in crores) 11855-10800 Gross Profit Margin = 11855 x 100

1055 = 11855 = 8.9 % x 100

Gross profit Ratio

9 8.9

8.5
Gross Profit (in %)

8.3 8 Gross Profit 7.5 7.57

6.5 2005 2006 Year 2007

From the above chart it is clear that the gross profit ratio has dipped in the year 2006 before going to an all-time high of 8.9 % in 2007. The gross profit might have increased in absolute terms but it has not done so in relation to sales. The total business revenue in terms of sales has increased constantly over the years. But the gross profit ratio has not increased constantly.

2. Operating Profit ratio By subtracting selling, general and administrative (SG&A), or operating, expenses from a company's gross profit number, we get operating income. Management has much more control over operating expenses than its cost of sales outlays. Thus, investors need to scrutinize the operating profit margin carefully. Positive and negative trends in this ratio are, for the most part, directly attributable to management decisions. A company's operating income figure is often the preferred metric (deemed to be more reliable) of investment analysts, versus its net income figure, for making inter-company comparisons and financial projections.

Operating profit = Profit before interest depreciation and taxes = Profit before tax + Depreciation + Finance Charges

Operating Profit Operating Profit Margin = Sales X 100

June 05 (Rs. in crores)

Operating Profit Margin = 308 X 100 7787

= 3.96 % June 06 (Rs. in crores) Operating Profit Margin = 396 X 100 11455

= 3.46 %

June 07 (Rs. in crores) Operating Profit Margin = 454 X 100 11855

= 3.83 %

Operating Profit Ratio 4 3.9

Operating Profit (in %)

3.96 3.83

3.8 3.7 3.6 3.5 3.4 3.3 3.2 2005 2006 Year 3.46

Operating Profit

2007

The operating profit ratio has seen a steep decline in the year 2006. The ratio has recovered in the year 2007 but still it has not been able to reach the previous level of 3.96%. 3. Net Profit ratio Often referred to simply as a company's profit margin, the so-called bottom line is the most often mentioned when discussing a company's profitability. While undeniably an important number, investors can easily see from a complete profit margin analysis that there are several income and expense operating elements in an income statement that determine a net profit margin. It behooves investors to take a comprehensive look at a company's profit margins on a systematic basis. The net profit ratio tells us the amount of net profit per Rupee of turnover a business has earned. That is, after taking account of the cost of sales, the administration costs, the selling and distributions costs and all other costs, the net profit is the profit that is left, out of which they will pay interest, tax, dividends and so on.

Significance of net profit ratio Net profit ratio shows the operational efficiency of the business. Decrease in the ratio indicates managerial inefficiency and excessive selling and distribution expenses. In the same way, increase shows better performance. Increase or decrease in the ratio is determined in comparison to previous years performance. In case of increase, performance of the management should be appreciated and plus points reinforced. In case of decline in the net

profit ratio an investigation to find out causes for the decline in the net profit is made and corrective action should be taken to remove the causes responsible for the fall in the net profit ratio. Net profit = earnings after depreciation, interest and taxes Net Profit Ratio = Net Profit X 100 Sales June 05 (Rs. in crores) Net Profit Ratio = 228 X 100 7787

= 2.93 %

June 06 (Rs. in crores) Net Profit Ratio = 280 X 100 11455

= 2.44 % June 07 (Rs. in crores) Net Profit Ratio = 316 X 100 11855

= 2.67 %

Net Profit ratio

3.5 3
Net Profit (in %)

2.93 2.67 2.44 Net Profit

2.5 2 1.5 1 0.5 0 2005

2006 Year

2007

The net profit ratio has also declined in the year as it is not immune to the effects of the other ratios. But a point to be noted here is that the net profit ratio has not declined as steeply as the gross profit or operating profit ratios. This might be due to less dividend or interest paid. Users of the accounting information need to understand that the absolute numbers in the income statement don't tell us very much, which is why we must look to margin analysis to discern a company's true profitability. These ratios help us to keep score, as measured over time, of management's ability to manage costs and expenses and generate profits. The success, or lack thereof, of this important management function is what determines a company's profitability. A large growth in sales will do little for a company's earnings if costs and expenses grow disproportionately.

B. Profitability ratios related to Investments RETURN ON INVESTMENTS

1. RETURN ON ASSETS This ratio indicates how profitable a company is relative to its total assets. The return on assets (ROA) ratio illustrates how well management is employing the company's total assets to make a profit. The higher the return, the more efficient management is in utilizing its asset base. The ROA ratio is calculated by comparing net income to average total assets, and is expressed as a percentage.

Variations: Some investment analysts use the operating-income figure instead of the net-income figure when calculating the ROA ratio. The need for investment in current and non-current assets varies greatly among companies. Capital-intensive businesses (with a large investment in fixed assets) are going to be more asset heavy than technology or service businesses. In the case of capital-intensive businesses, which have to carry a relatively large asset base, will calculate their ROA based on a large number in the denominator of this ratio. Conversely, non-capital-intensive businesses (with a small investment in fixed assets) will be generally favored with a relatively high ROA because of a low denominator number. It is precisely because businesses require different-sized asset bases that investors need to think about how they use the ROA ratio. For the most part, the ROA measurement should be used historically for the company being analyzed. If peer company comparisons are made, it is imperative that the companies being reviewed are similar in product line and business type. Simply being categorized in the same industry will not automatically make a company comparable. As a rule of thumb, investment professionals like to see a company's ROA come in at no less than 5%. Of course, there are exceptions to this rule. An important one would apply to banks, which strive to record an ROA of 1.5% or above.

Return on Assets =

Net Profit X 100 Average Total Assets

Total Assets = Fixed Assets + Investments + Current Assets Average total assets = (Opening Balance of Assets + Closing balance of Assets) / 2 June 05 (Rs. in Crores) Return on Assets = 228 X 100 1351

= 16.88 % June 06

(Rs. in Crores) Return on Assets = 280 X 100 1721 = 16.27 % June 07 (Rs. in Crores) Return on Assets = 316 X 100 2260

= 13.98 %
Return on Assets
18 16 14
ROA (in %)

16.88

16.27 13.98

12 10 8 6 4 2 0 2005 2006 Year 2007 ROA

Here, it can be seen that there has been a steeper decline in the ROA ratio in the year 2007 as compared to the previous year. This is because the total assets have increased at a greater rate in the latter year rather than the previous year. This has resulted in a greater increase in the denominator of the ROA ratio as compared to its numerator which is the net profit.

2. Return on Capital employed

This is one of the most important ratios for the measure of profitability. It is also known as Return on Investment ratio. It indicates the relationship of net profit with capital employed in the business. Here, return for calculating the return on investment will mean the net profit before interest, tax and preference dividend. Net profit means net profit of the year

excluding undivided profit and reserves. Investment here means capital employed meaning long term funds.

Significance Return on investment ratio measures, the operational efficiency and borrowing policy of the enterprise. It also shows how effectively the capital employed in the business is used. It shows the earning capacity of the net assets of the business. The ratio judges the performance of even dissimilar business or different departments of the same business.

Loan component in capital employed Capital employed consists of shareholders funds and long term loans. Loans have always been a blessing for an efficient company, because it earns income at rates higher than the rate of interest paid by it on loans. Loans, if judiciously used in productive activities earn income more than what the interest is paid on them, so in these cases shareholders gain from loan being as part of capital employed.

Uses: 1. Return on investment is a very significant ratio for measuring operation efficiency of the management. 2. It measures overall profitability of the business. 3. It is used for comparing the performance of the different departments and sections of the organization. 4. It can also be used to compare the profitability of the firm with other firms of the industry. 5. It helps in making investment decisions. 6. It also assists in planning capital structure of the company. It enables the enterprise in deciding the ratio of various long term sources in the capital structure of the company. 7. It helps in determining the price of the product.

The return on capital employed (ROCE) ratio, expressed as a percentage, complements the return on equity (ROE) ratio by adding a company's debt liabilities, or funded debt, to equity to reflect a company's total "capital employed". This measure narrows the focus to gain a better understanding of a company's ability to generate returns from its available capital base.

By comparing net income to the sum of a company's debt and equity capital, investors can get a clear picture of how the use of leverage impacts a company's profitability. Financial analysts consider the ROCE measurement to be a more comprehensive profitability indicator because it gauges management's ability to generate earnings from a company's total pool of capital.

Variations: Often, financial analysts will use operating income (earnings before interest and taxes or EBIT) as the numerator. There are various takes on what should constitute the debt element in the ROCE equation, which can be quite confusing. Our suggestion is to stick with debt liabilities that represent interest-bearing, documented credit obligations (short-term borrowings, current portion of long-term debt, and long-term debt) as the debt capital in the formula.

Significance: The return on capital employed is an important measure of a company's profitability. Many investment analysts think that factoring debt into a company's total capital provides a more comprehensive evaluation of how well management is using the debt and equity it has at its disposal. Investors would be well served by focusing on ROCE as a key, if not the key, factor to gauge a company's profitability. An ROCE ratio, as a very general rule of thumb, should be at or above a company's average borrowing rate. Unfortunately, there are a number of similar ratios to ROCE, as defined herein, that are similar in nature but calculated differently, resulting in dissimilar results. First, the acronym ROCE is sometimes used to identify return on common equity, which can be confusing because that relationship is best known as the return on equity or ROE. Second, the concept behind the terms return on invested capital (ROIC) and return on investment (ROI) portends to represent "invested capital" as the source for supporting a company's assets. However, there is no consistency to what components are included in the formula for invested capital, and it is a measurement that is not commonly used in investment research reporting.

Return on Capital Employed =

Net Profit X 100 Average Total Capital Employed

Total Capital = Shareholders Funds + Loan Funds Average total Capital Employed = (Opening Balance of Total Capital + Closing Balance of Total Capital) / 2

June 05 (Rs. in Crores) Average Capital Employed = (644 + 500) / 2 = 646 Return on Capital Employed = 228 X 100 646

= 35.3 % June 06 (Rs. in Crores) Average Capital Employed = (793 + 644) / 2 = 719 Return on Capital Employed = 280 X 100 719

= 38.94 % June 07 (Rs. in Crores) Average Capital Employed = (1108 + 793) / 2 = 951 Return on Capital Employed = 316 X 100 951

= 33.23 %

Return on Capital Employed 40 39 38 37 36 35 34 33 32 31 30

38.94

ROCE (in %)

35.3 33.23

Return on Capital Employed

2005

2006 Year

2007

There had been a phenomenal increase in the average total capital employed in the year 2007 in comparison to the year 2006. On the other hand, the net profit has not been able to keep pace with this increase in capital employed. This has resulted in a steep decline in the ROCE ratio after a modest rise in the previous year. 2. Return on Shareholders Equity

This ratio indicates how profitable a company is by comparing its net income to its average shareholders' equity. The return on equity ratio (ROE) measures how much the shareholders earned for their investment in the company. The higher the ratio percentage, the more efficient management is in utilizing its equity base and the better return is to investors.

Significance of Return on equity This ratio reflects how effectively equity shareholders funds are utilized. It measures the operational efficiency of the management. Higher ratio is always in the interest of the enterprise, because it proves efficiency of the management. This ratio helps in the comparison of performance and decision making regarding declaration of dividend and creation of reserve.

Variations: If the company has issued preferred stock, investors wishing to see the return on just common equity may modify the formula by subtracting the preferred dividends, which are not paid to common shareholders, from net income and reducing shareholders' equity by the

outstanding amount of preferred equity.

Significance: Widely used by investors, the ROE ratio is an important measure of a company's earnings performance. The ROE tells common shareholders how effectively their money is being employed. Peer company, industry and overall market comparisons are appropriate; however, it should be recognized that there are variations in ROEs among some types of businesses. In general, financial analysts consider return on equity ratios in the 15-20% range as representing attractive levels of investment quality. While highly regarded as a profitability indicator, the ROE metric does have a recognized weakness. Investors need to be aware that a disproportionate amount of debt in a company's capital structure would translate into a smaller equity base. Thus, a small amount of net income (the numerator) could still produce a high ROE off a modest equity base (the denominator).

Return on Shareholders Equity =

Net Profit X 100 Average Total Shareholders Equity

Total Shareholders Equity = Capital + Reserves and Surplus

June 05 (Rs. in Crores) Average Total Shareholders Equity = (555 + 423) / 2 = 489 Return on Shareholders Equity = 228 X 100 489 = 46.63 %

June 06 (Rs. in Crores) Average Total Shareholders Equity = (698 + 555) / 2 = 627 Return on Shareholders Equity = 280 X 100 627 = 44.66 %

June 07 (Rs. in Crores) Average Total Shareholders Equity = (860 + 698) / 2 = 779 Return on Shareholders Equity = 316 X 100 779 = 40.56 %

Return on Shareholder's Equity 48 47 46 45 44 43 42 41 40 39 38 37

Return on Equity (in %)

46.63 44.66 Return on Shareholder's Equity 40.56

2005

2006 Year

2007

The return on equity ratio has gone down over the period of three years which is a natural consequence of the gradual increase in the net profit and a rapid increase in the amount of loans and reserves and surplus without any increase in the equity capital. As a result the numerator of the ratio has increased gradually and the denominator has increased rapidly. This has brought down the ratio.

OTHER PROFITABILITY RATIOS:

1. EARNINGS PER SHARE Earning per share The ratio measures the market worth of the shares of the company. Higher earning per share shows better future prospects of the company. It measures the return per share receivable by equity shareholders.

Earnings per Share = Net Profit available to Equity holders No. of Equity shares Outstanding June 05 (Rs. in Crores) Earnings per Share = 2280000000 33,436,354 = Rs. 68.19 June 06 (Rs. in Crores) Earnings per Share = 2800000000 168729255 = Rs. 16.59 June 07 (Rs. in Crores) Earnings per Share = 3160000000 169152650 = Rs. 18.68
Earnings per Share 80 70 60
EPS (in Rs.)

68.19

50 40 30 20 10 0 2005 2006 Year 2007 16.59 18.68 Earnings per Share

The earning per share had a steep decrease in the year 2006. This was a direct consequence of the sudden rise in the number of shares in the year 2006. The company had tried to come back by bringing up the EPS in 2007 to a modest 18.68 as the number of shares had not increased much during that period.

2. DIVIDEND PER SHARE It is the amount of the dividend that shareholders have (or will) receive, over an year, for each share they own. It is similar to the EPS. Here the proposed dividend (the dividend declared by the company) is divided by the total number of ordinary shares.

Dividend per Share = Dividend paid to Ordinary Shareholders No. of ordinary Shareholders outstanding June 05 (Rs. in Crores) Dividend per Share = 334694000 33,436,354 = Rs. 10 June 06 (Rs. in Crores) Dividend per Share = 337500000 168729255 = Rs. 2 June 07 (Rs. in Crores) Dividend per Share = 339100000 169152650 = Rs. 2

Dividend per Share 12 10

DPS (in Rs.)

10

8 6 4 2 0 2005 2006 Year 2007 2 2 Dividend per Share

The dividend per share has also fallen drastically from Rs. 10 to Rs. 2 in the last two years. This is because the proposed dividend of the company depends upon two factors, namely, the profits available for appropriation and the number of shares. As there was a great increase in the number of shares, the proposed dividend had to come down especially due to the slow rise in profits.

3. PRICE EARNINGS RATIO

In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio doesn't tell us the whole story by itself. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects. The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings. It is important that investors note an important problem that arises with the P/E measure, and to avoid basing a decision on this measure alone. The denominator (earnings) is

based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number. Price Earnings ratio = Market price of shares Earning per share June 05 (Rs. in Crores) Price Earnings ratio = 756 68.19 = 11.09 June 06 (Rs. in Crores) Price Earnings ratio = 140 16.59 = 8.44 June 07 (Rs. in Crores) Price Earnings ratio = 185.3 18.68 = 9.92
Price Earnings Ratio 12 11.09 10
P/E Ratio

9.92 8.44 Price Earnings Ratio

8 6 4 2 0 2005

2006 Year

2007

The market value of the shares of HCL Infosystems has fallen in the year 2006 due to reduced EPS. This ratio reflects the price currently being paid by the market for each rupee of currently reported EPS. Since the EPS had fallen steeply in 2006, the Price earnings ratio has also come down. Then with an increase in the EPS the market had also reposed some trust in the company due to which the P/E ratio has risen in 2007.

SWOT ANALYSIS
Strengths: It has a large customer base in South India that can be utilized for introducing new products. Infosystems, network integration is a logical high that it had to take in a network-centric IT world. In the process, it gave its IT services customers benefit of a one-window source for not only IT hardware/software solutions, but also their networking needs. This IT powerhouse strongly believes that at the end of the day, applications is what matters to customers. HCL Infosystems has built a service model that utilizes all its intrinsic advantages. It has a layer of IT/networks support available in 151 locations as its foundation. For this integrator, the emphasis has been on the traditional manufacturing, and banking and finance sectors. It won two huge orders for networkingBank of Rajasthan and Indian Overseas Bank.

Weaknesses: Networking is a relatively new field for HCL It is not known for its networking solutions The initial research costs have run high which is reflected in its profitability ratios Large companies may opt for relatively experienced network service providers

Opportunities: However, it is aggressively looking to tap emergsing markets like the ISP and telecom sector. It has already done a few projects in this area with the implementation of its own sister company HCL Infinet. Likewise, this year HCL Infosystems is confident to do well in CTI, unified messaging and e-business solutions area, with the recent tie-up with Intel.

Threats: There are more established and focused players in the software market in India like Infosys.

Besides, software piracy has a direct effect on the revenue of these firms. To prevent this, a lot of money has to be spent.

RECOMMENDATIONS
On the basis of the above profitability analysis, the following recommendations are made: 1. Profitability ratios related to sales: Special attention has to be paid to the profitability ratios related to sales. The gross profit ratio has to be paid special attention to ensure that it grows at the same pace in which it has started growing from the last year. For this the cost of sales has to be brought down on the one hand and on the other hand, the revenue from sales has to be increased. For increasing sales, aggressive advertising and marketing strategies have to be taken. This might result in increase of selling expenses initially thereby affecting the operating profit. But it would reap benefits for the company ion the long term. Funds could also be diverted towards research and development of new software and improved hardware as these markets are very dynamic and there is strong competition in these markets. If the profit margins go down again like what happened in 2006, investor confidence on the ability of the companys capacity to give steady returns will diminish. Special attention should also be paid to the operating and net profit ratios which have not been able to come up to the levels achieved during 2005. For this, the administrative and selling expenses have to be brought down by way of efficient management. Also, a proper and effective dividend policy has to be adopted. If very low dividends are proposed then the net profit may be high but the market prices of shares may go down. So an optimum level of dividend has to be proposed.

2. Return on Assets: Coming to the profitability ratios related to investments, the ROA ratio has shown a trend of going down which is not good. The gross block has gone up but the investments have come down which is not a very healthy sign. The company should concentrate more on investments so that it can get return on its investment. The present investment policies do not seem to be very fruitful. The company should invest in places where the rate of return is higher.

3. Return on Capital Employed: The return on investment or capital employed is in a serious situation indeed. The number of shares has increased rapidly in the last year.the sudden increase in capital in the last year has been due to two main reasons, namely, increase in reserves and surplus and increase in unsecured loans. On the other hand, there has been no increase in the capital at all. So this shows that the funds of the company by way of reserved profits are not utilized properly. The held up reserves and surpluses are not even invested fruitfully. Besides, the quantum of unsecured loans has also increased which is another ominous sign for the business. So the company should try to pay off its debts and raise more equity capital from the market. All these can happen only if the company makes proper policies in order to enhance sales, make fruitful investments, increase its goodwill in the market, etc.

4. Return on shareholders equity: The return on shareholders equity has also gone down simply because there had been a phenomenal rise in capital employed in the form of unsecured loans and reserves and surplus with little increase in the net profit on the other hand. This situation should be tackled as soon as possible or else the shareholders will lose confidence in the companys performance capacity and withdraw their money.

5. Earnings per Share, Dividend per Share & Price Earnings ratio: The EPS had taken a nosedive in the year 2006 due to the sudden rise in the number of shares. The EPS had now become stable because there had not been much rise in the number of shares in the last year. But the point of concern for the company should be that the EPS is very low, a mere Rs. 18.68. The EPS can be increased by only one way presently that is by increasing the amount of profit available for appropriation. The company should distribute a part of is reserves and surplus as it cannot invest that money efficiently now. The benefit of doing this would be that the DPS and the P/E ratio would go up and thus repose investors confidence in the company for the time being. The DPS and the P/E ratio are directly affected by the EPS. So they have also gone down along with the EPS though the P/E ratio has shown some signs of improving.

LIMITATIONS
1. Difficulty in comparison Firstly, HCL Infosystems closes its books on June 30 every year which is not the usual date of year ending for most of the companies. This creates difficulty in comparing the financial figures of HCL Infosystems with other companies in the same industry. 2. Conceptual diversity The companies operating in the same industry might follow different accounting policies. The choices of accounting policies may distort inter company comparisons. 3. Creative accounting or Window Dressing The businesses apply creative accounting in trying to show the better financial performance or position which can be misleading to the users of financial accounting. In order to improve on its profitability level the company may select in its revaluation programme to revalue only those assets which will result in revaluation surplus leaving those with revaluation deficits still at depreciated historical cost. 4. Ratios are not definitive measures Ratios need to be interpreted carefully. They can provide clues to the companys performance or financial situation. But on their own, they cannot show whether performance is good or bad. Ratios require some quantitative information for an informed analysis to be made. 5. Outdated information in financial statement The figures in a set of accounts are likely to be at least several months out of date, and so might not give a proper indication of the companys current financial position. 6. Seasoned factors As stated above, the financial statements are based on year end results which may not be true reflection of results year round. Businesses which are affected by seasons can choose the best time to produce financial statements so as to show better results.

CONCLUSIONS
On the basis of the above analysis and discussion, it can be said that HCL Infosystems are in the recovery stage now after going through a recessionary phase in 2006. But if the top

management does not frame suitable, efficient and affective policies at this stage, the overall profitability of the company may go down again. The recommendations made could be effective if they are implemented after doing a thorough cost analysis of the various departments. The company has to make a favorable impression in the minds of the investors. Only then it can aim for the success of its products and services. If the investors faith goes away, they may withdraw their money from the company which would result in a financial crunch for the company. The profitability ratios present a true picture of the companys performance. The actual figures may mislead the management if they are not compared with other ratios by way of various ratios.

ANNEXURE 2005

2006

2007