Profitability Analysis of Acquiring Companies

Fulbag Singh* and Monika Mogla**

This study examines the profitability of acquiring firms in the pre- and post-merger periods. The sample consists of 153
listed merged companies. Five alternative measures of profitability were employed to study the impact of mergers on the
profitability of acquiring firms. The results reveal that profitability declined in 55% of companies, and only 29% of
companies could improve their profitability. DuPont analysis reveals that profitability declined due to poor asset
utilization. It suggests that managers should give due attention to proper utilization of newly acquired assets. Acquisition
of neither healthy nor loss-incurring units contributed to the profitability of acquirers.

Introduction
In the past few years, India has followed the worldwide trends in consolidation amongst
companies through Mergers and Acquisitions (M&A). Companies are being taken over,
units are being hived off, joint ventures are being forged, and so on. Restructuring old business
has become a necessity in the wake of globalization and liberalization. As restrictions and
controls have been minimized in the new regime, restructuring has become essential.
Restructuring involves major organizational change, which includes change in corporate
strategies to meet increased competition. This can take place either internally in the form of
new investments in plant and machinery, and Research and Development (R&D), or it can
take place externally through M&A or joint ventures.
Merger is defined as combining two or more companies into a single entity where one
survives and the other loses its corporate existence. The survivor acquires the assets as well
as liabilities of the merged company or companies. Generally, the company which survives is
the buyer, and it retains its identity and the seller company is extinguished. Though
liberalization, initiated in 1991, propelled the M&A activity, yet the actual activity in the
Indian context is said to have started after 1994.
Many explanations have been advanced as to why mergers occur. Mergers are basically
inspired by two reasons: profit maximization and growth maximization. Profit maximization
benefits shareholders, as profits are distributed among shareholders, whereas
growth-maximizing mergers aim at expansion of size in terms of assets or capital employed
and net sales. Such mergers are inspired by the pursuit of managerial self-interest and are not
intended to improve profitability. The managerial interests may lead to the emergence of
‘unsuccessful’ mergers in terms of profitability and account for the poor average performance
often noted in the literature.

* Professor, Department of Commerce and Business Management, Guru Nanak Dev University, Amritsar 143005,
Punjab, India. E-mail: [email protected]
* * Lecturer in Commerce, Apeejay College of Fine Arts, Mahavir Marg, Jalandhar 144001, Punjab, India; and is
the corresponding author. E-mail: [email protected]

© 2010 IUP. All Rights Reserved.

72 The IUP Journal of Applied Finance, Vol. 16, No. 5, 2010
 Profit maximization hypothesis states that successful mergers must lead to enhanced
profitability of merging companies. A number of reasons have been quoted in the literature
as to how these gains may arise. The acquiring firm may obtain economies of scale by expanding
its operations geographically by acquiring another firm in a different region or it may seek
economies of scope by expanding its product line. Profitability may also be increased by
increasing the market share or vertical integration or diversification.
Another viewpoint is the impact on profitability through selection in the capital market.
This argument is based on the view that merger leads to efficiency improvements not through
any scale or complementary factors, but simply through the replacement of inferior by superior
management of existing assets in the market for corporate control (Cosh et al., 1995).
Profitability is not the objective of merger in all the cases. Therefore, only those mergers that
are inspired by the pursuit of managerial self-interest may appear to be unprofitable.
Whether mergers lead to improved performance is a debatable issue. Many studies have
examined the long-run operating performance of the acquiring firms after mergers. Using
this approach, research reports that on an average, takeovers reduce the value of the acquiring
firm (Meeks, 1977; Cosh et al., 1980; Clark and Ofek, 1994; Kruse et al., 2002; and Yeh and
Hoshino, 2002). However, a conclusion of underperformance is not conclusive, as results are
not all one-sided. Some studies, such as Healy et al. (1992), Heron and Lie (2002) and Rahman
and Limmack (2004), have documented a significant improvement in operating performance
after acquisitions.
Performance after mergers is a relative concept. Analysis of performance changes after
the merger is helpful in understanding the outcome of mergers. All the theoretical benefits
of mergers can be tested by analyzing the performance changes over the long run. Many
studies have compared the performance of the merged companies between the pre- and
post-merger periods. The purpose of this study is to provide a thorough analysis of the changes
in the post-merger profitability of the acquiring firms.
The study presents evidence on three issues. First, to assess the impact of mergers on the
profitability of the acquiring firms, the study compares the firms’ post-merger period
profitability with their pre-merger period profitability. Second, the decline in profitability
may be either due to poor asset utilization or lower operating profit margins. DuPont analysis
has been done to find out the causes for decline in profitability. Third, changes in profitability
are analyzed for two groups, i.e., loss-incurring acquisitions and healthy acquisitions.
This analysis helps to answer whether mergers are used as a tool to rehabilitate loss-incurring
units.
The contribution of this study is two-fold. First, we have employed five alternative measures
of profitability. Thus, sensitivity of the results to variation of the accounting measures is
ensured. Second, the sample spans the merger boom period, starting after 1994. Conclusions
are based on the mergers completed in the post-liberalization period.

Profitability Analysis of Acquiring Companies 73

Review of Literature
The economic consequences of mergers have been discussed in a large number of studies.
The empirical literature on the financial effects of M&A provides two sources of statistical
evidence—stock market data and accounting-based data. The scope of this study is limited to
accounting data-based studies.
The comparison of corporate performance before and after merger is used to determine
whether mergers result in gains. By comparing pre- and post-merger data, performance changes
resulting from acquisitions can be directly determined. Measurement of operating gains is
based on accounting data. This approach is used to test the differences between
post-takeover performance and pre-takeover combined weighted average of acquirer and
target performance. Using this approach, research concludes that on an average, takeovers
reduce the value of the acquiring firm (Meeks, 1977; and Cosh et al., 1980). Numerous studies
also analyzed the issue whether and to what extent companies improve their profitability
subsequent to the completion of mergers. While some studies documented a significant
improvement in operating performance after acquisitions, others evidenced a significant
decline. Furthermore, there are a number of studies that reported insignificant changes in
the post-acquisition operating performance.
Meeks (1977) explored the gains from mergers from a sample of companies based in the
UK between 1964 and 1971. He studied the change in Return on Assets (ROA) and observed
a decline in ROA for acquirers following the mergers. For nearly two-thirds of acquirers,
performance was below the industry standard. He reported a mild decline in profitability.
Ikeda and Doi (1983) examined the financial performance of merging companies in the
Japanese manufacturing industry. A total of 49 merged companies were selected over the
period 1964-75. Their performance was tested on parameters such as profitability, efficiency,
firm growth, and R&D. This study has reported financial performance results for two time
periods: 3 years and 5 years. Profitability was higher in the 5-year period, showing increase for
25 companies than for 19 companies in the 3-year period.
Cornett and Tehranian (1992) studied 30 to 36 large banks that underwent mergers
between 1982 and 1987. Overall, the banks outperformed their industry average after merger.
The improved performance of the merged banks appeared to result in their increased ability
to attract loans and deposits, in employee productivity and in profitable assets growth.
Healy et al. (1992) examined the post-acquisition performance for the largest US mergers
between 1979 and the mid-1984. Their study explored the sources of merger-induced changes
in cash flow performance. Results showed that the merged companies registered improvements
in the post-merger operating performance in comparison to that of their industry peers.
These increases arose from improvements in asset productivity.
Clark and Ofek (1994) studied the effectiveness of mergers in restructuring the distressed
companies by examining the role of the determinants of the success of these restructurings in
their post-merger performance. Though the study concluded that bidder shareholders lost, it
did not suggest that mergers were a poor choice for restructuring a distressed target.

74 The IUP Journal of Applied Finance, Vol. 16, No. 5, 2010

 Pilloff and Santomero (1998) reviewed the literature on the value of bank M&A.
They stated that on an average, there was no statistically significant gain in value or performance
from the merger activity. It was evident both from the accounting data and market value of
equity that acquired firm shareholders gained at the expense of the acquiring firm.
Beena (2000) analyzed the significance of mergers and its characteristics. The study
reported that the merger movement of the 1990s was dominated by mergers between
companies belonging to the same business group or house with similar product lines. It also
revealed that mergers between unrelated companies were gaining ground. Mergers contributed
significantly to asset growth in only one-fifth of the sampled companies studied.
Langhe and Ooghe (2001) examined the performance of smaller unquoted companies
involved in the takeover. Their findings showed that following the takeover, profitability,
solvency and liquidity of most of the merged companies declined.
Pawaskar (2001) analyzed the post-merger operating performance of the acquiring
companies and attempted to identify the sources of merger-induced changes. The mergers
had a negative impact on the acquirers’ performance, as indicated by all the profitability
measures. When the post-merger profitability was compared with the pre-merger profitability,
no significant improvement in profitability was found. The positive impact of merger was
noticed in increased size and leverage.
Sharma and Ho (2002) analyzed the operating performance of 36 Australian companies
involved in mergers. Applying various accrual cash flow measures, the study reported a decline
in operating performance after mergers.
Rahman and Limmack (2004) analyzed control-adjusted operating cash flow performance
using a sample of Malaysian companies involved in takeovers during the period 1988-1992.
Their study examined whether shareholders’ wealth increased as a result of takeover.
The study results suggested that acquisitions led to improvements in the long-run operating
cash flow performance.
Powell and Stark (2005) compared post-takeover performance with combined
pre-takeover performance and suggested that there were no significant improvements in
operating performance.
On the whole, no definite conclusion emerges from the review of the above-mentioned
studies. Thus, there is a need to explore the issue further.

Data and Methodology

Universe and the Sample
The study is based on the investigation of 153 listed merged companies, the data for which
was compiled from 1993 till 2003. All the companies which merged after 1990 constituted
the universe of our study. However, keeping in view the time, resource constraints and data
availability, our study was confined to the 153 acquiring companies. Unlisted companies and
financial sector companies were excluded. The study is based on the secondary data collected
Profitability Analysis of Acquiring Companies 75
from the corporate databases of CMIE and Capitaline. The data pertains to the period
1993-2003. As mentioned earlier, the Indian economy opened up in the year 1990. Therefore,
the period 1993-2003 was chosen to examine the impact of mergers in the post-liberalization
period.

Sub-Sample
Furthermore, the sample of acquirer companies was categorized on the basis of the financial
health of the target in the pre-merger period. The first category comprises the acquirers who
were merged with loss-incurring companies, while the second group comprises acquirers
merged with financially healthy companies. ‘Loss-incurring’ is defined here as negative average
Net Profit Margin (NPM) in the three years prior to merger. Following the above criterion,
two groups of acquirers were identified, i.e., 38 sick acquisitions and 115 healthy acquisitions.
Profitability changes after the merger were analyzed within the two groups. Such categorization
of the sample was made with a view to assess the actual impact of mergers on the profitability
of companies after taking over a healthy unit vis-à-vis a sick unit. Theory hypothesizes that
mergers help in reviving sick companies. This comparative analysis was carried out to know
whether loss-incurring acquisitions contributed to bringing improvements in the performance
of acquiring companies.

Accounting Measures of Performance

To determine profitability, financial ratios have been divided into three main groups
(Courtis, 1978): Net Profit Margin (NPM), Return on Capital Employed (ROCE), and Return
on Net Worth (RONW). Net profit margin here refers to net profit after tax divided by net
sales. ROCE is denoted by earnings before interest and tax divided by net capital employed.
RONW is denoted by profit after tax minus preference dividend divided by equity net worth.
We have further examined the sources of operating profit gains or losses from mergers.
If post-merger ROCE is negative, we identify explanations as to why it is negative.
The DuPont equation allows us to examine individual efficiency arguments for M&A, because
it breaks ROCE into these two components, viz.,:
1. Operating profit margin; and
2. Assets turnover ratio
Thus,
ROCE = Operating Profit Margin x Assets Turnover Ratio
Operating profit margin is operating profit divided by net sales, whereas net assets turnover
is net sales divided by net capital employed. The individual components of DuPont have
been computed over the same time period as ROCE was computed (Table 1).
The time span in this study for assessing post-merger performance as against their
pre-merger performance is three years prior to and three years subsequent to the financial
year of the merger. The pre-merger performance is a consolidated measure. Following Healy
et al. (1992), performance of acquirer and acquired is combined on weighted average basis in
the pre-merger period. Net capital employed is used as a weight to combine the performance.

76 The IUP Journal of Applied Finance, Vol. 16, No. 5, 2010

 Table 1: Parameters of Financial Performance
Variables Code Definition

Operating Profit Margin OPM Earnings Before Interest and Tax (EBIT)/Net
Sales*100

Net Profit Margin NPM Net Profit After Tax/Net Sales*100

Return on Net Capital Employed ROCE Earnings Before Interest and Tax (EBIT)/Net
Capital Employed*100

Return on Net Worth RONW Profit After Tax (PAT)—Preference Dividend/

Equity Net Worth*100

Net Assets Turnover Ratio ATR Net Sales/Net Capital Employed

Research Method
The impact of merger on profitability of acquiring companies has been studied by comparing
the pre-merger performance with post-merger performance. We have focused upon three
pre-merger and three post-merger years. Year (0) has been excluded from the analysis. Year (0)
figures are affected by one-time merger costs incurred during that year, making it difficult to
compare them with the results for other years (Healy et al., 1992). The above-mentioned
profitability measures have been computed firstly on a firm-by-firm basis. The average
performance of post-merger period is compared with the average performance of pre-merger
period for all sampled companies individually. Then, average values are computed for all
sampled companies collectively. Paired samples t-test is carried out to assess the difference in
performance between post-merger and pre-merger periods. The paired samples t-test compares
the means of two variables belonging to the same group. It determines whether the difference
between the means of the two variables is significantly different from zero. If there exists a
significant change, it can be attributed to the merger.

Profitability Comparison
We present the results and analysis of profitability in three stages. Firstly, analysis has been
presented for all the sampled firms individually. Pre-merger performance is compared with
post-merger performance for 153 firms. Secondly, a comparative analysis was carried out on
an average basis for all the firms collectively for pre- and post-merger periods. Thirdly, a
comparison was made between profitability of healthy acquisitions and loss-incurring
acquisitions.

Firm-By-Firm Analysis
The performance comparison was made for the acquirer as a single entity in the pre-merger
period with combined performance in the post-merger period. The analysis is done for
companies on an individual basis. It gives average values of profitability (as defined earlier) in
both pre- and post-merger periods. The post-merger performance of companies can be classified

Profitability Analysis of Acquiring Companies 77

into three categories—declined, improved, and neutral. Such categorization has been done
by observation only. Table 2 shows the number of companies falling into each such category.

Table 2: Profitability Changes of Acquiring Companies

Changes in Profitability After the Merger No. of Sick Acquisitions (%)
Declined 85 (55)
Improved 44 (29)
Neutral 24 (16)
Total 153
Source: Data Compiled from Capitaline

The total number of companies showing a decline in performance following the merger
was 85(55%); 44 (29%) companies showed improvement in performance; and 24(16%) did
not change much. Thus, the sample includes acquirers who experienced a decline in
profitability after the merger as well as the acquirers who suffered losses following the deal.
Nearly about 20 companies suffered losses after the mergers.
It signifies that profitability results were not robust to the various measures applied in
the study. Going by the above observations, it can be inferred that different measures of
profitability provided different results, and ROCE, which is called master ratio, seemed
a better measure of profitability than RONW.
The second group of companies experienced improvements in profitability after the
mergers. A few companies in this group were such whose overall profitability improved but
their RONW declined.
The third group of companies showed similar performance in both pre- and post-merger
periods. The decline or improvement in profitability between the two periods was not much.
So, they were separated from the above two groups. It is difficult to say that merger left any
impact on these companies.

Composite Analysis
After analyzing profitability on firm-by-firm basis, it was analyzed for the total sampled firms
collectively. Average values for 153 firms were computed for both pre- and post-merger
periods and compared with the help of t-test. Table 3 presents the profitability analysis for
both pre-merger period (denoted as 0) and post-merger period (denoted as 1).
As is evident from Table 3, profitability declined in the post-merger period quite
significantly. All three measures of profitability, i.e., profit margin, ROCE, and RONW, report
the same thing, thus making the results more reliable. Asset Turnover Ratio (ATR) and
operating profit margin are two parts of the master profitability ratio ROCE. An analysis of
the two parts reveals that asset turnover declined significantly following the merger. However,
operating profit margin improved significantly. The reasons for decline in profitability can
be explained with the help of DuPont analysis. Negative asset turnover nullified the positive

78 The IUP Journal of Applied Finance, Vol. 16, No. 5, 2010

 Table 3: Comparison of Profitability Between Pre- and Post-Merger Periods
Variables Mean Paired Differences Std. Deviation t-Value Sig. (2-Tailed)
PM0 7.0566 9.6787
PM1 1.5235 –5.5332 27.9673 4.043 0.000
ROCE0 19.6778 13.5834
ROCE1 16.6712 –3.0066 19.8657 3.314 0.001
RONW0 17.4497 27.8012
RONW1 11.2791 –6.1705 33.3277 3.263 0.001
ATR0 150.6949 109.1367
ATR1 136.4573 –14.2375 96.0408 3.714 0.000
OPM0 19.9757 16.3663
OPM1 23.0119 +3.0362 204.9325 –0.343 0.732
Note: 0 refers to pre-merger period and 1 refers to post-merger period.

impact of increased OPM and thus resulted into profitability decline. The merged entities
could not utilize their assets efficiently. They should rather make up new strategies to better
utilize the enlarged asset base and thus improve their profitability.

Yearly Pairwise Comparison of Profitability

Earlier comparison took place between two periods, i.e., pre- and post-merger. But that did not
reveal the specific years in which change in profitability occurred. Therefore, a year-to-year
comparison was also carried out (Table4).
The yearly pair-wise comparison is able to reveal that significant decline in profitability
occurred in the first and third years of merger. Profitability declined in all the years of merger,
but the decline in the second year was insignificant. Thus, the data indicates that mergers led to
a decline in profitability immediately after the mergers. In the second year following the merger,
the profitability decline was mild. But again in the third year, profitability declined significantly.

Table 4: Yearly Comparison of ROCE Between Pre- and Post-Merger Periods

Year-Wise Pairs Mean Differences Std. Deviation t-Test Sig. (2-Tailed)
–3,+1 –3.1225 16.5884 2.454 0.015
–3,+2 –2.1245 25.7184 1.077 0.283
–3,+3 –4.3337 19.2221 2.940 0.004
–2,+1 –3.0953 14.9512 2.699 0.008
–2,+2 –2.0973 26.3551 1.038 0.301
–2,+3 –4.3065 18.6398 3.012 0.003
–1,+1 –2.5889 11.7982 2.861 0.005
–1,+2 –1.5909 25.3134 0.819 0.414
–1,+3 –3.8001 17.1267 2.893 0.004

Profitability Analysis of Acquiring Companies 79

DuPont Analysis
Significant profitability decline is evident from Table 4. However, what caused this decline?
Analyzing the reasons for the declined profitability is equally important. DuPont analysis helps
to identify the causes for this decline. The first component of DuPont analysis is Asset Turnover
Ratio (ATR). Mergers lead to an increase in the size of the merged entity. Managers have to
show their prudence in managing the assets efficiently after the merger, otherwise profitability
may deteriorate. Table 5 presents asset utilization of the acquiring firm by year-wise pairs.
It can be observed from Table 5 that asset utilization has depleted following the merger.
The acquiring firms were bestowed with huge assets as a result of merger. But they could not
utilize it efficiently, thus resulting into declined profitability. The second component of
DuPont analysis is the operating profit margin. It highlights the operating efficiency of the
merged entities. Table 6 shows the year-wise comparison of operating profit margin between
pre- and post-merger periods.
Table 5: Yearly Comparison of ATR Between Pre- and Post-Merger Periods
Year-Wise Pairs Mean Differences Std. Deviation t-Test Sig. (2-Tailed)
–3,+1 –17.5327 84.4126 2.708 0.007
–3,+2 –15.9823 91.9669 2.266 0.025
–3,+3 –19.2518 100.4776 2.498 0.013
–2,+1 –16.7940 80.1548 2.732 0.007
–2,+2 –15.2435 86.9124 2.287 0.023
–2,+3 –18.5130 103.3229 2.336 0.021
–1,+1 –8.2172 69.6473 1.538 0.126
–1,+2 –6.6668 78.0471 1.114 0.267
–1,+3 –9.9362 88.6920 1.461 0.146

Table 6 reveals interesting things. It shows that OPM turned insignificantly positive in
the second year of the merger. Acquiring firms obtained insignificant operating efficiencies
Table 6: Paired Samples Test (OPM)
Year-Wise Pairs Mean Differences Std. Deviation t-Test Sig. (2-Tailed)
–3,+1 –1.3385 75.2019 0.232 0.817
–3,+2 +20.1993 246.7953 –1.067 0.287
–3,+3 –10.6965 226.9650 0.614 0.540
–2,+1 –0.8574 77.4989 0.144 0.885
–2,+2 +20.6803 248.2125 –1.086 0.279
–2,+3 –10.2154 228.0347 0.584 0.560
–1,+1 +0.8752 79.7242 0.143 0.886
–1,+2 +20.6625 249.5077 –1.080 0.282
–1,+3 –10.2332 229.0807 0.582 0.561

80 The IUP Journal of Applied Finance, Vol. 16, No. 5, 2010

in the second year of the merger. But in the third year, the operating efficiencies eroded.
Positive OPM in the second year of merger is the reason for ROCE to be positive in the
second year, but negative ATR in the second year of the merger nullified the positive impact
of OPM and, therefore, ROCE became insignificantly positive. Thus, merged entities made
their efforts to obtain operating synergies, but could not succeed in the third year following
the merger. A longer period of study may make the actual picture clear.

Healthy Versus Loss-Incurring Acquisitions

Out of the total 153 acquirers, 38 companies were such which acquired sick units, and the
remaining 115 acquired healthy units. Profitability analysis (as defined earlier) was conducted
for these two groups. Out of the 38 companies, which acquired sick units, 21 showed declined
performance after the mergers, 9 improved profitability, and 8 remained almost the same
with regard to profitability after the merger. The profitability position of the 115 acquirers
taking over healthy units was: profitability declined in 64 companies, improved in 35, and
remained more or less the same in 16 companies. Table 7 shows the profitability position of
the two groups.
Table 7 indicates a decline in profitability following the mergers for acquiring companies.
Around 55% of companies experienced a decline in profitability following the merger, whereas
only 28% of companies showed improvement in profitability. Around 16% of companies
were not affected much and their profitability position remained the same even after the
merger. Thus, by and large, mergers did not bring benefits for shareholders. This analysis
gives us the explanation that mergers could not rehabilitate the sick units. Had they been
rehabilitated, their improved performance would have benefitted the acquirer. Since the
acquirers of loss-incurring acquisitions did not gain after merger, it is validated that no
rehabilitation took place.

Table 7: Profitability Analysis of Healthy Versus Loss-Incurring Acquisitions

Changes in No. of Sick No. of Healthy Total No. of

Profitability Acquisitions Acquisitions Acquisitions
After the Merger (%) (%) (%)

Declined 21 (55.26) 64 (55.65) 85 (55.55)

Improved 9 (23.68) 35 (30.43) 44 (28.76)
Neutral 8 (21.05) 16 (13.91) 24 (15.69)
Total 38 (24.84) 115 (75.16) 153 (100.00)
Source: Data Compiled from Capitaline

Conclusion
The study results reveal that a majority (55%) of the companies reported a decline in
performance after the merger. Only 29% of the companies could improve their performance
following the merger. Profitability results were not robust to the various measures applied in

Profitability Analysis of Acquiring Companies 81

the study. For a few companies, though OPM, NPM, and ROCE declined, their RONW
improved. ROCE, which is called master ratio, seemed a better measure of profitability than
RONW. Out of the total 153 acquirers, 38 companies acquired sick units, and the remaining
115 acquired healthy units. Profitability analysis was conducted for these two groups. Around
55% of the companies experienced a decline in profitability in both the groups. DuPont
analysis reveals that ATR declined significantly, whereas OPM improved significantly
following the merger. Therefore, profitability declined due to poor asset utilization. Irrespective
of the fact whether the acquired units are healthy or loss-incurring, profitability of acquirers
remained the same in both the cases. 

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Profitability Analysis of Acquiring Companies 83

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