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Hussain Muhammad, Bahadar Shah, Zia ul Islam / Journal of Industrial Distribution & Business 5-2 (2014) 13-20 13
Received: March 19, 2014. Revised: April 08, 2014. Accepted: May 07, 2014.
1. Introduction:
Abstract
Capital structure plays a vital role in financial decision making
Purpose The purpose of this study is to empirically inves- process, maximizing the firms performance and its value. The
tigate the impact of capital structure on firm performance. term capital structure is the mix of different securities issued by
Research design, data, and methodology This study exam- firm to finance its operations. These mixes of different financing
ined the impact of capital structure on the performance of ce- methods issued by firm are called firms capital structure. Saad
ment companies listed on the Karachi Stock Exchange during (2010) argue that in financial term capital structure means the
the period 2009-2013. The authors hypothesize that there is a way a firm finance their assets through the mix of equity, debt
negative relationship between capital structure and firm or hybrid securities. Similarly, capital structure is used to signify
performance. To examine the association, the authors run a the proportionate relationship between debt and equity.
Pearson correlation and multiple regression analysis. The origin of capital structure theory begins from Modigliani &
Results Results reveal a strong negative relationship be- Miller (1958), capital structure theories operates under perfect
tween debt to asset and firm performance variables (GPM, market. They argue that under various assumptions of perfect
NPM, ROA, and ROE). Further, there is a positive relationship capital market, such as investors, homogenous expectations, no
between debt to equity and firm performance variables (GPM taxes, no transaction costs, and efficient market, capital struc-
and NPM), anda negative relationship between debt to equity ture is irrelevant in determining firms value. Therefore,
and firm performance variables (ROA and ROE). Moreover, cap- Modigliani & Miller (MM) theorem is famous for "Theory of ir-
ital structure variables significantly impact firm performance. relevance" of capital structure and reveals that capital structure
Conclusions This study concluded that financial analysts is independent of firm performance.
and managers should emphasize on the optimal level of capital The expansions of capital structure theory relax some as-
structure and efficient utilization and allocation of resources to sumptions of the original MM theory of irrelevance. MM (1963)
achieve the targeted level of productive efficiency in business. 1 & Miller (1977) 2 publish articles relax the assumptions that
there is no personal and corporate taxes. They conclude that
Keywords: Capital Structure, Firm Performance, Cement firms are encouraged to use debt in their capital structure, be-
Industry, Pakistan. cause tax regulation allows firms to deduct debt interest pay-
ments as an expense. Similarly, tax deductibility of interest pay-
JEL Classifications: G1, G3. ment protects the pre-tax income of the firm and eventually low-
ers the weighted average cost of capital. However, the extent
literature is full of theories on capital structure since the seminal
work of MM.
The main focus of this study is that no prior research work
was done in Pakistani market on the impact of capital structure
decisions on firm performance in the Cement Industry, which is
* The authors are thankful to the Managing Editor Myoung Kil Youn considered capital intensive industry where optimal capital struc-
and the three anonymous reviewers for their helpful comments ture decisions are primary to the firm performance. The current
and suggestions that have substantially improved the article. study uses two measures of capital structure including debt to
** Corresponding Author, Research Scholar, Department of Management
assets and debt to equity.
Sciences, Hazara University Mansehra, Pakistan. Tel:
+92-33-3850-8159. E-mail: hussain.edu.pk@gmail.com.
*** Chairman, Department of Management Sciences, Hazara University
1.1. Debt to Assets
Mansehra, Pakistan.
**** Research Scholar, Department of Management Sciences, Hazara The debt to assets ratio measures the percentage of funds
University Mansehra, Pakistan.
14 Hussain Muhammad, Bahadar Shah, Zia ul Islam / Journal of Industrial Distribution & Business 5-2 (2014) 13-20
provided by creditors (Brigham & Houston, 2011). It also refers cash flows produced by the operating cycle as a result of asset
to the percentage of all assets that are financed by debt or investment outlays. It is the return for forsaking immediate
(Fraser & Ormiston, 1998). spending (Vernimmen et al., 2005).
Debt to Assets = Total Liabilities / Total Assets Return on Assets = Net Income / Total Assets
The debt to equity ratio measures the riskiness of the com- Return on Equity is an accounting indicator of value creation
panys capital structure in terms of the relationship between the and measures the profitability of equity invested in the business.
funds supplied by creditors (Fraser & Ormiston, 1998). It is equal to net income dividing by shareholders equity
Debt to Equity = Total Liabilities / Total Shareholders Equity (Vernimmen et al., 2005).
Return on Equity = Net Income / Shareholders Equity
2. Firm Performance:
3. Literature Review:
Performance concept is a contentious matter in finance most-
ly due to its multidimensional meanings. Murphy, Trailer, & Hill, Based on literature review there is an abundance of research
(1996) argue that research on firm performance originates from which intends to enlighten the relationship between capital struc-
strategic management and organization theory. Chakravarthy ture and firm performance, empirical evidence yields contra-
(1986) demonstrates that performance is measures either organ- dictory and inconsistent findings. Empirical results and argu-
izational or financial. The core of the firms effectiveness is fi- ments have gone both ways. Some researchers document that
nancial performance such as profit maximization, maximizing there is positive relationship between capital structure and firm
profit on assets, and maximizing shareholders benefits. performance, whereas others oppose by arguing that there is a
Sandberg & Hoffer (1987) evaluate that operational performance negative effect on firm performance. For instance, Gleason et al.
measures, such as growth in market share and sales give a (2000) reveal that firms capital structure has a significant and
broad meaning of performance that focus on the factors that fi- negative relationship with firms performance measured by return
nally direct to financial performance. Therefore, financial perform- on assets (ROA) and profit margin in the European countries.
ance is considered a major standard to measure a company By contrast, Hadlock & James (2002) find a positive relationship
operational and financial efficiency. The current study uses four between capital structure and firms performance. Further, they
measures of performance including gross profit margin, net profit note that firms with high level of profitability use high level of
margin, return on assets and return on equity. debts. Similarly, Holz (2002) also show a positive relationship
between capital structure and firms performance.
2.1. Gross Profit Margin Deesomsak et al. (2004) report a negative relationship be-
tween capital structure and firms performance measured by
Gross Profit Margin shows the total increase between cost of gross profit margin in the Malaysian firms. They indicate that in
goods sold and sales revenue. It also reflects the efficiency with Singapore, Taiwan and Australian the relation of leverage with
which management produces each unit of product (Stapleton et firms performance is negative but statistically insignificant.
al., 1981). Moreover, the effect of firm size on leverage is significant and
Gross Profit Margin = Sales Cost of Goods Sold / Sales positive for all the countries except Singapore, because in
Singapore firms have government support and are less exposed
2.2. Net Profit Margin to financial distress costs. On the same manner, Frank & Goyal
(2004) also find a negative relationship between capital structure
and firms performance by giving the predictions of pecking order
Net Profit Margin signifies the overall measure of a com- theory in contrast to the off theory.
panys ability to turn each rupee/dollar sales into net profit. It al- Abor (2005) investigate the relationship between capital struc-
so establishes relationship between sales and net profit. Further ture and profitability of listed firms on Ghana Stock Exchange.
it indicates managements efficiency in administering, manu- He reveals a positive relationship between short term debt to to-
facturing and selling the products (Stapleton et al., 1981). tal assets and return on equity due to low interest rates.
Net Profit Margin = Net Income / Sales Further, he suggests that in Ghanaian firms short term financing
shows 85 percent of total debt and is considered a main ele-
2.3. Return on Assets ment of financing for them. Moreover, a negative relationship
find between long term financing and equity returns, and a pos-
Return on Assets or Investment is the estimated raise in the itive relation exists between total debt and profitability. He also
Hussain Muhammad, Bahadar Shah, Zia ul Islam / Journal of Industrial Distribution & Business 5-2 (2014) 13-20 15
suggests that debt is considered as a major source of financing of capital structure on performance of 12 commercial banks list-
for high profitable firms. ed on Amman Stock Exchange during 2007-2011. He finds that
Huang & Song (2006) find a negative relationship between bank performance measured by net profit, return on capital em-
capital structure measured by long term debt and total debt and ployed and net interest margin related significantly and positively
performance measured by return on assets. They indicate that with total debt, whereas total debt is found insignificant with re-
Chinese markets are, in developing phase for equity financing turn on equity in the banking industry of Jordan.
and firms should depend on debt capital from banks. However,
Chinese most firms are state controlled and favor equity financ- <Table 1> Summary Table for Literature Review
ing rather than debt financing because they still hold the con-
Relationship b/w Capital
trolling interest and weak laws exist to keep shareholders rights. S# Year Authors Name
Structure and Firm Performance
Further, profitable firms use more debt and increase leverage
Gleason, Mathur, &
due to increase in firm size. 1 2000 Negative
Mathur
Weill (2008) examines the relationship between financial lever- 2 2002 Hadlock & James Positive
age and firms performance in seven European countries. He 3 2002 Holz Positive
finds that in Spain and Italy financial leverage related sig- Deesomsak, Paudyal,
4 2004 Negative
nificantly and positively with firms performance, while significantly & Pescetto
and negatively in France, Norway, Germany and Belgium, but 5 2004 Frank & Goyal Negative
6 2005 Abor Both Positive & Negative
insignificantly in Portugal. Li Meng et al.(2008) also investigate
7 2006 Huang & Song Negative
that financial leverage has a negative relation with firm perform- 8 2008 Weill Both Positive & Negative
ance measured by return on assets, but has a positive relation 9 2008 Meng et al Both Positive & Negative
with return on equity. 10 2009 Ebaid Negative
Ebaid (2009) reveal that capital structure has a very weak re- Nimalathasan &
11 2010 Positive
Brabete
lationship with performance on the emerging market economy of
12 2011 San & Heng Both Positive & Negative
Egypt. He shows that capital structure measured by short term,
13 2011 Pratheepkanth Negative
long term and total debt to total assets related insignificantly 14 2012 Khan Negative
with firms performance measured by return on equity. While 15 2013 Taani Positive
short term debt and total debt to total assets related negatively
and significantly with firms performance. Further, long term debt
related negatively and insignificantly with performance measured
by return on assets. Moreover, he also shows insignificant rela-
4. Objectives of the Study:
tionship between capital structure and gross profit margin.
Nimalathasan & Brabete (2010) evaluate the relationship be-
The present study is planned to accomplish the following ob-
tween capital structure and profitability for listed manufacturing
jectives;
companies in Sri Lanka. They reveal that capital structure
y To identify the nature of relationship between capital struc-
measured by debt to equity related positively and significantly
ture and firm performance.
with firms profitability measured by gross profit, operating profit
y To investigate the impact of capital structure on firm
and net profit margin.
performance.
San & Heng (2011) study the relationship between capital
structure and performance of Malaysian Construction Industry in
the financial crises of 2007-2008 that badly affect the econo-
mies of Malaysia. They demonstrate a weak relationship exists 5. Research Methodology:
between leverage and performance measured by return on as-
sets and return on equity of Malaysian Construction Industry. The present study uses secondary data, because of the main
Further, Pratheepkanth (2011) find a negative relationship be- purpose is to empirically investigate the impact of capital struc-
tween capital structure and financial performance of business ture on performance of cement companies in Pakistan listed on
companies in Sri Lanka during 2005-2009. Karachi Stock Exchange for the period 2009-2013. Secondary
Khan (2012) shows the relationship of capital structure deci- data is defined as data that are already available i.e. it refer to
sion with performance of 36 engineering firms in Pakistani mar- the data which have already been collected and analyzed by
ket listed on Karachi Stock Exchange during 2003-2009. He someone else (Kothari, 2004). Secondary data are typically past
finds a negative and significant relationship between financial data and do not need access to subjects or respondents be-
leverage measured by short term debt to total assets (STDTA) cause it is already assembled. The current data is obtained
and total debt to total assets (TDTA) and firm performance from the annual reports and financial statements of 25 cement
measured by return on assets (ROA), gross profit margin (GPM) companies listed on Karachi Stock Exchange for the period
and Tobins Q. By contrast, Taani (2013) examines the impact 2009-2013.
16 Hussain Muhammad, Bahadar Shah, Zia ul Islam / Journal of Industrial Distribution & Business 5-2 (2014) 13-20
Empirical literature uses many variables in a capital structure Table 2 reveals the summary of descriptive statistics for all
choice which will affect a firm performance. Abor (2005 & 2007) dependent and independent variables of the study. The results
and Ebaid (2009) used the three (Short term, long term and to- of descriptive statistics indicate that mean of debt to assets for
tal debt) to total assets as measures of capital structure. This cement companies listed on Karachi Stock Exchange during
study uses two of the most important measures of capital struc- 2009-2013 is 64.51%, whereas mean of debt to equity is
ture i.e. debt to assets and debt to equity. Moreover, literature 171.71%. It shows that about 64.51 percent of total assets of
also uses a number of different measures of firm performance cement companies are financed by debt. Further the table
include accounting based measures calculated from firm financial shows that mean of gross profit margin, net profit margin, return
statements such as GM, NM, ROA and ROE (Abor, 2005; on asset and return on equity are 8.81%, -19.7%, 2.4% and
Meng et al., 2008; Ebaid, 2009). This study uses four account- 5.38% respectively. These results indicate a poor performance
ing based measures of performance include GPM, NPM, ROA by cement companies during 2009-2013.
and ROE. The figure 1 shows the conceptual framework of the
study. <Table 2> Descriptive Statistics
Pearson Correlation 1
Debt to Assets Sig. (2-tailed)
N 125
Pearson Correlation -.019 1
Debt to Equity
Sig. (2-tailed) .835
N 125 125
Pearson Correlation -.557** .066 1
GPM Sig. (2-tailed) .000 .466
N 125 125 125
Pearson Correlation -.528** .254** .602** 1
NPM Sig. (2-tailed) .000 .004 .000
N 125 125 125 125
Pearson Correlation -.569** -.031 .555** .532** 1
ROA
Sig. (2-tailed) .000 .736 .000 .000
N 125 125 125 125 125
Pearson Correlation -.022 -.555** .026 -.036 .404** 1
ROE
Sig. (2-tailed) .807 .000 .776 .692 .000
N 125 125 125 125 125 125
Based on above results hypothesis H1 is accepted because all the predictors simultaneously is 0.669, R2 = 0.447 and the
the results reveal a negative relationship between debt to asset adjusted R2is 0.429 that indicate 42.9% of the variance in debt
and firm performance variables. Further, the relationship between to asset can be predicted from independent variables (GPM,
debt to equity and firmperformance variables show different NPM, ROA, and ROE), whereas the remaining 57.1% influenced
results. The relationship between debt to equity and firmperform- by others which are not considered for this study. According to
ance variables (GPM & NPM) is positive and research hypoth- Cohen (1988), this is a large effect.
esis H2 is rejected. Whereas the relationship between debt to The table further uses Durbin Watson statistic to find out the
equity and firm performance variables (ROA & ROE) is negative existence of autocorrelation in the residuals. According to Al
and the research hypothesis H2 is accepted. saeed (2006), if Durbin Watson values are between 1 and3,
then there is no autocorrelation problem. As shown in table,
6.3. Regression Analysis Durbin Watson value is 2.131, which represent no autocorrela-
tion problem in the regression models. In addition, it also dem-
Regression analysis is a statistical method to measure the onstrates that overall F statistics is 24.244, which indicates the
impact of one (independent) variable on other (dependent) combination of independent variables (GPM, NPM, ROA, and
variable. Therefore, this study uses regression analysis to test ROE) significantly predict debt to asset.
the hypothesis H3 to measure the impact of capital structure on Table 5 indicates the regression analysis between dependent
firm performance. variable (debt to equity) and independent variables (GPM, NPM,
Table 4 indicates the regression analysis between dependent ROA, and ROE). The beta coefficient represents that net profit
variable (debt to asset) and independent variables (GPM, NPM, margin and return on equity significantly predict debt to equity
ROA, and ROE). The beta coefficient shows that gross profit when all variables included. It also shows collinearity statistics
margin and return on asset significantly predict debt to asset where tolerance and VIF give the same information (Tolerance
2
when all variables included. It also indicates collinearity statistics = 1/VIF). If the tolerance value is low (< 1-R ), then there is
where tolerance and VIF give the same information (Tolerance probably a problem with multicollinearity. The tolerance value is
2
= 1/VIF). If the tolerance value is low (< 1-R2), then there is 0.615 (1-R ) which reveals no problem with multicollinearity.
probably a problem with multicollinearity. The tolerance value is
0.553 (1-R2) which shows no problem with multicollinearity.
The model summary reveal the correlation coefficient R, using
18 Hussain Muhammad, Bahadar Shah, Zia ul Islam / Journal of Industrial Distribution & Business 5-2 (2014) 13-20
<Table 4> Regression Analysis between Debt to Assets and Independent Variables
Coefficients
Standardized
Unstandardized Coefficients Collinearity Statistics
Model Coefficients t Sig.
<Table 5> Regression Analysis between Debt to Equity and Independent Variables
Coefficients
Unstandardized Standardized
Collinearity Statistics
Model Coefficients Coefficients t Sig.