The Eastern University Journal, Vol.

5, Issue 2, December 2014

Impact of Capital Structure on the Financial Performance of the Banking

Sector of Bangladesh

Dewan Muktadir-al-Mukit*
Md. Rizvy Ahmed**

Abstract

The study was conducted to determine the impact of capital structure on financial
performance of the Banking sector of Bangladesh. The study used return on equity
(ROE), return on asset (ROA) and earnings per share (EPS) as dependent variables
in three different models to represent the financial performance and long-term debt
to capital ratio (LTDTC), short-term debt to capital ratio (STDTC) and total debt to
capital ratio (TDTC) as independent variables to represent the capital structure. The
study used a sample of 19 banking firms listed on Dhaka Stock Exchange (DSE)
during the period of 2008-2012. The findings of the study show that long-term debt
to capital ratio, short-term debt to capital ratio and total debt to capital ratio have
significant connection with financial performance of the banking firms measured by
ROA and EPS whereas ROE is not significantly associated with the capital structure
variables. The overall result of the study shows that capital structure has significant
impact on the financial performance of the banking sector of the Bangladesh.

Keywords: Capital Structure, Financial Performance, Banking Industry,

ROA

Introduction

Capital structure is under the consideration of the financing decision which is one of the major
decisions in finance. Thus the study of Capital structure and its impact on value or performance of the
firm is one of the very complex issues in the area of finance. The term capital structure is defined as
the blend of debt and equity capital maintained and used by a firm to finance itself. Therefore, it is
important to take under consideration such facts since claim on firm's cash flow and the distribution of
that cash flow is highly dependent on Firms capital structure. If the firm is all equity finance, then the
shareholder will get full claim on the cash flow; on the other hand, if the firm is part debt- financed
then it needs to dedicate the cash flow to its debt holder first, since the debt holder is the first claimant
on firm's earnings.

The study of capital structure has been researched upon by many scholars, yet it has remained the
most debatable issue in the field of finance during the past half century (Bradley et al., 1984). It is
traditionally believed that by increasing the operating and financial leverage the firm can maximize its
value up to a certain point. However, after that, further increase in leverage will increase the weighted
average costs of capital and thus will lower the value of the firm. Scholarly research (Modigliani and
Miller, 1958; Baxter, 1967; Stiglitz, 1972; Groth & Anderson, 1997) suggests that there is an optimal
capital structure range; however, it is not yet possible to provide a specified methodology for use in

*
Senior Lecturer, Faculty of Business Administration, Eastern University, Dhaka, Bangladesh.
**
Senior Lecturer, Faculty of Business Administration, Eastern University, Dhaka, Bangladesh .
 Mukit & Rizvy

determining a firm’s optimum capital structure. Nonetheless different financial theories offer how a
chosen financing mix affects firm’s performance. The theory was first introduced by Modigliani and
Miller in the 1950’s with extensive study. They developed the capital-structure irrelevance
proposition. Essentially, they hypothesized that, in perfect markets, it does not matter what capital
structure a company uses to finance its operations. They showed that the market value of a firm is
determined by its earning power and by the risk of its underlying assets, and that its value is
independent of the way it chooses to finance its investments or distribute dividends.

A number of researches have been carried out on this subject with the objective of determining the
impact of capital structure on corporate performance (Krawish and Khraiwesh 2010). These studies
were conducted in the past on the determinants of capital structure in both developing and developed
country perspectives; For example, Bevan and Danbolt (2000, 2002), among many others, used data
from developed economies. But for developing economies, only a few studies have been carried out
on the subject; for example, Pandey (2001) used data from India, Iwarere and Akinleye (2010) used
data from Nigeria. In both developed and developing economies, the researches on the topic have
used different variables believed to be empirical determinants of the capital structure. Though
numerous empirical researches (Ebaid, 2009; Heng, 2011; Stiglitz, 1972; Groth & Anderson, 1997;
Roden and Lewellen, 1995; Amidu, 2007) have been conducted to determine the relationship between
capital structure and firm’s performance, Bangladesh has very little contribution to this literature.
Therefore, this study analyzes the impact of capital structure on the most leading industry of
Bangladesh, the banking sector. This study will help to understand the general practices of capital
structure in banking industry and also the sensitivity of leverage on the performance of this industry.

The purpose of conducting the study is to measure the impact of capital structure on financial
performance of the banking sector of Bangladesh over a period of 2008 to 2012. The rest of the paper
is organized as follows: Section two provides the literature review. Section three discusses the data,
variables and methodology. The empirical findings and discussion are presented in section four.
Lastly, section five concludes the study.

Literature Review

Ebaid (2009) examined the capital structure and performance of firms listed at Egyptian stock
exchange during the period of 1997 to 2005. The study shows that there is a negative significant
influence of short term debt and the total debt on the financial performance measured by the return on
asset (ROA) but no significant relationship was found between long term debt and ROA. He also
reported that there is no significant influence of the debt whether total, short term or long term on
financial performance measured by both gross profit margin and Return on Equity.

San and Heng (2011) examined the relationship of capital structure and corporate performance of
firms before and during the 2007 crisis. They selected a total of 49 construction companies listed in
stock exchange of Malaysia from 2005 to 2008. In this study capital structure was represented by a
number of independent variables which are long term debt to capital, debt to capital, debt to asset,
debt to equity market value, debt to common equity, long term debt to common equity while the
dependent variables of return on capital (ROC), return on equity (ROE), return on asset (ROA),
earnings per share (EPS), operating margin (OM) and net margin (NM) were used to represent the
corporate performance. The result finds significant relationship between capital structure and
corporate performance, in the interim the results also indicate that there is no relationship between the
various variables that are examined in this study. For the big construction companies only return on
The Eastern University Journal, Vol. 5, Issue 2, December 2014

capital and earnings per share have significant relationships with capital structure. Debt equity to
market value, long term debt to capital and debt to capital have direct influence on corporate
performance of the large companies but other independent variables do not affect the dependant
variables. Debt to capital has direct impact on corporate performance of small companies and yet
other independent variables (debt to asset, debt to equity market value, debt to common equity, long
term debt to common equity) do not affect the dependent variables mentioned here.

Roden and Lewellen (1995) employed a sample of 48 U.S. firms during 1981-1990 and found a
positive relation between profitability and capital structure. Margaritis and Psillaki (2010) used a
sample of both low and high growth French firms for the period 2003-2005 and reported a significant
positive relation between leverage and firm’s performance. Aliakbar, Seyed and Pejman (2013) also
found a significant positive relationship between capital structure and firm performance in the Tehran
Stock Exchange.

Ahmad, Abdullah and Roslan (2012) investigated the impact of capital structure on firm performance
by analyzing the relationship between operating performances of Malaysian firms. They selected 58
firms as sample from the period of 2005 to 2010. The dependent variables used in this research are
ROA( return on asset), ROE (return on equity) and firm size (SIZE), sales growth (SG), asset growth
(AG), firm efficiency as control variables where independent variables are long-term debt (LTD),
short-term debt (STD) and total debt (TD) . Findings of the study validated that STD and TD have
significant relationship with return on asset (ROA) while return on equity (ROE) and all capital
structure indicators have significant relationship. The significant relationship between short-term debt,
long-term debt and total debt with ROE is consistent with the findings of Abor 2005; Mesquita and
Lara 2003. The positive significant relationship between long-term debts with ROA is coherent with
the findings of Philips and Sipahioglu, 2004; Grossman and Hart, 1986. This indicates that higher
levels of debt in the firm’s capital structure is directly associated with higher performance levels.

Amidu (2007) conducted a study to investigate the dynamics involved in the determination of the
capital structure of the Ghana banks. The dependent variables used in that paper are the leverage
(LEV) as total debts divided by total capital; short-term debt ratio (SHORT) as total short-term debt to
capital and long-term debt ratio (LONG) as the total long-term debt divided by total capital. The
explanatory variables include (PRE) profitability, (RSK) risk, and asset structure (AST), tax (TAX),
size (SZE) and sales growth (GROW). The result of the regression model used in the research shows a
negative relationship between profitability and leverage.

Abor (2007) examined capital structure of Ghanaian SMEs according to industry classification. The
result shows that farming, pharmaceutical as well as healthcare sectors rely much more upon long-
term as well as short-term debt. The outcomes additionally display how the building as well as
exploration business are actually not as likely to rely on short-term financial debt (STD), whilst
resorts as well as food rely much more upon long-term debt and less upon short-term debt.

Pratheepkanth (2011) conducted a study to determine the impact of the capital structure on financial
performance of the firms during 2005 to 2009 in Sri Lanka. The result shows a negative relationship
between capital structure and financial performances of the Sri Lankan companies. Salim and Yadav
(2012) studied the relationship between capital structure and firm performance in Malaysian
companies for the period of 1995-2011. Their analysis revealed that firm performance measured by
ROA, ROE and EPS have negative relationship with the capital structure while Tobin’s Q has
significantly positive relationship with Short term Debt and long term Debt.
 Mukit & Rizvy

By employing cross sectional tie series fixed effect model, Chowdhury and Chowdhury (2010)
attempted to determine the association between capital structure and firm value in Bangladesh. They
found that maximizing the wealth of shareholders demands a perfect mixture of debt and equity,
whereas cost of capital has a negative correlation in this choice and it has to be as least as possible.
Alom (2013) also reported a significant negative relation between profitability and leverage in
Bangladeshi firms.

Research Hypothesis

Following hypothesis is developed to investigate the impact of capital structure on financial

performance of banking sector of Bangladesh:

H0 = Capital structure has no significant impact on financial performance of banks.

H1 = Capital structure has significant impact on financial performance of banks.

Methodology

The paper is based on secondary data that have been collected from annual reports of the nineteen
(19) commercial banks listed at Dhaka Stock Exchange (DSE) for the year of 2008 to 2012. This
analysis has been carried out through constructing panel data. Descriptive statistics, correlation matrix
and regression models have been used for analyzing the data.

Variables
The independent variables consist of long-term debt to capital ratio, short-term debt to capital ratio
and total debt to capital ratio. Dependent variables are Return on Equity (ROE), Return on Asset
(ROA) and Earnings Per Share (EPS). The details of the variables are given below:

Long term Debt to Capital Ratio (LTDTC): Mesquita and Lara (2003) and Abor (2005) have
used long term debt to capital as a measure of capital structure and it is calculated by the following
formula:
LTDTC =Long term debt/ Capital

Short term Debt to Capital Ratio (STDTC): Abor (2005; 2007) said that short-term Debt to
capital ratio is measured by dividing short-term debt with total capital:

STDTC = Short-term Debt/Capital

Total Debt to Capital Ratio (TDTC): For the purpose of study, this ratio is calculated as dividing
total debt by capital.

TDTC = Total Debt/ Capital

Return on Assets (ROA): Return on Assets measures the profitability of the firms and calculated
as.
ROA = Net income/ Total assets.
The Eastern University Journal, Vol. 5, Issue 2, December 2014

Return on Equity (ROE): Return on Equity is used to calculate a firm’s profitability by revealing
how much profit a firm generates with money invested by shareholders and its formula is given
below.
ROE = Net Income/ Total Equity

Earnings per Share (EPS): Earnings per Share is the portion of the company's distributable profit
which is allocated to each outstanding equity share and calculated by this formula.

EPS = Net Earnings/ Number of shares outstanding.

Model Specification
Multiple regression models are used to find out the association between capital structure
characteristics and firm performance as per suggested by previous studies of Salteh et al. (2012),
Salim and Yadav (2012), Abor (2005) and Hasan et al. (2014). Three regression models are
formulated to check the relationship between capital structure and banking performance. Our base
models take the following form:

Y it = α + βXit + μit
Where:
Yit is the dependent variable.
α is the intercept
β is the slope coefficient
Xit is the independent variable.
μit are the error terms.
i is the number of firms and
t is the number of time periods.

Model-1:
ROAit =β0it+β1 LTDTCit +β2 TDTCit + β3STDTCit +μit

Model-2:
ROEit = β0it+β1 LTDTCit +β2 TDTCit + β3STDTCit +μit

Model-3:
EPSit = β0it+β1 LTDTCit +β2 TDTCit + β3STDTCit +μit

Where, ROA (return on asset), ROE (return on equity), and EPS (earning per share) are financial
performance indicators for firm i in year t. LTDTC, TDTC and STDTC indicate long-term debt, total
debt and short-term debt to capital ratios for firm i in year t, respectively. SPSS version 17.0 software
were used to perform all the statistical computations necessary for this study.

Results and Discussions

Descriptive Statistics
Descriptive statistics of study are given in Table 1. The mean of the LTDTC, STDTC and TDTC is
94.12, 97.95 and 107 percent respectively which indicates that most of the Banking firms in
Bangladesh are highly levered. However, the mean of ROA, ROE and EPS is 5.95 percent, 15.34
percent and Taka 28.42 respectively which reveals that the Banking firms have poor return or
performance during the sample period.
 Mukit & Rizvy

Table 1: Descriptive Statistic

Variables ROA ROE EPS LTDTC STDTC TDTC

Mean .0595 .1534 28.4213 .9412 .9795 1.7004

Max .10 1.25 255.59 11.26 11.21 6.57
Min .03 -.15 1.01 .32 .15 .47
Standard .01274 .17262 39.11761 1.04973 1.56671 1.09359
Deviation
Observations 100 100 100 100 100 100

Correlation Matrix

Table 2 shows the correlation matrix which tells us the relationship among variables in this study.

Table 2: Correlation Matrix

Variables LTDTC STDTC TDTC
LTDTC 1
STDTC -0.79176 1
TDTC -0.75531 0.998344 1

Long term debt to capital (LTDTC) has negative association with all variables. Short term debt to
capital (STDTC) has positive correlation with total debt to capital ratio (TDTC) and negative
association with a long term debt to capital (LTDTC). Finally, total debt to capital (TDTC) shows a
negative association with long term debt to capital (LTDTC) but a positive association with short term
debt to capital (STDTC).

Multiple Regressions

Table 3 shows the results of regression analysis of panel data which depicts the impact of capital
structure on the firm’s performance.

Table 3: Regression Model

Dependent Variables
Model-1 Model-2 Model-3
ROA ROE EPS
Coefficient t- Sig Coefficient t- Sig Coefficient t- Sig
statistic statistic statistic
Constant .087 6.256 .000 .265 1.362 .177 -60.531 -1.409 .162
LTDTC -.014* -1.822 .072 -.064 -.610 .544 52.268** 2.260 .026
TDTC -.015* -1.924 .057 -.065 -.594 .554 48.799** 2.018 .046
STDTC .011* 1.664 .099 .060 .649 .518 -44.123** -2.157 .034
Adjusted R- 0.037 0.006 0.031
Square
F-value 2.285 0.179 2.06
Prob(statistic) 0.084* 0.910 0.10*

Note: * significant at 0.10, ** significant at 0.05 level

The Eastern University Journal, Vol. 5, Issue 2, December 2014

For model-1, outcome of regression analysis shows a positive relation between ROA and STDTC
where it shows ROA has negative relationship with LTDTC and TDTC. The slope coefficient of these
three independences variables is statistically significant at 10% level. Moreover F=2.285 and P= .084
show the overall significance of the model. This means that the capital structure has significant
impact on the ROA of the Banking firms.

For model-2, the result shows a positive relation between ROE and STDTC where it shows ROE has
negative relationship with LTDTC and TDTC. But the slope coefficients of these independences
variables are not statistically significant. Moreover F=0.179 and P= .910 indicates that the overall
model is not significant. This means that the capital structure has no significant impact on the ROE of
the Banking firms.

For model-3, outcome of regression analysis shows that EPS has positive relationship with LTDTC
and TDTC where it has negative association with STDTC. The slope coefficients of these three
independences variables are statistically significant at 5 % level. Moreover F=2.06 and P= .10 show
the overall significant of the model. This means that the capital structure has significant impact on the
EPS of the Banking firms.

Conclusions

The aim of this study was to provide an empirical evidence regarding the influence of capital structure
on profitability of banking sector in Bangladesh. The study finds that long term debt to capital
(LTDTC) and total debt to capital (TDTC) have a negative and significant relationship with return on
asset (ROA) where short term debt to capital (STDTC) has a positive but significant relationship with
ROA. The overall significance of the model indicates that capital structure has significant impact on
the ROA of the Banking firms. On the other hand, the study reveals that the relationship of return on
equity (ROE) with long term debt to capital (LTDTC) and total debt to capital (TDTC) is negative but
with short term debt to capital (STDTC) is positive but these relationships are found to be
insignificant. The findings depict that capital structure has no significant impact on the ROE of the
Banking firms. Finally, the study shows that earning per share (EPS) has a positive and significant
relationship with long term debt to capital (LTDTC) and total debt to capital (TDTC) where it has
negative but significant association with short term debt to capital (STDTC). The overall significance
of the model indicates that capital structure has significant impact on the EPS of the Banking firms.

The overall result indicates that capital structure has significant impact on the financial performance
of the banking sector of Bangladesh. Thus the study suggests that managers should consider the
factors influencing capital structure and should go for optimal mix of debt and equity capital in order
to maximize firm’s value.

However, the limitations of this study can create an opportunity for further research work in this area.
In fact, the result may vary from industry to industry. By increasing the time frame and incorporating
different industries may produce different results. Moreover, researchers can consider identifying new
explanatory variables that have impact on capital structure of the firms which is left for future
research work.
 Mukit & Rizvy

References

Abor, J. (2005). The Effect of Capital Structure on Profitability: An Empirical Analysis of Listed
Firms in Ghana. The Journal of Risk Finance, 6(5), 438-445.
Abor, J. (2007). Corporate Governance and Financing Decisions of Ghanaian Listed Firms. Corporate
Governance, 7, 83-92.
Abor, J. (2007). Debt Policy and Performance of SMEs: Evidence Form Ghanaian and South African
Firms. The Journal of Risk Finance, 8(4), 364-379.
Ahmad, Z., Hasan, N. M. A., & Roslan, S. (2012). International Review of Business Research Papers,
8(5), 137-155.
Akinlo, O. (2011). The Determinants of Capital Structure Evidence from Nigeria Panel Data. African
Economy and Business Review, 9(1):1-16.
Alom, K. (2013). Capital Structure Choice of Bangladeshi Firms: An Empirical Investigation. Asian
Journal of Finance & Accounting, 5(1), 320–333.
Aliakbar, R., Seyed, H. S. N., & Pejman, M. (2013). The Relationship between Capital Structure
Decisions with Firm Performance: Comparison between Big and Small Industries in Firms
Listed at Tehran Stock Exchange. World of Sciences Journal, 1(9), 83–92.
Amidu, M. (2007). Determinants of Capital Structure of Banks in Ghana: an Empirical Approach.
Baltic Journal of Management, 2(1), 67-79.
Baxter, N. (1967). Leverage, Risk of Ruin and the Cost of Capital. Journal of Finance, 22(3), 395-
403.
Bevan, A. & Danbolt, J. (2000). Dynamics in the Determinants of Capital Structure in the UK,
University of Glasgow, Working paper , 1-10.
Bevan, A. & Danbolt, J. (2002). Capital Structure and its Determinants in the UK- A Deco
Positional Analysis, Applied Financial Economics, 12, 159-170.
Bradley, M., Jarrell, G.A., & Kim, E.H. (1984). On the existence of an optimal capital structure:
Theory and evidence. Journal of Finance, 39, 857 –878.
Chowdhury, A. & Chowdhury, S.P. (2010). Impact of Capital Structure on Firm’s Value: Evidence
from Bangladesh. Business and Economic Horizons, 3(3), 111-122.
Ebaid, E. I.(2009). The Impact of Capital-Structure Choice on Firm Performance: Empirical Evidence
from Egypt. The Journal of Risk Finance, 10(5), 477-487.
Grossman, S. & Hart, O. (1986). The Costs and Benefit of Ownership: A Theory of Vertical and
Lateral Integration. Journal of Political Economy, 94, 691-719.
Groth, J.C., & Anderson, R.C. (1997). Capital Structure: Perspectives for Managers. Management
Decisions, 35(6), 552-561.
Hasan, M.B., Ahsan, A.F.M.M., Rahaman, M.A., & Alam, M.N. (2014). Influence of Capital
Structure on Firm Performance: Evidence from Bangladesh. International Journal of Business
and Management, 9(5), 184-194.
Mesquita, J.M.C. & Lara, J. E. (2003). Capital Structure and Profitability: The Brazilian Case
Working Paper. Academy of Business and Administration Sciences Conference, Vancouver,
July 11-13.
Modigliani, F. & Miller, M.(1958). The Cost of Capital, Corporation Finance and the Theory of
Investment. The American Economic Review, 48(3), 261-97.
Phillips & Sipahioglu (2004). Performance Implications of Capital Structure Evidence from Quoted
UK Organizations with Hotel Interests. The Service Industries Journal, 24(5), 31-51.
Pratheepkanth, P. (2011). Capital Structure and Financial Performance: Evidencefrom Selected
Business Companies in Colombo Stock Exchange Sri Lanka. Journal of Arts, Science &
Commerce,23.
The Eastern University Journal, Vol. 5, Issue 2, December 2014

Khrawish, H. A. & Khraiwesh, A. H. A. (2010). The Determinants of the Capital Structure: Evidence
from Jordanian Industrial Companies. JKAU: Econ. & Adm., 24 (1), 173 -196.
Margaritis, D. & Psillaki, M. (2010). Capital Structure, Equity Ownership and Firm Performance.
Journal of Banking & Finance, 34(3), 621–632.
Pandey, M. (2001) Capital Structure and the Firm Characteristics: Evidence from an Emerging
Market, Indian Institute of Management Ahmedabad, Working paper, pp: 3-5.
Roden, D. & Lewellen, W. (1995), "Corporate Capital Structure Decisions: Evidence from Leveraged
Buyouts", Financial Management, 24,76-87.
Salim, M. & Yadev, R. (2012). Capital Structure and Firm Performance: Evidence from Malaysian
Listed Companies. Social and Behavioral Sciences, 65, 156–166.
Salteh, H. M., Ghanavati, E., Khanqah, V. T., & Khosroshahi, M. A. (2012). Capital Structure and
Firm Performance; Evidence from Tehran Stock Exchange. International Proceedings of
Economics Development & Research, 43, 225–230.
San, O.T. & Heng, T.B. (2011). Capital Structure and Corporate Performance of Malaysian
Construction Sector. International Journal of Humanities and Social Science, 1(2), 28 -36.
Stiglitz, J.E.(1972). A Re-Examination of the Modigliani-Miller Theorem. American Economic
Review, 59, 784-793.