The main focus of this thesis is to evaluate, whether there is any relationship between leverage (DEBT) and size of the firm on the profitability of the firm. For that purpose two main sectors, Cement and Textile are taken into account. Capital structure of 10 companies each; in both textile and cement sectors are taken covering a period of 6 years from 2004 to 2009. The hypotheses are proved on the basis of regression analysis and descriptive statistics conducted in empirical studies.
Introduction
Operating Leverage and Financial Leverage; are the two basic types of leverage for a firm. Operating Leverage is the percentage of the fixed costs in the cost structure of the company. Generally, capital intensive firms have a higher proportion of fixed costs in the cost structure. Similarly, labor-intensive or firms with lower fixed costs have a lower operating leverage. Financial Leverage is referred to the debt based financing part, when the companies take debt then they have a financial leverage. For a company with no debt, 100% equity financed there is no financial leverage, it has only operating leverage. Companies having both Operating and Financial leverage are more risky as compared to a firm which has only operating leverage.
There seems to have very little work done to prove the relationship between these. Some of the theories which explain the relationship between profitability and leverage are as follows;
The Trade-off theory portrays a positive relationship between Profitability and Leverage because firms having a high debt would have to pay more interest expense which would provide them a tax shield and lower expected bankruptcy costs as well.
The Signaling theory; this theory was suggested by Ross in 1977, he states that there is a positive relationship between leverage, profitability ands possibility of bankruptcy. He was of the opinion that when the company is taking more debt, it acts as a signal to the investors about the high quality of the firm, so the managers try to maximize the market value of the firm, but if the firm fails, then the blame of the bankruptcy is put on the managers.
Pecking Order Model (Stewart C. Myers and N. Majluf 1984) the companies give preference to the sources of finance from the internal sources i.e. retained earning to issue equity because it requires e least effort to obtain the funds. Therefore, internal funds are used first, followed by debt, and if it is not feasible to issue debt anymore, then equity is issued.
Literature Review
In the research paper "Financial Leverage and Investment - The case of Mauritian Firms" written by Mohun Prasadsing Odit and Hermant B. Chittoo in 2008 took a sample of 27 companies listed on the Stock exchange of Mauritius for the period 1990 to 2004 on a annual basis. The variables included in the research are net fixed investment, cash flow, leverage, sales and profitability (ROA). The research methodologies used are econometrics analysis and regression analysis. According to the result there is a negative relationship between leverage and investment, there is also a relationship among the independent variables e.g. a high correlation between profitability and cash flow and sales growth. Profitability is positively related to investment and liquidity and investment is also positively related with each other. For low growth companies, the relationship between leverage and investment is negative and is statistically significant, on the other hand for high growth companies although the relationship between leverage and investment is negative and is statistically insignificant.
According to Matjaz Crnigoj and Dusan Mramor in the paper "Alternative Capital Structure Explanations" written in July 2006 uses the variables e.g. volatility, tangibility of assets, profitability and employee's power in corporate governance to see their impact on leverage. The time period taken in account is from 1999 to 2004, the period before the privatization in Slovenia on an annual basis. The data is taken from AJPES (Agencija Republike evidence in storitve), the data includes the income statement, balance sheet and some other financial data about the Slovenian limited liabilities companies and PLC registrations which according to law, they are obliged to report annually. The methodology used in the research includes regression analysis and descriptive statistics which show the result that tangibility of assets is said to negatively correlated with leverage. Earning volatility is also negatively correlated with leverage. Moreover, according to the Pecking Order theory there is a negative relationship between profitability and leverage. But, growth rate and leverage are said to positively related to each other. So, in the case of the Slovenian limited companies, although there has been a change in corporate governance with stakeholders, the financial behavior of companies in transitional economies is different from the financial behavior in mature market economies.
In the research paper, "The Effect of Competitive Structure on the relationship between Leverage and Profitability" by author Christine Harrington in January 2005 takes the data from financial source of COMPUSTAT annual research files from the period 1982 to 2001 on an annual basis and the U.S. Census Bureau constructs the Herfindahl-Hirschman Index (HHI) which shows all the manufacturing firms in U.S. every five years. This study is limited to only the manufacturing companies due to this. The sample size includes 198 manufacturing companies in which the research methodology includes descriptive statistics. The variables included are total assets, sales, operating cost, EBITDA, Depreciation, size, Market to Book Value, Research and Development (R+D), Debt/Book value, long term debt and Debt/Equity. The results show that profitability is more persistent in concentrated industries. The differences between leverage and profitability in concentrated and unconcentrated industries are due to the differences in the speed of reversion in profitability. The findings in this paper also support the earlier findings of Sarkar and Zapatero in 2003. So, the manufacturing firms belonging to the concentrated industries have a slower rate of mean reversion in profitability compared to firms in more competitive industries. Hence, leverage varies negatively with profitability.
According to authors F. Schoubben and C. Van Hulle (2004) in the paper "Determinants of leverage; Differences between Quoted and Non-Quoted Firms"; a study which covered the period from 1992 to 2002 for all non-financial Belgian companies in which the figures were gathered from consolidated financial statements through the NBB (National Bank of Belgium) and Van Dijck Belfirst. The variables for leverage include total debt divided by total assets and short term debt over total assets, for mix debt the variables include, BANKLEV which is equal to total bank debt (Long + short term) divided by total debt, TRADCRED which is total amount of trade credit over total debt and STDEBT which is short term debt over total debt, LNTA which is natural logarithm of total assets and LNVA which is natural logarithm of value added. The methodology used for these variables included Univariate Statistics, Descriptive Statistics and Univariate Correlations. This analysis shows that profitability, risk, growth and tangibility have an expected impact on the leverage of the firm. The results were according to the Pecking Order theory which was written by Myers and Majluf in 1984 as discussed in the introduction as well. Other theories discussed in the paper i.e. Trade-off, Signaling and Agency problems did not had much support from the information. Therefore, profitability is a significant driver of the total leverage.
In the research paper "Profitability Mean Reversion of Leverage Ratios, and Capital Structure Choices" (April 2004) takes into account figures from the financial accounting data from COMPUSTAT'S P/S/T and research annual industrial tapes from the period 1971 to 2002 [1] and equity return facts from the center for Research in security prices. The variables included total debt over market value of assets (TDM), long term debt over market value of assets (LDM), Total debt over book value of assets (TDA) and Long term debt over book value of assets (LDA). The methodology used includes Univariate analysis, Multivariate analysis and Multinomial logit regression. The lagged leveraged ratios are negatively related to changes in the leverage ratios i.e. mean reversion. On the whole, there is dependable relationship between leverage ratios, change regressions and the financing decision regressions. The analysis shows that firms that are more profitable tend to rely on lower leverage ratios, since they give preference to their internal funds and give little preference to rebalancing their leverage ratios.
According to author Rashmi Banga and Uday Bhanu Sinha (January 2003) in the research paper "Does the structure of Debt Affect the Output and investment strategies of the firm?" tells that debt has a negative relationship with output and investment in companies. The variables taken in to account include total debt, short term debt and long term debt and their impact on output, investment, technology up gradation. The data has been collected from the Capitaline package which is provided by Capital Markets Limited, which includes data for 7000 Indian firms, out of which only those firms are taken in the research which are in oligopolistic industries. The methodologies used are Univariate analysis, multivariate analysis and descriptive statistics. The result for all the oligopoly industries shows that firms with high debt and low debt differ with each other in respect to investment, asset structure and profitability of the company. Generally higher debt firms have more fixed assets, less investment, and less profitability as compared to low debt firms. In contrast, companies with higher short term debt have lower sales in comparison to companies with lower short term debt. Overall, higher leverage firms use more aggressive strategies, as they are more risky and debt financed companies are at a competitive disadvantage in comparison to equity financed companies.
According to Abdel-Hameed M. Bashir (January 2001) in "Assessing the performance of Islamic Banks- Some evidence from the Middle East" the research which was conducted to assess the performance of Islamic Banks from the period 1993 to 1998, included variables e.g. Capital ratios, Leverage, overhead, loan and liquidity ratios and foreign ownership for the internal measurement of the companies. The data was gathered from the income statements and balance sheets of 14 Islamic banks from eight countries, from the Bankscope database which was gathered by IBCA. The methodology used was regression analysis and the results showed that the relation between profitability and bank's characteristics shows that both EQTA (Book value to equity) and LOANTA (Ratio of loans to total assets) have a positive relationship with profitability. This indicates that higher leverage and higher loans to assets ratios would lead to higher profits. This shows that Islamic bank's profitability responds positively to the increase in capital and loan ratios. In addition to this, tax aspect is also important in determining the performance of the bank.
In the research "Dynamics of Capital Structure- The case of Korean Listed Manufacturing companies" by author Kyesung Kim, Almas Heshmati and Dany Aoun conducted for the period 1985 to 2002 on a annual basis, used the data source of KIS2003 which is the corporate information database provided by the Korean Information service. The sample of 617 companies was taken from there along with 30th largest business groups and their affiliated firms from the data released by the Korea's Fair Trade Commission. The research methodology used included dynamic and static capital structure model based on estimated non-linear and linear least square estimation respectively and Descriptive statistics. The variables included in the capital structure are variability, growth, tangibility, size, profitability, non-debt tax shield, uniqueness and trend. The result of these variables showed that income was negatively related to leverage which means that more volatile income, the higher the possibility to default. Secondly, growth opportunity also showed a negative sign in the static model and restricted dynamic model but showed a positive sign in unrestricted dynamic model. Thirdly, there is a positive relation between size and leverage because larger firms are in a better position to raise debt as compared to smaller companies. Fourthly, profitability showed a negative relationship with leverage, the coefficient was also negative. Lastly, the time trend is expected to be negatively correlated with the leverage because of the adverse effects of the financial crisis on the Korean credit market. This show that overall there is a negative relationship with profitability, growth opportunity on one side and leverage on the other side.
Hypothesis
HO: Profitability is affected by higher degree of leverage
HO: Profitability of the firm is also affected by size of the firm
Empirical Analysis
Descriptive Statistics for Textile Industry
N
Range
Minimum
Maximum
Mean
Statistic
Statistic
Statistic
Statistic
Statistic
Std. Error
Liquidity
50
1.66
0.08
1.74
0.9790
0.03012
DOL
50
135.85
-36.33
99.52
2.7252
2.77272
DFL
50
6.06
-2.92
3.14
0.5962
0.09415
Profitability
50
6609.97
-213.00
6396.97
485.4240
137.90574
Valid N
50
Std.
Variance
Skewness
Kurtosis
Statistic
Statistic
Statistic
Std. Error
Statistic
Std. Error
Liquidity
0.21300
0.045
-0.534
0.337
8.525
0.662
DOL
19.60610
384.399
3.257
0.337
14.698
0.662
DFL
0.66571
0.443
-1.937
0.337
19.734
0.662
Profitability
975.14087
950899.71
4.867
0.337
28.243
0.662
Valid N
In the textile sector, DOL is more volatile than then DFL. DOL is positively skewed and DFL is negatively skewed. The profitability measure in the textile industry has more variance implying that the companies in the textile sector have large difference in the earnings and profits which could be due to the size of the firm. Large firms, due to the larger scale of operations, earn high profits and small firms, due to their small size, do not operate on such a large scale, and report lower profits and earnings in comparison. The profitability measure is also positively skewed in the textile industry. Kurtosis is positive for the all variable such as DOL, DFL, and Liquidity.
Descriptive Statistics for Cement Industry
N
Range
Minimum
Maximum
Sum
Mean
Statistic
Statistic
Statistic
Statistic
Statistic
Std. Error
Liquidity
50
2.78
0.29
3.07
58.60
0.09704
DOL
50
174.61
-45.08
129.53
187.69
2.97519
DFL
50
19.26
-16.32
2.94
24.25
0.36224
Profitability
50
3949.53
-461.00
3488.53
37393.28
124.71706
Valid N
50
Std.
Variance
Skewness
Kurtosis
Statistic
Statistic
Statistic
Std. Error
Statistic
Std. Error
Liquidity
0.68617
0.471
1.129
0.337
0.451
0.662
DOL
21.03774
442.587
4.302
0.337
27.127
0.662
DFL
2.56145
6.561
5.978
0.337
39.628
0.662
Profitability
881.88279
777717.26
1.008
0.337
0.942
0.662
Valid N
In the cement setctor, the descriptive statistics show similar findings as compared to the textile sector. Here also like textile sector DOL is more volatile than DFL; DOL has more variance and fluctuation than DFL. Profitability is also having more variance which shows that companies in the cement sector have large difference in their earnings. The Skewness show that DOL is positively skewed where as DFL is negatively skewed. The profitability measure is also positively skewed in the analysis. The Kurtosis is positive for all the measures i.e. DFL, DOL, Profitability and Liquidity.
While looking at the descriptive statistics of both the industries, one shoud see the same trend in both the industries. Analysis show that both the sectors have same trend in variance, skewness and kurtosis, which means that profitability of the firm is affected by financial leverage, operating leverage, size of the firm, liquidity in the same manner in both the industries. After looking at the descriptive statistics of both the industries exhibiting the same characteristics, a look at the regression analysis would provide more meaningful picture about the empirical analysis.
Regression Analysis for Textile Industry
Model
R
R Square
Adjusted R Square
Std. Error of the Estimate
1
.422(a)
.178
.124
912.55433
a Predictors: (Constant), Liquidity, DOL, DFL
ANOVA(b)
Model
Sum of Squares
Df
Mean Square
F
Sig.
1
Regression
8287337.341
3
2762445.780
3.317
.028(a)
Residual
38306748.618
46
832755.405
Total
46594085.959
49
a Predictors: (Constant), Liquidity, DOL, DFL
b Dependent Variable: Profitability
Coefficients(a)
Model
Unstandardized Coefficients
Standardized Coefficients
t
Sig.
B
Std. Error
Beta
B
Std. Error
1
(Constant)
-1241.535
621.609
-1.997
.052
DFL
99.493
197.500
.068
.504
.617
DOL
11.826
6.704
.238
1.764
.084
Liquidity
1670.492
622.256
.365
2.685
.010
a Dependent Variable: Profitability
The R-Square of 0.178 shows that the variation in probability is 17.8%, which means that the impact of these dependent variables on profitability is only 17.8%. The F Stat of 3.317 indicates that the overall model is quite good, although some variables still are not taken into account which has impact on profitability. The coefficient for DOL, DFL and liquidity are positive. The positive coefficient of DOL negates with the theory of Pecking Order Model, which states that the coefficient of DOL will be negative. The coefficient for DOL is 0.068, for DFL is 0.238 and for liquidity is 0.365. The t test is positive for all the three discussed variables i.e. DOL, DFL and liquidity.
Regression Analysis for Cement Industry
Model Summary
Model
R
R Square
Adjusted R Square
Std. Error of the Estimate
1
.201(a)
.041
-.022
891.53912
a Predictors: (Constant), Liquidity, DOL, DFL
Coefficients(a)
Model
Unstandardized Coefficients
Standardized Coefficients
t
Sig.
B
Std. Error
Beta
B
Std. Error
1
(Constant)
472.109
251.672
1.876
.067
DOL
-1.832
6.071
-.044
-.302
.764
DFL
22.253
50.234
.065
.443
.660
Liquidity
231.945
187.648
.180
1.236
.223
a Dependent Variable: Profitability
ANOVA(b)
Model
Sum of Squares
Df
Mean Square
F
Sig.
1
Regression
1545413.236
3
515137.745
.648
.588(a)
Residual
36562732.401
46
794842.009
Total
38108145.637
49
a Predictors: (Constant), Liquidity, DOL, DFL
b Dependent Variable: Profitability
The coefficient of DOL is 0.044, DFL is 0.065 and Liquidity is 0.180 is insignificant and shows that there are other variables not taken into consideration in the regression analysis which have a significant impact on the profitability of the company. The R-Square of 0.041 shows that the variation in probability is 4.1% which means that the impact on profitability of these dependent variables is only 4.1%. The F stat of 0.648 indicates that the overall model is not good, as compared to textile sector, because there are other variables then the ones discussed in the regression analysis, that have a significant impact on the profitability of the company. The findings of the The study supports the null hypothesis set in the paper, that leverage has an impact on the profitability of the company. The t test for DOL is negative and low, the t test for DFL is positive but low and the t test for liquidity is better and positive. The coefficient for DOL is negative where as the coefficient for DFL and Liquidity is positive. The negative coefficient for DOL is according to the theory of the Pecking Order Model as discussed in the introduction of the thesis.
Conclusion
To conduct this research I analyzed the sample of 10 companies, each from textile and cement sectors listed in Karachi stock exchange. I have taken the data from the year 2004 to 2009. I have used the regression analysis and descriptive statistics to test the hypothesis, the result of the analysis shows that:
Profitability of the firms is positively affected by leverage (Debt) (H0 proved).
Profitability and size of the firm are also positively related to each other. (H0 proved)
According to the, F. Schoubben and C. Van Hulle (2004) in the paper "Determinants of leverage; Differences between Quoted and Non-Quoted Firms" shows that profitability, risk, growth and tangibility have an expected impact on the leverage of the firm which proves the hypothesis set in the thesis.
According to Abdel-Hameed M. Bashir (January 2001) in "Assessing the performance of Islamic Banks- Some evidence from the Middle East" the research paper indicates that higher leverage and higher loans to assets ratios would lead to higher profits. This shows that Islamic bank's profitability responds positively to the increase in capital and loan ratios. This research paper also supports the hypothesis that there is a positive relationship between leverage and profitability.
The trade-off theory and the Signaling theory both show that there is a positive relationship between leverage and profitability, which allows the companies to have lower bankruptcy costs, provides them a tax shield as their interest expense provides them a cover against taxes.
