There are many studies on the relationship between firms capital structure, liquidity and performance but this particular study is about the oil gas sectors and selected industrial(textile) firms registered in KSE 100 index (Karachi stock exchange) of Pakistan. Capital is very important for every business, to choose a capital structure which will maximize the company's profits at minimum cost, so selection of such capital structure is dilemma for the businesses all the time. Liquidity is very important to able a firm to do its business successfully, there must be balance in firms liquidity level; it should not go through excess or shortage in meeting its short term obligations. Profitability of firm is vital for long term growth, so these components of firm's finances should be understood and firm's management will only be able to take important decisions about firm's capital structure and its assets liquidity and performance when they have clear knowledge of these relationships.
Capital is lifeblood for every organization and organizations always strive for getting capital at lowest possible cost for maximizing profitability of firms. Companies do this also to remain competitive in market.
Firms Capital structure is a mix of different securities issued by firm for raising capital. Every firm wants to maximize profitability by choosing level of capital structure which generates maximum return for the firm. This is most controversial topic in corporate finance and still no consensus is built on the capital structure level which generates maximum revenue for the firm.
The idea of optimal capital structure is first explained by Miller and Modigliani study (Modigliani & Miller, 1958) when they presented MM Proposition 1, in which they presented the idea that capital structure is irrelevant with the valuation of the firm in perfect market where no transaction fees, no taxes, free market with the large number of buyers and sellers. But this proposition only hold under perfect market, when it comes to inefficient market this assumption will not hold longer as there is no perfect market in world.
In the real world (Modigliani & Miller, 1963) MM Proposition 2 states that financial distress, bankruptcy costs and tax shields present, which leads to optimal capital structure and maximizes the value of the firm. When the level of debt is increased in capital structure of the firm than the tax shield increased, which is followed by the increase in profitability of the firm. However, as we add more debt cost of financial distress is also increase so the value of the firm is maximized when the tax shield compensates the increase in present value of cost of financial distress.
By adding more debt to get maximum tax shield as it is explained by adding more debt cost of financial distress also increase and another factor is the coast of equity also increase which is due to adding more debt the risk for equity holders increase, an important aspect to this factor is debt holders have prior claim to profit than equity holders.
So under inefficient market capital structure may have impact on cost of capital which rise, as shown in a study by (Ben-Shahar, 1968).
Liquidity is the extent to which a company's assets or securities can be easily converted into cash without losing too much value or at low cost. Liquidity is important for the companies in such way that it provides an opportunity to survive in the period of low earnings as on that time external financing is not easily available or at higher cost.
It is well understood phenomena in finance is; "higher the risk, higher will be the return" to get higher profit investor should have to bear higher returns these two factors are related, holding an asset in liquid form also have drawback that firm frequently sacrifice an opportunity to invest in project which can give higher returns in stake of higher risk.
When firms need finances and in case of external finances which are only available at higher cost than retain earnings can serve as liquid asset and firm can enjoy it at lower cost which is opportunity cost of that fund, which firm have in shape of retain earnings. So leverage and liquidity may have positive or negative relationship which varies by different factors.
It can be assume that liquidity may have relationship with firms capital structure which include different types of funds choices by firms which are usually debt financing, equity and preferred stocks, it can vary from firm to firm depending upon its financial positions and type of business.
To measure the relationship, there are different ratios by which liquidity can be measured and same for capital structure. Profitability is another important factor which is always under great concern with the firm's operations.
In previous studies different measures have been taken to estimate the relationship, in this study we will use long term debt ratio, short term debt ratio, total debt ratio as proxy for capital structure and current ratio, quick ratio fir liquidity and for the firms performance gross profit ratio, return on equity ratio and earnings per share ratio.
Research questions:
"Is there any relationship between firm's capital structure, liquidity and performance?"
"Does the firm's liquidity have negative relationship with firm's capital structure?"
"Does the firm's performance have positive relationship with firm's capital structure?"
Hypothesis:
Null hypothesis Ho: "there is positive relationship between firm's liquidity and capital structure and negative relationship between capital structure and performance of firm."
Ho:
H1: "capital structure significantly impact on liquidity and profitability of firm."
H2: "there is negative relationship between firm's liquidity and capital structure and positive relationship between firm's performance and capital structure"
H2:
Research objective:
To estimate the relationship between capital structure, liquidity and firm performance
To find ways that can enhance performance of firm
To what extent of liquidity that firm should hold
To determine determinants of capital structure.
To enable firm's managers to take appropriate decision in choosing firms best capital structure in relation to firm's liquidity and profitability.
6. Literature review:
To find the relationship between firm's capital structure, profitability and liquidity many studies have significantly contributed, but this study has its own importance, as there is very little work or studies have conducted in Pakistan. In previous studies on other countries have some contradiction in their results, so a study on developing country like Pakistan in this particular area of finance will have its own implication?
A study conducted by (Anderson, 2002) on UK and Belgian listed non financial firms and collected data from annual reports for the period of 1989-2001 for UK firms and for Belgian firms data of non financial firms for the period through 1986-1999 and there results were contradictory for both countries which were: the relationship between long term leverage and liquid asset holding is positive and it is negative for short term leverage and liquid asset holding for the UK firms and when they tested same variables for Belgian firms results were inverse in both cases of long term and short term leverage with liquid assets holding.
So it means that different countries show different behavior for this relationship.
(Ortiz-Molina & Phillips, 2010) in his study has shown assets liquidity affects firms cost of capital in both the cross section and time series, they find the negative relationship between firms liquidity and cost capital, sample for the study included 6260 firms and for the period of 1984-2006, as if firms hold liquid assets than in the period of low cash flows, liquidity will provide benefit by providing finds but firms have to lose its long term investment opportunities.
A lot of work has been done on the relationship between firms cost of capital and capital structure, according to M&M theory under efficient market when there is no taxes than cost of capital and capital structure is independent.
(Ben-Shahar, 1968)When capital structure is efficient than the cost of capital will constant but it rises when capital structure of firm become inefficient. The relationship between cost of capital and assets liquidity is negative, so it is cleared that when firms operate in inefficient markets, there cost of capital increase and is positively related with capital structure, so capital structure is negatively related with firms liquidity.
(Amihud & Mendelson, 2008) used NYSE and AMEX listed firms over the period of 1960-1980 to test the relationship between liquidity and asset returns and find positive relationship. In the implication of capital structure and liquidity they established relationship as in inefficient market as if transaction and information cost increase, liquidity of firms stock is affected by the capital structure of firm particularly its equity cost of capital, if company's debt to equity ratio increase than the risk for equity holders increase thus cost of capital increase.
A study conducted by (Lipson & Mortal, 2007)on the relationship between liquidity and capital structure of firm on the U.S companies data from 1986-2004 which raises outside capital, if the company hold more liquid stocks than it more likely prefer equity as compare to debt, so it can assume that capital structure should have relationship with firms liquidity.
In this study author finds out the impact of capital structure on profitability of 272 firms listed in NYSE for the period of three years (2005-2007).Authors selected two industries one is manufacturing and service industry for comparison purposes. After regressing dependent variable capital structure on independent variable corporate performance results shows positive relationship between Short-term debt to total assets and profitability of the firm in the services industry and total debt to total assets and profitability(ROE) of firms in the services industry. These results also show positive relationship between short-term debt to total assets and profitability of firms, long-term debt term debt to total assets and profitability, total debt to total assets and profitability in the manufacturing industry(Gill, Biger, & Mathur, 2011).
This paper studies the relationship between capital structure and profitability of firms operating in Tehran stock exchange(TSE) authors selected sample of 320 listed manufacturing firms for the period of (2003-2009).Results generated through regressing using pooling methods (fixed effects model, Hausman tests) and F-tests. Results indicate profitability, which is measured Tobin, s Q and EPS are positively related with the capital structure, on the other way capital structure is negatively related with profitability measure(ROA).Moreover results postulates insignificant relationship between capital structure on profitability measure(ROE)(Saeedi & Mahmoodi, 2011).
In this study, author examines the relationship between capital structure and financial performance by taking sample of 28 non financial firms from Palestine stock exchange (PSE) for the period of (2006-2010).After regressing variables results shows that capital structure is positively related to marketing performance measures(Tobin's Q,EPS,MBVR) and accounting measures (ROA and ROE) these are also statistically significant with TDTA except MBVR, which is significant with TDTA as well as with SDTA so finding to suggest the significant impact of debt on firms profitability(Abu-Rub, 2012).
Another analytical study which shows the relationship between capital structure and financial performance of firms, Authors takes the sample of 30 firms from Colombo stock exchange for the period of (2005-2009) after correlation analysis author showed results that weak positive relationship exists between capital structure and Profitability measure (gross profit) and negative relationship between capital structure and profitability measures(ROA and ROI) also overall results shows insignificant negative association exists between capital structure and financial performance of firms(Pratheepkanth, 2011).
Another study examines the effect of capital structure on profitability of firms by taking 50 non financial firms from the Nigeria stock exchange for the period of (1990-2004).Authors used pool, random effect and fixed model and shows results that profitability is positively associated with short-term debt and equity and negatively correlated with long-term debt. Moreover, results show negative relationship between total debt to total assets and profitability of the firm. These findings suggest that firms in Nigeria more dependent on external financing(Salawu, 2009).
In Another study, author takes the sample of 127 industries, and he takes 1143 observations collected from all manufacturing firms excluding chemical industry for the period of (1990-2004) he examines firm performance with the distress events in the industry so with simple and random effects model shows results that debt ratio is negatively associated with profitability of firm and firm size is the firm size is positively related to industry adjusted profitability. Moreover, higher pre distress profitability seems to be more post distress profitability(Ramachandran & Nageswara Rao, 2010).
In Another study, authors proved the capital structure in Taiwan firm's authors examined the relationship between capital structures on firm performance; they take the sample of 37 non financial firms for the period of (1987-2007) by using ROE as a proxy for profitability. They explains optimal capital structure in Taiwan shows the tendency that debt ratio of firm's moves toward the optimal capital structure year by year author also states that this movement towards the optimal capital structure is in line with the past historical behavior which is consistent with trade off theory(Chou & Lee, 2010).
Another paper also studies this relationship of corporate structure on financial performance of firms in the construction sector of Malaysia with context to 2007 crisis.
Authors take the sample of 49 construction companies listed in the main board of bursa Malaysia for the period of (2005-2008).Authors divided firms according to size of firms with paid up capital. This study shows contradicting results. For big companies (ROC) return on capital with (DEMV) Debt equity market value and (EPS) with (LDC) long run debt capital shows positive relationship and on other hands, it shows (EPS) with (DC) is negatively related and in medium firms only (OM) operating margin and (LDE) has positive relationship and (EPS) with (DC) shows negative relationship in small firms of construction industry(San & Heng, 2011).
Research Methodology:
This study will conduct to test the relationship between firm's capital structure, liquidity and performance of oil & gas sector and selected industrial(textile) firms registered in KSE 100 index (Karachi stock exchange) of Pakistan.
For this purpose secondary data will be collected from the KSE official web site of listed companies and from the company's own web site for the period of 2006-2011.
To test the relationship correlation and regression analysis tools will be used. In this study only nonfinancial firm's will be selected because the difference of financial firms in the characteristic of capital structure and liquidity.
Y=0+
Control variables: firm size, business risk
Capital structure=
REFRENCES:
Abu-Rub, N. (2012). Capital Structure and Firm Performance; Evidence from Palestine Stock Exchange.
Amihud, Y., & Mendelson, H. (2008). Liquidity, the value of the firm, and corporate finance. Journal of Applied Corporate Finance, 20(2), 32-45.
Anderson, R. W. (2002). Capital structure, firm liquidity and growth. National Bank of Belgium(27), 1-19.
Ben-Shahar, H. (1968). The Capital Structure and the Cost of Capital: A Suggested Exposition. The Journal of Finance, 23(4), 639-653.
Chou, S. R., & Lee, C. H. (2010). The Research on the Effects of capital Structure on Firm Performance and Evidence from the Non-financial Industry of Taiwan 50 and Taiwan Mid-cap 100 from 1987 to 2007. Journal of Statistics and Management Systems, 13(5), 1069-1078.
Gill, A., Biger, N., & Mathur, N. (2011). The Effect of Capital Structure on Profitability: Evidence from the United States. [Article]. International Journal of Management, 28(4), 3-15.
Lipson, M. L., & Mortal, S. (2007). Liquidity and firm characteristics: evidence from mergers and acquisitions. Journal of Financial Markets, 10(4), 342-361.
Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. The American economic review, 48(3), 261-297.
Modigliani, F., & Miller, M. H. (1963). Corporate income taxes and the cost of capital: a correction. The American economic review, 53(3), 433-443.
Ortiz-Molina, H., & Phillips, G. M. (2010). Asset liquidity and the cost of capital: National Bureau of Economic Research.
Pratheepkanth, P. (2011). Capital structure and financial performance: Evidence from selected Business companies in Colombo stock exchange Sri Lanka. Journal of Arts, Science & Commerce, 171-181.
Ramachandran, V. S., & Nageswara Rao, S. V. D. (2010). Capital Structure, Industry Pricing, and Firm Performance. [Article]. International Journal of Business Insights & Transformation, 3(2), 5-12.
Saeedi, A., & Mahmoodi, I. (2011). Capital Structure and Firm Performance: Evidence from Iranian Companies. [Article]. International Research Journal of Finance & Economics(70), 20-29.
Salawu, R. O. (2009). THE EFFECT OF CAPITAL STRUCTURE ON PROFITABILITY: AN EMPIRICAL ANALYSIS OF LISTED FIRMS IN NIGERIA. [Article]. International Journal of Business & Finance Research (IJBFR), 3(2), 121-129.
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.
