According to the study by Ramadan and Ramandan (2015),
capital structure is inversely related to profitability of a frim. Their research
was based 72 industrial companies in Jordan that were listed on Amman Stock
Exchange. The time frame of their data was from 2005 to 2013. In their
regression model, they used long-term debt to capital ratio, total debt to
capital ratio and total debt to total assets ratio as their capital structure
variable and ROA as their performance variable.
The result of Ramadan and Ramadan (2015) was consistent with
that of Nassar S (2016) and Siddik et al
(2017) even though their research data were different. Nassar S used data on 136
listed companies on Istanbul Stock Exchange from 2005-2013. The capital
structure indicator of his research was total debt to total asset ratio and
performance indicators were ROA, EPS, and ROE. Saddik et al also used data on
22 banks in Bangladesh from 2005 to 2014. Banks performance was defined by ROA,
ROE, and EPS while capital structure was defined by STDTA, LTDTA, TDTA. They
also included firm specific variables and macroeconomic variables mentioned
earlier in their regression model for which they observed that growth
opportunities, size, and inflation have positive relationship while GDP has
negative relationship with performance of banks
The results from these studies mentioned above support the
Peking order theory, which states that highly profitable firms are less
dependent on external source of finance and thus there is an inverse
relationship between profitability and borrowing hence capital structure.
The study results of S.F. Nikoo (2015), and Abor (2005) were
however in contrast with the above results. They found out that capital structure
and profitability are positively related which supports the tradeoff theory.
Nikoo’s research analyzed data on banks listed Tehran Stock Exchange from
2008-2012. In his paper, capital structure was expressed by debt to equity
ratio and bank’s performance was expressed by ROE, ROA, and EPS. Abor on the
other hand focused on listed firms on the Ghana stock exchange and the data was
for a 5 year period. It is worth noting that in Abor’s results if STDTA is
excluded from the capital structure, then there will be an inverse relationship
between capital structure and profitability since he found that STDTA and TDTA
had a positive relationship with ROE while LTDTA has a negative relationship.
Just as the researchers mentioned above found a relationship
between capital structure and profitability be it negative or positive, Al-Taani
(2013) and Ibrahim El?Sayed Ebaid (2009) papers showed evidence that there is
significantly weak to no relationship between capital structure decision and
profitability of a firm. Their results supports the capital structure
irrelevance theorem by M. Al-Taani studies was also on listed companies in
Jordan from a period of 2005-2009. He used profit margin and ROA as
profitability measure and STDTA, LTDTA and TDTA as capital variable. The
analysis of El?Sayed Ebaid was based on non-financial Egyptian listed firms and
the data was from a period of 1997-2005.
Equity over Debt?
It is evident from various studies that debt financing does
not always lead to improved firms’ performance, so before employing debt
finance firms should have to a large extent exhausted shareholders’ funds. As a
result, risks associated with debt financing e.g. interest on debt exceeding
the return on assets financed by the debt will be minimized. In situations
where firms have exhausted equity financing and needs to finance the expansion
of its operation, reference should be made to the firm’s asset structure to ensure
that assets financed using debt financing earn higher returns than the interest
to be paid on the debt.
It could be said that capital structure is a vital key to the
profitability and survival of firm. Obtaining an optimal capital structure
which maximizes shareholders value and minimizes cost of capital and risk is
therefore important. In order to achieve this, management needs to first analyze
whether the firm is over or under levered or has the right mix. Based on the
result of the analysis, decision on whether to move gradually or immediately
towards the optimal has to be made.
For over levered firms with the threat of bankruptcy, debt
should be reduced by embarking on equity for debt swaps. While without
bankruptcy threat reduction of debt can be based on whether the firm has good
projects i.e. ROE and ROC is greater than cost of equity and cost of capital
respectively. In cases where they are greater, the projects are financed
through retained earnings or new equity whereas in the cases where they are not
greater debts are paid off using retained earnings or issuance new equity.
For under levered firms which are takeover targets, leverage
is increased through debt for equity swaps or
borrow money to buy shares. In case the firm is not a takeover target, and the
firm has good projects i.e. ROC greater is than cost of capital, the projects
are financed using debt otherwise dividends are paid to shareholders or the
firm buys back stocks.
This essay provides evidence from various researches that
analyze the impact of capital structure on profitability of a firm. Although
there is no clear cut conclusion as to whether it is a positive or negative
relationship it is important to note that optimal capital structure is vital
since wrong mix of debt and equity may profoundly affect the performance and
long term survival of the firm.