LEVERAGING AND CORPORATE PERFORMANCE: EVIDENCE FROM SARAWAK BASED PUBLIC LISTED COMPANIES CHUA CHEE BING ( )

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1 LEVERAGING AND CORPORATE PERFORMANCE: EVIDENCE FROM SARAWAK BASED PUBLIC LISTED COMPANIES By CHUA CHEE BING ( ) A Thesis Submitted in Partial Fulfillment of the Requirements for the Degree of Corporate Master in Business Administration Faculty of Economics and Business UNIVERSITI MALAYSIA SARAWAK (2014) I

2 APPROVAL PAGE I certified that I have supervised and read this study and in my opinion it conforms to acceptable standards of scholarly presentation and is fully adequate in scope and quality as a research paper for the degree of Corporate Master in Business Administration. Professor Dr Abu Hassan Bin Md. Isa Supervisor This research paper was submitted to the Faculty of Economics and Business, UNIMAS and is acceptable as partial fulfillment of the requirements for the degree of Corporate Master in Business Administration. Dr Mohammad Affendy Arif Dean, Faculty of Economics and Business UNIMAS II

3 DECLARATION AND COPYRIGHT Name : CHUA CHEE BING Matric No. : I hereby declare that this research paper is to the best of the author s knowledge that of the author except where due reference is made. Signature : Date by CHUA CHEE BING and UNIMAS III

4 ACKNOWLEDGEMENTS First, I would like to express the deepest appreciation to my supervisor, Professor Dr Abu Hassan Bin Md. Isa for his professional manner of guidance in terms of advices, comments and suggestions in regard to this research. Without his guidance and persistent to help in this dissertation would not have been possible. Also, I would like to express my gratitude to the Dean of Faculty of Economics and Business, Dr Mohammad Affendy Arif, the course coordinator, Madam Sharon Cheuk and other UNIMAS lecturers for their kind sharing, advice and encouragement. Not forgotten are my helpful friends and classmates that have extended their resources of information, comments, idea, time and support during the course of the study. I am grateful to my supportive parents and family members for their loves, wishes, tolerance, understanding, support and sacrifice that made this dissertation possible. Thank you to all of you. Chua Chee Bing 2014 Kuching, Sarawak IV

5 ABSTRACT FINANCIAL PERFORMANCE AND CORPORATE PERFORMANCE: EVIDENCE FROM SARAWAK BASED PUBLIC LISTED COMPANIES By Chua Chee Bing Capital structure decision is vital that it would affect the corporate performance in terms of profitability and investment value. Leveraging, one of capital structure decision involves extending the company resources through external resources such as loans and borrowing, either for long term or short term. Many financial advocates proposed that leveraging improves corporate performance by exploring the greater market opportunities, achieving economies of scale and producing better financial ratios in terms of valuation. However, theories may not always work in real life environment. This study takes on twenty five selected public listed companies in Bursa Malaysia which criteria to be Sarawak-based companies. Sarawak is indeed the best choice for study due to wide geographical and coverage areas, which basically push these companies to incur more costs to reach every corner of the market to excel in a competitive market condition. The relationship between leveraging and corporate performance is undertaken by using financial ratios as indicator, where correlation analysis is used to determine the relationship between independent variable (represented by Gearing Ratio) with dependent variables ( represented by ROA, ROE, PM and EPS ratio). The findings revealed that Gearing Ratio has significant positive negative with ROA, with the remaining relationship were insignificant. Further V

6 revelation indicated that Short Term Borrowing factored the positive relationship with both ROA and ROE. This suggests that these companies preferred external borrowing while preferring to commit in higher short term borrowing rates rather than tied up to long commitment. In reflect of negative impact of leveraging, we encourage companies to acquire funds internally or taking up long term borrowing to increase fund. VI

7 ABSTRAK Pengurusan struktur modal adalah penting kerana ia memberi kesan kepada prestasi korporat dari segi keuntungan dan nilai pelaburan. Pinjaman salah satu keputusan dalam pengurusan struktur modal yang melibatkan perluasan sumber kewangan syarikat melalui sumber pinjaman dari luar, sama ada untuk jangka panjang atau jangka pendek. Ramai penasihat kewangan mencadangkan bahawa pinjaman berupaya memperbaiki prestasi korporat dengan membolehkan syarikat meneroka peluang pasaran yang lebih besar, mencapai ekonomi skala dan menghasilkan nisbah kewangan yang lebih baik untuk penilaian. Walau bagaimanapun, teori-teori tidak semestinya begitu dalam kehidupan sebenar. Kajian ini memilih dua puluh lima syarikat tersenarai di Bursa Saham Malaysia yang berasas dari negeri Sarawak. Syarikat tersebut merupakan pilihan ideal untuk kajian ini kerana keluasan geografi dan liputan perkhidmatan yang besar menyebabkan mereka untuk menanggung kos yang lebih tinggi untuk mencapai seluruh sudut pasaran yang kompetitif ini. Hubungan antara pinjaman dan prestasi korporat dikaji melalui analisis korelasi antara ratio kewangan ROA, ROE, PM, EPS dan Gearing Ratio. Hasil kajian menunjukkan bahawa Gearing Ratio mempunyai negatif impak ke atas ROA and hubungan ini adalah signifikan. Selain daripada itu, tiada hubungan yang signifikan antara Gearing Ratio dengan ROE, PM dan EPS yang ditemui. Kajian mendalam menemui bahawa pinjaman jangka pendek yang menjadi faktor hubungan signifikan pinjaman terhadap ROA dan ROE. Ini jelas menunjukkan bahawa syarikat dalam kajian ini lebih bergantung kepada pinjama dari luar daripada menawarkan saham kepada pelabur yang sedia ada mahupun pelabur yang baru. Walaupun ketika memilih pinjaman untuk menjana dana wang, syarikat dalam kajian lebih mementingkan pinjaman jangka VII

8 pendek di mana kadar faedahnya lebih tinggi. Oleh itu, kami memberi rekomendasi kepada syarikat untuk menawarkan saham pelaburan ataupun memilih pinjaman jangka pangjang dalam menjana dana kewangan untuk syarikat mereka. VIII

9 TABLE OF CONTENTS CONTENT APPROVAL PAGE DECLARATION AND COPYRIGHT.... ACKNOWLEDGEMENTS.. ABSTRACT TABLE OF CONTENT. LIST OF TABLES..... LIST OF FIGURES... PAGE II III IV V VIII X XI CHAPTER 1: INTRODUCTION 1.0 Introduction Leverage and Types Business Environment in Malaysia and Sarawak Problem Statement Research Questions Research Objective General Objective Specific Objectives Significance of the study Chapter Remark 12 CHAPTER 2: LITERATURE REVIEW 2.0 Introduction Theories of Financial Leverage Leverage and Performance Chapter Remark 22 IX

10 CHAPTER 3: RESEARCH METHODOLOGY 3.0 Introduction Selection of Sample Company Data Collection Method Theoretical Model Research Framework The Hypothesis, Data Analysis Chapter remark. 30 CHAPTER 4: DATA ANALYSIS AND FINDINGS 4.0 Introduction Preliminary Data Analysis Descriptive Analysis Correlation Analysis Short Term Debts vs Long Term Debt. 39 CHAPTER 5: CONCLUSION & RECOMMENDATIONS 5.0 Conclusion Policies Recommendation Limitation of Study Future Research Recommendations. 44 REFERENCES X

11 LIST OF TABLES Page Table 1: Sample of Unlevered Public Listed Companies from 2000 to Table 2: Summary of Relationship Between Variables 20 Table 3: List of Selected Sarawak Based Public Listed Companies 22 Table 4: Effects of Debt on Performance 24 Table 5: Mechanism of Leverage As Explained by ROE 25 Table 6: Yearly Performance Summary 30 Table 7: Descriptive Analysis for Variables 31 Table 8: The Correlation Between Variables 33 Table 9: Correlation between Variables with Short Term and Long Term Debt 37 Table 10: Summary of Hypothesis, Findings and Conclusions 38 XI

12 LIST OF FIGURE Page Figure 1: Research Framework 26 Figure 2: Redefining Net Income with Total Debt 35 LIST OF GRAPH Page Graph 1: Line Graph of 5 Years Performance 30 XII

13 CHAPTER 1 INTRODUCTION 1.0 Introduction to Debt Resources of an individual is usually limited; thus it explains why we take up loan or hire purchase facilities from financial institutions to finance the asset that beyond our ability to purchase with existing cash money. This does not exclude big institutions or corporations that have hundreds of shareholder and millions of capital in hand. As resources is scarce, corporations are taking up loans and debts to finance many activities to ensure its sustainability or even capturing prospect of generating greater return. This is a usual business practice named leveraging. Borrowing, or debt, is a cheap source of funding for most companies. Interest paid for service debt is tax deductible and therefore, reducing a company s tax liabilities and reduces the cost of borrowing indirectly. Many believed that company should incur debt in order to grow big enough to reap greater opportunities for profit. Big corporations for example, incurred hundred millions of debt in order to be financially fit to generate hundred millions of sales from it. However, borrowing may stifle a company s operations through the debt covenant and fixed repayment commitments especially in the event of economic downturn. Furthermore, the share of profit left after payments to debt holder may not pleased the shareholders as well. Debt is strong, contagious and increasing at a worrisome state. As at 2012, World Bank reported that Malaysia s household debt is recorded at 83%, an increase from 2009 s 70%. What has been borrowed must be eventually repaid back. Unfortunately, figures provided by Statistics Department stated that as much as 80% 1

14 of Malaysian households are earning less than RM 5,000 per month, which sparks the doubts on their repayment ability in the presence of escalating inflation rate. Malaysian corporations, on the other side, are registering the same trend too even when they turned to be more prudent on debt since Asian financial crisis in Malaysia s corporate leverage of both corporate bonds and bank loans, have risen to 95.8% of GDP as at 1Q2013 (Yeap, 2013). It was an immense jump from 79.9% in 4Q2007. In fact, even Government takes up debt, from both internal and external source to finance its operations to in order to keep the country serving its nation. Malaysia has recorded a total public and private debt of US$87.81 billion as at 31 st December (World Bank, 2013) The world leader, United States of America, is piling up its external debt at a staggering amount of almost US$17 trillion and is facing possible default risk in January The clock is ticking and the world debt increases by every second as someone in the world takes up debt. There must be a reason to explain these phenomena that justify the actions of debt-holders to take up loans. Thus, leveraging, either by individuals or even by corporations, are serious issues that requires great consideration and deliberation as it will affect nation and global as a whole. This is evidenced by Asian Economic Crisis back in 1997 where domestic banks had great impact with high non-performing loan stemming from debt-servicing problem by individuals and corporations. This worldwide phenomenon has eventually initiated this study to take place. In the following section, we discuss further in depth into the types of financial leverage and the composition that constitute such leverage. Then, we discuss on the basic reasons that corporations commit themselves to leverage, justifications behind the actions and implications towards its stakeholders. Further, we posed several 2

15 questions that this study aims to answer through the statistical analysis of data collected in the later chapter. Then, we wrapped this chapter with the significant of this study as in contribution to individual, potential investors and existing shareholders or even other small entities in the same operating region. 1.1 Leverage and Types Leverage, as a business term, refers to borrowing of funds by corporation to reap larger potential gains, or reduce expenses that would not be possible if using own existing resources and fund. There are basically three types of leverage ; operating leverage, financial leverage and total or combined leverage. Operating leverage is leverage incurred to finance the fixed costs of a company, usually in large scale production with various expensive plant and machineries. Capital intensive firm, such as automobile manufacturing firm, are subject to high operating leverage due to high fix costs to finance the expensive equipment even in the event of low production stage. These companies will usually be affected seriously during an economic slowdown as compared to other companies with least capital intensive. Financial leverage is defined as potential use of financial costs through issuance of debt and preferred shares, to magnify return of a corporation as measured by Earning Before Interest Tax (EBIT) and Earning Per Share (EPS). From the definition, financial leverage has impact to shareholder through the changes of capital structure composition and sensitivity towards return through dividend payment policy and disposal income. Financial leverage has not been in favor of shareholder as the loan payments, debt holder interest and preferred shareholder s dividend are fixed and priority over ordinary shareholder s dividend payment. Shortly, in the event of 3

16 default, these parties have priority claim over the company s asset whereas ordinary shareholder s are only distributed with leftovers after these payments are fulfilled. Funds flow in from financial leverage may be utilized for many activities, such as maintain cash flow operations or finance project based initial outlay or R & D costs. Comparing and contrasting operating leverage with financial leverage could be done by easily referring to balance sheet items. Financial leverage refers to the right hand side of balance sheet which constitutes the information on how the firm will pay for it and how the operation is financed. Operating leverage refers to the left hand side of the balance sheet which constitutes the composition plant and equipment section. The combination of both leverages is known as total or combined leverage where leverage is grouped and serves the finance both operating and finance function. In determining the leverage of a business firm, Debt to Equity Ratio (D/E Ratio) or Gearing Ratio is usually used. This is a simple ratio showing the proportion of debt of a company as compared to the equity of that firm. However, rule of thumb for debt to equity ratio ranges from 35 % to 50%, depending on the business nature and industry. Manufacturing companies like auto car maker and electronic manufacturing companies may require a large sum of resources to finance its everchanging technological asset, production plant and R&D costs. Gearing ratio has been used widely as an indicator of the risk that a particular business is holding due to the mix of capital structure (debt and equity) management. Certainly, the business risk of a corporation, specifically liquidity risk, increases along with the level of debt. Leveraging is an important element in a corporate capital structure decision making as it affects other financial decision variables. The level of debt affects the level of net income, thus affect other financial ratios such as Return on Assets, Return 4

17 on Equity, Profit Margin and Earning per Share. Therefore, managers strive to achieve optimal capital structure decision to lower cost of capital and increase the value of firm at the same time. By using optimal amount of debt, a typical firm could increase its value by 15% assuming that it follows a conservative debt policy (Graham, 1996). However, companies that do not have debts have the ability to survive better during recession (Lemmon et al, 2008). 1.2 Business Environment in Malaysia and Sarawak Malaysia was the ranked the third largest economy in South East Asia after Indonesia and Thailand and 29 th largest economy in the world by purchasing power parity in the year At the latest stand, Malaysia has an estimated Gross Domestic Product, measured by PPP of US$521 billion projected for year World Bank ranks Malaysia 18 th in ease of doing business, tribute to ease of getting credit as main factor and protection towards investor and ease of trade across border the following contributing factors. Malaysian Government is taking initiatives to set up more business environmental friendly to businesses trading in the country, which includes PEMUDAH task force to ease restrictions and requirements for business trades. On reviewing the financial fitness of companies trading in Malaysia, the corporate leverage of both corporate bonds and bank loans currently stands at 95.8% of GDP as at 1Q2013 (Yeap, 2013). To date, there are 819 numbers of public listed companies trading in Main Board in Bursa Malaysia Market but surprisingly, not all listed companies are practicing leveraging strategy. Table 1 sampled several unlevered public listed companies from the period 2000 to

18 Table 1: Sample of Unlevered Public Listed Companies from 2000 to 2009 No. Name of Company 1. London Biscuit Berhad 2. Ajinomoto (M) Berhad 3. Appollo Food Holdings Berhad 4. Nestle (M) Berhad 5. Padini Holdings Berhad 6. Apex Healthcare Berhad 7. UMW Holdings Berhad 8. Yeo HiapSeng (M) Berhad 9. Hirotako Holdings Berhad 10. KinsteelBerhad 11. BinaPuri Holdings Berhad 12. Hock Seng Lee Berhad This study opted to focuses the scope of study into Sarawak based public listed companies as Sarawak has its own uniqueness and distinctive business environment as compared to the Peninsular region. Sarawak is the largest state in Malaysia covering an enormous area of 124,450 km² which equivalents to the total areas of 11 states constituting Peninsular Malaysia. Even so, some 75% of the state is still covered with primary rainforest (State Planning Unit, 2013). As at 2010, the total population of Sarawak is approximately 2,420,000 with high density populating in Northern Sarawak. The state has a great contribution to the country s revenue through its rich natural resources such as LPG, timber logging and palm oil plantation. Department of Statistics reported that Sarawak was the third largest state economy in Malaysia in year 2010 contributing a total nominal GDP of RM 50,804 million. In the consequent year, Sarawak has recorded a GDP growth of 4.5% factoring to the exportation of its natural resources. Sarawak is indeed an interesting study focus as the geographical nature made it tougher for local business operators to expand its coverage as compared to other businesses operating in Peninsular Malaysia. Thus, business operators such as utilities 6

19 provider, telecommunications provider and transportation services are required to take up high fixed costs to built its network to deliver offered services. However, the opportunities offered by Sarawak are not limited. With the great initiative by Sarawak Government through the development of SCORE project, it offers immense investment opportunities for local and overseas investors to invest in local mass production. Now, it is only left the industry players to gather fund or utilize the offer for greater investment opportunities. 1.3 Problem Statement Managers strive to maintain good financial tracks in order to satisfy the interest of shareholders. Business expansion is a necessity in order to achieve growth in business size, which eventually will help corporation to achieve economies of scale, target higher revenue record, increasing product s market share and generate growing earning. Resources are limited for each corporation, fortunately, can be borrowed using existing asset as collateral. Other than serving as prerequisite for business expansion and growth, debt helps corporation to finance through hard times to ensure its survival in the long run. However, many issues that corporation shall consider when opting for leveraging strategy. Leverage hurts company performance and value by the way of putting the company at risk, increasing its gearing ratio and default risk. After committing itself to debt, company is tied to long term commitment to repay what they borrowed and for certain, reducing its profit for the long run for interest payment. Although company may enjoy tax shield for the interest costs of debt but lowered tax payable, consequently, its lowers the earnings after tax and earnings per share too. 7

20 Reduced earnings after tax may affect manager s decision in distribution of dividend per share, or in the worst case, not declaring any dividend at all. This chain of action may eventually leads to unhappy shareholders, thus putting the managers performance in question. Another reason that shareholders may not prefer managers to take debt is the corporate governance issues in their agency relationship. Managers may forsake a long run survival for a short term benefit as long as the financial figures satisfy the shareholders during their tenure as managers. Furthermore, debt is likely to signal bad information about the company is not doing well to both shareholders and investors. Company is turned financially sensitive to accommodate the debt covenant imposed by debt holders. As financial fitness of a company is an important criterion in assessing its share value, its debt level would hurt the rating given by investment experts. Again, this would hurt the share value of the company that trades on the board according to investor s perception and expectation on that company. Debt seems to be more costly to issue than equity and therefore prudent managers would prefer to raise fund through issuance of additional equity shares. Equities offer managers with great flexibility such as non-fixed dividend payment and buy back option when it has the adequate resources. Company that does not have debts on their balance sheet is perceived to survive better during recession. (Lemmon et al, 2008). Eventually if managers opted to play safe with maintaining low debt to equity ratio, it signalled their ineffectiveness in managing its resources to achieve optimal return. Withholding high amount of cash in hand may reduce the risk of default, nevertheless, forgone the opportunities to generate higher returns. 8

21 Companies trading in Sarawak are much challenged than their Peninsular counterparts due to the wide geographical area. With 13 divisions to serve, companies incurred much higher fixed cost in order to get their network covered. Thus, leveraging issues are bought into these companies by investigating whether leveraging helps to improve corporate performance from the year 2008 to Research Questions Discussing through the problem statement in the earlier part resulted questions to ponder on why corporations still practicing leveraging in spite knowing that the setbacks it may result towards the corporation, its stakeholders, and even the directors themselves. (i) Does leveraging (debt) have influence over corporate performance (ratio) in the context of Sarawak-based public listed companies in Malaysia? (ii) If leveraging has influence over corporate performance, what type of relationship (positive or negative) that the both variable has? These research questions set as a preliminary guidance in order to set research objective and formulate research methodology in the later part. 9

22 1.5 Research Objective General Objective In general, this paper aimed to strive the following general objective :- (i) To investigate the relationship between leverage and corporate performance of selected Sarawak-based public listed companies in Malaysia Specific Objectives As the terms used representing the variables in the general objective is wide, we thus redefine the scope of objective into more specific terms structured as follows:- (i) To measure the relationship between Return on Assets (ROA) and Gearing Ratio (GR) of selected Sarawak based public listed companies from year 2008 to year (ii) To measure the relationship between Return on Equity (ROE) and Gearing Ratio (GR) of selected Sarawak based public listed companies from year 2008 to year (iii) To measure the relationship between Profit Margin (PM) and Gearing Ratio (GR) of selected Sarawak based public listed companies from year 2008 to year (iv) To measure the relationship between Earning per Share (EPS) and Gearing Ratio (GR) of selected Sarawak based public listed companies from year 2008 to year

23 1.6 Significance of the study In general, this study attempts to assess the overall corporate health and wealth of Sarawak based public listed companies for the past five years from 2008 to These large corporations possess great influence on its stakeholders and the economic growth of Sarawak as well. For example, Cahya Mata Sarawak (CMS) is the leading construction material manufacturer that generated most of its revenue from distribution of construction Portland cement throughout the state. Along with CMS, most of the public listed companies are involved in construction related industries ; development and construction (Hock Seng Lee Berhad, Ibraco Berhad, Naim Holdings Berhad, Shin Yang Corporation Berhad, Zecon Berhad), construction material provider (Pansar Berhad, Sarawak Cable Berhad, Quality Concrete Holdings Berhad, Weida (M) Berhad, Ta Ann Holdings Berhad, WTK holdings Berhad, KKB Engineering Berhad, Kim Hin Industry BerhadYKGI Holdings Berhad, Sarawak Consolidated Industries Berhad). On the other side, plantation related companies (BLD Plantation, SOP, Sarawak Plantation, Subur Tiasa, Rimbunan Sawit) are reaping good profits from planted materials on natural resources (land) that could generate great revenue through exports. These companies are vital in contributing to the growth of Sarawak into a developed state. In an effort to push SME s performance to a higher stage, Government has created various channels and aids in support for SME s growth. With less restriction on borrowing at most of the commercial banks, SME are encouraged to leverage at lower rate. However, SME players are more risk adverse and therefore, hesitant to take up these greatly offered debt to grow larger. Without risk, there will be no return to compensate the resources invested in running a business. Therefore, it is important to educate SME players to be financial literate to measure and balancing their risk and 11

24 return in a way that advantages them. This study therefore gives SME players a larger picture of leveraging by large corporations in the real-life situation. Though assessing the benefit of long term and short term borrowing towards corporate performance, these will assist managers to formulate appropriate financing policies and avoid debt overhanging situation. 1.7 Chapter Remark Leverage helps corporations to capture business opportunities and growth. As a result of leverage, the resources a corporation increases and making it capable of entering expansionary investment projects. In short, leverage has a great impact to a corporation s performance and growth, however, risk and implications shall be assessed before committed in leverage. The remaining of this paper is organized as follows; Chapter 2 begins with literature review to provide an overview of previous relevant studies. Chapter 3 outlines the methodology and method of measurement employed in this study. Chapter 4 discusses the findings obtained from the empirical analysis of data collected while Chapter 5 concludes the study with recommendations to the problem statement and suggestions for future research. 12