Jordan-Amman (11931), P.O. Box (166) Nimer Sleihat Amman Arab University, Faculty of Business, Accounting Department

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1 The Impact of Profitability on Obtaining Debt through the Financial Leverage: Comparative Study among Industrial Sectors in Jordan Lina Warrad Applied Science University, Faculty of Economic and Administrative Science, Accounting Department Jordan-Amman (11931), P.O. Box (166) Nimer Sleihat Amman Arab University, Faculty of Business, Accounting Department Jordan-Amman (11953), P.O. Box (2234) Rania Al Omari Applied Science University, Faculty of Economic and Administrative Science, Accounting Department Jordan-Amman (11931), P.O. Box (166) Munther Al Nimer Applied Science University, Faculty of Economic and Administrative Science, Accounting Department Abstract Jordan-Amman (11931), P.O. Box (166) This study is conducted to investigate the impact of profitability on financial leverage, thus, on obtaining debt through financial leverage among Industrial sectors in Jordan. As far as this study is concerned the profitability which expressed by variables including gross profit margin (GPM), operating profit margin (OPM), net profit margin (NPM), return on asset (ROA), and return on equity (ROE), and financial leverage which expressed by debt ratio, and equity ratio. For the analysis the multiple regressions cover a period , used to examine the extent that the profitability impact on obtaining debt through financial leverage among different industrial sectors. Among sectors the study found that the Pharmaceutical and Medical Industries sector has the highest gross profit margin and the Glass and Ceramic Industries has the lowest gross profit margin. The Mining and Extraction sector has the highest earnings before interest and tax (EBIT) while the lowest the Glass and Ceramic Industries. The Mining and Extraction sector has the highest net profit margin (NPM), return on asset (ROA), return on equity(roe) while the lowest the Glass and Ceramic Industries, also found that the Electrical Industries sector has the highest debt ratio (DEBT) while the lowest the Glass and Ceramic Industries. But The Glass and Ceramic Industries have the highest equity ratio (EQUITY) and the lowest equity ratio (EQUITY) for the Electrical Industries sector. The study revealed that profitability has a significant relationship with debt ratio (DEBT); also has a significant relationship with equity ratio (EQUITY), because the test was at level 5%. Keywords: Financial Leverage, Profitability, Gross Profit Margin, Operating Profit Margin, Net Profit Margin, Return on Asset, Return on Equity, Debt Ratio, Equity Ratio, Amman Stock Exchange (ASE). 1. Introduction Profitability is the ability of a firm to generate earnings. Analysis of profit is a vital concern to stockholders because they derive revenue in the form of dividends. Further, increased profits can cause a rise in market price, leading to capital gains. Profits are also important to creditors because profits are one source of funds for debt coverage. Management uses profit as a performance measure. In the long run, a relationship exists between the reported income resulting from the use of accrual accounting and the ability of the firm to meet its long-term obligations. Although the reported income does not agree with cash available in the short run, the revenue and expense item eventually do result in cash movements. Because of the close relationship between the reported income and the ability of the firm to meet its long-run obligations, the entity's profitability is an important factor when determining long-term debt-paying ability. (Gibson, 2013) Financing decisions have been given large concern either within the sequence of perfect markets or imperfect markets. In perfect markets, if capital structure decisions are imaginary, then these should not make problems to companies. Since the risk in relation to financing can be diversified away, however imperfections are essential to market operations. There are many empirical implications of the foregoing models about debt-to-equity ratios. Risky companies should borrow less, whether the risk measured by vibrations in valuation or in earnings. Fast growing companies should borrow less because of their higher ratio of growth opportunities to existing capital and because of their greater tax corset from depreciation deductions and investment tax credits. COPY RIGHT 2013 Institute of Interdisciplinary Business Research 25

2 This paper will investigate the effect of profitability on obtaining debt through the financial leverage among industrial Sectors in Jordan. 2. Literature Review Capital structure determinants of Swedish firms is presented by Song H. (2005) study which based on a panel data for the period comprising about 6000 companies. Swedish companies are on average very highly leveraged, furthermore, short-term debt comprises include a large part of Swedish companies' total debt. An analysis of determinants of leverage based on total debt ratio may hide significant differences in the determinants of long and short-term shapes of debt. Therefore, the study investigated the determinants of total debt ratio as well as determinants of short-term debt ratio. The results showed that most of the determinants of capital structure suggested by capital structure theories appeared to be relevant for Swedish companies. Also found significant differences in the determinants of long and short-term shapes of debt. Due to data limitations, it was not possible decompose short-term debt and longterm debt into its components, but the results suggested that future analysis of capital choice decisions should be based on a more detailed level. The effects of macroeconomic conditions and financial ratios on debt ratio and return on equity ratio of the tourism firms is presented by Demirel, et al. (2011) study by selecting 6 lodging company financial ratios that included tourism sector index in Istanbul Stock Exchange (ISE) for the period from 2002 to The results suggested that debt ratio of the tourism firms has a function on GNP, interest rate, account receivables ratio, debt coefficient and cash ratio of the firms. Debt coefficient, GNP, interest rate positively affected and account receivables and cash ratios negatively affected on debt structure. Findings helps tourism sector managers forecast on different economic and financial structure conditions in order to optimize their debt and return on equity ratios. In order to concentrate on the different financing theories for discussing capital structure choice in the small and medium enterprises (SMEs) sectors in Mauritian, an empirical analysis has been done by M. P Odit, Y. D Gobardhun (2011) study over a panel data of a sample of 25 firms of SMEs from 2002 to 2008, using quantitative analysis. The results showed that short-term debt constitutes a relatively high proportion of total debt of Mauritian SMEs, and a positive relationship between the debt ratios and both Asset Structure and Growth are very critical in influencing SMEs' access to debt finance. The main implication of this study was to understand the position of small and medium enterprises in terms of their debt and its importance and contribution to the national income. Determinants that influence the capital structure in the Jordanian service companies for the period is presented by Al Shaher T. (2012) study by using multiple regression analysis and analysis of variance. Their model included financial leverage as a dependent variable affected by profitability, liquidity, total liabilities, long-term debts and working capital. The study revealed a significant positive relationship between financial structure expressed by leverage and liabilities, working capital, and long term debt at the level of 1%, also revealed a significant negative relationship between financial structure and profitability and liquidity at the level of 1%. Analysis of profitability ratio in public right issue decision at Indonesia Stock Exchange is presented by Fahmi I. (2013) study which investigates conditions of company in perspective profitability ratio before and after right issue. The results showed that conditions of company after right issue better before right issue. In statistic test with Wilcoxon Signed Ranks showed insignificant in profitability before and after right issue. The found of right issue can make company have program investment or make new product. Source of financial of right issue more safe if company of banking, specially risk management. COPY RIGHT 2013 Institute of Interdisciplinary Business Research 26

3 3. Research Methodology This section presents research methodology adopted in this study. It explains sample selection criteria, variables of the study and research model, hypotheses The Research Sample The study examines overall Industrial sectors listed on the Amman Stock Exchange (ASE) for the period from Variables of the Study Dependent Variable-Financial Leverage In the regression, our main proxies for Financial Leverage: Debt Ratio this ratio measure the percentage of total assets financed with debt. Generally higher debt means higher financial risk and thus weaker solvency. Debt Ratio= Total Debt Total Assets Equity Ratio measures the amount of debt capital relative to equity capital. Equity Ratio= Total Debt Total Shareholders' Equity Independent variables-profitability In the regression, our main proxies for Profitability: Gross Profit Margin (GPM) indicates the percentage of revenue available to cover operating and other expenses and to generate profit. Higher gross profit margin indicates some combination of higher product pricing and lower product costs. The ability to charge a higher price is constrained by competition, so gross profits are affected by (and usually inversely related to) competition. If a product has a competitive advantage (e.g., superior branding, better quality, or exclusive technology), the company is better able to charge more for it. On the cost side, higher gross profit margin can also indicate that a company has a competitive advantage in product costs. Gross Profit Margin= Gross Profit Revenue Operating Profit Margin (OPM) or (EBIT) is calculated as gross profit minus operating costs. So, an operating profit margin increasing faster than the gross profit margin can indicate improvements in controlling operating costs, such as administrative overheads. In contrast, a declining operating profit margin could be an indicator of deteriorating control over operating costs. COPY RIGHT 2013 Institute of Interdisciplinary Business Research 27

4 Operating Profit Margin= Operating Profit Revenue Net Profit Margin (NPM) is calculated as revenue minus all expenses. Net income includes both recurring and non-recurring component. Generally, the net income used in calculating the net profit margin is adjusted for non-recurring items to offer a better view of a company's potential future profitability. Net Profit Margin= Net Income Revenue Return on Asset (ROA) measures the return earned by a company on its assets. The higher the ratio, the more income is generated by a given level of assets. Return on Asset= Net Income Average Total Assets Return on Equity (ROE) measures the return earned by a company on its equity capital, including minority equity, preferred equity, and common equity. As noted, return is measured as net income (i.e., interest on debt capital is not included in the return on equity capital). A variation of ROE is return on common equity, which measures the return earned by a company only on its common equity. Return on Equity= Net Income Average Total Equity Major Hypothesis H01: There is no significant impact of independent variables (GPM, OPM, NPM, ROA, ROE) on debt ratio (DEBT). H02: There is no significant impact of independent variables (GPM, OPM, NPM, ROA, and ROE) on equity ratio (EQUITY) Research Model In order to test the study hypotheses, the research models can be designed as follows: Debt = GPM-.370OPM+.233NPM+3.316ROA-2.047ROE+e Equity = GPM+4.55OPM+.104NPM-3.323ROA+2.045ROE+e COPY RIGHT 2013 Institute of Interdisciplinary Business Research 28

5 4. Statistical Analysis This section presents the results of descriptive analyses for the study variables Descriptive analysis The overall the effect of profitability for 11 sectors is presented in table (1). Table (1) Raking of Sectors on Profitability ( ) SEC. NO. Sector Name GPM OPM NPM ROA ROE 1 Chemicals Glass And Ceramic Industries Paper And Card Pored Industries Pharmaceutical And Medical Industries Tobacco And Cigarettes Engineering And Construction Printing And Packaging Sector Electrical Industries Sectors Food And Beverage Textiles Leather And Clothing Sector Mining And Extraction Number 1 in ranking indicates the highest rank while 11 is the lowest rank. As can be seen from table (1) the Pharmaceutical and Medical Industries sector has the highest gross profit margin and the Glass and Ceramic Industries has the lowest gross profit margin. The Mining and Extraction sector has the highest operating profit margin (OPM) while the lowest the Glass and Ceramic Industries. The Mining and Extraction sector has the highest net profit margin (NPM), return on asset (ROA), return on equity (ROE) while the lowest the Glass and Ceramic Industries. Table (2) Raking of Sectors on financial leverage ( ) SEC. NO. sector name DEBT EQUITY 1 Chemicals Glass And Ceramic Industries Paper And Card Pored Industries Pharmaceutical And Medical Industries Tobacco And Cigarettes Engineering And Construction Printing And Packaging Sector Electrical Industries Sectors Food And Beverage Textiles Leather And Clothing Sector Mining And Extraction 3 9 Number 11 in ranking indicates the highest rank while1 is the lowest rank. The overall the effect of financial leverage and profitability for 11 sectors is presented in table (2). As can be seen from table the Electrical Industries sector has the highest debt ratio (DEBT) while the lowest the Glass and Ceramic Industries. But The Glass and Ceramic Industries have the highest equity ratio (EQUITY) and the lowest equity ratio (EQUITY) for the Electrical Industries sector COPY RIGHT 2013 Institute of Interdisciplinary Business Research 29

6 The study was conducted according to multiple liner regression, as statistical model to measure the impact of many independent variables on many dependent variables. To test the research hypotheses SPSS program was used to prepare the table of analysis of variance (ANOVA table) as shown in table below: Sum of df Mean F Sig. Squares Square Regression Residual Total a Predictors: (Constant), GPM, OPM, NPM, ROA, ROE b Dependent Variable: DEBT By reviewing the table above we find that the value of (F) is highly significant,, at α=5% and this supports the reject of the main null hypothesis. Debt = GPM-.370OPM+.233NPM+3.316ROA-2.047ROE+e There is significant impact of independent variables (GPM, OPM, NPM, ROA, and ROE) on dependent variable DEBT (ANOVA table) as shown in table below: Sum of Squares df Mean Square Regression Residual Total a Predictors: (Constant), GPM, OPM, NPM, ROA, ROE b Dependent Variable: EQUITY F Sig. By reviewing the table above we find that the value of P value is highly significant, at α=5% and this supports the reject of the main null hypothesis. Equity = GPM+4.55OPM+.104NPM-3.323ROA+2.045ROE+e There is significant impact of independent variables (GPM, OPM, NPM, ROA, and ROE) on dependent variable EQUITY 5. Summary and Conclusion This study is carried out by considering the Industrial sectors in Jordan that is one of the most important sectors in Jordan. For the analysis the multiple regressions cover a period , used to examine the extent that the profitability impact on obtaining debt through financial leverage among different industrial sectors. Among sectors the study found that the Pharmaceutical and Medical Industries sector has the highest gross profit margin and the Glass and Ceramic Industries has the lowest gross profit margin. The Mining and Extraction sector has the highest operating profit margin (OPM) while the lowest the Glass and Ceramic Industries. The Mining and Extraction sector has the highest net profit margin (NPM), return on asset (ROA), return on equity(roe) while the lowest the Glass and Ceramic Industries, also found that the Electrical Industries sector has the highest debt ratio (DEBT) while the lowest the Glass and Ceramic Industries. But The Glass and Ceramic Industries have the COPY RIGHT 2013 Institute of Interdisciplinary Business Research 30

7 highest equity ratio (EQUITY) and the lowest equity ratio (EQUITY) for the Electrical Industries sector. The study revealed that profitability has a significant relationship with debt ratio (DEBT); also has a significant relationship with equity ratio (EQUITY). Through the analysis of main hypothesis, we can conclude that the studied variables (GPM, OPM, NPM, ROA, and ROE) have significant relationship with leverage, because the test was at level 5% where the relationship was positive for the variables (DEBT, EQUITY). COPY RIGHT 2013 Institute of Interdisciplinary Business Research 31

8 References Al Shaher T.(2012),"The Impact of Determinants of Leverage on Capital Structure of service Companies in Jordan," International Research Journal of Finance and Economics, ISSN Issue 96 (2012). Benjamin M., Friedman, ed (1985), "Corporate Structures in the United States," chapter title: Real determinants of Corporate Leverage, chapter author: Alan J. Auerbach, page: Demirel, Engin, atakisi, Ahmet; Atmaca, Metin. "Financial and Economic Factors Affecting Debt Ratio and ROE; ISE Tourism Firms Case," European Journal of Scientific Research. 10/5/2011, Vol. 61, Issue 3, P Fahmi I. (2013), "Analysis of Profitability Ratio in Publishing Right Issue Decision at Indonesia Stock Exchange," International Journal of Business and Social Science, Vol. 4, No. 4, Feb Financial Reporting and Analysis, CFA, Program Curriculum, volume 3, level 1, Gibson C. (2013),"Financial Statement Analysis,"13 th edition. Song H. (2005), "Capital Structure Determinants An Empirical Study of Swedish Companies," This paper has been presented at the International PHD Workshop "Innovation, Entrepreneurship and Growth" at the Royal Institute of Technology (KTH) Stockholm, Nov M. P Odit, Y. D Gobardhun (2011),"The Determinants of Financial Leverage of SME's in Mauritius." International Business & Economics Research Journal, Vol. 10, No. 3, March COPY RIGHT 2013 Institute of Interdisciplinary Business Research 32

9 Annexure Sector wise Profitability ( ) SEC NO Sector Name GPM OPM NPM ROA ROE 1 CHEMICALS GLASS AND CERAMIC 2 INDUSTRIES PAPER AND CARD POARD INDUSTRIES PHARMACEUTICAL AND 4 MEDICAL INDUSTREIS TOBACCO AND CIGARETTES ENGINEERING AND 6 CONSTRUCTION PRINTING AND PACKAGING SECTOR ELECTRICAL INDUSTREIS 8 SECTORS FOOD AND BEVERAGE TEXTILES LEATHER AND 10 CLOTHINGS SECTOR MINING AND EXTRACTION Sector wise Financial Leverage ( ) SEC NO sector name DEBT EQUITY 1 CHEMICALS GLASS AND CERAMIC INDUSTRIES PAPER AND CARD POARD INDUSTRIES PHARMACEUTICAL AND MEDICAL 4 INDUSTREIS TOBACCO AND CIGARETTES ENGINEERING AND CONSTRUCTION PRINTING AND PACKAGING SECTOR ELECTRICAL INDUSTREIS SECTORS FOOD AND BEVERAGE TEXTILES LEATHER AND CLOTHINGS 10 SECTOR MINING AND EXTRACTION COPY RIGHT 2013 Institute of Interdisciplinary Business Research 33

10 Raking of Sectors on Profitability ( ) SEC NO Sector Name GPM OPM NPM ROA ROE 1 CHEMICALS GLASS AND CERAMIC INDUSTRIES PAPER AND CARD POARD 3 INDUSTRIES PHARMACEUTICAL AND MEDICAL INDUSTREIS TOBACCO AND CIGARETTES ENGINEERING AND 6 CONSTRUCTION PRINTING AND PACKAGING 7 SECTOR ELECTRICAL INDUSTREIS 8 SECTORS FOOD AND BEVERAGE TEXTILES LEATHER AND 10 CLOTHINGS SECTOR MINING AND EXTRACTION Number 1 in ranking indicates the highest rank while 11 is the lowest rank. SEC. NO. sector name DEBT EQUITY 1 Chemicals Glass And Ceramic Industries Paper And Card Pored Industries Pharmaceutical And Medical Industries Tobacco And Cigarettes Engineering And Construction Printing And Packaging Sector Electrical Industries Sectors Food And Beverage Textiles Leather And Clothing Sector Mining And Extraction 3 9 Number 11 in ranking indicates the highest rank while1 is the lowest rank. COPY RIGHT 2013 Institute of Interdisciplinary Business Research 34