Capital Structure and Firm Performance: A Case of Textile Sector of Pakistan Fozia Memon 1 Sukkur Institute of Business Administration Airport Road Sukkur, Sindh, Pakistan E-mail: fozia.memon@iba-suk.edu.pk Niaz Ahmed Bhutto 2 Sukkur Institute of Business Administration Airport Road Sukkur, Sindh, Pakistan E-mail: niaz@iba-suk.edu.pk Ghulam Abbas 3 (Corresponding Author) Sukkur Institute of Business Administration Airport Road Sukkur, Sindh, Pakistan E-mail: g_abbas@iba-suk.edu.pk ABSTRACT This study is aimed to investigate the impact of Capital structure on firm financial performance in textile sector of Pakistan. The data of 141 textile firms is collected from Balance Sheet Analysis (BSA), a document issued by State Bank of Pakistan from 2004-2009. Return on asset (ROA) is used as a proxy measure of firm s performance and size, tangibility, debt to equity ratio, amount of annual tax, growth of firm and risk associated with business entity are considered as the determinants of capital structure. Log linear regression model has been used to analyze the impact of capital structure on firm The results indicate the all the determinants of capital structure are significant and the findings suggest that Pakistan textile sector is performing below the optimum capital structure level and textile firms of large size remained fail to achieve the economies of scale. So, it is a matter of serious concerns for policy makers and financial managers and this problem should be dealt positively to improve the financial performance of firms. Keywords: Capital Structure, Firm Financial Performance (ROA), Textile Sector, Pakistan. 1. INTRODUCTION Capital structure refers to combination of different sources of funds that firm uses to finance its overall operations and growth. Capital structure is a financial term and it is a mean to finance company s overall assets by selecting the appropriate mixture of debt (long term and short term) and equity (common equity and preferred equity). Capital structure became a matter of great debate after the publication of seminal paper of Miller and Modigliani, (1958) which is famous for Theory of irrelevancy of capital structure and in which he revealed that capital structure is independent of firm Later on a great debate in this area has been started and a lot of research has been conducted in this area and it is still continued. 1 Ms. Fozia is a Ms-Finance Scholar at Sukkur Institute of Business Administration 2 Dr. Bhutto is an Associate Professor in Finance and Economics at Sukkur Institute of Business Administration 3 Mr. Abbas is a MS-Finance Scholar and Visiting Lecturer at Sukkur Institute of Business Administration Society for Business Research Promotion 9
As capital structure is ratio between debt and equity called leverage and have influence on firm s performance due to cost, they both incur. Equity holder demands for more return hence cost of equity rises when debt is used. When debt is used, the shareholders have residual claim on company assets and bear additional risk. Debt maturity also has an effect on firm financial (Myers, 1984) stated that firm along with risky debt and high growth opportunities, manager acting in the interest of shareholder may pass up positive NPV project because, the return from these projects would partially accrue to the debt holders. Hence due to such action of manager, firm seems to engage in attempting the underinvestment problems. In the Study of (Barclay and Smith, 1995 and Ozkan, 2002), they argued that not only firm s level of leverage cause firm s performance failure, but debt maturity structure also has impact on firm s Stulz, (1990) showed in his study that debt financing is a way to reduce overinvestment problems in the firm but it aggravates the underinvestment problems. He assumed manager as a one who always interested in making investment even if paying out dividend is better for the investors. In his study he further found that large and mature firm having low growth opportunities increases the level of leverage. Debt increases the likelihood for financial distress and debt also provides tax benefit. When calculating the taxable income leverage firms deduct the interest expense from EBIT, so, firm has to pay less tax and pay more to its investors and return on equity increases due to use of debt. Benefits and cost tie with the level of leverage so firm needs optimal capital structure which maximizes the overall value of firm and minimizes the financial cost and weighted average cost of capital and there is not any formula that helps manager to calculate the optimal capital structure. However Considerable work has been done on the factors that influence the level of leverage or the factors that influence the firm choice of capital structure like profitability, size, age, growth, and risk etc, as these factors influence the firm choice of capital structure. This shows that capital structure has definite influences on firm s performance and the main purpose of this study is to find out that influence of capital structure on firm s performance in view of Pakistani textile sector. 2. LITERATURE REVIEW Many researchers enlighten an importance of capital structure, how firm is financed is of paramount importance. If a wrong mix of finance is selected and then becomes problematic for both manager and firm. Many studies have shown that despite the tax benefit, increases in leverage, cause decrease in firm s Krishnan and Moyer, (1997) found negative relationship between debt to equity and return on equity. Importance of optimal capital structure has also been emphasized by many researchers (Brigham and Gapenski, 1996). They explained that optimal capital structure is a point where tax sheltering benefits provided by debt level is equal to the bankruptcy costs associated with debt. They suggested that managers of the firm should identify and maintain optimal capital structure. (Harris and Raviv, 1991) argued that manger is one who always wants to continue current operation even cash flows are poor and debt mitigate that problem and take firm toward the liquidation, but it incurs a cost. They further argued that there must be trade-off between the cost of liquidation and gain from liquidation. Jensen and Meckling (1976) in their paper, pointed out that the conflict of interest may generate agency cost; they indentified two types of conflict, conflict between manager and shareholders and conflict between shareholders and debt holders. Conflict between managers and shareholders arises when managers may take the action in their own interest at the expense of shareholders. However, some researchers such as Grossman and Hart (1982) and Williams, (1987) argued that high leverage encourages manager to act in the interest of equity holders and hence reduce agency cost; debt can be used as a disciplinary device to control manager from wastage of firm s resources. According to Altman and Titman, (1984) if the proportion of debt in the capital structure increases beyond the level, the opposite effect of leverage on agency cost will occur and high leverage may generate significant increase in agency costs. We find three reasons in literature which can cause this opposite effect, first association of bankruptcy cost with Society for Business Research Promotion 10
debt (Titman, 1984). Second, managers may not control risk which result in higher expected costs of financial distress, bankruptcy, or liquidation (Berger and Bonaccorsi di Patti, 2005). Finally, inefficient use of excessive cash used by managers for empire building would also increase agency costs (Jensen, 1986). Zeitun and Tian (2007), found that a firm s capital structure has a significant negative relation with firm performance indicators. Majumdar and Chhibber (1997) and Rao and Syed (2007) also found negative link between financial leverage and 3. DATA AND METHODOLOGY This study is based on secondary data and the textile sector of Pakistan has been selected because this sector is a large in size and a key industrial sector of Pakistan. It plays a very important role in the economy of Pakistan. How much its performance is related with the capital structure is the subject of this study. To achieve the purpose, six years data of 141 firms were used for the period of 2004 2009. All the data about the items of interest were collected from the Balance Sheet Analysis (BSA), official document issued by State Bank of Pakistan. At the start 150 firms were selected but after some screening process this sample size reduced to 141 firms. In the screening process those firms were excluded from sample list whose sales were zero or who deceased their operation during the period of study. 3.1 Hypothesis and Variables In the field of finance, various financial ratios (ROA, ROE and ROI) can be used as a proxy measure for firms performance but in this study we have used only return on asset (ROA) as a proxy measure of firm performance because it is more effective and widely acceptable measure of firms performance used in the existing literature. Chakravarthy (1986) stated that higher return on assets and higher return on equity indicate the firm s effectiveness. In this study focus is made on Return on Assets (ROA) and it is employed as a dependent variable because ROA shows effectiveness of firm toward utilization of assets and it explains how the firm is using its assets to generate earnings. In this study, we have use debt to equity, size of firm, tangibility, growth, risk and tax as independent variables. Hypothesis-1: A firm s capital structure influences its performance negatively. In this hypothesis we want to investigate that how much would be the impact of debt on assets utilization when the assets are financed with debt. So, debt to equity ratio is used as the independent variable and it is measured as total debt dividend by total equity. As the above literature shows that higher leverage generate cost and decrease the firm performance, so, we expect that there is a negative relationship between firm s performance and leverage. Hypothesis-2: Firm s size and performance are positively related. The firm s size is measured as the log of sales and it is considered as the major determinant of firm performance because larger firms are more diversified in nature and can enjoy the economy of scale. Larger firms have less amount of risk involved in its operations and have the lowest bankruptcy cost, so, it is assumed that firm s size has a positive impact on firm s Hypothesis-3: There is a positive relationship between firm s fixed asset (tangibility) and its Tangibility is measured as total fixed assets divided by total assets and tangible assets are used as the collateral and firm who possess more tangible assets having lowest borrowing cost. Akintoye (2008) argues that a firm which makes more investments in tangible assets will have smaller costs of financial distress than a firm that relies on intangible assets. Positive relationship between asset tangibility and firm performance is expected. Society for Business Research Promotion 11
Hypothesis-4: There is a positive relationship between a firm s growth opportunity and its It is always expected that if firm has high growth opportunities, it will perform well as compared to the firm having low growth opportunities. Zeitun and Tian (2007) in their study argued that growth opportunities make the firm able to generate profit from investment; hence we expect a positive relationship between growth opportunities and firm s Hypothesis-5: There is a positive relationship between risk and corporate Risk is measured by the standard deviation of cash flow (net income plus depreciation) and it has always been assumed that firms with higher variability in operating income are expected to have higher returns with high associated risk. Hypothesis-6: There is a positive relationship between amount of tax and corporate The amount of tax is also expected to have positive relationship with firm s performance, because when the firm is performing well and its return on assets ratio is high then their capital structure would be directed towards optimum level and firms will be paying higher amount of tax. 4. ECONOMETRIC MODEL ESTIMATION: Multiple regression model is used to estimate the cause and effect relationship. This model is being run on the panel data of 355 firm year observations and after adjustment and log linear model is used because most of the variables of this study do not possess the linear relationship with the dependent variables. So, we have used log linear model in this study. ROA = β0 β1leverage + β2size + β3growth + β4tangibility + β4risk+ β5 Tax 5. RESULTS AND DISCUSSION The impact of six explanatory variables i.e. leverage, size, growth, tangibility, tax and risk has been examined on firm s performance measure ROA in textile sector of Pakistan. Table- 1 reports the results of multiple regression analysis in which six independent variables are regressed by using the panel data of textile sector of Pakistan from 2004 to 2009. In the table the value of adjusted R-square is 0.51 which indicates that 51% of firm s performance is explained by the independent i.e. leverage, size, growth, tangibility, tax and risk. Statistical result of five variables (Leverage, Size, Tangibility, Risk and Tax) shows that the variable are statistically significant at 1% level and only one variable is significant at 5% level. These results indicate the validity of estimated model. Furthermore, the signs of coefficients in the regression model show that leverage, size and tangibility are negatively related to the return on assets (ROA) and risk, tax and growth are positively related to return on assets (ROA). In the Hypothesis-1, as it was expected that firm s capital structure influences its performance negatively and on the basis of estimation results, we cannot reject this hypothesis. The regression result in table-1 the coefficient of debt to equity ratio is negatively related to the accounting performance measure ROA and the result show that high level of leverage lead to lower ROA. Moreover, due to agency conflict, if firm over leverage itself then this will cause its performance down. Another interesting result from table-1 is that, we expected positive relationship between firm size and firm s performance but statistical result rejects the hypothesis-2 and shows that there is a significant negative relation between firm s size and As many researcher emphasized on optimal capital structure and larger firm use more debt due to low bankruptcy cost. We can say that as larger firm use more debt but it is possibility that Society for Business Research Promotion 12
larger firms can be incapable to trade off between cost of debt and benefit from debt that causes lower ROA. Hypothesis-3 is also rejected on the basis of statistical results in table-1 which show that there is a significant negative relationship between firm s performance measures ROA and tangibility. It implies that textile companies of Pakistan invest too much on fixed assets in a way that does not improve their It shows inefficient use of assets in the large firms and hence leaves negative impact on In hypothesis-4 it was also expected that firm s growth opportunities influence the firm s performance positively and result also supports this statement and shows a significant positive relationship between firm s growth and Significance of growth indicates that high growth rates in textile s firm are associated with lower cost of capital and high performance ratio of ROA. From the hypothesis-5, risk was expected to have a positive and significant effect on firm The significant result proves the classical risk return trade off arguments firm with higher variability in operating income have higher return. Similarly, higher the amount of tax payment shows better performance and significance of variable tax in table-1 shows that firm with high tax payment have better So, both of these hypothesis cannot be rejected. 6. CONCLUSION This paper examines the impact of capital structure on corporate financial performance in the textile sector of Pakistan. Limited studies have been conducted in this area so this study will fill the gap in this field in Pakistan. On the basis of the estimation results and discussion, it is concluded that the textile firms which are large in size are under performing and operating below the economies of scale. Moreover the textile firms possess high amount of fixed assets this leaves a negative impact on the performance of the firms. The textile firms in Pakistan are poor in terms of their productive and allocative efficiency. This inefficiency of textile sector is followed by some serious issues like sever energy crisis in Pakistan poor law and order conditions and political instability. Moreover, the textile firms in Pakistan, are also operating under the optimum level of capital structure and due to this poor selection of capital structure, the financial performance of textile firms is adversely affected. By keeping in view, the importance of this sector, it is suggested that the financial analysts and managers should emphasize on the optimum level of capital structure and efficient utilization and allocation of resources. This will help to achieve the targeted level of productive efficiency in textile sector of Pakistan. REFERENCES Varouj A. Aivazian, Ying Ge, and Jiaping Qiu*, 2005, Debt Maturity Structure and Firm investment, Journal of Financial Management, 107 119. R. Zeitun, G. G. Tian, 2007, Capital structure and corporate performance: evidence from Jordan, Australasian Accounting Business and Finance Journal Naveed Ahmed, Zulfqar Ahmed and Ishfaq Ahmed, 2010 Determinants of Capital Structure: A Case of Life Insurance Sector of Pakistan, European Journal of Economics, Finance and Administrative Sciences 24, 1450-2275. Onaolapo, Adekunle A and Kajola, Sunday O, 2010, Capital Structure and Firm Performance: Evidence from Nigeria, European Journal of Economics, Finance and Administrative Sciences 25, 1450-2275 AYDIN OZKAN, 2002, The determinants of corporate debt maturity: evidence from UK rms. Journal of Applied Science Economics 12, 19 24. Gurcharan S, 2010, A Review of Optimal Capital Structure Determinant of Selected ASEAN Countries, Journal of Finance and Economics 47, 1450-2887. Society for Business Research Promotion 13
Abubakr Saeed, 2007, The Determinants of Capital Structure in Energy Sector (A study of Pakistani listed firms), Aivazian, V.A. and J.L Callen, 1980, "Corporate Leverage and Growth: the Game-theoretic Issues," Journa/ of Financial Economics 8, 379-99. Aivazian, V.A., Ge, Y, and J. Qiu, 2005, "The Impact of Leverage on Firm Investment: Canadian Evidence,"Journal of Corporate Finance 11, 277-191. Baker, M. and J. Wurgler, 2002, "Market Timing and Capital Structure," Journal of Finance 57, 1-30. Barclay, M.J. and C.W. Smith, Jr., 1995, "The Maturity Structure of Corporate Debt," Journal of Finance 50, 609-632. Barclay, M.J., Marx, L.M., and C.W. Smith Jr, 2003, "The Joint Detenninant of Leverage and Debt Maturity," Journal of Corporate Finance 9, 149-167. Bamea, A.R., Haugen, S., and L.W. Senbet, 1980, "A Rationale for Debt Maturity Structure and Call Provisions in the Agency Theoretic Framework," Journal of Finance 35, 1223-1234. Cleary, W.S., 1999, "The Relationship between Firm Investment and Financial Status," Journal of Finance 54, 673-692. Diamond, D.W., 1993, "Seniority and Maturity of Debt Contracts," Journal of Financial Economics 33,341-368. Fama, E.F. and K.R. French, 2002, "Testing Tradeoff and Pecking Order Predictions about Dividends and Debt," Review of Financial Studies 15, 1-33. Guedes, J. and T. Opler, 1996, "The Determinants of the Maturity of Corporate Debt Issues," Journal of Finance 51, IS09-1834. Leary, M.T. and M.R. Roberts, 2005, "Do Firms Rebalance Their Capital Structure?" Journal of Finance(Forthcoming). Myers, S., 1977, "Determinants of Corporate Borrowing," Journal of Financial Economics 5, 147-175. Opler, T.C. and S. Titman, 1994, "Financial Distress and Corporate Performance," Journal of Finance 49, 1015-1104. Booth L., Aivazian V., Demirguc-Kunt A,2001 Capital structure in developing countries, Journal of Finance 56, 87-130. APPENDIX Table-1 Model Summary Variable Coefficient Std. Error t-statistic Prob. CONSTANT 24.93244*** 1.859186 13.41040 0.0000 LOG(DE_RATIO) -0.843438*** 0.218538-3.859449 0.0001 SIZE -4.048271*** 0.305290-13.26043 0.0000 TANGIBILITY -4.187210*** 0.854562-4.899830 0.0000 LOG(RISK) 2.437476*** 0.171578 14.20625 0.0000 LOG(TAX) 1.270278*** 0.207463 6.122920 0.0000 LOG(SALES GROWTH) 0.253770** 0.116703 2.174497 0.0303 Adjusted R-squared 0.510109 F-statistic 62.43501*** Prob(F-statistic) 0.000000 Durbin-Watson stat 1.428724 * Significant at 0.1 ** Significant at 0.05 Society for Business Research Promotion 14
*** Significant at 0.01 Table-2 Expected and Observed Relationship Determinant Measure (proxy) Expected Relationship Observed with ROA Relationship Size Log of Sales Positive Negative 1 Leverage (D/E ratio) Debt to Equity Ratio Negative Negative 1 Tangibility Growth Total Gross Fixed Assets/Total Assets Annual Percentage Change in Total Assets. Positive Negative 1 Positive Positive 2 Tax Tax rate Positive Positive 1 Risk (Earning Volatility) 1- Significant at 1% level. 2. Significant at 5% level. Deviation from mean Positive Positive 1 Society for Business Research Promotion 15