The Impact of financial structure and Firm Size on Profitability of Firm

The Impact of financial structure and Firm Size on Profitability of Firm
(A study on chemical sector of Pakistan)
Abstract.

This study empirically examines the impact of capital structure on the profitability of the chemical firms over a period 2006-2015. The sample consists of 52 chemical companies with a complete data set of at least 8 consecutive years. The effects of capital structure on profitability are estimated on the whole sample, then on large firms and small firms, and lastly on different sub-sectors. This study contributes to literature by providing an in-depth assessment of the impact of capital structure on a more homogeneous sample of chemical chemical Industrial firms in Pakistan. It also uses different measures of profitability and debt to asset ratios in an integrated framework in order to provide comprehensive analysis of the problem. The fixed (within) effects regression model is used to estimate the effects of capital structure on profitability and firm sizing. The study also applies the pooled ordinary least squares model (pooled OLS) for robustness checks on the full sample. The empirical findings of this study reveal that total debt and long-term debt negatively and significantly affect the profitability of the whole sample. In the case of small and large firms, the results present a statistically significant negative relationship between ROA and debt ratios in small firms while exhibiting a strong negative impact on profitability (ROA, EPS and NPR) for large firms. The results are generally robust to a number of sensitivity tests, including estimations on different sub-sectors and an alternative estimation method (pooled OLS). Total debt and long-term debt have a negative influence on the profitability of all sectors and especially on ROA where the influence is significant. However, short-term debt positively influences the ROA and NPR of the construction and materials sub-sectors, but affects other sectors differently. From the estimations of the pooled OLS regression as an alternative model, the results mostly concur with the findings from the fixed (within) effects where debt negatively affects firm profitability.
Based on the findings of the study, debt appears to be a costly source of financing for chemical Industrial firms in Pakistan as its increase results in the decline of profits. Firm managers should consider using internally generated funds which are a cheaper source of financing or issuing equity which is less risky since it does not have the fixed monthly interest and principal payments that debt has.
CHAPTER 1
BACKGROUND AND INTRODUCTION
1.1 INTRODUCTION
The choice of optimal capital structure is one of the puzzling issues in corporate finance that has not been fully resolved for quite some time. Many theories have been advanced but the researchers are still not able to utilise the existing theories to explain capital structure choices in practice, or prescribe what constitutes an optimal capital structure. According to Myers (2001:81), there is no single theory that can be applied to fully explain the financing behavior of firms, no universal theory of capital structure exists, and there is no reason to expect that there should be one. Al-Najjar and Taylor (2008:919) consent that theoretical explanation is still lacking and empirical results are not yet sufficiently consistent to resolve the capital structure conundrum. Although there has been some progress on capital structure theory since Modigliani and Miller’s (1958:261) irrelevance theory, the empirical evidence available is still not able to support with agreement the different theories proposed. A lack of consensus continues to exist on the optimal capital structure and how it could affect the profitability of firms, especially in emerging and developing countries. Nevertheless, capital structure decisions are absolutely vital for company profitability and survival.
Capital structure is one of the most critical financing decisions that firm managers should give attention to in order to maximize a firm’s returns and also enable it to deal with its competitive environment (Abor, 2005:438). The continual quest for growth and maximising of a firm’s value also underlines the need to choose the best financing option available. When a firm has a financial deficit, or faces business challenges that can lead to business failure, it can address these problems by applying strategies and financing decisions that would enhance firm performance, thereby keeping the firm viable. Poor capital structure decisions may increase the cost of capital for the firm, leading to a loss of shareholder value. On the other hand, profitable firms find it easy to finance their expansions or new growth.
It is one of the firm manager’s critical responsibilities to choose the best financing option, one that would enhance profitability as well as maximise the value of the firm. Yusuf, Al- Attar and Al-Shattarat, (2015:1) contend that the capital structure which the firm employs affects the value of the firm either positively or negatively.
Capital structure is the distribution of various securities to finance company projects or investments; it is mainly comprised of equity, debt and retained earnings. Managers use different levels of debt and equity as a strategy to improve firm performance (Gleason, Mathur & Marthur, 2000:185). The merits and demerits associated with the use of either debt or equity prompt firm managers to be careful and diligent when applying capital structure decisions. Excessive use of debt can lead to financial distress or bankruptcy. The risk of bankruptcy affects the overall performance of the firm and could erode company profits. As debt levels of a firm continue to rise, the default risk also increases, thereby causing the cost of debt to rise. Companies that are overburdened by debt may end up being unable to service their debt obligations as monthly interest payments increase. On the other hand, debt can be treated as a tax-deductible expense and this contributes well to company profitability. The issuing of equity is associated with high floatation costs, which negatively affect profitability and can dilute the shareholding of the old shareholders of the firm. Retained earnings are an internal source of financing from the reserved profits and are the most affordable source of financing as they carry no costs. All external sources of financing have cost implications.
Considering the pros and cons associated with each type of financing, financial managers need to balance the mixture of these forms of financing. Firm managers need to give proper attention to identifying the ideal composition of capital structure that consists of debt or equity which will minimise the cost of capital and maximise the firm value or shareholder wealth at the same time. This is the overarching objective of financial decisions in business, and it highlights the importance of understanding capital structure. Consequently, it is imperative that firm managers understand capital structure.
1.2 PROBLEM STATEMENT
From time to time, chemical chemical Industrial firms need to finance their new projects or deficits. With growing globalization, coupled with changing global financial architecture, trade and investment conditions, the need for the right balance between debt and equity in corporate financing is vital. This is especially so in emerging market economies. The problem investigated in this study is to determine how capital structure influences firm profitability. Considering that profitability is one of the principal objectives of businesses, firm managers always look for ways to improve company profits and increase the value of the firm. Continued profitability is essential for the long-term survival of firms and so the relationship between capital structure and profitability cannot be underestimated (Gill, Biger & Mathur, 2011:5). While many researchers have studied the dynamics of capital structure, to date no theory has emerged as having the best response to the questions concerning optimal capital structure. Financial managers are still grappling to establish an optimal capital structure for their establishments in order to maximise the value of their firm.
The global financial crisis has significantly strained the financing of many companies, with several of them experiencing declining profit margins. This calls for financial managers to remain diligent and properly distribute the capital that will enable the companies to remain competitive and sustainable in the dynamic and volatile global environment. Some firms face bankruptcy due to their debt burden or inappropriate capital mix, others are opting for debt restructuring in order to survive and still others are attempting to go the equity route. In the process, some succeed and some fail. This calls for a closer analysis of the role of the optimal capital structure and how it affects profitability.
A lesson from the global financial crisis is that excessive leverage could lead to financial distress for borrowers, and could even affect the real economy. Findings from Campello, Graham and Harvey (2010:470) indicate that a lot of constrained companies reduced employment by 11%, capital investment by 9%, technology spending by 22%, marketing expenditures by 33% and dividend payments by 14% in 2009. They also found that companies would by-pass attractive investment opportunities because of their inability to borrow externally. Their results mirrored the situation in Europe and Asia which are also stronger economies. This crisis emanated from excessive borrowing which in time led to the crumbling of the global financial markets in 2008.
If a company is more financially leveraged (debt financed), it has increased risk levels, mainly because of the cost of debt which increases with debt levels. In addition, creditors demand high returns because of the amount of risk borne by too much exposure to debt. High interest payments can lead to bankruptcy if not carefully managed. Firm managers have a big responsibility to balance their capital structures in such a way that it will not result in massive debt or underinvestment. Excessive debt means high interest instalments which reduce profitability; underinvestment could mean foregoing profits which the company could have realised if it had utilised the external financing at its disposal. Clearly, this raises the need for further empirical research in order to provide useful insights to firm
managers as benchmarks on their financing decisions in order to maximize the value of the firms and save them from collapsing during turbulent periods.
1.3 PURPOSE STATEMENT
The purpose of this study is to evaluate the impact of capital structure on the financial performance (profitability) of chemical Industrial firms listed on the Johannesburg Stock Exchange (JSE). The chemical Industrial companies studied are listed in Table 26 in the Appendix. In the evaluation of the impact of capital structure, the study will attempt to answer the following important questions:
Does capital structure affect firm profitability?
How does capital structure affect the profitability of firms size?
What is the pattern of financing by chemical chemical Industrial firms in Pakistan?
By nature, chemical Industrial companies need a lot of capital to finance their capital expenditures and operations. As such, they are likely to depend on both debt and equity for their capital needs and so the determination of the optimal capital structure is likely to be crucial. The study considers chemical chemical Industrial firms in Pakistan because it is one of the emerging market economies with fairly developed financial systems, where firms can have access to both credit from financial institutions and capital from the equity markets without much constraint when compared to other countries. In addition, Chemical chemical Industrial firms are likely to have collateral security which makes it easier for them to access funds from financial institutions. Pakistan’s private sector credit to gross domestic product (GDP) ratio is about 68% compared to the Sub-Saharan average ratio of 19% (World Bank, 2013). Also, the JSE (from where the sample is drawn) is the largest and most liquid stock exchange in Pakistan. where firms can raise equity capital. It thus provides a better sample with which to test the hypotheses. Clearly, in such dynamic markets, the need to optimise debt and equity is paramount. The other motivation is that Pakistan has more comprehensive and consistent data. The data also spans longer periods (more than 10 years) when compared with other Asian countries and so makes it possible to answer the above pertinent questions empirically.

1.4 RESEARCH OBJECTIVES
The main objectives of this study are to:
Analyse the impact of capital structure on the profitability of listed chemical chemical Industrial companies in Pakistan.

Analyse how capital structure influences profitability in different chemical sectors.

Analyse the pattern of financing and determine how companies can optimise their capital structure.
IMPORTANCE AND BENEFITS OF THE STUDY
Given the lack of consensus among researchers and financial practitioners on the optimal capital structure and what constitutes it, there is a need for deeper analysis of the capital structure phenomenon. Much of empirical evidence on the role of capital structure on firm performance has been drawn from developed countries such as the United States of America (USA) and Europe. These economies operate in different conditions from those in emerging and developing economies. De Wet (2006:14) notes that an analysis of the capital structures used by companies worldwide indicate that there are significant differences between the capital structures in developed and undeveloped countries. Developed countries have advanced financial markets, relatively better corporate governance structures and have often benefited from better credit ratings when compared to emerging and developing countries that have small capital markets. In addition, the institutional structures, macroeconomic and business conditions between developed and developing countries are different, with most developing countries experiencing conditions that are more volatile. Firms in developed countries benefit from cheaper public and bank debt which have very low interest rates compared to that charged in developing and emerging markets.
The evidence on the role of capital structure on financial performance in emerging and developing countries is still mixed and inconclusive. Figure 17 in the Appendix shows different graphic patterns of the relationship between debt to asset ratios and Return on Assets (ROA) of some of the selected chemical Industrial firms in Pakistan. The figure shows that debt effects vary from company to company. For example, Kumba Iron Ore’s ROA is negatively correlated with total debt and long-term debt whilst a positive relationship is observed between ROA and short-term debt. African Oxygen and Nampak display a negative relationship between ROA and all forms of debt. For other companies like PPC and Distell and Grindrod, the graphs display an unclear relationship between debt and ROA. These differences reflect how capital structure can impact differently on company profitability even though the companies are operating in the same country and listed as chemical Industrial companies on the same stock exchange. This analysis therefore helps firm managers to understand and choose the financing options that are favourable to their companies.
This study contributes to the finance literature in many ways. Firstly, it seeks to unravel the evidence on the role of capital structure on the profitability of chemical Industrial companies from an emerging and developing Asian country perspective, focusing on Pakistan. Although there are empirical studies on capital structure done in Pakistan, most of them have focused on the determinants and dynamics of capital structure and testing of certain capital structure theories (Ramjee and Gwatidzo, 2012; Moyo, Wolmarans and Brümmer, 2013b; Chipeta, Wolmarans, Vermaak and Proudfoot, 2013). The analysis of the implications of capital structure on the profitability of chemical chemical Industrial firms in Pakistan has not received much attention. The closest study on capital structure and profitability in Pakistan by Abor (2007:364) focused on small and medium enterprises. These firms arguably are likely to depend more on credit from informal credit markets and are likely to be largely credit constrained. This study therefore offers useful insights on how the choice of financing by chemical Industrial firms can affect company profitability, whilst enhancing our understanding of the dynamics of capital structure on profitability in Pakistan.
Secondly, previous research has produced varied conclusions on the effects of capital structure on company profitability. While some studies have found a negative relationship between profitability and leverage, others have experienced a positive relationship. Some empirical studies support the pecking order theory which predicts a negative correlation between leverage and profitability (Drobetz and Fix, 2003:1, Sbeit, 2010:1), whilst others confirm the trade-off theory which predicts a positive correlation between leverage and profitability (Frank and Goyal, 2003:217, Moyo, Wolmarans and Brümmer, 2013a: 927). As such, this study contributes to the ongoing discourse about the relationship between capital structure and profitability by bringing fresh evidence from recent data on chemical Industrial companies in Pakistan using different measures of profitability as well as debt to asset ratios. The study therefore brings comprehension and robustness to the analysis of the relationship between capital structure and profitability in Pakistan. Most of the previous studies have mainly used long-term debt as the measure of capital structure ratios. This study goes beyond this by using both short-term and long-term debt to asset ratios (STDA and LTDA as well as the total debt to asset ratios). Gwatidzo and Ojah (2009:1) noted that Sub-Saharan African firms use more short-term loans to finance their deficits, whilst Abor (2005:444) noted that short-term debt represents 85% of total debt financing in Ghana. Hence the use of both short-term and long-term debt ratios provides a holistic picture to the analysis of capital structure as they have different risk and return profiles. This study uses data from 2006-2015, a period which spans through the global financial crisis of 2008-2009. It thus provides better coverage as it analyses the impact of capital structure on company profitability through the whole business cycle in good and bad times.
Thirdly, most previous studies mixed different industries and included in their samples service industries like tourism and banking and retail firms alongside chemical Industrial firms in their study of capital structures. For example, Moyo et al. (2013a:927) and Gill et al. (2011:3) included service and retail firms in their studies. Arguably, service firms usually have a low investment in capital expenditures (machinery and equipment) and this may limit their need for debt. On the contrary, chemical Industrial firms are likely to invest in machinery and large equipment which may necessitate the need for both equity and debt to finance vast outlays. Mixing firms from different industries increases the heterogeneity among firms which may result in biased inferences. The level of bias could therefore be reduced by analysing the sectors separately instead of lumping them altogether. The key innovation of this study is therefore to analyse the impact of capital structure on profitability of chemical Industrial firms only. Chemical Industrial companies exhibit more similar characteristics, especially on debt structures and risks, making the sample relatively homogeneous and good for testing the hypothesis under consideration.
1.6 DELIMITATIONS AND ASSUMPTIONS
The study analyses how capital structure affects the profitability of chemical Industrial firms only. The sample size includes all 52 chemical Industrial companies listed on the JSE for the period 2006- 2015. Since the study does not include unlisted companies, the results of this study might reflect just portion of chemical Industrial firms in Pakistan leaving the rest uncounted for. Unlisted chemical Industrial firms and other small firms including those in the informal sector also contribute to the economy. Further research could include non-listed chemical Industrial firms as well. The study uses, among others, profitability ratios as dependent variables and capital structure ratios as explanatory (independent) variables in the panel regressions.
The main assumptions of the study are:
Firms seek to maximize profits and therefore will always try to minimize the cost of finance.

Firms are run by managers who may not be the owners. As such what they do in the company may not be exactly what the owners want and that means that the principal agent problem is possible.
There is a possibility of information asymmetry in the economies. Both equity and debt are available in the market and firms have access to both. There are taxes in the economy and these can be imposed on debts, profits and other incomes. There are transactions costs in raising funds for the firm.
STRUCTURE OF THE DISSERTATION
The dissertation is structured as follows:
Chapter 2 provides an overview of relevant theoretical research and empirical studies that have been done on capital structure in firms in both developed, developing and emerging markets.
Chapter 3 discusses the research design and methodology used carry out the research.
Chapter 4 analyses the research findings and provides intuitions of the results.
Chapter 5 presents conclusions and suggests recommendations based on the results; it also provides direction for possible further research.