The Efforts, Journal of Education and Research

Volume 4, Issue 1, February, 2022, pp. 102-111

The Impact of Capital Structure and Firm Size on Financial

Performance of Commercial Banks in Nepal
- Dhan Raj Chalise1, Naba Raj Adhikari2
1 2
Shankar Dev Campus, TU, Central Department of Management, TU

Abstract
This paper aimed to examine the impact of capital structure and firm size on
financial performance of Nepalese commercial banks. The study used a sample of 14
commercial banks covering government owned, joint venture and private banks over the
period 2013/2014– 2018/2019 with secondary sources of data. Regression analysis was
used in the estimation of functions relating the Return on Assets (ROA) and Earnings
per Share (EPS) with measures of capital structure and firm size (total assets). The
results revealed a negative relation of ROA and EPS with capital structure
(Debt/Equity). However, it showed a positive relationship of ROA and EPS with size
(total assets). The findings provided the evidence in support of high-level equity capital
employed in the capital structure of Nepalese commercial banks.
Keywords: capital structure, financial performance, commercial banks, return on assets,
earning per share
Introduction
In finance, capital structure refers to the way in which an organization is
financed a combination of long-term capital. Capital structure decisions are among the
most important and crucial decisions for any business because of their effect on the
performance of firms (Birru, 2016). It is important because of the need to maximize
returns of the firms, and because of the impact, such a decision has on the firm’s ability
to deal with its competitive environment (Abor, 2005). The relationship between capital
structure and financial performance is considerable importance to all banking industry.
The banking industry is especially sensitive to changes in financial leverage due to their
low level of equity capital to total assets (AL- Kayed et al., 2014). In addition, the
capital structure of banks is highly regulated. One of the important issues during the
capital structure decision-making is to deal with the determination of optimal capital
structure of the firm (Chandra & Sharma, 2015).

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 The Modigliani-Miller theorem opened a literature on the fundamental nature of
debt versus equity. The capital structure of a firm is the result of various financing
source. In the perfect capital markets, the costs of different forms of financing do not
vary independently and therefore there is no extra gain. As a consequence of taxes,
differences in information and agency costs, the financing clearly matters the gain.
Capital is a necessary requirement for any business. The capital requirement for the
business depends upon the nature of the business, the size of the business and different
policies related to the business. Capital required is raised mainly from two sources,
equity and debt. Equity provides the ownership of an individual over the firm while debt
is the borrowed fund with fixed charges (interest or coupon rate). The capital structure
refers to the proportion or mix of financing methods (i.e. debt and share/equity capital).
Also, it can be termed as the composition of long-term finance such as long-term debt,
preference capital and equity capital. Capital structure is decided as per the need of the
company, so the capital structure varies from one another. For example, some
companies use share capital only and others may use high debt capital while may
choose a different mix of sources. A good capital structure will reduce the overall cost
of capital for the capital employed. The low cost of capital means the high discounted
value of the cash flows which will be generated in the future. This will maximize the
overall value of the firm. The objective of the capital structure is to find the lowest
possible cost of capital and consequently maximizing the value of the firm.
Modugu, (2013) studied on different dimensions of capital structure and
concluded that the companies’ assets are financed by either internal or external capital.
The determination of appropriate mix of capital source is one of the strategic decisions
and public interest entities are confronted for. In deciding whether to finance the firm’s
assets with equity, debt or both, certain conditions must first be considered. A wrong
composition of a firm’s capital structure can result in liquidity and solvency problems.
In taking this strategic decision, managers must of necessity apply caution in ensuring
that a right mixture of equity and debt are used to harness the benefits accruable from
such combination. Financing a company solely with equity or debt may not be an
optimal capital structure decision. Capital structure decision affects the value of the
firm. A proper balance between debt and equity is necessary to ensure a trade-off
between risk and return to the shareholders. The bank should decide the capital structure
so that the value is maximized. There should be proper practice for making optimal
capital structure so that cost of capital is minimized and the firm’s value is maximized.
The Modigliani-Miller theorem opened a literature on the fundamental nature of debt

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versus equity. The capital structure of a firm is the result of various financing sources.
In the perfect capital markets, the costs of different forms of financing do not vary
independently and therefore there is no extra gain. As a consequence of taxes,
differences in information and agency costs, the financing clearly matters the gain
(Visinescu, & Micuda, 2009).
The financing or capital structure decision influences the shareholder return and
risk (Birru, 2016). The market of the share is also affected by the capital structure
decision (Harris & Raviv, 1990). The financial manager of a firm has to analyze the
merits and demerits of various sources of funds before selecting the best one keeping in
mind the optimal capital mix or the one that reduces the capital cost. The decision
regarding capital structure is a continuous process. It is said to be an optimal one when
it maximizes the market value of the firm. The relationship between capital structure
and financial performance of the firm has been a subject of considerable debate. In
examining the impact of capital structure on firm performance, two kinds of
performance measures can be identified in the existing finance literature, namely, the
traditional accounting measures of performance return on assets, return on equity,
earnings per share and Tobin’s Q and profit efficiency measures such as frontier
efficiency (Berger and di Patti, 2006).
The banking sector has an important role in the development of the country.
Economic development and financial development are closely related. Effective,
efficient and disciplined banking systems can bring rapid changes to the economy. The
banking sector promotes capital formation; investment and promotion of trade,
commerce and industry. The banking sector is the financial institution that accepts
deposits from the public and provides loans to the public. Bank has various sources of
income; they lend money as loans, services like Automated Teller Machine (ATM)
service, annual charges and more. Rajakumaran, and Yogendrarajah, (2015) empirically
investigated impact of capital structure on profitability in trading companies in Sri
Lanka taking capital structure as independent variable capital structure of the
company’s is measured by leverage ratios of Debt to Equity Ratio and Debt to Assets
Ratio whereas Gross Profit Ratio, Net Profit Ratio, Return On Assets, Return On Equity
and Return on Capital Employed are used as the dependent variables. The study
revealed that 44% of the total assets in the trading companies of Sri Lanka are
representing by debt and on the basis of correlation analysis debt to equity ratio and
debt to total assets ratio positively and moderately correlated with gross profit ratio,
negatively and moderately correlated with net profit ratio, positively and weakly created

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with return on capital employed and negatively and weakly correlated with other
profitability ratios.

There has been a debate centered on whether the proportion of debt usage is relevant
or irrelevant to individual firm’s value. Eriotis et al. (2002) who investigated the
relationship between debt-to-equity ratio and firm’s profitability. Fama and French
(2002), Gill, Biger & Mathur (2011) found a positive relationship between capital
structure and profitability. Goyal (2013) identified a positive relationship of debt with
profitability. The study of Twairesh (2014) also found the significant impact of leverage
on firm’s performance. Pouraghajan & Malekian (2012); Quang & Xin (2014) found a
significant and negative impact with statistical significance on firm’s financial
performance. Ibrahim (2009) identified that the capital structure has a weak to no
impact on firm performance. Olokoyo (2013) showed a significant negative effect of
leverage on firm’s performance. Study by Zeitun & Tian (2007) in taking 167 Jordanion
companies over fifteen-year period, found a significant negative impact of firm’s capital
structure on the firm’s financial performance. In addition Doku, Kpekpena &
Boatengthe (2019) examined that bank capital to asset ratio has a strong and found
positive driver of bank financial performance. The empirical relationship between a
firm's size, structure, and profitability has been found that size is positively correlated
with profitability (Gichura, 2011), with the profit rate of the market positively correlated
with the concentration ratio and negatively correlated with the marginal concentration
ratio (Adams and Buckle, 2003). Most of the Nepalese commercial banks have used
debt capital. In this context, this study tried to answer the following questions in the
Nepalese commercial banking literature:
• Is there relationship between capital structure and financial performance?
• Does capital structure impact on ROA?
• Does capital structure impact on EPS?
• Does the bank’s size affect on financial performance?
Objective of the Study
The general objective of this study was to examine the impact of capital
structure and firm size on financial performance of commercial banks in Nepal. The
other specific objectives were:
• To identify the impacts of capital structure on ROA.

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• To analyze the impacts of capital structure on EPS.
• To examine the effects of bank’s size on financial performance.
Methodology
The study uses fourteen banks covering government owned, joint venture and
private banks. Data for 6 fiscal years period (2013/2014–2018/2019) have been taken
for the study. ROA and EPS have been taken as the financial performance measure to
identify the impact of capital structure (Debt/Equity) and the size (total assets). This
study has followed descriptive research design using secondary sources of data. Banks
using both debt and equity capital are taken as sample under judgmental basis.
Regression analysis was used in the estimation of functions relating the ROA and EPS
with measures of capital structure and total assets.
Following regression model was developed for the examination.

Where: EPS= Earnings per Share, ROA=Return on Assets, D/E = Debt-equity

ratio, Size= Total assets, constant, and are coefficients of variables included
in the model and is error term.

Results and Discussion

Table 1: Relationship Analysis
ROA EPS D/E Ratio Size
ROA 1
EPS .723* 1
D/E Ratio -.493** -.248*** 1
Size .606* .703* -.138*** 1
*=sig. at 0.01, **= sig. at 0.05, ***= sig. at 0.10
Table 1 presents the relationship between the arrangements of variables. As
indicated by the idea of productivity, earnings per share and return on assets are the
significant wellsprings of financial performance. The outcome supports to such idea.
The relationship of EPS on ROA appears to be 72.3%. Nonetheless, these two have

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been considered in this investigation as reliant factors and consequences for these by the
free factors have been assessed independently with the regression models. The
outcomes from the relationship network demonstrate that bank's EPS is contrarily
connected with D/E ratio and emphatically corresponded with size. Then again, steady
with the priori desire, ROA is contrarily connected with D/E ratio and emphatically
connected with size increment.
Table 2: Degree of Relationship with Earning per Share
Model Summary
Model R R Square Adjusted R Square Std. Error of the Estimate F Sig.
1.719 0.517 0.43 8.84938 5.896 0.00
a. Predictors , Size, Debt- Equity Ratio
b. Dependent Variable: Earning Per Share

Table 3: Coefficient
Un-standardized Coefficients Standardized Coefficients
Model 1 T Sig.
B Std. Error Beta
(Constant) 5.912 10.926 .541 .599
D/E Ratio -33.263 45.718 .154 -.728 .482
Size 3.0130 .000 .682 3.223 .003
a. Dependent Variable: Earnings per Share

Table 2-3 presents model summary and regression result of the effect of debt
equity proportion and size of the business on one of the significant performance
measures, EPS. The outcomes of R2 and adjusted R2 address the degree of the
variability of ward variable can be explained by the independent variable. These results
express the general useful force of the regression model. The overall regression model is
significant, F = 5.896, P < 001, R2 = 0.517. This exhibits most outrageous 51.7% of the
assortment in the earnings per share can be explained by the assortment in the variables.
Moreover, with the results of coefficients table D/E proportion is
inconsequential indicator whereas size of the business huge indicator in the challenge of

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Nepalese financial enterprises. From this assessment, it tends to be inferred that those
Nepalese commercial banks have gained equity capital according to heading of Nepal
Rastra Bank's capital extension and then debt obligation extent is declined and
legitimate.
Table 4 Degree of Relationship with Return on Assets
Model Summary
Model R R Square Adjusted R Square Std. Error of the Estimate F Sig.
1 .733 0.538 0.454 0.00270 6.397 0.00
Predictors , Size, Debt- Equity Ratio

Dependent Variable: Return on Assets

Table 5 Coefficients
Un-standardized Coefficients Standardized Coefficients
Model t Sig.
B Std. Error Beta
(Constant) .013 .003 3.795 .003
D/E Ratio -.028 .014 .417 -2.015 .069
Size 7.5581 .000 .548 2.648 .001
a. Dependent Variable: Return on Assets

Table 4-5 represents model summary and regression result of the effect of debt
equity proportion and size of the business on one of the significant performance
indicators, ROA. The outcomes of R 2 and adjusted R 2 address the degree of the
variability of dependent variable can be explained by the independent variable. These
results expressed the general useful force of the regression model. The overall
regression model was significant, F = 6.397, P < .001, R 2 = 0.538. This exhibits most
outrageous 53.8 % of the assortment in the return on assets that can be explained by the
assortment in the variables.
Furthermore, the results of coefficient table indicate that D/E proportion is
inconsequential indicator whereas size of the business huge indicator in the challenge of
Nepalese financial enterprises. From this assessment it tends to be inferred that those
The EFFORTS, Journal of Education and Research, Volume 4, Issue 1, February, 2022 – 108
Nepalese commercial banks have gained equity capital according to heading of Nepal
Rastra Bank's capital extension and then debt obligation extent was declined and
legitimate.

Conclusion
The financing decision of capital structure and their impact on financial
performance has been a major field in the corporate finance literature. This paper aimed
to examine the impact of capital structure and firm size on financial performance of
commercial banks. ROA and EPS were used as the financial performance indicators.
The studies revealed a negative relation of ROA and EPS with capital structure
(Debt/Equity) and it lied in the line of (Timsina, 2018). It indicates that, there is no
impact of capital structure on ROA and EPS. However, it shows a positive relationship
of ROA and EPS with total assets (Size) and lies in the line of Merikas et al., (2006) to
support a positive relationship between firm size and profitability. The findings provide
evidence in support of high-level equity capital employed in the capital structure of
Nepalese commercial banks. This study is useful to the managers of banking industry
for taking any decisions on improving financial performance.
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Contributor: Mr. Chalise, Lecturer of Shankar Dev Campus, TU, is an aspiring
researcher. His major areas of researching are accounts, finance, marketing and general
management.
Email ID: [email protected]
Mr. Adhikari, Associate Professor of Centre Department of Management, Tribhuvan
University. His areas of research are marketing, finance and general management.
Email ID: [email protected]

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