Asian Journal of Managerial Science

ISSN: 2249-6300 Vol.7 No.2, 2018, pp. 1-6

©The Research Publication, www.trp.org.in

Impact of Capital Structure on Profitability: An empirical analysis of

listed firms in India
Atif Ghayas1 and Javaid Akhter2
1
Research Scholar, 2Professor, Department of Business Administration,
Aligarh Muslim University, Aligarh, Uttar Pradesh, India
E-Mail: [email protected]

Abstract - This study aims to empirically examine and analyze variables while predicting the relationship between capital
the impact of capital structure decision on the firm’s structure and profitability.
profitability by using a sample of 35 Indian pharmaceutical
companies listed on Bombay Stock Exchange (BSE) during the II. LITERATURE REVIEW
period of 5 years from 2012 to 2016. Regression Analysis is
used to measure the extent and nature of the relationship. A. Theoretical Literature
Capital structure variables used in the study are ratio of long-
term debt to total assets (LDA), ratio of short-term debt to MM Theorem: Modigliani and Miller in their seminal work
total assets (SDA) and ratio of Total debt to total assets (DA) „MM irrelevance proposition (1958)‟ asserted that the value
while profitability has been measure by Return on Equity of the firm is independent of its capital structure decision.
(ROE). Firms Size (SIZE) and Sales growth (GROW) are also
The theorem proposes that firm has a set of expected cash
used as control variables. Results reveal a positive effect of
SDA and DA on ROE, while a weak-to-no effect was found of flows, capital structure decision only affects how these cash
LDA on ROE. flows are divided among the debt and equity investors. The
Keywords: Capital structure, Profitability, Leverage, theorem is based on certain assumptions of perfect capital
Pharmaceutical, India market, absence of taxes, rational Investors, homogeneous
expectations and equivalent risk classes. There are two
I. INTRODUCTION propositions, first is based on the arbitrage process which
says that investors can use home-made leverage for
Financing decision is one the most important decision of corporate leverage which results in independence of firm
every firm as it has its direct implication on the profitability value from its leverage. Hirshleifer (1966) and Stiglitz
of the firm. Every firm seeks to design a perfect capital (1969) are additional contributors to this theorem. Second
structure with an ideal ratio of debt and equity source of proposition suggests that dividend policy of a firm does not
finance, which can minimize the overall cost of financing affect its current share price as well as total shareholder
while maximizing the value of the firm. The issue of capital returns. (Miller and Modigliani, 1961). Hence, neither
structure and its relationship with firm value gained capital structure nor dividend policy decisions matter in
attention with Modigliani and Miller‟s irrelevant perfect market conditions.
proposition (1958). It proposed that capital structure choice
has no effect on value of the firm under certain assumptions. Later on, many researchers tried to relax some of the
These assumptions were: absence of corporate taxes, free assumptions considered in MM hypothesis like Taxes,
access of market information to investors and no transaction transactions cost, agency issues, bankruptcy cost, lack of
cost. information symmetry between stakeholders, time-varying
financial market opportunities, etc. As a result, many
However, as these assumptions don‟t hold in real world, different theories have been proposed.
MM revised their proposition and included corporate taxed
in the original proposition. Thus, they suggested that value Trade-off Theory: „Trade-off‟ refers to the theory which
of the firm will increase with increase debt financing as proposes that firms balance between various costs and
interest income is taxes deductible. Later on, several benefits of using debt to create an optimum capital
researchers found many other variables which affect capital structure. There are three factors which influences capital
structure decisions as well as financial performance such as structure decision. Firstly, interest payments reduces the
fixed assets, liquidity, size, firm age, growth etc. This study taxes of the firm as it is a tax deductible expense and
attempts of find the nature of effect of capital structure increases cash flows after tax. Secondly, due to the Agency
choice on the profitably of the firms in Indian Costs. According to Jensen & Meckling (1976), “It is the
pharmaceutical companies listed on Bombay Stock costs of monitoring the managers so that they act in the
Exchange. As it is evident from the previous studies that interests of the shareholders”. Thirdly, Bankruptcy Costs,
firm size and firm growth also influence the profitability of which occurs due to the possibility of default on debts. The
the firms, these factors are also considered as control bankruptcy cost increases with the level of debt after the
optimal point. Dynamic trade off theory takes into account

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Atif Ghayas and Javaid Akhter

the time element. This theory leads to accurate financial relationship. Findings revealed that firm structure is a major
decisions as it also considers financial margins and future factor which influences profitability.
possibilities. For e.g. any firm may expect to pay funds and
other may need to raise funds. The funds can be acquired Zeitun, R. and Tian, G. G., (2007) used panel data to
through debt source or through equity source or a examine the impact of capital structure on corporate
combination of both. Firms keeps high levels of debt to performance in Jordan and found that a capital structure has
benefit from the tax savings as they as they spend costlessly a strong negative influence on the firm‟s accounting as well
to adjust to the shocks. Goldstein et al. (2001) analyzed that market performance measures. Ibrahim El‐Sayed Ebaid,
low leverage firms today have an option to increase its (2009) studied Egyptian firms to assess the influence of
leverage tomorrow. Strebulaev (2007) and Fischer et al. capital structure decision on performance. Using ROE,
(1989) proposed similar models. ROA, GPM, results indicated a weak impact of Capital
structure choice on profitably. Nimalathasan B., Brabete V.
Pecking Order Theory: According to this theory, firms (2010) selected Sri Lankan firms to study the
exhibit a particular preference of internal sources over interrelationship and found that D/E ratio is positively and
external sources while fulfilling their capital requirement strongly associated to all profitability ratios GPR, OPR and
needs. In case of additional capital needs, Firms first utilize NPR except ROCE and ROI. D/A ratio is has a positive
their retained earnings, then debt financing and ultimately relationship with OPR, NPR and ROCE. Also CG ratio is
equity sources. This is based on two factors, financing cost also positively related to GPR and NPR.
of capital as well as information dissemination about the
firm. Internal sources of funds doesn‟t have any financial Azhagaiah R., Gavoury C., (2011) used a sample of 102 IT
cost associated with them as in case of debt and equity firms categorized into three categories on the basis of two
financing, which makes internal sources prime choice of the attributes firm revenue and firm size. They found a strong
firms. Moreover, external financing like debt and equity inverse association between capital structure and
issue entails some critical information about the firm‟s Profitability. Gill A, Biger N, Mathur N, (2011) reexamined
health which may alter the perceived value of the firm‟s the Abor‟s (2005) results of 272 American service and
assets in the mind of potential investors. Thus, managers try manufacturing firms listed on New York Stock Exchange
to minimize the involuntary flow of negative information to and found a positive relationship between STD to TA, LTD
investors by choosing internal source over external sources to TA and TD to TA and profitability. Shubita M.F.,
as demonstrated by the model of Myers and Majluf (1984). Alsawalhah J.M., (2012) also reexamined Abor‟s (2005)
According to Frank and Goyal (2007), Agency cost is also findings on Amman Stock Exchange. The results indicated
an important factor in pecking order theory. Transaction an inverse relation between debt and profitability. Chisti
costs of debt is less than equity resulting in debt preference. K.A., Ali K. & Sangmi M., (2013) studied automobile
Managers don‟t want to dissolve their control over the firm, industry in India and found that D/E ratio is inversely
thus avoiding equity issue. Holmes and Kent (1991), related to profitability ratios. D/A ratio and Interest
Hamilton and Fox (1998). coverage ratio are positively related to profitability ratio.
D/A ratio and Interest Coverage ratios are negatively related
Market Timing Theory: According to this theory, market with D/E ratio, but D/A ratio is positively related with
fluctuations affect capital structure of the firms. Firm tries Interest Coverage ratio. Zadeh R.A., Nemati F., Babaei B.,
to time its equity issues when the market is overpriced and Narimani,S., (2014) studied The relationship between
avoid when market is underpriced. Thus, in later case, firms Profitability and Sustainability of the Capital Structure of
prefer other sources of finance such as retained earnings and firms on Tehran Stock Exchange. Findings revealed a direct
debt. There are two approaches, First considers market association between company's growth opportunities and
agent to be rational which averts the information asymmetry the ratio of changes in debt. Additionally, an inverse
problem and other considers agents to be irrational, due to relationship was found between profitability index and the
which stocks are considered mispriced. (Baker and Wurgler, ratio of changes in debt of companies.
2002).
C. Research Gap
B. Empirical literature
The existing literature primarily consists of studies
Many studies have been done around the world to test the regarding relationship between financial leverage, firm‟s
above theories of capital structure. Abor J. (2005) examined size and fixed assets. Literature regarding the nature of
the nature of the association between capital structure and impact of financial leverage on profitability is scarce.
profitability of listed firms in Ghana. With the help of Moreover, how the factors like firm size and growth
panel-data methodology, found a positive association influences this relationship is also not known very well.
between Short term leverage and total leverage with Additionally, most of the studies are related to the
profitability. While an inverse relationship was found developed economies and researches in emerging
between long term leverage and profitability. Abu-Tapanjeh economies like Indian are very few. Thus, there is an
A.M., (2006) studied factors such as firm size, age, debt eminent need to shed some light on this relationship in
ratio and ownership structure to study the above Indian context. This study seeks to study the effect of
capital structure on the profitability of Indian

AJMS Vol.7 No.2 July-December 2018 2

 Impact of Capital Structure on Profitability: An empirical analysis of listed firms in India

Pharmaceutical firms listed on the Bombay Stock Exchange ROE = β0 + β1SDA + β2SIZE + β3GROW + e (1)
(BSE). ROE = β0 + β1LDA + β2SIZE + β3GROW + e (2)
ROE = β0 + β1DA + β2SIZE + β3GROW + e (3)
D. Objectives of the study
Where:
1. To study the capital structure of selected trading ROE: Return on Equity
companies of India. SDA: Short-term debt divided by the total Assets
2. To examine the nature of relationship between capital LDA: Long-term debt divided by the total Assets
structure and profitability of Indian Pharmaceutical DA: Total debt divided by the total Assets
companies. SIZE: Log of Total Assets
3. To study the effect of factors like firm Size and Sales GROW: Sales Growth
Growth on the relationship between capital structure e: Error term.
and profitability

E. Hypothesis of the study

1. There is no significant impact of ratio of Short-Term

Debt to Total Assets (SDA) on Return on Equity
(ROE).
2. There is no significant impact of ratio of (SDA) Long-
Term Debt to Total Assets on Return on Equity (ROE).
3. There is no significant impact of ratio of (DA) Total
Debt to Total Assets on Return on Equity (ROE).

II. METHODOLOGY
A. Data Fig. 1 Conceptual model of the Study

This study uses data of all the pharmaceutical firms that III. ANALYSIS AND RESULTS
have been listed on the S&P BSE 500 index over a five-year
period from the year 2012 to 2016. Thus a sample of 35 A. Descriptive Statistics
firms was chosen to be included in the analysis.
Summary of the descriptive statistics of all the dependent
B. Variables and in depended variables used in the study are presented in
the Table 1. Mean value of ROE suggest that average ROE
The study uses most popular proxy for Accounting based in the sample Pharmaceutical firms is 18%, which can be
profitability measure used in the previous studies i.e. Return considered as satisfactory performance. The average value
on Equity (ROE), calculated by dividing earnings before of SDA is 0.312 indicating that short-term debts comprises
interest and taxes (EBIT) to total equity. Similarly, variables of nearly 31% of total enterprise value of the firms. On the
which are used in the previous studies for measuring other hand, the average value of long-term debt to total
leverage are used. These are Short-term Debt to the Total assets (LDA) is 0.149, suggests that long-term debts
Capital (SDA), Long-term Debt to Total Capital (LDA); and finances around 15% of the total assets of the firms. The
Total Debt to Total Capital. (DA). Previous studies suggests variable Total Debt to total Assets (DA) suggests that nearly
that factors such as Firm Size (SIZE) and Sales Growth 46% of total assets are financed through debt capital. The
(GROW) also influence the relationship between capital results indicates that the sample firms used for the study are
structure and profitability, hence these factors are included highly leveraged at 46% with majority of leverage is
in the model as control variables. composed of short-term leverage which stands at 31%.
C. Method of data analysis B. Regression Results
The sample collected for the study is panel in nature i.e. The results of the regression models 1, 2, and 3 testing the
cross-sectional data has been collected over several time relationship between capital structure and firm‟s
periods. OLS Regression analysis technique is used to test performance are presented in the table 2, 3 and 4
the relationship between capital structure ration and respectively. Ordinary Least Square regression technique
profitability variables. Below figure (Fig. 1) shows the was used to examine the target relationship between capital
conceptual model used in the study. structure and profitability variables. Regression technique
was applied after fulfilling all the assumptions of regression
D. Regression Model
analysis. Hausman test have been applied to each of the
The relationship between capital structure and profitability model to choose between fixed effect and random effect
is estimated in the following regression models: model. The results from the regression models (1), (2), and
(3) suggests that the selected independent variables explains

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Atif Ghayas and Javaid Akhter

about 42, 2.2 and 23 percent influence on the dependent significant at the confidence level of 95 percent.
variable respectively. All the coefficients are statistically
TABLE I DESCRIPTIVE STATISTICS
ROE SDA LDA DA SIZE GROW
Mean 18.65783 0.312193 0.149514 0.461707 4.356233 0.184635
Median 17.11000 0.272070 0.125089 0.448656 4.354287 0.146088
Maximum 215.3900 1.660594 0.542935 1.775172 5.590742 2.012772
Minimum -234.0600 0.101622 0.001165 0.148092 3.011444 -0.503428
Std. Dev. 32.24820 0.180908 0.117067 0.207576 0.552693 0.286816

In the following tables, table II shows result of model 1, relationship between the variable SDA and ROE at the
which examines the impact of Short-term debt to Total confidence level of 95 percent. This indicates that any
Asset ratio (SDA) on ROE. Table III shows the results of change in Short term debt in the firm‟s capital structure has
model 2, which examines the impact of Long-term debt to a direct impact on the firm‟s profitability. However, the
Total Asset ratio (LDA) on ROE. Table IV shows the control variable SIZE and GROW doesn‟t have any
results of model 3, which examines the impact of Total debt significant impact on the dependent variable ROE. The
to Total Asset ratio (DA) on the performance variable ROE. result is consistence with the previous studies examining the
SIZE and GROW are used in each of the equations as debt level and profitability relationship e.g. Abor, (2005)
control variables. and Gill, et al., (2011). The result underlines the fact that
short-term debt is less expensive, and thus increasing the
Regression result of the model 1 presented in the table II, usage of short-term debt carrying low interest rate will
which examines the impact of Short-term debt to Total result in increase in firm‟s profits.
Asset ratio (SDA) on ROE reports a significant positive

TABLE II REGRESSION RESULTS OF MODEL 1

Variable Coefficient Std. Error t-Statistic Prob.
C -22.24680 27.59756 -0.806115 0.4213
SDA 41.45299 15.23692 2.720563 0.0072
SIZE 6.180885 5.792587 1.067034 0.2875
GROW 5.621521 8.218063 0.684045 0.4949
R-squared: 0.42228

Table III presents the results of the regression model 2 This could be due to the fact that Long term debt carry high
which examines the impact of Long-term debt to Total interest and its high usage may decrease the profitability.
Asset ratio (LDA) on ROE shows that there is no significant The results support earlier findings by Fama and French
relationships between Long term debt and Profitability. (1998), Graham (2000) and Booth et al., (2001).
However, the coefficient of LDA is negative which suggests Insignificant relationship is also found between SIZE and
that Long-term debt and profits has inverse relationship. GROW variables and ROE.

TABLE III REGRESSION RESULTS OF MODEL 2

Variable Coefficient Std. Error t-Statistic Prob.
C 15.37010 23.68094 0.649049 0.5172
LDA -10.94590 24.50541 -0.446673 0.6557
SIZE 0.991716 5.519430 0.179677 0.8576
GROW 3.272155 8.439221 0.387732 0.6987
R-squared: 0.02293

The results presented in the Table IV of the model 3 which structure leads to the increase in the profit levels of the firm
examines the impact of Total debt to Total Asset ratio (DA) i.e. the higher the debt, the higher the profitability. This
on ROE shows that there exists a significant positive finding is consistent with the prior studies like Abor, (2005).
relationship between Total Debt and profitability. This Gill, et al., (2011), Nirajini. A, Priya, K.B., (2013).
suggest that increase in the debt level in the firm‟s capital

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 Impact of Capital Structure on Profitability: An empirical analysis of listed firms in India

TABLE IV REGRESSION RESULTS OF MODEL 3

Variable Coefficient Std. Error t-Statistic Prob.

C -5.985676 26.19344 -0.228518 0.8195
DA 25.66375 12.94581 1.982399 0.0490
SIZE 2.697788 5.509717 0.489642 0.6250
GROW 5.644515 8.375732 0.673913 0.5013
R-squared 0.23588

From the above results, it can be summarized that debt has a the precious studies like Hadlock and James (2002),
significant influence on the profitability of the Indian Petersen and Rajan (1994) and Roden and Lewellen (1995)
Pharmaceutical firms. Increase in the debt usage, especially that profitable firms use more debt. However, control
the short-term debt leads to an increase in the firm‟s variables used in the study, SIZE and GROW doesn‟t have
profitability. This means that profitable firms depends more any impact on the firm profitability.
on debt financing compared to equity and is consistent with

C. Hypothesis Testing
TABLE V HYPOTHESIS TESTING

S. No. Hypothesis Result

1 There is no significant impact of ratio of Short-Term Debt to Total Assets (SDA) on Return on Equity (ROE). Rejected
2 There is no significant impact of ratio of (LDA) Long-Term Debt to Total Assets on Return on Equity (ROE). Accepted
3 There is no significant impact of ratio of (DA) Total Debt to Total Assets on Return on Equity (ROE). Rejected

IV. CONCLUSIONS
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